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Dollarization and the Real Exchange Rate
This original version of this post is co-authored with Emilio Ocampo.
In a recent article, I emphasized the importance of integrating the "Lucas Critique" into any analysis concerning the impact of dollarization on the Argentine economy’s functionality.
Among the variables profoundly affected by dollarization is the real exchange rate (RER), representing the relative price of tradable goods to non-tradable (NT) goods, expressed in the country's currency. Tradable (T) goods encompass items traded internationally, like agricultural products and manufacturing, while non-tradable goods include items not traded globally, such as transportation and government services. Mathematically, RER is represented as:
where E is the nominal exchange rate. As a small economy, Argentina acts as a price-taker (the price of tradable goods is fixed in world markets).
The real exchange rate is a pivotal relative price in any economy. If the prices of tradable goods consistently deviate from non-tradable goods, it influences resource allocation and the economy's structure. Holding other factors constant, a higher RER strengthens the tradable sector’s influence and vice versa.
Furthermore, heightened RER volatility complicates private sector resource allocation between sectors. Such uncertainty leads to increased investor errors and resource misallocation, ultimately impacting economic growth negatively. In an ideal scenario, the central bank maintains an equilibrium RER and mitigates external shock impacts by reducing volatility.
Various factors can drive tradable goods prices down. Global deflation, as seen in the 1930s, is one instance. Another is a significant devaluation of a major trading partner's currency, making exchanged goods cheaper for both nations. A case in point is Brazil’s devaluation of the real in early 1999, which triggered a real peso appreciation despite the maintained dollar parity.
It’s important to differentiate the RER from terms of trade (ToT), which gauge exported goods and services’ price relative to imported ones. An adverse ToT shock might coincide with a RER appreciation (i.e., tradable goods’ prices falling relative to non-tradables). This was evident in Argentina from late 1998 to early 1999. However, from mid-1999 onward, the two variables followed different paths.
Unlike a fixed exchange rate system, a flexible one can partly counteract price movements. The costs and benefits of various exchange rate regimes (fixed, floating, and intermediate) are extensively discussed in the literature.
Dollarization, eliminating the peso, removes the E from the TCR equation. While the government can't directly alter this vital relative price under dollarization (though trade policy remains a tool), the impact of such a fundamental shift in the economy’s institutional structure cannot be dismissed.
In an economy like Argentina’s, characterized by pronounced relative price imbalances, it's advisable to address corrections before dollarization, especially if it involves a steep local currency devaluation, to prevent excessive dollar inflation. Ecuador’s case illustrates this: adjustment occurred post-dollarization, causing nearly 100% annual inflation in the subsequent year. Hence, the equilibrium RER may differ before and after dollarization, possibly declining post-dollarization, particularly if paired with greater trade openness.
It’s crucial to distinguish between observed and equilibrium RER (unobservable). Equilibrium RER relates to overall economic productivity. Less productive, more closed economies generally have higher equilibrium RER.
Consequently, it’s a misconception to equate RER appreciation with decreased competitiveness. Ecuador’s experience counters this notion. Between 2000 and 2019, despite a 45% real exchange rate appreciation, exports and industrial exports as a percentage of total exports increased, indicating competitiveness growth.
The graph below highlights total and non-oil exports next to a RER appreciation starting in 2008. Non-oil exports increased in real terms and as a percentage of total exports, even amidst rising oil prices and RER appreciation.
Hence, the initial consideration is that dollarization alters the equilibrium RER. Building on Lucas's insights, we mustn’t assess dollarization assuming pre- and post-dollarization equilibriums are identical.
Another aspect to address is RER volatility. Ideally, monetary or exchange rate policies should dampen RER volatility. While dollarized economies might seem more susceptible to external shocks, this isn't consistent with data on economic activity and RER volatility (see here and here).
Analyzing dollarization’s desirability requires avoiding a Nirvana fallacy. The relevant comparison pertains to RER volatility between a dollarized economy and Argentina’s central bank, not between a dollarized economy and an unattainable high-quality central bank.
Concerns about RER in a dollarization scenario are natural, and data from dollarized nations provide valuable insight. These fears, at times exaggerated to oppose dollarization, need careful evaluation.
Additionally, the economy’s currency mismatch disappears under dollarization, particularly in the financial sector. However, problems stemming from exchange rate mismatches arise due to RER shocks, which would persist even after dollarization.
For instance, even with no currency mismatch in the tradeable goods sector due to a strong RER appreciation, financial issues can emerge if the sector is debt-laden. This impacts creditworthiness and raises non-performing loans, affecting the banking sector. Similarly, a RER depreciation could financially trouble the non-tradable goods and services sector.
Yet, this argument doesn’t apply to Argentina, where the state is the primary debtor in the banking system, holding debt in dollars while generating income in pesos. Given the country’s over-indebtedness in dollars, fiscal crises are inevitable, amplifying problems for tradable and non-tradable sectors and the banking sector’s leverage. Thus, the state’s debt contaminates the banking sector, converting fiscal crises into economic crises, as Ecuador’s case highlights positively.
Dollarization eliminates the currency mismatch in the public sector, lowering country risk premiums and debt roll-over risks. Furthermore, Guillermo Calvo notes that trade policy can mitigate RER shock impacts.
In summary, a refined analysis of dollarization is essential for accounting for equilibrium RER changes and evaluating RER volatility. Carefully examining data from dollarized economies prevents over-exaggeration of concerns. Additionally, dollarization’s impact on currency mismatches must be contextualized within broader economic realities.
The original post in Spanish can be found here.
Next: Credibility and Institutional Reform Reversibility.
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