Written by E. C. Arroyo
Dollarization is when “a country adopts as legal tender another country’s currency [and] the adopted currency takes over all the functions of domestic currency: a unit of account, medium of exchange, and store of value” (Quispe-Agnoli and Whisler, 55). According to Hira and Dean, there exist two forms of dollarization. “De facto dollarisation is spontaneous adoption of the dollar (or any foreign currency) by the general public without supporting government legislation, a process which has been well underway in Latin America for many years . . . De jure dollarisation, by contrast, entails government legitimization, which may range from simply declaring the dollar to be legal tender, to withdrawing all domestic currency, to abolishing all other legal tender” (Hira and Dean, 462).
In 1904, Panama was the first Latin American country to implement official dollarization, however, more recently, Latin American policymakers have employed official dollarization as a policy tool to defuse exchange rate crisis, or as part of a larger policy package designed to compliment structural adjustment and other reforms. In Ecuador during 1999 and 2000, President Jamil Mahuad and his successor Gustavo Noboa implemented official dollarization to combat a severe bout of hyperinflation, which saw the Sucre drop 25,000 to 1 vs. the U.S. dollar. Shortly after during 2001, El Salvador’s President, Francisco Flores, replaced the Colon with the U.S. dollar to compliment a series of policy packages recommended by the International Monetary Fund. “While we normally think of monetary reform in terms of central bank engineered or supply-side reform, [unofficial] dollarization is a reform occurring from demand-side initiative. The failure of [Latin American] central [banks] to provide a high-confidence domestic money leads money demanders to substitute away from the domestic currency toward a more stable valued dollar” (Melvin, 551). Needless to say, the U.S. dollar has long been a medium of exchange throughout Latin American countries, but as can be expected, the prevalence of unofficial dollarization is unknown, because it is often difficult for monetary authorities to discern the amount of foreign currency in circulation. Depending on the extent of unofficial dollarization that occurs within an economy, it may make monetary sense for Latin American governments to implement de jure dollarization, rather than function under a system of de facto dollarization. In order to provide some guidance to Finance Ministers, Central Bank officials, and those within government possessing leadership roles, this selection will address the steps needed to implement dollarization, the macroeconomic effects and the cost and benefits of dollarization, and the circumstances under which currency substitution is a viable policy alternative. As to be anticipated, with any drastic changes in monetary policy, there will always be winners and losers, however, by outlining the experiences of countries that have dollarized, such as Panama, Ecuador, and El Salvador, it is expected that governments will make more informed policy decisions. This is with the hope that transition towards using a new currency will be more stable and free from economic shocks, thus minimizing the socioeconomic impact of currency substitution. Despite that dollarization is useful in bringing macroeconomic stability to some countries, it is important for governments to consider those groups at the margins of society, who argue that they have yet to reap the benefits of using a foreign currency. While dollarization is supported by some who are active participants in the formal economy and who are well connected to international financial and trade circles, there are those who stand to lose. Recognition of this problem is the first step governments can take to formulate policy initiatives to counter any widespread social discontent owing to dollarization. Consequently, this selection will also address specific actions that can be taken by governments to neutralize the negative effects of dollarization.
The Denomination Displacement Method: Approximations of Unofficial Dollarization
“The dollarization of Latin America has received only slight attention as a significant economic phenomenon. This lack of attention is probably due to the unavailability of data on dollar assets used in financing Latin American transactions” (Melvin, 544). For government officials, the inability to measure dollars in circulation is an impediment to pursuing official dollarization. Thus, being in charge of a Central Bank in a Latin American country, the first step necessary to implement dollarization is to research how much foreign currency is already in circulation. If there is a lack of information on the current amount of dollars in circulation, the Central Bank will be unaware of the correct number of dollars needed to replace the domestic money supply. Although unlikely, this could prompt a situation by where the Central Bank ends up releasing more dollars than necessary into the economy, prompting an inflationary crisis. In addition, the Central Bank can inadvertently purchase more dollars than it needs from the U.S. government and increase its dollar-denominated liabilities. According to Feige, Faulend, Sonje, and Sosic, the IMF looks at the “. . .foreign currency deposits held with domestic banks,” to determine the extent of unofficial dollarization, but unfortunately, there is still a lack of information regarding “foreign currency (cash) in circulation outside the banking system (FCC)” (Feige, Faulend, Sonje, and Sosic, 220). Some estimates put the number of dollars in circulation outside the U.S. to be 40% to 60% of the entire U.S. currency supply, however, to acquire more exact data, foreign governments can check with the U.S. Customs Service to obtain the sum of U.S. dollars that have crossed into their border (Feige, Faulend, Sonje, and Sosic, 224). As mandated by the Bank Secrecy Act, “persons or institutions importing or exporting currency. . .” in excess of $10,000 U.S. dollars are required since 1980 to file a Report of International Transportation of Currency or Monetary Instruments (Feige, Faulend, Sonje, Sosic, 224). “The largest component of cross-border currency flows is wholesale bulk shipments of U.S. currency by large financial institutions that specialize in the international transport of currency” (Feige, Faulend, Sonje, and Sosic, 225). Additional ways by which U.S. dollars reach foreign nations is via multinational firms, individual tourists carrying less than $ 10,000 U.S. dollars, and illegal transfers stemming from money laundering and drug-related activities (Feige, Faulend, Sonje, and Sosic, 225).
