Dollarization and other Dilemmas

By Jeff Frieden

Currency policy is one of the most important choices facing Latin American governments and peoples today. Exchange rates have long made front-page news in Latin America. Argentina's "Convertibility Plan," which tied its peso to the U.S. dollar, has impressed many in the region with its ability to end the country's chronic hyperinflation. On the other hand, the1994-1995 Mexican peso crisis threatened to bring down all Latin American economies, as did the1997-1998 crisis of the Brazilian real. Current discussions of "dollarization," the adoption of the U.S. dollar as the national currency, are the most recent headline appearance of formerly arcane exchange-rate issues.

This great- and increasing- prominence of exchange rates in Latin American economics and politics is not surprising. The region's countries have opened their borders to international trade, finance, and investment over the past 20 years. Higher levels of cross-border economic activity expose ever-larger segments of the economy to currency movements. Businesses, farmers, and workers who used to be comfortably ensconced behind high trade barriers and capital controls are now subject to the pressures brought about by exchange rate changes.

Yet currency policy remains poorly understood by many observers and participants. In particular, there has been very little analysis of the political economy of currency policy, of how economic and political factors influence governments as they make exchange rate decisions - even though all agree about the fundamental interaction of economic and political conditions in this realm.

A government typically faces two interrelated choices with regard to its currency. The first is whether and how the monetary authorities should maintain the national money's value in terms of other currencies. At one extreme, the government might fix the exchange rate against another currency, typically the dollar, and commit itself to sustain this "peg." This is the case of Argentina, which has held one peso equal to one dollar since 1991. At the other extreme, the government might let the exchange rate be determined by foreign currency markets, so that if demand outstrips supply the currency rises (and vice versa). This is the case of Peru, where the sol has been allowed to fluctuate more or less freely for most of the Fujimori regime. Many possibilities exist between these two extremes. A government might announce that it will only allow the currency to move up or down five percent against the dollar, but that within this "band" it will not intervene. Or a government could try to manage the currency only to avoid rapid fluctuations in its value, without keeping to any particular exchange rate against the dollar or other currencies. In the past year, there have been proposals that countries go even farther than the Argentine-style extreme of pegging to the dollar, and actually abandon national currencies to adopt the dollar (as in fact several small countries in the region, such as Panama, have long done). This choice, over the management of the currency relative to others, is usually called the decision over the exchange rate regime.

The second, related choice that governments must make involves the currency's value. Analysts typically distinguish between strong or appreciated currencies and weak or depreciated currencies. And while governments cannot move currencies at will, they can often affect the strength or weakness of the exchange rate for relatively long periods, perhaps three to five years in the medium-size countries of the region (very small countries have less leeway). This choice, over the relative value of the currency, is usually called the decision over the exchange rate's level.

These two choices can be politically controversial. The first, over the exchange rate regime, is a particularly hot issue when the question is whether to fix the currency. Supporters of fixing typically argue that it reduces the unpredictability of volatile exchange rates, and that it helps bring inflation down. The effect on predictability is straightforward: a fixed rate does not fluctuate against the partner currency (the dollar, for most of Latin America). The anti-inflationary effect holds because if the national currency is held constant against the dollar, this means local prices can only rise by roughly as much as American prices (otherwise local goods would be driven out of the market by imports). When the Argentine peso was fixed against the dollar in its currency-board arrangement, Argentine inflation was forced down from over 2000 percent in 1990 to just four percent by 1994 - only a bit above American levels.

While most people favor currency stability and low inflation, there are tradeoffs, and this is why fixing exchange rates can be controversial. A country on a fixed rate against the dollar essentially gives up its own monetary policy, and is forced to follow that of the United States. This is true if the country is financially open, which virtually all of Latin America is - at least to the extent necessary for this to apply.

If interest rates go up in the United States, they must go up in Argentina - otherwise people would sell their pesos and buy dollars in order to be able to earn the higher U.S. rates. This makes it impossible for the Argentine government to use monetary policy for domestic purposes, say to lower interest rates and stimulate a stagnant economy. Those more concerned about a local recession than about inflation or currency volatility - small businesses, labor and the unemployed, for example - may oppose tying the government's hands in this way.

