Would Dollarization Be a Successful Strategy for Venezuela?

The Venezuelan Observatory of Real Economy looks at one of the hottest topics in Venezuelan economics: the pros and cons of dollarizing the economy.

By Wilmer Torrealba – Venezuelan Observatory of Real Economy
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Venezuela’s currency has suffered a severe devaluation in recent years
Venezuela’s currency has suffered a severe devaluation in recent years. (Archive)

Not more than five years ago, one US dollar would have bought you around ten bolivars. Currently, it can buy you 400,000 bolivars. The systematic devaluation of Venezuela’s currency, which in part occurs due to structural problems in the economy, and in part due to foreign-based induced exchange rate manipulation, has helped contribute to an almost daily inflation of prices, prices which follow the illegal parallel dollar exchange rate closer than anything else.

One of the possible solutions economists are discussing is following the decision taken in pre-Correa Ecuador and dollarizing the economy.

As elections loom, the two forerunners seem to have very different views on this topic.

Maduro has claimed that he will “defend” the bolivar by using the new Petro cryptocurrency to bypass dollar-controlled financial mechanisms and removing three zeros from it in an attempt to counter its devaluation.

The opposition’s man, Henri Falcon, has on the other hand appointed Francisco Rodriguez, an open supporter of dollarizing the economy, as his main financial advisor, and has promised to give every Venezuelan a debit card charged with dollars for their personal use.

But in a mono-producing country with currency controls, huge capital flight, dependent on importing most of what it consumes, with significant subsidies on basic goods, huge problems of smuggling and price speculation, and most importantly vast fields of natural wealth below its surface, what would dollarizing the Venezuelan economy really mean for the country?

Here the Venezuelan Observatory of Real Economy takes a look. For nearly 50 years the bolivar has undergone a process of systematic deterioration and for nearly 20 years some economists have raised the topic of dollarizing the economy.

It is well known that before the 1970s the bolivar was one of the strongest currencies in the world. Confidence in it was such that in many countries is was accepted as a means of payment and exchange, but this changed halfway through the decade. The question that everyone must be asking is why did this happen?

As the main response to this question, we must continue to look at our history. In the ‘70s three key events occurred that explain the Venezuelan economy today: one of them was the nationalization of the oil industry; the second was then US President Richard Nixon’s breaking with the Bretton Woods agreement, causing large amounts of dollars to flow into international markets, thus causing energy demand to grow; and the third was the conflicts in the Middle East which produced the closure of the Suez canal and problems that caused the global oil supply to contract and hence the famous boom in international oil prices. The Suez crisis caused a large amount of foreign currency to flow into our national treasury, which at the end of the day engendered a process of destabilization in the Venezuelan foreign exchange market due to the lack of fiscal discipline and a great waste of resources. This issue of the market exchange rates culminated at the beginning of the ‘80s with the famous [18 February 1983] "Black Friday" [collapse of the bolivar].

All of the above happened at the same time as multiple economic crises in South American countries during the same decade, where among the many proposals dollarization was raised as a solution.

Since some dollarized countries had yielded favorable results, since the late 1990s many raised the possibility of such a strategy in our country.

Now that we have mentioned where this idea comes from, and regretting not having a larger space to develop other complex problems of the national economy, we must now talk about the positive aspects of dollarization, raised by its supporters.

  1. It removes the privilege that a few have over foreign currency access. In exchange rate terms, the somewhat random supply of cheap dollars wouldn’t exist, i.e. it would eliminate the possible parallel markets, and hence stabilize the flow of capital.
  2. This implies that there should be an equilibrium in the balance of payments.
  3. Point one also assumes that interest rates may start to stabilize in real terms.
  4. Those that defend dollarization advocate that it removes the privilege over money and democratizes the international monetary reserves. In other words, it would oblige governments to exert fiscal and monetary discipline since they wouldn’t be able to inorganically print more money.
  5. This implies that the tax that the citizenry pays for the inorganic printing of money, which we call inflation, is removed from the national treasury and tacitly would help contribute towards the aforementioned discipline fiscal.
  6. Dollarization implies completely eliminating the possibility of devaluing the currency. Sometimes policy makers boast that they can give competitiveness to the economy by devaluating, but in countries that lack a productive export-oriented apparatus, devaluations turn into more inflation.
  7. In Venezuela it is assumed that the economy is already dollarized and that all prices are based on the behavior of the parallel market, and that therefore any devaluation eliminates the speculative component of the dollar and therefore relative prices will stabilize.
  8. It is assumed that since the dollar is a reliable currency, it will instantly inject greater security to financial investors, productive investment, national savings and therefore also generate stability in the flow of capital.