Although studying the data collected by the U.S. Customs Service is one way to obtain an approximation of the number of U.S. dollars in circulation, there are other means by which U.S. dollars can enter a country that cannot be accounted for by reviewing Customs reports. For instance, if there was a dollar outflow from the U.S. to Mexico and then a dollar outflow from Mexico to El Salvador, there is no way to determine the number of dollars in El Salvador by simply looking at Customs reports. The U.S. Customs Service may perhaps underreport the extent of unofficial dollarization in El Salvador, due to imperfect information regarding the inflow of U.S. dollars to El Salvador through a third country. For this reason Feige, Faulend, Sonje, and Sosic have proposed denomination displacement as a method by which policymakers considering dollarization can determine the number of dollars already in circulation. The denomination displacement method is based on the hypothesis that as the extent of unofficial dollarization increases within a country, people will tend to use higher denomination foreign currency bills for their larger transactions (Feige, Faulend, Sonje, and Sosic, 230). This is particularly the case in a country where prices are increasing as well. Specifically, “. . . countries that are heavily (unofficially) dollarized with large-denomination foreign bills will have domestic currency (LCC) [local currency in circulation outside the banking system] denomination structures that are unusually skewed away from higher denomination domestic bills” (Feige, Faulend, Sonje, and Sosic, 230). “Denomination displacement occurs as higher denomination [foreign] bills substitute for the high-denomination [domestic] bills” (Feige, Faulend, Sonje, and Sosic, 230). By looking at the shifts in the denomination structure of those countries for which there is accurate information regarding the number of dollars (Argentina) and comparing them to those countries where there is insufficient data, it is possible to determine the number of dollars in circulation. The use of economists and finance specialist well versed in monetary policy is recommended throughout this process, because solving of mathematical equations and complex use of regression analysis is required. “. . . It is possible to obtain an estimate of the unknown amount of foreign currency in circulation in by substituting the known values of the independent variables [for a particular country] and solving the equation for the unknown quantity of FCC [(foreign currency in circulation)]” (Feige, Faulend, Sonje, and Sosic, 236). The known values in this case would be the domestic currency in circulation and the amount of domestic currency deposited in local banks (Feige, Faulend, Sonje, and Sosic, 220).
Dollarization: A Catalyst for Deeper Economic Reforms?
Now that the initial phases of the dollarization process have been dealt with, officials must be forced to think about why they are carrying out dollarization. If they expect dollarization to be a panacea for their economy, they are mistaken; however, if they deem currency substitution to be only one element of an integral program of numerous structural reforms, then it may help the economy in the long-term. Hira and Dean suggest, “because of the political difficulties of developing second generation reforms, dollarisation is being sold politically in Latin America as a substitute for tough reforms (Hira and Dean, 478). As in the case of Ecuador, monetary officials saw dollarization as a means by which to give “shock therapy” and accelerate transformations in other sectors of the economy; however, currency substitution is no replacement for making politically unpopular decisions. Dollarization must be an adjunct to deeper reforms, such as improving labor flexibility, reducing government spending, balancing the budget, and cutting populist social programs.