Some worry about fixing the exchange rate because it risks inviting "speculative attacks" on it currency. In difficult economic times, a government is often tempted to abandon its fixed-rate commitment, in order to devalue and lower interest rates to help stimulate the local economy. Domestic and international investors understand that recessionary conditions make a devaluation more likely, and get their money out of the currency (and the country) - which just puts more pressure on the government and the economy. Eventually, the authorities can be forced to devalue by speculative pressures, and such forced devaluations can lead to substantial economic crises - as in much of Latin America in the early 1980s, in Mexico in 1994-1995, and much of Asia in 1997-1998.

But there remains strong support for fixed exchange rates, and for using them to ensure low inflation. Those particularly heavily involved in international trade and payments - financial, commercial, and investment groups, for example - are most likely to support a fixed rate because cross-border exchange becomes more predictable. Those most concerned about inflation most likely also support a fixed rate for anti-inflationary purposes. In Latin America, two kinds of countries have been the most prone to adopt fixed rates. The first are the very open, usually small, economies, such as the nations of the Caribbean and Central America, whose citizens engage in so much cross-border exchange that currency volatility is very inconvenient. The second are countries such as Argentina that have run very high or hyper-inflation, where the return for help in defeating persistent inflation is worth risking problems of fixed rates.

The second controversial exchange-rate policy choice concerns its level, whether the government should try to keep the currency strong or weak. Here the tradeoff is straightforward. A strong currency raises the value of the nation's money. But it also raises domestic prices above foreign prices - a 10 percent increase in the peso against the dollar raises Argentine prices by 10 percent in dollars. This makes the country's exports expensive to the rest of the world, and the country's imports from the rest of the world inexpensive. If a currency strengthens (appreciates), citizens can buy imports more cheaply. This is good for local purchasing power and real incomes, but bad for local producers who compete against imports and for local producers who sell for exports.

In other words, a strong currency risks pricing local producers out of their markets, by making local goods too expensive. Not surprisingly, many Latin American firms competing with foreigners on world or domestic markets - especially manufacturers - want to keep the exchange rate low (depreciated). They also oppose fixing because the currency could not be devalued if local producers should face competitive pressures or a weak local economy. And the movement from high inflation and a floating rate to low inflation and a fixed rate can be very difficult. In Argentina between 1991 and 1994, for example, local prices rose nearly 40 percent while prices in the United States rose by only about 10 percent - putting Argentine producers at a 30 percent cost disadvantage against American and other foreign goods. Here too, policymakers face difficult options: to pursue a strong currency and risk driving domestic firms out of business because they cannot compete, or to pursue a weak currency and reduce the living standards of local residents.

Electoral factors, too, can affect exchange rate policies. A government can gain popularity with consumers through an appreciated currency, which increases local income. Middle-class consumers especially can take advantage of a strong currency to buy imported consumer goods, such as television sets and automobiles, at artifically cheap prices. As elections near, Latin American governments often engineer or allow a strengthening of the currency to increase the electorate's purchasing power. Although the exchange rate will eventually have to be devalued, this temporary boost to consumer income can help get governments reelected - and serves to destabilize economies. It is no coincidence that recent Mexican, Colombia, and Brazilian currency crises all came in the context of this sort of electoral manipulation of the currency. Incumbent governments delayed depreciation, keeping their currencies artificially strong, until after the elections - at which point serious speculative pressure helped force devaluations that dragged the economies into recessions.

Over the past year, the success of the Argentine currency board, the example of European monetary union, and the failures of less firmly fixed rates in Asia and elsewhere has led some in Latin America to champion the dollarization of the region's monetary systems. This would represent a particularly strict version of a fixed exchange rate, giving up any semblance of national monetary independence for the benefits of lower inflation and greater integration with the United States. These proposals have been as hotly contested as earlier currency policies. However, they are unlikely to fade from the political agenda. Indeed, as economic and political integration in the region grows - whether under the auspices of NAFTA, Mercosur, or other regional institutions - arguments for some form of monetary unification will also likely increase.

Whatever the future of current debates, government exchange rate policy is a serious matter that can affect societies in dramatic ways. The complex economics and politics of Latin American currencies will be at the center of the region's development for the foreseeable future.