Source: The Rio Times.
On January 22, 2023, Luiz Inácio “Lula” da Silva and Alberto Fernández—the presidents of Brazil and Argentina—announced they would start preparations for a common currency: the sur. The stated goal for these presidents in creating a common currency is to reduce reliance on the dollar and foster regional integration. Economists across the world wasted no time in lambasting the proposal—American economist Paul Krugman called it a “terrible idea,” not meeting any of the requirements of an optimum currency area, Brazilian-Argentine economist Fabio Giambiagi described it as a “waste of time,” and Egyptian-American economist Mohammad A. El-Erian explained how neither Argentina nor Brazil has the “initial conditions to make this succeed and attract others.” Along these lines, Larry Summers also deemed the sur highly problematic while others referred to the idea as “insane, irrelevant, and unfeasible.” The reproach was not limited to the realm of economists either. Fábio Ostermann, a Brazilian congressman from Rio Grande do Sul, likened the venture to “opening a joint bank account with that deadbeat friend who owes everyone money and is unemployed.”
The wide range of critiques may be valid for a traditional currency union, such as the euro, for Latin America. However, the more limited Lula-Fernández proposal to use the sur only as “a common unit of trade” has merit and has been overlooked in the global barrage of criticism. That is to say, rather than replacing domestic currency in circulation, the goal of the sur is to facilitate regional trade as well as reduce dependency on the dollar. Not only is this achievable, but due to the powerful phenomena of third-country pricing—a limitation that has become increasingly debilitating for Latin America since COVID-19 rocked the region—it is increasingly important.
Latin America’s Third-country pricing challenge
The majority of Latin American countries—with the exception of the dollarized economies—have floating exchange rates, meaning that value of their currency is determined by the demand and supply of that currency. In theory, one benefit of this currency flexibility is the process of “expenditure switching”: a depreciating currency will allow for rebalancing between expenditures on foreign and domestic goods. For example, with a weakening Argentine peso, Argentine goods become cheaper for foreign buyers, while imports to Argentina become relatively more expensive in peso terms. This results in increased demand for Argentine goods from the rest of the world, thus stimulating the Argentine economy. College economics majors might recognize this as a key assumption of the Mundell-Fleming model—weaker currencies lead to an increase in net exports, which in turn raises aggregate income (and the inverse is also true). This allows floating currencies to provide a counter-cyclical boost to national economies.
However, when countries use a third-country’s currency for trade—for example, when Argentina’s trade with Brazil is invoiced not in the peso, but the U.S. dollar—this rebalancing does not take place. Imports do indeed become more expensive in peso terms for Argentine consumers as the peso weakens, but Argentine exports do not become more competitive as its trading partners’ currencies may not have weakened vis-à-vis the dollar. In other words, when trade is invoiced in U.S. dollars, Brazilians do not have a financial incentive to purchase more Argentine goods and services when the peso weakens against the dollar. This means that the exchange rate does not play that crucial counter-cyclical role in the Argentine economy. Instead, balancing occurs in the short run, but only through a painful compression of imports rather than being coupled with an expansion of exports. That is to say that as the U.S. dollar strengthens it has a contractionary impact on global trade in the short-term by lowering demand for imports throughout the developing world—particularly in Latin America.
When we see dollar appreciation in terms of Brazilian and Argentine currencies over the past five years, this cost becomes even clearer. The Brazilian real has held relatively steady since its initial weakening in 2022, in part due to aggressive COVID-19 related interest rate hikes. However, it has experienced an overall weakening trend vis-à-vis the dollar. Argentina’s experience is more extreme. Whereby 1 dollar cost 19 pesos in early 2018, one must now forgo over 180 pesos for that same dollar. How does this relate to third-country pricing? Neither country benefits from the increase in competitiveness that would otherwise be associated with their weakening currencies.
Sources: FRED Federal Reserve Economic Data, and Yahoo Finance
Today, most global trade is invoiced in either the dollar or the euro—regardless of the countries involved. The vast majority of trade in the Americas is invoiced in the U.S. dollar. This is driven by myriad factors—with proximity to and trade with the United States certainly being among them. Additionally, for smaller or less stable economies, their currencies are not accepted as a means of payment or a store of value in the international market. Market actors are therefore less likely to conduct large transactions in a volatile currency. Using the dollar is also a way to keep costs and revenues in the same currency as finished goods often use imported inputs priced in dollars. To an extent, this is also a self-fulfilling prophecy. If a company’s international competitors sell in dollars, there is an incentive for the company to do so as well to protect it from price fluctuations that competitors might not face.
Source: Federal Reserve FEDS Notes, October 06, 2021, “The International Role of the U.S. Dollar”
A shared unit of account – a reachable goal
Given these trends and challenges, it is clear that Latin American economies could benefit from finding a viable alternative to the dollar for financial transactions. These benefits have very little to do with the political leanings of the region’s most recent “pink tide” or specific imperatives of individual leaders. Even if the implementation of a virtual sur never results in a full-fledged currency union or meaningfully increases regional integration, it would still aid Latin America’s economies through its role as a shared unit of account.
The key is to make the sur a credible alternative to the dollar. And herein lies the rub. What would compel Latin American industry to use the sur as opposed to the greenback? How could Brazil and Argentina develop the legitimacy and confidence in this new currency which is so crucial to its use and survival?
The coming months will be telling. Attracting other South American countries to participate in and help capitalize the planned South American Central Bank would certainly help. Using the existing “Local Currency Payment System,” established by Brazil and Argentina in 2008 to foster the use of existing domestic currencies, could provide institutional support. There are also historical examples of virtual currencies that can serve as helpful examples. Brazil itself successfully launched a virtual currency, the “URV,” in 1994 after struggling with decades of inflation and helped convince Brazilians that their government was finally capable of providing price stability. A similar strategy could be utilized with the sur. The creation of the ECU in 1979 serves as another example of disparate economies successfully creating a common accounting unit for financial transactions as opposed to a physical currency.
However, one enormous irony remains: given that the capitalization of the new South American Central Bank would rely in part on the international reserves of participating countries, comprised predominantly of U.S. dollars, any weaning of dollar dependency will still be a long way off.
Britta Crandall teaches Latin American political economy at Davidson College, and is the author of Hemispheric Giants: The Misunderstood History of U.S.-Brazilian Relations (Rowman and Littlefield, 2011) and the co-author of Our Hemisphere? (Yale University Press, 2021). She has also authored shorter pieces on Latin America’s political economy, including analysis of pension reform in Chile and dollarization in Ecuador and El Salvador. Prior to teaching at Davidson, she was associate director for Latin American sovereign risk analysis at Bank One in Chicago and worked as an international program examiner for the Office of Management and Budget, the budget arm of the White House. From 2007-2017, she served as a South America consultant for Freedom House, an independent watchdog organization dedicated to the expansion of freedom around the world.