In the dispute that occurred in the European Union between the monetarists and the economists at the start of eurorization, the debate concerning the outlook for economic reforms under a currency substitution arrangement is illustrated (Eichengreen, 2). “The “economists,” German officials for present purposes, argued that economic policies and performance had to converge and institutions had to be harmonized before Europe could proceed to monetary union” (Eichengreen, 2). The “monetarists” (French officials), on the other hand, argued that eurorization itself would bring about convergence between newly eurorized and previously eurorized countries (Eichengreen, 2). Convergence entailed the lowering of inflation rates, capital mobility, elimination of the fiscal deficit, and in general, harmonization of economic policies with the wider EU. In the end, the “economists” won out and it was required that before countries joined the EU, they follow a strict set of macroeconomic restructuring programs to bring their economic houses in order. It is essential to bring focus to the eurorization debate because Latin American officials need to be aware that official dollarization requires economic policies to synchronize and converge with those in the United States. If stark macroeconomic disparities between the U.S. and the dollarized country are existent, the decisions made at the Federal Reserve will not be effective in jumpstarting or cooling the economy of the dollarizer. “Monetary policy is optimally used differently where unemployment and business conditions fluctuate differently. The interest rate cuts needed to moderate increases in unemployment and the interest rate increases needed to counter increases in inflation will occur at different times in countries across which conditions differ” (Eichengreen, 16). Therefore, it is imperative that politicians make reforms accordingly to tie their economy to that of the country whose currency they are using.
Barry Eichengreen, who looked at whether dollarization alone would accelerate the pace of labor market reform, fiscal reform, and financial sector reform, found that dollarization alone is not enough. In the case of Argentina, “observers of Argentine convertibility will be skeptical that a hard exchange rate constraint guarantees labor market reform [because] bargaining in Argentina remains centralized, encouraging wage compression and limiting flexibility. . .” (Eichengreen, 5). Unemployment remains high in Ecuador, El Salvador, and Argentina, hence, this is “hardly evidence of adequate labor market flexibility” (Eichengreen, 5). Granted, Argentina has yet to officially dollarize, however, it has maintained a hard peg of 1:1 to the U.S. dollar since the early 1990’s. In regards to fiscal discipline, those in favor of early dollarization argue that limiting the ability of the government to print money to finance budget deficits will prevent overspending. As has occurred in the past in Latin America, “if an irresponsible central bank is given freedom to issue pesos without worrying about the consequences for the exchange rate, it will simply print pesos to its heart’s content to fund a large budget deficit or to provide cheap credits to the banking system” (Sachs and Larrain, 81). Dollarization will surely prevent this type of self-destructive behavior. Yet, one could argue that the increased availability of commercial credit lines from private banks after official dollarization will encourage governments to get into debt instead of printing money to finance their spending. Essentially, they will have debt-led economic growth and will be swapping one destructive economic policy for another. The point is then made that if government’s in Latin America simply attempt to use dollarization as a temporary patch to boost their economy, their intentions will quickly become evident throughout the international economic community. International investors will quickly lose confidence, and the country’s credit rating will drop, making it difficult to acquire capital in international financial markets. Policymakers must be wholly committed to solving the deeper structural issues facing their economy, if they have the desire to make constructive reforms under a dollarized regime.
Macro and Microeconomic Effects of Dollarization
Once a Latin American government has decided to dollarize and has in essence tossed the key to the central bank, what can the country expect in terms of macroeconomic effects of dollarization? (Eichengreen, 3). “The main benefit [of dollarization] is increased efficiency in transactions between countries and thus, increased trade. . . A second benefit to a country that gives up full control over its currency is an increase in the stability and credibility of its macroeconomic policy” (Jameson, 6). One significant effect of dollarization is that interest rates in the foreign country will tend to converge with U.S. interest rates. This can help the country in several ways, one being that interest paid on debts held with the IMF or foreign sector banks will dramatically decrease, freeing up government revenues (Eichengreen, 2). Clearly, international financial institutions will charge higher interest if they are loaning in a currency not renowned for stability. “Banks and firms seeking funding abroad find themselves unable to borrow in the domestic currency. Since this leaves them saddled with mismatched dollar liabilities and domestic-currency-denomination assets, they get smashed whenever the currency depreciates” (Eichengreen, 8). However, loaning money to a country that is officially dollarized puts downward pressure on interest rates because loans are made in a stable currency. Specifically, “dollarization will enable the government to lengthen the term structure of its debt by removing the currency risk that causes investors to prefer short maturities. [Furthermore, dollarization will increase] the government’s access to commercial credit lines, arming it with the resources to provide at least limited lender-of-last-resort services” (Eichengreen, 2). Additional revenues available, as a result of not having to pay high debt servicing costs can be spent on infrastructure projects or education. An alternative option is to place funds in an interest bearing account to be used at a future date.
