Today’s video is sponsored by the Daily Upside, a totally free, high quality daily
business and finance newsletter.
Visit the link in the description to learn more.
Brazil and Argentina made a recent announcement that they are considering the idea of a common
currency between the two countries, and that they would hope to eventually invite other
Latin American nations to join the union in a move that could someday create the world’s
second-largest currency bloc, next to the Euro.
Brazil has suggested that the new currency could be named the “Sur” (meaning south)
and that it could boost trade within the region and reduce regional reliance on the US dollar.
The idea (as it has been expressed so far) is that the new currency would at first run
in parallel with the Brazilian real and Argentine peso at first being limited to use in trade,
not unlike the way the Euro was initially launched.
Argentina’s economy minister described the project to the FT as the first step on a long
road which Latin America must travel.
Brazil’s president told reporters in Buenos Aires earlier this week at a summit that he
was attending that, “God willing”, the finance ministers and leaders of the two central
banks would have the “intelligence, competence and good sense” to begin work that could
eventually produce a common currency.
Now, Brazil and Argentina have discussed the idea of a common currency in the past, but
nothing much has ever come from it.
Economists have been very skeptical about this idea since it began being discussed a
few weeks ago, but political analysts have been much more positive, pointing out that
Latin America’s mostly leftwing leaders have an urge to move towards greater regional
integration and might want to challenge the US dollar’s dominance in the region.
Now that both Brazil and Argentina have leftwing leaders, there might be greater political
interest in an idea like this, but it is not obvious to me that this is much more than
political signaling for the time being.
To begin with, policymakers in neither country will be excited about giving up power to the
other nation, but possibly more importantly, an argument over whether they put Maradona
or Pele on the highest denomination banknote is likely to lead to an argument that brings
the whole project to a halt.
There are just some things that are more important than politics or money in Latin America.
At present, there is no real detail to the plan, it is just something that has been put
forward and the two countries have agreed to begin analyzing the requirements for putting
a common currency into place in the region, and that analysis includes everything from
understanding the mechanisms of trade integration, fiscal policies and the role of the two central
banks.
Now, as I mentioned earlier, there has been a general move to the political left in Latin
America, and most left leaning Latin American politicians tend to take an anti US stance.
Many of these governments thus want to reduce their dependance on the United States and
see the idea of a common currency for the region as a way of doing this, while also
bringing about greater political union on the continent.
If a Latin American currency union were to come to fruition, it would represent around
five percent of global GDP, which compares to the approximately 14 per cent of global
GDP that is represented by the Euro.
Joint currencies are obviously not a new thing, and they tend to boost trade between the countries
involved as they get rid of conversion costs and exchange rate uncertainty.
The euro is used in 20 European Union member states and is second to only the US dollar
in international reserve holdings.
The CFA franc and the East Caribbean dollar are other examples of joint currencies.
But one downside of common currencies is that they can spread economic shocks between the
countries that have adopted them, so we need to look at how that can happen.
Latin American politicians have discussed ideas like this for quite a while.
The Southern Common Market, known as Mercosur was set up in 1991 with the idea of promoting
free trade and the movement of goods, people, and currency within the member states.
It currently works as a customs union between the member countries and has signed free trade
agreements with a number of countries around the world, including the EU.
Argentina’s former central bank chief Sturzenegger, who served from 2015-2018 was supportive of
establishing a central bank among members of the Mercosur countries.
Brazil former finance minister Guedes has discussed in the past how a regional common
currency would impose fiscal discipline on the region and that there would likely be
fewer global currencies in the future so it would be beneficial if the region had its
own.
Economists have tended to criticize prior proposals for a joint South American currency,
noting that it would tie together several volatile economies with high levels of inflation
and debt.
The other small joint currencies like the CFA franc which is used by some African countries
and pegged to the euro, and the East Caribbean dollar, make up a much smaller slice of global
economic output and they do have their problems.
We also have currencies like the Hong Kong Dollar which is pegged to the US Dollar, and
it works quite well despite there being no strong relationship between the two economies.
I’ll come back to that in just a minute.
