Could Argentina abandon the peso and switch to the dollar?

In the second round of the elections in Argentina, the right-wing liberal Javier Milei was elected yesterday as the country’s new president with 56 percent of the votes.

Thus, a radical right-wing politician will govern Argentina, whose economy is in a very difficult situation due to triple-digit inflation, increasing poverty and the next recession, for 4 years.

In his speech after the results, Milei said: “We are facing enormous problems such as inflation, unemployment and poverty. “The situation is critical, there is no longer room for small and insufficient measures,” she said.

PROMISED ‘SHOCK TREATMENT’

Considering applying “shock therapy” to the economy, Milei’s promises include closing the central bank, abandoning the peso, reducing public spending and economic reforms.

So can Argentina really close its central bank, abandon the peso and switch to the dollar?

First, it is useful to look at the prospects for the Argentine economy.

OUTLOOK OF THE ARGENTINE ECONOMY

In the country where 4 out of 10 citizens live in poverty, annual inflation reached 143 percent as of October. Economists’ year-end inflation expectation is 185 percent.

Due to high inflation, the Central Bank of Argentina increased its reference interest rate to 133 percent. Although this situation encourages peso savings, it negatively affects access to credit and economic growth. Therefore, an economic recession is expected in the country. This year a contraction of 2 percent is expected, also due to the effect of the drought.

The country also has very strict capital controls to prevent flight into foreign currency. Currently 4 different exchange rates apply. While Milei has promised to quickly reverse capital controls and eventually dollarize the economy, a sharp devaluation in the near future is likely to bring official and parallel exchange rates closer together.

IS DOLLARIZATION POSSIBLE?

The economic promises of Milei, who ran for president on a promise to “destroy the status quo,” were based on his desire to dollarize the Argentine economy. Dollarization means that the country abandons the Argentine peso and uses the US dollar as its currency.

Ecuador and El Salvador had also previously dollarized their economies to combat inflation. But no country the size of Argentina has ever handed the reins of its own monetary policy to policymakers in Washington.

Milei’s proposal to change the Argentine currency from the peso to the US dollar is based on the argument that the dollar is stronger than the peso and, unlike the peso, cannot be printed at will, which reduces inflation, which increases through the money supply.

DELIVERY OF NATIONAL SOVEREIGNTY

Dollarization also causes a country to lose its autonomy to influence the economy through monetary policy measures, such as changes in interest rates. Milei’s opponent in the second round, Sergio Massa, criticized the dollarization plan as a surrender of national sovereignty.

The Cato Institute, a liberal think tank based in the United States, supports this measure as a practical strategy to control economic problems that have dragged on for decades.

“Dollarization is the best tool available to quickly and permanently reduce inflation to single digits,” wrote Daniel Raisbeck, a Latin American policy analyst at the institute, in his analysis after the election. “Accepting the dollar as legal tender also protects citizens’ purchasing power by making it impossible for the local currency to lose value against the dollar.”

On the other hand, Milei’s party does not currently control Congress. The party appears likely to form a coalition with the centre-right Together for Change party. For this reason, it is considered very difficult for some of Milei’s extremely radical plans to be approved by Congress.

Furthermore, dollarization faces serious economic challenges. If such a situation were to occur, the Central Bank of Argentina would need sufficient dollar reserves not only to purchase all currencies in circulation, but also to provide banks with a reliable cushion to deal with a possible increase in withdrawals.

According to analysts, the country’s foreign exchange reserves are approximately $50 billion below the amount required for dollarization. The country could try to fill this gap by raising money from foreign investors in the bond market and weakening the official exchange rate.

On the other hand, it is an extremely controversial opinion that the most important source of inflation is the money supply and government spending. Although there is more than one reason for inflation, recent serious studies have shown that one of the most important sources of inflation is the ultra-profits of companies.

WILL LOSE INDEPENDENT MONETARY POLICY

The biggest problem with dollarization is the loss of an independent monetary policy. Countries that adopt the dollar cannot adjust interest rates to regulate the money supply in response to changing economic conditions. Because this function is transferred to the US Federal Reserve, which determines interest rates according to the needs of the US economy.

For example, the Argentine economy is currently expected to contract by 2 percent in 2023, as the Federal Reserve continues its tight monetary policy to combat inflation. While looser monetary policy is expected to intervene in a shrinking economy under normal circumstances, the United States remains dependent on the Federal Reserve because its priorities are different.

U.S. Treasury officials have traditionally advised countries considering dollarization that dollarization is not a substitute for sound macroeconomic policies, including responsible fiscal management.