De-Dollarization — Solution to El Salvador’s Fiscal Deficit or Catalyst for Instability?
If the draft 2021 budget presented by El Salvador’s government is approved, the country's debt would increase next year by at least $1.4 billion dollars. It’s very likely that the debt increase could be even larger, since the budget’s estimate of increased government revenue is overly optimistic. This raises the question of where will the funds to cover this gap come from?
To answer, it’s important to analyze how the fiscal deficit could be funded. The government intends to spend more than it will take in, so it will need to obtain capital from domestic or international creditors. The following paragraphs examine three options for obtaining this capital.
The first option is to increase short-term debt. That is, the government has to issue more Treasury notes (Letras del Tesoro Público de El Salvador, or LETES) and Treasury certificates (Certificados del Tesoro, or CETES) to finance the fiscal deficit. However, short-term debt has already reached record levels this year (currently around $2 billion), so it’s unlikely to be a major source of capital in 2021.
The second option is to contract debt with multilateral organizations, which implies negotiating loans with the International Monetary Fund (IMF), the World Bank (WB), the Inter-American Development Bank (IDB), or the Central American Bank for Economic Integration (CABEI). This is an attractive option due to the low interest rates offered by these institutions, but availability of these loans will be quite limited in 2021 unless the government decides to negotiate an agreement with the IMF.
The third option is to issue bonds in the international capital markets, which seems to be the most feasible option. The problem is that this debt is more expensive. El Salvador’s most recent bond issue a couple of months ago carried a 9.5 percent rate. It’s a very high rate and will oblige the country to allocate more resources to service the debt interest. Any new bond issues will probably also pay high rates, as the country risk (the risk of lending to El Salvador) has increased. This is illustrated in the graph below, which shows the evolution of the Emerging Market Bond Index (EMBI), the most widely used metric to approximate country risk.
Since none of these three options are very palatable, many have suggested de-dollarization as a better way to deal with the deficit. However, I believe that this measure would be disastrous for the Salvadoran economy. The COVID-19 pandemic has taken a very heavy toll on the economy, and de-dollarization would have some profound social repercussions, further compounding this disaster. Furthermore, the idea that the de-dollarization process can be conducted in an orderly manner is a myth. But as the subject has been garnering more attention recently, let's see what the reintroduction of the colon (or another national currency) to the Salvadoran economy would look like.
The argument for de-dollarizing the economy
A de-dollarization storyline would go something like this, “Let’s withdraw all the colones currently held by the Central Bank so that the government can use these colones to pay salaries and suppliers, thus reducing its need for external financing.” Supporters of this approach often add, “The public shouldn’t worry because even though public employees will now be paid in colones instead of dollars, their purchasing power will remain intact.”
The exchange rate could be set at 8.75 colones to the dollar (to return to the pre-dollarization rate), or even 10 colones to the dollar, to make mental calculations easier. Thus, if a liter of milk costs $1, it will now cost 10 colones, and if your salary is $500, you will now be paid 5,000 colones. Just add a zero to each conversion.
Advocates of de-dollarization say that going back to the colon will restore a source of national pride, and will reduce the need to acquire debt. The government will provide reassurances that the colon is reliable, that no one has to worry about accepting colones, and that the use of both currencies will be permitted. Everything will be fine, they say, concluding that this will dismantle an exchange rate scheme that leaves the government with little room to maneuver.
The government will undoubtedly issue communications expressing confidence in the new currency, but how will the public react? Below we explore how a de-dollarization program could unfold.
1. De-dollarization Punctuated by a Bank Freeze
Let’s suppose that, in general, you support the government and believe everything is going well. Still, the reintroduction of the colon will certainly raise some doubts in your mind. You have a savings account in dollars. The government has declared that your savings are safe, but since there is so much uncertainty, you decide to be cautious and withdraw some of your savings. It’s very likely that many people think the same way, causing a massive outflow of deposits from the banking system.
The problem is that banks can’t give you back all your savings when a bank run occurs. After all, banks are in the business of intermediation, and your deposits are loaned out to others that need credit. In fact, banks are only required to maintain the percentage of total deposits that meets liquidity reserve requirements (legal reserve).
That’s why a widespread bank run will force the government to limit withdrawals from the financial system to avoid bankruptcy. When Argentina experienced a bank run in 2001-2002, the government limited withdrawals to $250 a week. Restricting the outflow of deposits and foreign currency leads to a slowdown in economic activity.
All of this will unfold even if the banking system is solid, liquid, and well-capitalized. It’s a phenomenon that springs from the uncertainty regarding the new currency, and the preference for maintaining liquid balances in dollars. The tendency of investors to migrate towards less risky assets in uncertain scenarios is known as the “flight to quality.” In our example, the dollar is perceived as less risky than the colon.
The lesson here is that a de-dollarization program will slow the financial system down to a crawl, and will require restrictions on the use of bank deposits. This, in turn, has an enormous impact on economic activity, employment, welfare and even political and social stability, as evidenced by the countries that have lived through similar experiences.
2. The return of the inflation tax
The government has to put large amounts of colones into circulation to meet its liabilities and other obligations. Remember that the return of the colon was motivated by a fiscal crisis in the first place, so as the amount of colones in circulation increases, they begin to devalue. This is known as an inflationary process. For example, if a liter of milk costs 10 colons at the beginning of the month, it will cost 11 colons a few weeks later. The problem is that you will earn the same 5,000 colones in salary, so your purchasing power declines. This is known as the inflation tax.
