Dollarization

Tyler Maroney

  • Backgrounder

Brief History

Dollarization is the process by which a country abandons its own currency and adopts the currency of a more stable country as its legal tender. Though the concept was coined in reference to the US dollar, the conversion to any foreign, stable currency—the European euro, the Japanese yen, the German mark, for example—is usually known as dollarization. There are two types of dollarization: full and unofficial.

Full Dollarization

This occurs when a government makes the official decision to use a foreign currency for all transactions including government and private debt—both public and private bank accounts are converted to dollars. The outgoing domestic currency is normally honored until it is drained out of circulation. In full dollarization, businesses pay their employees in dollars, and consumer transactions “on the street” are conducted in dollars. In making this conversion, countries must set the rate at which old debts, contracts, and financial assets will be converted to the new currency.

Unofficial Dollarization

Sometimes known as “currency substitution,” unofficial dollarization is much more common. Most emerging-market countries are unofficially dollarized, some more drastically than others. Unofficial dollarization happens when the value of the local currency becomes too volatile and so the more dependable dollar is then used to make purchases, for personal savings and when borrowing money.

In many countries, such as Cuba, Peru and even Vietnam, as well as a number of countries of the former Soviet Union, for example, tourists often pay for taxi cabs and Coca-Colas in dollars, which coexist with the local currencies. Similarly, before the Argentine peso was devalued in January, 2001, most major transactions such as car loans and mortgages were conducted in dollars. At the height of the country’s financial crisis at the turn of the century, dollarization in Argentina was seriously discussed as an option to solve the problem.

Why Dollarize?

The decision to dollarize is made, in part, because a country is suffering from uncontrollably high inflation and devaluation which threaten the country’s economic health. Those willing to hold the local currency start demanding higher rates to protect themselves from the erosion of its value. The central bank validates higher rates as a means to defend the currency from falling too sharply. In such a desperate environment, many businesses borrow in dollars to get lower rates. When people lose faith in the local currency and buy dollars, this leads to further devaluation. Despite higher interest rates, households are less likely to save in the local currency and many businesses export their capital out of the country.

Dollarization, it must be stressed, as a system of currency exchange, does not guarantee stability and economic growth in and of itself. When a country makes the decision to dollarize, it adopts the monetary policy of the United States central bank, the Federal Reserve Board, therefore freeing itself from the cycle of devaluation and inflation.

Although dollarization did not become fashionable until the last decade, it is not a new exchange rate system. Panama has been dollarized for almost a century. Economists have long debated the merits of dollarization which some years ago attracted more attention because of the official dollarization of Ecuador and El Salvador.

Conditions for Successful Dollarization

For dollarization to succeed, a number of prerequisites are necessary. First, the dollarizing country, which has opted to exchange all local currencies into dollars, must have sufficient external reserves: a holding of the non local currency. Otherwise, there may be a shortage of dollars. If there isn’t enough hard currency to cover all the reserves, the government may have to accept a weaker exchange rate.

Second, the country must have a strong banking sector. Weak banking sectors are susceptible to collapse. The severe economic impact of a collapsing banking sector can be staved off, usually, by providing it with emergency liquidity. A dollarized economy, by definition, cannot do this. In other words, the central bank loses the ability to actively prevent banking failures because it forfeits control to the central bank of the adopted currency's government.

Finally, it is best to have a low fiscal deficit. In a dollarized economy, a government often does not have the luxury of running a large deficit, of spending much more than it makes. This is because large deficits, in a dollarized economy, can no longer be financed, or brought under control, by printing money.

COUNTRIES THAT HAVE DOLLARIZED

Panama

The first country to fully dollarize was Panama. Since 1904, when the country separated from Colombia, Panama’s economy has run on the greenback. This has had many positive effects on the economic health of the country. For example, in the 1990s, inflation barely exceeded one percent per year. And yet, reliance on the dollar has not alleviated Panama’s dependence on outside help. Since 1973, Panama has had more than fifteen International Monetary Fund programs, and dollarization did not prevent Panama from defaulting on its foreign debt in the mid-1980s.