Taking into account the above, the next question to consider is whether we should view dollarization as a magic formula to achieve macroeconomic stability. The answer to this question is extremely complicated, and goes further than the majority of economists care to look.

Among the experiences of dollarization in the world, which are not many, we have the cases of Ecuador, Panama, El Salvador and the latest one of Zimbabwe. Two of the four cases have not achieved the desired results (in this case El Salvador and Zimbabwe who had little success). Certainly there are four other economies which are dollarized (Palau, Micronesia and the Marshall Islands, which were former colonies of the United States, and East Timor, which is a country that historically had intense political conflicts, and which is known as one of the last colonies of Portugal) who all assumed the dollar economy due to very different historical circumstances from the political economic decisions taken by the countries previously mentioned.

On the other hand, we know of many other experiences of stagflation, inflation and depression around the world in which countries have managed to escape such problems without dollarizing, such as the cases of Peru, Bolivia, Paraguay, Brazil, just to mention the Latin American experiences.

But, as discussed with respect to the pros of dollarization, now it is time to talk about the problems of some previous arguments and also other cons.

  1. One of the problems of dollarization is that if any complications arise after its application it is very difficult or almost impossible to get rid of the policy.
  2. One of the pros of dollarization is that it obliges governments to apply monetary and fiscal discipline which on one hand is true, but this means more than that. Since monetary policy will not be applied by the governing body, namely the central bank, any financial imbalance, specifically in the banking sector, will not handled by domestic economic policy or in the best of cases it would be difficult to do so. This is something that not even the country of origin of the dollar suffers from. The U.S. has the power to manage its own monetary policy: in fact after the great financial crisis of 2008-2009, the Federal Reserve and the U.S. government made a huge bailout the financial system.
  3. This implies that in cases of runs on the financial system it might be difficult for the central bank to respond, since it may not have savings in foreign currency, and thus would be without sufficient coverage to get the financial system back on track.
  4. On the other hand, one of the benefits of dollarization is that this can create fiscal discipline since the central bank won’t be able to issue bills. However, machine printing of money is not the only way to create money. Public borrowing can also achieve this, meaning that a squandering of the debt can create destabilized prices and interest rates in the economy will continue to show a strong and new fiscal imbalance which would cause inflationary problems.
  5. Likewise, the government is not the only actor that can create inorganic money. Private banks through credit anarchism can create a fictitious money supply which can cause erratic behavior in the economy, not to mention that they can also incur debts and inject money without backing and stimulate a crisis through international markets.
  6. Point 8 of the pros of dollarization has as one of the reasons for implementing the strategy the excuse that all prices follow the parallel dollar. First of all, that depends on the good one is talking about and/or the market. There are different reasons why prices may vary, as for example the relative scarcity of a good, the seasonality of demand, inadequate monetary and fiscal policy, monopolistic structures in the market, and so on.
  7. The previous elements make it seem that inflation won't stop after dollarization, that there are structural elements in the economy which must change to really stabilize the formation of relative prices.
  8. It is believed that dollarization as previously mentioned can encourage fiscal discipline and thus encourage the government to save foreign currencies. However, a mono-producing and highly dependent oil economy make these considerations extremely complicated. In this sense, the orientation of economic policy should be to encourage exports of diversified activities. There are issues that need covering that address tax stability, which can be accomplished without dollarization, for example the subsidy on gasoline that causes large deficits in [state oil company] PDVSA and the National Treasury, the subsidy to various services such as electric power, underground transport, water, etc. that are a barrier to ensuring public savings and investment.
  9. Dollarization does not create confidence immediately. It is the confidence in the institutions, laws, rules of the game and decision-makers which may lead to trust in the economy. Even though the economy uses dollars, the flow of dollars won’t enter the economy, but rather they may continue to leave it in the medium and long term.

It is worth remembering that so far there have been dollarization processes that have worked with drawbacks, as already mentioned at the beginning of this article, but it all depends on the conditions that are occurring in society (economic security, political and institutional).

On the other hand, dollarization may have greater success in those cases in which there is a high political and economic integration with the United States. It can also be successful in those economies with productive apparatuses oriented towards a diverse range of exports in order to procure greater foreign currency earnings (trying to trade in currencies of greater influence in international trade, not only with the dollar to reduce the risk to the crises).

If the country in question undergoes dollarization, it may have as a consequence a closer relationship and even dependence on US trade, which may be positive given the size of the US market but can also be negative since a severe crisis in the US would significantly affect the other country’s economy.

All of the above goes to show that dollarization is an extensive topic, and there are various international experiences in which economic policy has not been dollarization yet a stable economy has been achieved.

Translated by Paul Dobson for Venezuelanalysis.com.