Venezuela has suffered catastrophic economic decline and hyperinflation in recent years. A first step in restoring order would be to stabilize prices by linking the currency to the dollar.

Dollar linkage constrains governments from printing money, but it isn’t a free lunch because it reduces policy flexibility. The regime can be hard to maintain and costly to abandon.  There are lots of examples of broken pegs in emerging markets. But Venezuela’s currency has weak credibility, and dollars are already used in the economy.

“You dollarize because you don’t have the credibility to stabilize,’’ said Alessandro Rebucci, the head of research at the Andersen Institute who has worked on emerging economy policies at both the IMF and the Inter-American Development Bank.

Here is a look at three ways economies can link to the dollar and what might work in the Venezuelan context.

Pegging

Pegs can take various forms. Nations can fix to a specific currency like the dollar at a specified exchange rate; or they can fix the exchange rate’s value against a basket of currencies as in the case of China. There are also managed floats within tight bands. The national currency remains the medium of exchange, but both monetary and fiscal authorities must be disciplined. Several countries around the world use dollar-linked currencies with varying degrees of success, such as Qatar and Bahrain. High domestic real rates may have to be used at times to defend the pegs, which can crimp the domestic economy.

Pegs may not work in economies with recent hyperinflation. The chance to exchange local currency for dollars at a stable rate may simply trigger widespread migration to the dollar, exhausting reserves and testing the peg’s credibility. A managed peg seems like a weak option for Venezuela if only because the population already prefers dollars for many transactions.

Currency Board

A currency board is a peg that is hard to break because the central bank holds enough foreign reserves to cover (and typically exceed) the total potential demand to convert the monetary base into the reference currency at the fixed rate. Banks and grocery stores continue to accept local currency, and contracts are typically written in domestic currency.

This is the most rigorous form of dollar pegging short of unilateral adoption of a foreign currency as legal tender. The central bank is fully constrained. Local currency is issued by the central bank only insofar as foreign currency flows into the country. The currency board automatically shrinks the monetary base if dollars leave the country. The local currency is preserved, leaving some very limited room for policy to accommodate big shocks. Hong Kong has successfully operated with a currency board since 1983.

Full Dollarization

This is where a country eliminates its local currency by law and makes the dollar the legal unit of account for which all contracts are written and settled. Ecuador and Panama are dollarized.

The case of Ecuador is interesting. The country dollarized in 2000 amid an economic and political crisis that saw rapid currency depreciation. Only two years after dollarization, the country was working on a fiscal responsibility law to help protect it. Bank deposits grew 65% in a year, said Francisco Zalles, an adviser to the finance ministry at the time, and mortgage lending revived.

Dollarization would be the “fastest most efficient solution’’ to Venezuela’s “macroeconomic disequilibrium,’’ he said. “It provides the most efficient way to import institutionality into an economy that has been ravaged by politically extractive institutions.’’ The credibility of linking to the dollar typically rises as you move from a conventional peg to a currency board and then to full dollarization. The harder the linkage is to reverse, the more investors believe that it will be maintained, which can lower currency risk and support a more stable, investment-friendly environment. But that same “hardness” increases the required discipline—especially on fiscal policy, financial supervision, and wage and price flexibility.

Bottom Line

Hard-currency linked exchange rate regimes can stabilize inflation, but to different degrees all have built-in risks especially when it comes to adjusting to imbalances and shocks.

In the case of external account imbalances, such as a trade deficit, the exchange rate can’t depreciate to lower the cost of exports in international markets, for example. There are limited choices to deal with this imbalance when the exchange rate is fixed, and all are hard, such as lowering wages, taxing imports, or improving productivity over time with significant investment in education and the capital stock. These choices have both political and economic costs.

“It isn’t obvious that the cumulative cost of being locked to the dollar isn’t higher than doing fiscal reform and setting up an independent central bank with a flexible exchange rate,’’ Rebucci said.

Venezuela may be a different case, however.

Given the widespread use of the dollar already, formal adoption could serve as a credible signal of a break from past policies for people who have suffered from hyperinflation.

“Venezuelans have already chosen what currency they want,’’ said Zalles.