The attractions of a common currency are probably most obvious for Argentina, where the economy
is in freefall.
Annual inflation in Argentina is approaching 100 per cent as of December as the central
bank prints money to fund spending.
It is not so surprising that Argentina might want a more stable currency.
Argentina has a very dollarized economy, and that is just what happens in economies where
inflation gets really extreme.
You can see this happening in Turkey right now too.
In an extreme inflation situation like this, the internal economy moves to trading in some
other currency, which could be euros or dollars or something else, but something that has
some stability, as people lose faith in the national currency.
The Argentinian economy has been dollarized for quite some time, for example, if you wanted
to make a big purchase like buying a house in Argentina, you would have to pay in dollars,
because no one in Argentina would sell their house for Argentinian pesos, as why would
you trade a real asset like a house for a rapidly depreciating currency.
Similarly, in such situations, contracts begin being written in foreign currency too, as
they are too problematic when written in local currency.
Brazil, on the other hand is a functioning economy, with a reasonably orthodox central.
Inflation was high, but they have brought it down.
Inflation in Brazil was due to the deficit as Brazil has quite a lot of debt…
Brazilians, as you can imagine will be quite concerned about being strapped to a country
like Argentina that has huge outstanding debt and an extremely volatile economy that has
been mostly cut off from international debt markets since it defaulted in 2020.
I asked a friend in Brazil what he thought of the proposed currency union, he replied
“we have a saying in Brazil about ideas like this.
We describe it as the hug between those about to drown…
Before we go through the big problems with a currency union between Brazil and Argentina,
let me tell you quickly about today’s video sponsor – The Daily Upside.
If you find yourself sifting through multiple news sources trying to find unbiased and insightful
news, the Daily Upside might be the solution to your problem.
The Daily Upside is a totally free daily email newsletter, written by a team of financial
professionals with real industry experience and is read by close to a million investors
every day.
It’s become the first thing I read every morning as it is informative, entertaining,
and not dumbed down.
They give you the most important news with real analysis.
They had an excellent piece a few days ago on this joint currency proposal which was
helpful in making this video.
Whether you are a financial professional or just looking for a great source of business
news, the daily upside will help.
It is totally free to sign up and they send you one information filled email every morning.
I can’t recommend it enough.
Sign up using the link in the description below.
OK, so why are economists so dismissive of the idea of this currency union between Brazil
and Argentina?
Well, when you link two currencies, the two countries basically need to have the same
interest rates as each other, otherwise there would be arbitrage opportunities, where you
could borrow money in one country at a low interest rate, invest it in bonds in the other
country at a high interest rate and make a risk free profit because they both use the
same currency.
Interest rates are very much a function of the economic and business cycle, so for a
currency union to work between two countries, the business cycles need to be reasonably
aligned.
If you have recession in one country and growth in another, the two countries should have
different interest rates.
Thus, if you have two countries with very different business cycles and the same interest
rates, you’ll have a lot of problems, things will break.
When we look at Argentina and Brazil, the two economies are extremely different.
Almost the only thing exported from Argentina is food, and Brazil’s economy is heavily
weighted towards manufacturing and fuel.
It would be very difficult for countries like these to have a common currency, as big macro
changes would affect each country quite differently causing big changes in the equilibrium real
exchange rate.
A big change in the price of oil for example would create huge adjustment problems.
So why can using one currency work in a big country like the United States, where the
individual states might have very different economies, but not work between a group of
neighboring countries.
This is because within a country, there is free movement of labor and capital, and there
are fiscal transfers between poor and rich regions.
These types of transfers are not controversial within a country, but would be quite controversial
between countries.
For this reason, despite their proximity, it would make no sense for the Canadian dollar
to be pegged to the US Dollar, as Canada has a very resource driven economy.
If there was a natural resources boom or bust, it wouldn’t make sense to have the same
interest rate in Canada as in the United States, as the interest rates would need to relate
to the Canadian economy.
The more integrated economies are, the better it can work.
In Europe the various countries have reasonably similar economies, but when there are big
differences, fiscal transfers are required and that can be politically difficult.