As mentioned previously, bilateral trade between the dollarized country and the United States will increase exponentially, once currency risk is removed from the equation. “. . . Dollarisation eliminates the transactions costs of exchanging one currency for another and [it] allows a country to make maximum use of the de facto dollars that are already part of the economy” (Hira and Dean, 463). Making use of the de facto dollars in circulation provides for greater transparency and can assist law enforcement agencies in combating money laundering and drug smuggling activities. Eradication of transaction costs enhances trade because firms save on the cost of currency insurance and they avoid having to engage in hedging, such as currency swapping and trading in forward markets. Foreign investors will not be as hesitant to invest their capital to purchase assets denominated in dollars, because the threat of massive currency devaluation is minimized. Above all, the capital account will flourish because of an increase in both portfolio investment and foreign direct investment. Domestic companies also have greater access to capital after dollarization, because they are able to list on international stock exchanges in New York, London, and Tokyo, to attract a diverse array of international investors. The ability of domestic companies to access long-term capital in international markets provides an incentive to undertake larger projects, thus contributing to economic growth and job creation for the entire economy. Firms eventually will move up on the experience curve and develop economies of scale, opening up the possibility of becoming internationally competitive. “. . . Dollarization, by downsizing the safety net, will force managers to reinforce their own precautionary measures and intensify their peer monitoring, or go out of business” (Eichengreen, 9).
At the microeconomic level, the opportunity for consumers to access affordable consumer credit becomes a reality. It has been confirmed repeatedly that giving consumers in developing countries access to credit is the surest way to improve the standard of living of the poorest sectors of the population. The Grameen Bank in Bangladesh and its micro-credit program that has a 99% repayment rate, is just one example of the difference credit can make in the lives of those working in the informal sector. In regards to creating more responsive government institutions, the best prescription to constrain irresponsible Central Banks and spendthrift government agencies is dollarization, because printing money is not available as a means to finance deficit spending. “No longer can [the] government influence the exchange rate, and limits are imposed on expansionary economic policy” (Jameson, 6). Historically, overspending has been a huge problem in Latin America because the government chooses to live beyond its means. Yet, under a dollarized regime, inflation is automatically brought into line with the U.S. inflation rate because politicians are cut off from the purse strings of the Central Bank. Dollarization then has the effect of insulating the citizenry from the bad decisions made by their government, and at the same time, political demagogues no longer exploit their spending power before election time to entice masses of voters. Currency substitution also creates greater transparency in the commercial and financial sectors; because banks and firms must conform to international standard practices and be open to scrutiny should shady dealings occur. As international scrutiny increases, risk management practices will be enhanced and banks will better screen their clientele to avoid making bad loans.
The Costs of Losing Monetary Sovereignty
At first glance, the benefits of dollarization would overwhelmingly convince government officials that it is preferable to operating under a fixed or floating exchange rate regime, but nevertheless, there exist many downsides to currency substitution that have yet to be discussed. An area where dollarization can have a negative impact, at least in the short term, is on the balance of trade. Under an arrangement where a country operates with a domestic currency, exports to the United States and other developed nations tend to thrive, since monetary authorities can use currency devaluations to make exports cheaper for consumers in the importing country. Exports are a particularly vital component of Latin American economies, which specialize in the production of raw materials or commodity products, such as cooper, petroleum, shrimp, sugar, coffee, and bananas. Unfortunately, once full dollarization becomes official, exports become more expensive and priced out of the reach of consumers in developed countries. The current account deficit can deteriorate if the U.S. dollar were to appreciate versus other major world currencies, i.e. the Euro, Yen, or British Pound. “Countries that have greater amounts of trade with third-party (non-US) countries stand to suffer from a reduction in export competitiveness should the dollar appreciate against these third-party currencies. Within countries, regions that have higher proportions of third-party trade may suffer recessionary effects” (Hira and Dean, 476). The only way then to make exports from Latin American countries more competitive is to lower production costs. This is what Sach’s describes as a monetary straitjacket. “If a country abandons its national currency in favor of the U.S. dollar, the result is very much like a pegged exchange rate, only with less room to maneuver. First, of course, there is no longer the “shock absorber” of exchange rate depreciation. The only alternative is a cut in wage levels, which is likely to be a long, drawn out affair, with lots of interim unemployment” (Sachs and Larrain, 86).
