Mixed Signals

Following his election as Argentina’s new president, Javier Milei surprised markets by naming Luis Caputo as his finance minister. Caputo, who held the office under former president Mauricio Macri, has spoken out against dollarization in the past, whereas Milei’s flagship campaign proposal was the full dollarization of Argentina’s economy, together with the permanent closure of its central bank.

Specifically, Caputo said that the new government’s priority should be to implement an “orthodox stabilization plan,” so that dollarization will not be immediate. He also purportedly told a group of Argentine bankers that dollarization was off the table. Nonetheless, on November 26, the president-elect’s office issued a statement to affirm that the closure of the central bank and dollarization were non-negotiable parts of his agenda. The messaging regarding dollarization, in other words, has been mixed.

Yesterday, Caputo announced the government’s initial—and much anticipated— economic measures: a slew of emergency policies meant to improve the precarious fiscal balance as rapidly as possible. Crucially, Caputo also updated the official exchange rate from 400 to 800 pesos per dollar. As of this writing, the so-called “blue” dollar, the black-market mechanism that most closely resembles the free market rate, rose to 1,150 pesos per dollar from a level of below 1,000 last week. Caputo also remained silent on dollarization during his televised address.

Some opponents of dollarizing the economy have interpreted both Caputo’s appointment and the government’s first set of economic measures as signs that the dollarization plan is dead. However, Milei could well intend to dollarize still. In which case it is fitting to ask when is the optimal moment to do so.

Leliqs

According to one theory, getting rid of the Argentine peso is unfeasible as long as the central bank remains saddled with its liquidity note or Leliq problem. These are short-term bonds issued by the central bank, which have constituted roughly 40 percent of commercial banks’ assets. Leliqs, which pay well over 100 percent in interest per annum, but only through the issuance of new short-term bonds, are a monetary and fiscal time bomb with a very short fuse.

For years, the main source of profit for Argentina’s private banks has not been their normal, commercial operations, but rather the interests received from Leliqs, which mature in 28 days at the most. Thus, the fate of the national banks became tied to that of the central bank, all while the latter was financing the government’s deficits. As things stand, the central bank must issue pesos to keep the banks solvent.

This is why the Leliq scheme, which was originally meant to strengthen the peso by reviving demand for the local currency, ended up having precisely the opposite effect: it drastically increased the monetary base, boosted inflation, and weakened the peso to the lowest level vis-à-vis the dollar in its history. 

Since the Argentine central bank has no assets with which to pay interests on its liabilities, so the thinking goes, the Argentine state itself has insufficient dollars with which to dollarize. This is a false assumption, as we discussed here. Nonetheless, Milei’s government will have to address the liquidity note problem—urgently—with or without dollarization.

In this sense, it is noteworthy that, in the weeks since Milei’s election, the market itself largely swept away the Leliqs. Banks quickly redeemed them and turned instead to “Pases Pasivos,” which offer slightly lower interest rates but are renewed every 24 hours. At the moment, Pases make up 74 percent of the central bank’s interest-bearing liabilities.

The large accumulation of Pases is still unsustainable. These contain the same essential flaw as the Leliqs: they are financed only through the issuance of more of the same (ultra) high-yield instruments. Caputo seems to recognize as much. According to media reports, he plans to convert the Leliqs and Pases into treasury bonds. Although the terms of said bonds (if they are issued) are not yet known, the measure would be logical.

As we wrote in July, the issue at stake is that the Argentine state must pay its obligations. Given the Leliqs’ explosive nature, holders will have to accept a restructuring of some sort. This is precisely what the conversion into treasury bonds—especially bonds with longer maturity terms—would mean. 

Some fear that converting Leliqs and Pases into treasury bonds might affect the banking system’s liquidity. But such a restructuring would increase the value of banks’ assets, especially if they are denominated in a stable currency and the government offers a credible payment plan.

If said conversion takes place, it will be evident that there was no need to “rescue” the entire amount of Leliq debt at a moment’s notice. Hence, the argument that Argentina could not dollarize due to Leliq and Pases debt will be revealed as spurious. In fact, insofar as dollarization is the most rapid method to reduce inflation, the corresponding reduction in interest rates will ease the future payment of all debt.

