Editor's note: This is the second installment of a two-part series on the impacts of Argentina's potential dollarization under Javier Milei, should he win the country's presidential election. The first part, which can be found here, examines the way dollarization affects emerging economies, and the second analyzes challenges specific to Argentina.
In Argentina, presidential candidate Javier Milei — a libertarian who has promised to overhaul the country's economic system, including by replacing the Argentine peso with the U.S. dollar — is currently leading the polls ahead of the Oct. 22 presidential election, fueling fears that the country could soon be ''dollarized.'' In light of Milei's expected victory, it's important to look at the unique challenges dollarization would pose in Argentina, given the country's history of hyperinflation, economic crises and political instability.
The Importance of Trade Structures
Dollarization is most practical for countries that are highly integrated in terms of international trade and financial flows, particularly those of the economy whose currency they adopt. For example, European countries' economic interdependence facilitated their adoption of the euro, which has been broadly successful. Similarly, countries that conduct a large share of their trade with dollar-based economies may find that a fixed exchange rate improves access to their markets by creating exchange rate stability.
However, less than 10% of Argentine exports go to the United States. Thus, if Argentina dollarizes and the dollar appreciates by a significant percentage against all other currencies, Argentina's exports will become less competitive. Moreover, the prices of most of Argentina's exports (such as agricultural products, energy and metals) tend to fluctuate more frequently and more widely than those of manufactured goods. This makes Argentina even more vulnerable to real exchange rate misalignment and large commodity shocks resulting from decreased export revenue.
One way countries with fixed exchange rates try to adjust their economies to such external shocks is by a so-called ''internal devaluation'' by way of domestic prices and lower wages, thereby raising the competitiveness of their exports. This strategy works best for countries whose trade makes up a large part of their economy. However, Argentina is a very closed economy, with trade accounting for only one-third of gross domestic product. This means the primary strategy that Argentina could use to protect itself from shocks caused by lower export revenues would be difficult to execute and could cause significant harm at home.
Operational Challenges
Operationally, Argentina would need to acquire sufficient dollars to dollarize its economy. However, the government is a net foreign currency debtor, as well as a net international debtor, meaning it does not have enough dollar assets to finance a major dollar purchase. In fact, the government just repaid the International Monetary Fund in yuan rather than dollars. Even the Central Bank, typically a net foreign currency creditor, sits on a negative net dollar position. Argentina may be on the verge of yet another default, which would make it even more unrealistic to borrow the dollars required to replace the peso. Finally, a recent ruling by a New York court that awarded $16 billion worth of damages to a plaintiff to compensate it for financial losses incurred in the context of Argentina's expropriation of state-run energy company YPF a decade ago will further complicate Argentina's attempt to raise dollars, whether it defaults or not in the coming months.
To get around this challenge, Argentina could nationalize private-sector dollar assets, but this would be politically controversial and could scare off future foreign investment. It may not even help Argentina make dollar purchases because few foreign investors might be prepared to enter a transaction where such assets are pledged as collateral or where they would be expected to purchase them outright, given that they could become subject to litigation. In short, it is not clear where Argentina would find the dollars to dollarize its economy.
Adding to these challenges is that political risk could rise and a bank run could quickly emerge. First, it is important to consider that the Ecuadorian president who decreed dollarization in 2000 was ousted within a few weeks of his decision. So regardless of the economic-financial effects of a conversion, political risk might increase independently. In addition, if depositors were to withdraw their funds in order to try to convert them into dollars, it could trigger a banking crisis.
While a new government could impose a bank holiday to try to mitigate this risk, Javier Milei, Argentina's leading presidential candidate, has made dollarization a key part of his campaign. While Milei has more recently slightly backtracked on his radical proposals due to pushback from the private sector, citizens will not wait for him to take office and will increasingly start to pull their deposits if his victory looks likely. Current polls suggest that no presidential candidate will reach the threshold needed to win outright in the first round on Oct. 22. The period between then and the likely runoff race on Nov. 19 could thus be particularly precarious as depositors get nervous about an eventual Milei victory.