Another danger to the balance of trade is that if international investors and currency speculators lose confidence in the U.S. dollar as the international reserve currency, the price of imports from Latin America’s third country trading partners, such as the European Union and China, suddenly become quite expensive. As investors sell the dollar short in currency markets, dollar depreciation leads to a loss of purchasing power. Although most bilateral trade within dollarized countries occurs with the U.S., there are still a certain number of inputs for production and extraction of raw materials, which may be required from third countries. If Latin America cannot afford the necessary imports necessary for those industries in which it possesses a comparative advantage, the export sector will suffer leading to a recession or even a depression. On the other hand, one may argue that the risk of a devaluation of the U.S. dollar is too far fetched, and the immediate gains attained from the increased purchasing power of the dollar far outweigh the risk. “The reverse effect, that imported inputs should now be cheaper, could lead to gains in the manufacturing area, even where manufactures are exported. . .” (Hira and Dean, 465). Nonetheless, gains in the manufacturing sector in Latin America may not be as beneficial as presumed because “. . .these sectors tend to be highly limited in most Latin American countries. . .” (Hira and Dean, 465). As mentioned earlier, most Latin American exports are raw materials sent to the developed world, where most of the value is added after being converted into finished products. Only after value-added activities are completed, is it that these products are exported back to Latin America. In this instance, “dollarisation may perpetuate or even exacerbate the current account deficit by spurring increases in imports at a much faster rate than exports” (Hira and Dean, 469).
Previously, the benefits of being able to list a firm on an international stock exchange were discussed; however, the positive aspects of being able to raise equity in international capital markets are accompanied by costs borne by small-scale Latin American companies. If a firm is to list itself in New York, it will tend to forget about local equities markets in Mexico City or Bogotá. “While de-listing may improve access to international capital for the top Latin American companies, it also underscores and may increase the weakness of local equity markets. De-listing thus may weaken access to capital for local companies not able to list on US exchanges” (Hira and Dean, 476).
In terms of monetary costs of dollarization, it is far from being free. Another expense that must be considered is that the dollarizer must purchase the U.S. dollars needed to replace the domestic currency from the U.S. Federal Reserve. Most countries hold diverse types of foreign currency that they place into interest bearing accounts, however, to initialize official dollarization, it is required that reserves be sold off in exchange for U.S. dollars. There is a tremendous cost to bear in terms of interest proceeds lost after selling previously held foreign exchange reserves. “Argentina, for example, would have to spend $15 billion initially to swap its peso currency notes for U.S. dollars. As the economy grows and needs more greenbacks, there would be a continuing price to pay” (Sachs and Larrain, 86). The loss of seigniorage is another negative aspect of dollarization. “When a small country dollarizes, the U.S. collects seigniorage equal to the difference between the amount of dollars that the country holds in the new steady state and the amount it had before the dollarization” (Lamdany and Dorlhiac, 97). Seigniorage is “the ability [of a nation] to increase its resources from minting or printing the domestic currency” (Jameson, 531. In other words, seigniorage is an inflation tax that the government exacts from its citizens by printing currency at the mint. Since it takes some time before the additional money printed at the mint passes through the economy and becomes inflationary, the government can temporarily take advantage of this revenue stream. In Argentina and Bolivia, the total amount of seigniorage collected has been close to 70% of revenue at certain times, while in other countries, it has been close to 20% of total earnings (Melvin, 552). Under a dollarization regime, however, all seigniorage revenues would go directly to the U.S. treasury, unless the United States chose to share seigniorage revenues among dollarized countries. In the words of Lamdany and Dorlhiac, the possibility of collecting seigniorage revenues “creates an incentive for the U.S. to “bribe” the small country into switching currency” (Lamdany and Dorlhiac, 97). However, the possibility that the U.S. would share seigniorage revenues “seems a particularly distant political prospect” according to Sachs and Larrian (Sachs and Larrian, 97). “Since Latin American nations have used the seigniorage from money creation as an important source of government revenue, they have a large stake in controlling [or even preventing] the dollarization process” (Melvin, 552).