Ecuador

Ecuador made the conversion in early 2000. The country dollarized as a last resort, as an attempt to dig itself out of a devastating economic crisis: a collapsing banking system, sliding local currency (the sucre) and outcries from the indigenous population. When the then President Jamil Mahuad announced in January 2000 his intention to seek dollarization, the process was already in the works, as the country was already heavily dollarized. His announcement, however, led to a coup d’etat and he was forced to resign. Civilian rule was reestablished and in February, the Ecuadoran congress passed legislation allowing for full dollarization.

Before adopting the dollar, Ecuador had unsuccessfully tried a variety of currency exchange schemes including fixed exchange rate systems and crawling pegs. The world economic crisis that began spreading from banking problems in the rich world in 2008 has complicated all judgments, so it is difficult to say whether dollarization has been helpful for the Ecuadorean economy. However, even populist President Rafael Correa, who won three successive terms, has continued with the policy, though the country announced a default on its foreign debt at the end of 2008.

El Salvador

In late November of 2000, El Salvador’s legislature passed a law mandating the full dollarization of the country. On New Year’s Day, 2001, automated teller machines were programmed to dispense dollars and bank accounts were converted. The move was made not as much out of economic desperation – as was the case in Ecuador. In fact, the Salvadoran inflation rate was low, about 1.3 percent, for the previous decade. Rather, it was to make El Salvador more attractive to international investors.

Salvadorans were not as stunned when their country dollarized as were Ecuadorans because the colon, El Salvador’s former currency, had already been fixed to the dollar for eight years. Again, it is still too early to weigh the benefits of dollarization. But there were some early promising signs: the day after El Salvador adopted the new currency, the interest rate on consumer loans and mortgages fell from 17 to 11 percent. However, the economy has remained vulnerable to interest rate rises in the United States, especially as inflation began rising in the middle of the first decade of the century. And the country’s growth rate has remained sluggish throughout the dollar regime, averaging less than 3 per cent a year. The sharp rise in the US currency caused by the growing economic crisis of 2008/09 has also made El Salvador’s exports more expensive relative to its competitors. While eight or nine years might seem a long time, it is still too soon to say how sustainable the policy will prove, especially as the world economy convulses.

Other Cases

A few years ago, the United Nations announced that the dollar would become the official currency of East Timor, which had just gained its independence from Indonesia. In December 2000, Guatemala passed a law allowing the free circulation of dollars, although it stopped short of full dollarization. And a whole host of other countries have considered dollarizing— Costa Rica, Honduras and Nicaragua, to name a few. Some have proposed that Afghanistan dollarize as well, but only as a temporary measure until a more stable political regime assumes control of the government. While many countries are run primarily on the dollar, no country has ever reversed a policy of full dollarization, and it is generally considered a permanent move.

The Benefits

Probably the biggest advantage to dollarization is the economic stability that comes with it. High inflation is brought almost immediately under control. The US dollar has been the most trusted currency in the world and any country that adopts it also adopts the monetary policy of the Federal Reserve Board. Dollarizing, therefore, eliminates the risk of sharp devaluations reducing, in turn, local interest rates. Furthermore, it attracts foreign investors, who know that the monetary value of their assets is safe, all of which leads to growth and further investment. Psychologically, dollarization reduces economic anxiety. However, again, the world economic crisis could change all that.

The Costs

Although dollarization can make a country more stable, it becomes vulnerable to changes in the value of the dollar even though those fluctuations are the result of US domestic economic conditions. When and if the dollar fluctuates against international currencies, which it often does, sometimes wildly, there is no way to respond to such a crisis. This is because any dollarized country forfeits control of its centralized, independent monetary policy to the central bank of the country whose currency has been adopted. What is more, the Federal Reserve Board acts with the interests of the United States in mind, without particular concern for the international fallout on dollarized economies. This has been particularly evident in US policy-makers’ responses to the financial crisis of 2008.