But Argentines who withdraw their deposits will find that the black market exchange rate has already adjusted in anticipation of dollarization, with dollars likely to become increasingly scarce — putting further pressure on the peso exchange rate and inflation. They may then quickly realize that they'd prefer to keep their funds in interest-bearing bank deposits instead of moving their money under mattresses, particularly given Argentina's very high inflation. But just because depositors may not be able to purchase the dollars after emptying their bank accounts does not mean they won't initially do so; after all, fear often outweighs complex economic logic during times of crisis. Instead, history has repeatedly shown that depositors, even if they are unlikely to benefit, will rush to remove their funds — meaning Argentina's banking sector could come under severe liquidity pressure, unless the government steps in forcefully.
How Have Other Dollarized Economies in Latin America Fared?
Dollarization poses plenty of risks, particularly in Argentina. It's thus key to consider how other regional economies fared after dollarizing. In Latin America, Panama adopted the dollar in 1904, Ecuador in 2000 and El Salvador in 2001. Panama has arguably been the most successful of the three, even though it did on occasion experience exogenous shocks and financial instability. But over the past 119 years, Panama has managed to maintain dollarization, low inflation and fair levels of economic growth. Moreover, neither Ecuador nor El Salvador has experienced an economic or financial meltdown since dollarizing, but both countries are currently on the verge of a sovereign default. In fact, Ecuador restructured its debt with China in 2022, highlighting the fact that its dollarized economy is financially fragile. Given its history and current economic situation, Argentina is more likely to follow the path of Ecuador and El Salvador rather than of Panama.
For dollarization to work, governments need to run disciplined fiscal policies and create ample space to respond to economic and financial shocks. If they cannot do this, dollarization will lead to a build-up of financial vulnerabilities, financial instability and sovereign default. And a default in a dollarized regime is extremely messy, economically and politically, as banks are typically government creditors, forcing banks to write their creditors, including depositors.
What to Glean From Argentina's Political History
Argentina's economic and political history gives little reason for optimism that full dollarization will be sustainable in the longer term. Argentina has defaulted nine times in its history and has experienced high or even hyperinflation. The country even managed to default on its IMF loans and may soon do so again. Unless Argentina manages to fundamentally change its politics and maybe political system, the government will be too weak and/or the political-distributional conflict over economic and fiscal resources will be too high for the country to muster the economic discipline needed to maintain dollarization.
Full dollarization will only prove sustainable if policymakers pursue fiscally responsible policies. But in Argentina's case, dollarization is being promoted precisely because the government cannot maintain macroeconomic discipline. Leaving aside operational-political issues (such as whether a new president would be able to slash spending, particularly if he or she lacks sufficient support in Congress), maintaining long-term discipline is crucial for the system to deliver both low inflation and financial stability. If Argentina dollarizes, its economy and financial fate will continue to hinge on the government's ability and willingness to act in a financially responsible way. Otherwise, dollarization will go the way of Argentina's failed currency board, which pegged the peso to the U.S. dollar between 1991 and 2002.
A Risky Option
Since Argentina's economic history casts significant doubt on policymakers' ability to maintain fiscal discipline, the country would likely be better off reforming its economic regime as neighboring Chile, Colombia and Peru have done. These countries have independent central banks and pursue fairly disciplined fiscal policies, which enable them to operate fairly flexible exchange rate regimes and conduct more independent interest rate policies capable of absorbing exogenous shocks. Similar to Argentina, both Chile and Peru are highly susceptible to terms-of-trade shocks on account of their commodity-heavy export structure, showing that Argentina does, in fact, have options if it ever manages to resolve the aforementioned domestic political and structural economic challenges. Even Brazil's economic policy regime suggests that a somewhat less disciplined fiscal policy can be compatible with reasonable levels of inflation as long as the central bank is independent. Unlike Argentina, Brazil benefits from a low level of foreign-currency debt, making it easier for policymakers to let the exchange rate float and target inflation. But if Argentina managed to put in place such a regime, there would be no need to run the greater financial instability risks that come with dollarization.
In this sense, full dollarization is the second-best solution to the inflation and economic instability problem. It is also a solution that is fraught with very substantial risks. Such a regime would limit the monetary policy discretion and translate into lower inflation. But as long as the government is unable to conduct a disciplined fiscal policy, dollarization will not provide anything close to a sustainable solution to Argentina's long-standing economic problems. In short, if the next president decides to dollarize the economy, Argentina's goal of economic and financial stability will remain elusive in the long run.
