Dollar can help Latin America, but not cure all

April 20, 2001|By David H. Feldman

WILLIAMSBURG, Va. -- If President Bush wants to make an immediate political and economic impact on the Western Hemisphere, he can encourage an existing trend toward dollarization of Latin American economies.

Most Latin American currencies are tied to the dollar. Some nations use traditional fixed exchange rates in which the central bank promises to redeem domestic currency for dollars at a set price. Argentina's 10-year-old currency board is stricter. It must hold a dollar in assets for every peso liability it creates. More recently, Ecuador, El Salvador and Guatemala have decided to join Panama as fully dollarized economies.

Whatever the particulars, the motivation is the same -- to restore government credibility and stabilize the economy. The fixed rate anchors the domestic prices of most goods to U.S. levels. It also provides extra anti-inflation discipline since large government budget deficits cannot be financed by the printing press without blowing up the all-important exchange rate.

Countries like Argentina already have paid much of the costs of dollarization but have yet to reap the full benefits. When a nation stakes its credibility on a fixed exchange rate, it gives up the ability to use U.S.-style monetary policy to manipulate domestic interest rates or to use devaluation to pump up demand for domestic goods.

In other words, Latin America has accepted the Fed's lead on interest rates and formal dollarization would not change that.

Yet real stability remains elusive. Much like a run on a bank, once a critical mass of investors believes the monetary authorities lack the will or the resources to exchange dollars for pesos on demand, the system risks a spectacular collapse.

That a currency crisis could erupt at any time also means there is a risk to holding local currency. This translates into real interest rates that are permanently higher than they need be, which reduces investment and the rate of growth.

Dollarization eliminates this risk, but at a price.

Countries must convert their holdings of U.S. Treasury securities, which pay interest, into cash, which pays none. Then they buy back the domestic currency monetary base and replace it with dollars. For a country like Argentina, which would need to convert between $15 billion and $20 billion in T-bills, the foregone interest is roughly $1 billion dollars annually.

Here is where the United States can help.

Guillermo Calvo of the University of Maryland, College Park has proposed that Washington agree to buy back the bonds in exchange for newly minted cash, which would then form Argentina's monetary base.

If the United States agrees to return to Argentina some fraction of the interest savings (say $600 million annually), both nations would benefit. Argentina can dollarize at a fraction of the cost and the U.S. budget is spared sizable interest payments.

Argentina also could use the annual payment as collateral to back a line of credit exceeding $10 billion to provide a safety net for its banking system. Lastly, the United States could use some of its own savings to compensate the smaller countries that have proceeded to dollarize on their own.

Dollarization is not a cure-all, and not all countries are equally ready. More effective bank oversight procedures and policies to broaden the tax base must complement any moves to replace the national currency.

But together with these needed reforms dollarization can make a contribution to a stable and prosperous region. To some, the currency remains a potent national symbol, but for many nations these paper symbols surely have outlived their usefulness in an era of increasingly internationalized capital markets.

David H. Feldman is a professor in the Department of Economics at the College of William & Mary.

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