For the same reason, it is impossible to respond to economic shocks, such as the volatile price of oil on the international market, by tweaking exchange rates. Dollarization leads to the loss of the exchange rate as a policy instrument. External shocks—of which a fluctuating dollar is but one—are no longer absorbed by the local currency but now get transmitted through the real economy.

In addition to losing the ability to print money, which is a huge fiscal advantage, a dollarized country loses seignorage benefits. Seignorage, essentially, is revenue earned from issuing currency. This is a profitable business because the costs of printing and circulating bills (essentially worthless pieces of paper) are much lower than the value of the goods that paper will buy. The US government makes about $25 billion a year in net seignorage and when residents of another country hold dollars, they are creating income for the Treasury department. There has been talk of sharing seignorage benefits with a dollarized country but to date, the US has never allowed that to happen.

Further disadvantages of dollarization include the fear of counterfeiting (fake bills are hard enough to identify in the US). In addition to producing cocaine, Colombia is notorious for its dollar “factories.” There is also the political risk. When El Salvador dollarized, opposition politicians blasted the government for selling out to economic imperialism. It can also be difficult to persuade indigenous populations to use money that is not recognizable to them. One of Argentina’s biggest obstacles to dollarizing was cultural: dollarizing would have been akin to succumbing to a kind of colonialism and surrendering a symbol of pride.

But one of the biggest downsides to dollarization is that while it may help stabilize hyperinflation, it plays no role in financial and political reform. In other words, many economists argue, it has almost no affect on social woes such as tax evasion, poor living standards, unemployment, and corruption. Those who disagree with this say that an economically stable environment is much more conducive to reform than one that is not. Dollarization, therefore, is a necessary but not necessarily sufficient economic strategy.

Conclusion

In the final analysis, it is important to stress that dollarization is no panacea. As many students of dollarization have pointed out, it is difficult to weigh the true costs and benefits for one simple reason: lack of precedent. There is virtually no historical record with which to contrast and compare the results of an adopted currency. Most analysis is theoretical. Only a handful of countries have fully dollarized and each one was different in size and made the conversion for different reasons and under different circumstances. Panama is the only country with a long history of dollarization and it has a very close political and economic relationship to the United States.

Many economists believe that dollarization will succeed best in small, open, flexible economies that have strong trading relationships with the US. El Salvador is one such guinea pig. As we have noted, however, it will take years to measure its success.

What is more, dollarization is permanent. After a country officially adopts the dollar, trying to revert back to a local currency undermines any decision and threatens to sow more confusion. Until more countries have lived under the dollar for at least a few decades, it will be difficult to assess the effectiveness of full dollarization.

WHAT TO WATCH FOR

The level of “unofficial” dollarization

Understanding this will help reporters figure out the potential difficulty a country would have in making the transition to a more stable currency. And El Salvador, as noted, had already pegged its currency to the dollar, making the transition smoother.

The severity of inflation

In the early 1980’s Argentina suffered from hyperinflation that reached 5,000 percent annually, which, at the time, was the highest rate in the world. When Ecuador made the decision to dollarize, inflation was completely out of control.

The Rate of Dollarization

The decision about the rate of a country’s dollarization (one-to-one, say, or two-to-one) is a political one. A minister of finance or a president, for example makes a decision that, for many, can quickly change their lives. The rate of dollarization can, for example, double the rent of those living in a newly dollarized country. If you dollarize at too cheap a level, you risk inflation because the currency is weak. Learning the rate of dollarization is a helpful way of studying some of the political and social fallout.

How closely linked the local currency is to the dollar

El Salvador and, until 2002, Argentina had pegged their currencies to the dollar. This makes for an easier transition to full dollarization because it eliminates the potential for widespread confusion over new exchange rates and identifying new money. Look to see if a currency board or some kind of peg exists and how long that system has been in use.

Reserves of dollars in the central bank and the private financial system

Research how many dollars both local banks and the central bank hold. And find out and how much money is sent home from people living in the US. Very often, this income equals a substantial percentage of the gross domestic product.

Publication Information

Type Backgrounder
Program Journalism Backgrounders
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