Dollarization

Dollarization is a monetary regime where a country adopts a foreign currency, usually the US dollar, as a means of payment for its residents' transactions, instead of its own domestic currency. Dollarization can be full or partial and, in most cases, it is imple- mented as a preferred choice for countries looking for monetary stability and protection from exchange rate volatility. Most countries that have dollarized their economy have done so during periods of economic instability. They also tend to have major economic links with the US economy whether through tourism, trade or as the recipient of significant US aid.

Full dollarization arises when a country completely abandons its own currency and adopts a foreign currency (very often the US dollar) in all its residents' financial transac- tions and dischargement of debt. All assets and liabilities are thereby denominated in that foreign currency; the national central bank stops issuing local currency. Ecuador is a noteworthy example, as it officially dollarized its economy in January 2000; El Salvador followed in 2001, while Panama dollarized in 1904.

Partial dollarization, also known as de facto dollarization or semi-official dollarization, occurs when a country allows a foreign currency (the US dollar) to circulate alongside its local currency and be used as a means of payment (see Calvo, 1996). This practice can be formal and regulated, or informal without official and legal framework. Partial dollariza- tion is fairly widespread as several countries today have many of their assets and liabili- ties denominated in US dollars. Countries that are partially dollarized are the Bahamas, Cambodia, Haiti, Laos, and Liberia, among others.

Full dollarization is said to carry significant economic advantages, although there can be some important disadvantages as well. With respect to defacto dollarization, Eichengreen and Hausmann (1999) argue that the inability of a country to issue debt in its local cur- rency leads to further weakening of the domestic financial market. The authors call this situation an "original sin", as the de facto dollarized economies are often financing local investment with US dollars only for those projects that generate revenue denominated in local currency. The solution, for these authors, would be to fully dollarize.

However, three further problems exist with dollarization: the loss of seignioriage revenue, the loss of control over monetary policy and interest rates, and the loss of the central bank's role as lender of last resort for dollarized countries. Hence, dollarized countries lose most of their economic policy tools that are critically needed during a crisis. A dollarized country would be in even greater hardship if the US economy were performing poorly and were the source of the crisis.

Dollarization poses obvious challenges for central banks in conducting monetary policy. If the central bank does not issue its own currency, it loses sovereignty over mon- etary policy, and hence cannot set interest rates. In the absence of the ability to operate in their interbank markets, dollarized countries therefore must depend on interest rates set by the US Federal Reserve System. In tandem with this, central banks also lose their role as lender of last resort, and policy makers can no longer intervene in order to stabilize their banking system or conduct expansionary fiscal policy. A dollarized country can only spend what it earns or what it borrows on international markets at current interest rates. Deficit spending is not possible.

Another disadvantage associated with dollarization is the issue of national pride and the loss of a currency that usually carries a national symbol.

However, full dollarization presents some advantages, it is argued. The elimina- tion of a currency necessarily implies the elimination of exchange-rate devaluation or volatility, and therefore of exchange-rate risk. This should increase foreign confidence and boost foreign direct investment. Further, some economists argue that dollarization reduces transaction costs related to trade between countries using the same currency. For instance, according to Rose (2000), dollarization leads to significant increases in trade and greater economic integration between the dollarized economy and the United States.

Berg and Borensztein (2000) also cite among the benefits of dollarization lower inflation and interest rates. As such, the principal attraction for countries to dollarize would seem to be the expectation that the elimination of exchange rate risk will lead to greater stability in international capital flows, trade and therefore economic growth (Grubel, 1999).

Finally, dollarization is not the same as currency union, as under the latter all countries abandon their currency in order to adopt a newly-created currency. An example of this is the euro. In a dollarized regime, the United States does not abandon its currency, but retains full control over the conduct of its monetary policy, and bears no responsibility for setting interest rates according to economic conditions in dollarized countries. Also, the United States is under no obligation to offer a seat at the US Federal Open Market Committee to representatives of dollarized countries (Rochon and Seccareccia, 2003).

To date, full dollarization remains limited to few small economies, and its effects have been mitigated. Edwards and Magendzo (2006) empirically studied a number of countries that proceeded with currency substitution in general and dollarization espe- cially, and found a combination of two outcomes. Even though the rate of inflation was indeed lowered, other macroeconomic variables like growth of per-capita gross domestic product and employment levels were not decisively affected by the adoption of a stronger foreign currency.

See also:

Dollar hegemony; Federal Open Market Committee; Federal Reserve System; Interest rates setting; Lender of last resort; Original sin.