Make no mistake: Argentina’s debt problem is severe. In fact, with debt levels of 80 percent of debt to GDP, the largest debt burden of any country to the International Monetary Fund, and large, impending payments to service the interest on the latter, Argentina is facing—as Milei has said—what is arguably the worst debt crisis in its history. And Argentina’s history is largely a history of debt crises.

Rather, the point is that not dollarizing now presupposes that monetary stimulus is at least part of the solution to Argentina’s current fiscal and debt problems. This is obviously not the case in terms of the country’s dollar-denominated debt; the Argentine central bank cannot print US dollars to pay its creditors or those of the central government. On the other hand, the growth of the Leliq pyramid scheme suggests quite clearly that the central bank’s ability to print pesos led to the current disaster in the first place. This is why Milei and Caputo should ask themselves what the price of delaying dollarization can be.

The Ecuador Model

The case of Ecuador provides the most relevant parallel. Towards the end of 1998, inflation soared and Ecuadorians continued to flee from the sucre, the national currency, by buying dollars. The exchange rate stood at 6,700 sucres per dollar, compared to 4,400 sucres per dollar at the end of 1997. A few individuals suggested that the government should recognize the monetary reality—that is, that fewer and fewer people were willing to hold any sucres at all— and officially dollarize. Nonetheless, most economists held that dollarization was an overly harsh measure and that the central bank did not have enough dollars to dollarize, save at an extremely high exchange rate. Thus, the political class stalled as the situation rapidly worsened.

In March 1999, with an exchange rate of 10,000 sucres per dollar compared to 7,200 two months prior, there was a run on the banks as savers sought to redeem their deposits. The exchange rate crisis had become a banking crisis. Then-president Jamil Mahuad responded by freezing all bank accounts for five days. By the first week of January of 2000, the exchange rate had reached 24,000 sucres per dollar and Mahuad’s government was crumbling.

In an attempt to hold on to power, Mahuad dollarized—defying the wishes of the IMF and the consensus among economists—at a rate of 25,000 sucres per dollar.

Though overlooked, the ensuing history of dollarization in Ecuador has been a resounding success, especially since the country has maintained one of the lowest inflation levels in Latin America (along with dollarized peers Panama and El Salvador).

The relevant lesson for today’s Argentina, however, is that there is a price to pay for delaying dollarization. Had Mahuad dollarized Ecuador some 18 months before January 2000, he would have saved Ecuadorians who held sucres a 78 percent loss of their purchasing power vis-à-vis the dollar. The price of allowing the market to force dollarization upon you is steep indeed. 

Root and Branch Financial Reform

In terms of the much-needed, root and branch reform of Argentina’s entire financial system, dollarization would ensure that the crooked partnership between the political class and the big banks—the foundation upon which the Leliq pyramid was built—cannot be reestablished. Once again, Ecuador provides a blueprint.

Beginning in the early 1980’s, the Ecuadorian government constantly bailed out private banks by paying their dollar-denominated debts to foreign creditors. Banks were then able to repay the central bank in chronically devalued sucres. Once Ecuador dollarized and there was no lender of last resort, politicians could no longer bail out banks, whose profitability no longer depended on their political connections. Rather, banks had to compete among themselves to satisfy their customers. With a hollow central bank, which does not issue its own currency, politicians’ inclination to spend far above the state’s means stopped infecting the rest of the economy.

The new dynamic proved to be a blessing for banks’ customers, but also for the banks themselves. While the latter were practically bankrupt in early 2000, the mere announcement of dollarization produced a confidence shock in the banking system and a subsequent, successful “bail in.” That is, Ecuadorians saved the banks with a deluge of deposits, their cash previously having been kept outside the formal banking system or held abroad. Ecuador also saw a large increase in foreign direct investment; the country suddenly came to be seen as a favorable destination to invest due to its absence of exchange rate risk. 

In Argentina’s case, Caputo’s assurance to Argentina’s largest banks—to their relief— that the dollarization option was off the table is telling. As in Ecuador in the late 1990’s, Argentina’s bankers are among the most vocal opponents of dollarization. But there is little harmony with the interests of ordinary, peso-holding Argentines.

While Caputo’s measure to bring the official exchange rate far closer to the “blue dollar” is the correct step to have taken, Ecuador’s experience suggests that, when getting rid of a national currency, it is far better to act sooner rather than later. Indeed, delaying Argentina’s dollarization may not be as prudent an option as many now think.