Economists call this an unlegislated tax. The government puts money into circulation to pay some of its obligations (it monetizes its debt), but as the supply of money increases, prices expressed in colones also rise, which in turn causes a loss of purchasing power for people with income in colones. Therefore, the government has financed itself at the cost of a decline in the overall well-being of families, who now buy less.
Anyone who took an introductory macroeconomics course will remember the term “seigniorage,” which refers to the benefit that feudal lords obtained by minting coins to finance themselves. Many will also remember one of economist Milton Friedman’s most famous phrases: “Inflation is always and everywhere a monetary phenomenon.” If the amount of money in circulation grows steadily (without an increase of the same magnitude in demand), there is a general increase in the prices expressed in that currency.
It’s important to note here that the inflation tax is a regressive tax, and affects households with lower incomes more, since they tend to have a greater share of their wealth in cash and conduct a greater percentage of transactions in bills and coins. In contrast, households with higher incomes tend to seek mechanisms to mitigate the effect of inflation, since they have a smaller percentage of their wealth in liquid assets.
The lesson here is that reintroducing the colon and using it to finance state expenditures would increase the prices of goods and services, triggering an inflationary process. This affects everyone, but hurts the most vulnerable households the most, as they would experience a further reduction in their purchasing power.
3. Debt and savings converted to colones
You have been saving in dollars, you have a time deposit in dollars, and now you’re wondering whether you should withdraw your savings in colones or dollars. Just like in Argentina, the Salvadoran government can promise that your savings will not lose value, and that if you have saved in dollars, you will be able to withdraw dollars.
But just like Argentina, it’s very likely that the Salvadoran government’s promises won’t be fulfilled.
This is because the value of a currency does not hinge on what a politician wants or says. The value depends primarily on the confidence that different actors have in the conduct of economic policy, and in the strengths and vulnerabilities of the economy. If a government to assure you that by law, the exchange rate is “x” colones to the dollar, but then doesn’t back this up with a plan and the appropriate implementation of fiscal and monetary policy, such assurances are no better than a Twitter post.
Therefore, the key to determining the value of a currency is trust, and trust is not achieved with political communications or epic TV commercials, but with clear actions taken to ensure macroeconomic stability.
In Argentina’s case, savers lost with the “peso-fication” of their savings, as they were converted from dollars to pesos and lost part of their purchasing power as a result of inflation. More specifically, Argentina carried out an “asymmetric peso-fication,” so that the banks’ assets (their outstanding loans) were converted at a rate of one peso per dollar for loans made to the private sector, and 1.4 pesos per dollar for loans to the public sector, and for bank deposits. The intended effect of the peso-fication was to protect companies and households that had debts in dollars, but in reality it only shifted the cost of the adjustment to the taxpayers, since debt had to be issued to compensate the banks for this asymmetry.
Thus, the Argentine government implemented a scheme that involved different and unsustainable types of exchange, which resulted in strong redistributive effects. This was summarized by a former president of the Central Bank of Argentina: “I have debt in dollars, but then I pesoify and make my debt liquid. You, on the other hand, deposited dollars to finance me, are pesoified and get screwed. The person without a single penny in deposits, pays the difference between what I pay and what you receive. In other words, we get saved, you get screwed, and they pay our debt.”
The lesson here is that the reintroduction of the colon presents an enormous challenge in terms of the assets (loans) and liabilities (savings) of the financial system, and their conversion to colones. Governments may be tempted, as was Argentina, to apply different types of exchange rate, which ends up having strong redistributive effects, benefiting certain groups at the expense of others, in addition to further complicating the exit from the crisis. Depositors lose to the extent that their deposits are returned in colons at a lower rate than the market rate. In addition, fiscal costs are incurred as the government seeks to compensate affected groups.
4. Paralysis of economic activity and social instability
The uncertainty that would be caused by de-dollarization compounded by a paralyzed financial system, will surely slow down investment, affect foreign sector transactions, reduce the country’s access to external resources, and change the consumption and investment decisions of households and businesses. This would translate into a contraction of economic activity, higher unemployment, and therefore, a drop in family income.
De-dollarization is a bad idea at any time, but it’s terrible when a country is in the same circumstances as El Salvador: a high level of fiscal fragility, high indebtedness, and little room to maneuver to access external resources.
Is de-dollarization inevitable?
There are some who think that de-dollarization is not ideal (they recognize its high cost), but that it may be inevitable. I do not agree. Let’s remember the root causes of the problem: the deterioration of the country’s fiscal situation, government expenditures that are growing more quickly than revenues, and attempts to close the gap with increasingly scarce financing. Therefore, if the problem is fiscal, the solution must also be fiscal.
What is required is a thorough review by the government of the country’s fiscal sustainability, an analysis of measures for recovering macroeconomic stability, and specific action to put the debt on a downward trajectory. The debt has risen from 70 percent of GDP at the beginning of the year to a projected 90 percent by the end of 2020, and will exceed 94 percent by 2021. Although it won’t admit it, the government is aware that this is not sustainable, and that the responsible thing is to give up the confrontational rhetoric to engage instead in a real fiscal dialogue.
The experience of Argentina, which had five presidents in three weeks between 2001 and 2002, instructs us that avoiding a disorderly adjustment is not only the responsible thing to do, but also the best way to avoid high costs to the populace. It’s also in the best interest of the government.
FI name: October 2020