We saw this in the European debt crisis in 2010, which many people viewed as conflict
between prudent Germany and the irresponsible peripheral countries.
This was not really accurate however, some of the overheating European economies in the
early 2000’s and the debt problems that occurred later were driven more by interest
rate mismatches between the different European countries.
At times in Europe there are real advantages to being a peripheral economy, as peripheral
states receive large capital transfers to maintain regional coherence, along with most
of the funds aimed at economic convergence.
The Core countries in Europe on the other hand are counter-cyclical, in that they benefit
from monetary policies and fiscal policies, and can run current account surpluses (meaning
that they export more than they import) through any downturn.
In the downturn, peripheral countries saw a sudden stop of foreign capital coming in
and couldn’t resort to devaluation due to the common currency, this depressed domestic
demand during the crisis within those countries and increased the hardship of their citizens.
But getting back to Brazil and Argentina.
A currency union can also make a certain amount of sense between economies that are each other’s
primary trading partners.
Despite their geographic proximity, Brazil and Argentina don’t trade that much with
each other.
Argentina buys only 4.2 percent of Brazil’s exports, and Brazil buys only around 15% of
Argentina’s exports.
The benefits that would come from eliminating currency conversion costs would be minimal
in such a situation.
A big issue for a union like this is that unless labor and capital can move freely between
the countries in a currency union and unless it is set up such that there are large fiscal
transfers from wealthier to poorer regions, very different economies like the Brazil and
Argentina could only share a currency if the less economically active country was willing
to accept brutally difficult adjustments.
We saw this in Europe, where the economies have much more in common than Brazil and Argentina
do.
Whenever there is regional concentration of economic activity, stresses will occur.
Essentially, the more integration you have between economies that share a currency, the
better currency union can work.
The closer you are to acting like one country, where labor and capital can move freely the
better it can be expected to go.
In South America, the free movement of labor faces significant obstacles due to anti immigration
policies and visa restrictions within the different countries.
In a situation like that, adjustments that would normally occur through changes in the
value of the currency would instead occur through surges in unemployment and downward
pressure on wages.
I mentioned earlier that the Hong Kong Dollar is pegged to the US Dollar, which might be
surprising as there are no real links between the two economies (no fiscal transfers or
free movement of labor and capital), but this seems to work just because the two economic
cycles are quite similar.
Even that is under strain right now, as Hong Kong interest rates are higher than they might
naturally be right now because US rates are high.
This demonstrates how an economy has to be willing to endure a certain amount of pain
if they are going to tie their economy to another country’s business cycle, where
there are no fiscal or any other linkages.
So, as you can see, a plan like this currency union faces a lot of problems, and we’ve
barely touched on the issue of the terrible state of Argentina’s economy.
Someone joked on Twitter earlier this week that it would be just like Europe, but everyone’s
Greece.
Argentina and Brazil are in very different economic situations right now.
Argentina has been cut off from international debt markets since its default in 2020 and
has tight foreign exchange controls in place.
Brazil on the other hand has inflation under control.
The Brazilian Real is fully convertible, and Brazil’s better grip on government spending
means that Brazil while highly indebted has full access to international markets.
Annual inflation in Argentina as I mentioned earlier is close to 100%, compared to Brazil’s
5.79 percent, meaning that Argentina has more inflation in a single month than Brazil has
in an entire year.
The Argentinian economy would need to stabilize before any currency union could ever occur.
It is not obvious how Brazil would benefit from such a union.
I discussed the situation with a friend this morning who is an Emerging Markets expert
and he joked that the only real path towards a currency union right now would be for Brazil
to become a basket case economy, and then the two countries could struggle out of their
problems together.
Otherwise, he saw no chance of this happening in the near future.
For now, I would argue that this talk of a Latin American currency union is mostly political
signaling driven by a general desire to reduce reliance on the United States.
If you enjoyed this video, you should watch this one next.
Don’t forget to check out our sponsor The Daily Upside, by clicking on the link in the
video description, it’s a great newsletter that I can firmly recommend.
Talk to you again soon, bye.