In general, it is understood that a country is dollarize when the currency it issues is replaced in its basic functions by a currency issued by another country. The US dollar has been, until now, the monetary unit most used as a substitute for local currencies.
Because money fulfills three fundamental functions (it is a unit of measurement, a store of value, and a transactional medium), transactional dollarization is usually differentiated from financial dollarization.
It is also necessary to distinguish between official and de facto dollarization, as well as between partial and full or complete dollarization. Venezuela is, today, a case of transactional and financial dollarization, de facto and partial.
Why does an economy dollarize?
In the vast majority of cases, dollarization occurs as a consequence of economic and financial crises that have been accompanied by fiscal policies with which excessive use has been made of the financing of government expenses through the issuance of local currency (the ticket printing machine).
In such circumstances, inflation accelerates, even becoming hyperinflation, and the value of the local currency depreciates rapidly. The result is, inevitably, the rejection by the economic agents of the local currency as a means of exchange, a unit of measurement and a store of value; that is, the demand for local money is reduced and tends to cancel itself out.
In Latin America, several countries have experienced intense dollarization processes in recent times (Peru, bolivian and Uruguayamong others). Venezuela is the most recent case.
The reasons for homo oeconomicus
The dollarization of the Venezuelan economy is the rational response of its economic agents to protect their wealth and income in a context of high inflation and low credibility in economic policy, and, above all, due to the application of deficient fiscal policy.
Although, formally, this process began in 2018, the substitution of financial assets started in the eighties of the last century, while transactional dollarization was introduced more recentlyin the middle of the second decade of this century.
This dollarization has been imposed de facto, although the Venezuelan government has had to tolerate it due to the strong economic and social restrictions that its own policies have generated.
The effects of dollarization
Dollarization is not related to economic prosperity, let alone a substitute for structural economic reforms. Although it can reduce inflation in the short term, its effects in the medium and long term can be very negative.
These effects are related to changes in the mechanisms and channels of transmission of shocks and economic policies, which are consolidated as the degree of dollarization of the economy increases. It is no coincidence that bi-monetary economies show greater volatility in their growth rates and are more exposed to experiencing financial crises.
More specifically, dollarization makes it difficult to respond to external shocks given the impossibility of applying effective stabilization policies (fiscal, monetary, and exchange rates). As the ease with which depositors can change the monetary denomination of their transactions and portfolios increases, it becomes more difficult for central banks to stabilize both prices and output.
As the State’s capacity to design and manage economic stabilization policies is reduced, external shocks have to be adjusted through the goods and factor markets, raising the social costs of these shocks. The adjustment processes are, therefore, even longer and more painful, especially if the economy does not have a developed and well-regulated financial system.
Risks for the national economy
From the perspective of fiscal policy, one of the most relevant effects of dollarization is the loss of the ability to generate income through the seigniorage (the circulation of national currency through financial institutions), due to the reduction in demand for local currency.
If the State does not have access to this financing in an economy that has been informalized and has seen its production capacity constantly reduced, as is the case in Venezuela, the loss of seigniorage makes public spending even more procyclical, increasing vulnerability to the shocks and social costs of the inevitable adjustments in the real economy (production and employment).
The greater elasticity and variability of the demand for money also affects the variance of the exchange rate upwards and the speed at which exchange rate adjustments are transmitted to prices. This dynamic makes expectations unanchored extremely easily, compromising the possibility of success of stabilization policies, even if they have been well defined.
Risks for local banks
If the central bank does not have a high level of international reserves, as is the case with the Central Bank of Venezuela, cannot exercise its role as lender of last resort, since it does not control monetary aggregates or interest rates. In this case, local financial institutions become extremely vulnerable to sudden changes in capital movements and suffer serious liquidity and solvency problems due to greater exposure to currency risks. currency mismatch and deadlines.
For this reason, in unstable bi-monetary economies, banks are obliged to maintain high levels of liquidity and immobilize a significant part of their availability in foreign currency, thus affecting domestic credit. Of course, this greater fragility of the financial sector limits the countercyclical capacity of exchange, monetary, and fiscal policies.
Banking fragility, the greater speed of transfer of the exchange rate variation to prices and the volatility of expectations encourage the Central Bank to try to use the exchange rate as a nominal price anchor and, with it, the rate. The exchange rate tends to appreciate continuously, increasing the restrictions on growth and diversification of the economy.
Reform to de-dollarize
Dollarization is characterized as a resilient process. To the extent that a bi-monetary economy is consolidated, important structural, institutional and regulatory changes take place that make it very difficult to reverse dollarization.
Agents that have learned to deal with currencies, network economies that have developed as currency substitution has progressed, the dynamic inconsistency that characterizes economic policy management, and the traumatic experience of decades of high inflation, crisis foreign exchange and banking explain why in economies where stabilization has been successful and progress has been made in structural reforms, high levels of dollarization still persist.
In fact, only a few countries they have managed to de-dollarize, after a long process of economic and institutional reforms and efficient management of economic policy. In no case have the attempts to impose de-dollarization through laws or decrees achieved their objective. De-dollarization, and with it the recovery of the capacity to carry out stabilization policies that cushion external shocks, more than an explicit objective of economic policy, is the consequence of the execution of a successful disinflationary program and structural reforms.
This article is a summary of the document “Dollarization and De-dollarization, a dilemma in Venezuela?”, published in number 16 of Notes on the Venezuelan Economypublished by the Institute of Economic and Social Research, IIES, of the Andrés Bello Catholic University.
Luis Zambrano-SequinResearch professor, Andres Bello Catholic University
This article was originally published on The Conversation. read the original.
