On Currency Substitution – Can dollarisation save an economy?

Source: The post on Currency Substitution has been created on the article “Can dollarisation save an economy?” published in “The Hindu” on 28^th November 2023.

UPSC Syllabus Topic: GS Paper 3 Economy –Issues relating to planning, mobilization of resources, growth.

News: The article discusses the possible advantages as well as the challenges of currency substitution (dollarisation by Argentina, in this case).

Background:

Javier Milei, the recent winner of Argentina’s presidential election, has plans to replace the country’s currency of peso with the dollar (dollarisation). Argentina has been suffering under inflation levels greater than 100%, high rates of poverty and declining purchasing power.

What is dollarisatioon?

Dollarisation is the term for when US Dollar is used in addition to or instead of the domestic currency of another country. It is an example of currency substitution. Dollarization usually happens when a country’s own currency loses its usefulness as a medium of exchange, due to hyperinflation or instability.

What are the benefits of dollarisation?

1. Tackles Hyperinflation: If the domestic currency is replaced by dollars, the money supply in the economy can no longer be controlled by vested political interests who can increase spending (and hence the money supply) for political ends (such as unsustainable freebies).
   The rise of prices would be forced to moderate since consumers would no longer be able to access currency easily, thus slowing down consumption demand.
2. Accelerate Growth: This can be achieved through:
   a. Increase Investments & Exports: To access dollars through foreign trade and/or capital inflows, the economy will have to focus on increasing exports and easing conditions for the movement of foreign capital.
   b. Ensure Financial Stability: The stable value of the dollar ensures that economic agents, both foreign and domestic, would be able to make long-term plans regarding economic activity.
   c. Loss of the Ability to Manipulate Currency: It would ensure the government resorts to productive methods to increase exports, instead of merely artificially depreciating the currency.

What are the challenges with dollarisation?

1. Loss of the ability to control money supply: The adoption of dollars implies that the economy loses its hold on monetary policy (controlling the money supply in the economy).
   For instance, Greece, in the wake of the Eurozone crisis (the struggle faced by Eurozone countries in paying off debts they had accumulated over decades), was left without the ability to control both fiscal and monetary policy.
2. Loss of the ability to depreciate one’s currency: On the foreign trade front, countries would no longer be able to take recourse to depreciation of currency to boost exports.
3. Not enough on its own: For instance, after dollarisation, the Ecuadorian economy showed considerable progress on economic indicators. However, dollarisation was not the sole reason for success. Policy decisions such as new contracts with oil exploration companies, social spending, restructuring of debt, etc. played an important role in its economic success.

What should be done?

The achievement of economic prosperity is a complex affair that requires sustained engagement with policy-making. Thus, dollarisation, if used well in conjunction with smart domestic policy, can offer a route to economic success.

Question for practice: 

Currency substitution may have various advantages which may help the economy; however it must be complemented with sound economic policy-making as well. Comment.