Another risk of official dollarization is the loss of ability by the Central Bank to be the lender-of-last-resort to the domestic banking system. Loss of lender-of-last- resort privileges occurs due to the abolition of the entire Central Bank, which could previously print money on-demand in case of an emergency, should the government request it. Regrettably, under an official dollarization regime, citizens will distrust domestic banks because they know there is a lack of liquidity to effectively counter a run on the banking system. The loss of faith in the ability of banks to pay depositors their money under official dollarization underscores the fragility of domestic banks and will hurt their international competitiveness in the long-term. Once the newly dollarized nation liberalizes the financial sector and foreign banks compete directly with domestic banks, the general public, and the business sector, is likely to shun domestic banks in favor of foreign banking conglomerates such as Bank of America, Chase Manhattan, and Citibank. Citizens and businesses will be aware that foreign banks are a safe haven supported by the U.S. Treasury, while domestic banks are buttressed only to the extent that they can access loans on international capital markets.
Needless to say, what typically occurs in a situation when a country asks to borrow money to deter a run on the banking system is that its ability to access liquidity is limited because its international credit rating has already fallen, and “producing adequate collateral [to put creditors at ease] could prove difficult” (Sachs, and Larrain, 87). As is evident from U.S. Senator Connie Mack’s recent proposal titled, International Monetary and Stability Act. “. . .a Latin American dollarizer that experienced a debt crisis would be left by the Fed to stew in its own juices. . .” (Eichengreen, 15). The International Monetary and Stability Act, which is a law, intended to encourage dollarization gives the “U.S. Secretary of the Treasury the discretion to encourage official dollarization by offering to rebate quarterly to any country that dollarizes 85 percent of the resulting increase in U.S. seigniorage revenues. The law makes clear, however, that the United States would have no obligation to serve as lender of last resort to dollarized countries, to consider their economic conditions when setting monetary policy, or to supervise their banks” (Kehoe, 595). Evidently, before policymakers settle on dollarization as the best solution to their nation’s economic woes, it is recommended they consider whether they have sufficient credit available to prop up their domestic financial sector, should a crisis ensue.
Dollarization Case Studies: Panama, Ecuador, and El Salvador
Up until present, we have discussed the steps necessary to implement dollarization and the macroeconomic effects of currency substitution (both positive and negative); however, we have yet to discuss case studies of dollarized countries. For purposes of this selection, we will examine three countries, Panama, Ecuador, and El Salvador, and discuss how they have managed under a dollarized economy.
Dollarization in Panama has produced a vital transformation of the economy, because it has generated a thriving service sector and allowed the country to become fully integrated with international financial markets. Panama, as a tiny Central American country, would under normal circumstances, be ignored by foreign investors, but because of the Panama Canal and the countries strategic importance as a trade route, Panama attracts abundant foreign investment. Panama does not face any of the above-mentioned dilemmas that are normally associated with currency substitution, such as a loss of liquidity or poor export performance. Namely, this is because it has a well-established history of stability and commitment to the norms of the international financial system. In Panama, for instance, the “stability of export prices tends to preempt terms-of-trade shocks: the unified currency removes any exchange risk, transfer risk, or currency mismatch associated with devaluation. No financial or banking crises take place because of financial integration with world-connected banking. Domestic inflation or fiscal crises have not occurred because the government cannot monetize its deficits. Inflation in Panama is systematically lower than in the United States due to the Balassa-Samuelson effect, thereby providing stability to the real exchange rate” (Moreno-Villalaz, 132).
Specifically, one sector that has thrived in Panama because of dollarization is the home mortgage industry. Since there is heavy competition among the banking sector and there is a system by where home mortgage payments and other debts are automatically deducted from payroll checks, there is less credit risk for banks (Moreno-Villalaz, 131). “The bank and the borrower sign an irrevocable contract, accepted by the employer, to discount loan payments from wages, which effectively gives mortgage loans a senior debt status” (Moreno-Villalaz, 131). This enables banks to charge lower interest rates than normal, providing an end benefit to consumers. “For example, banks routinely offer 30-year mortgages at 5 to 6 percent variable interest rates, with a down-payment requirement of 0 to 2 percent. . . In addition, the government gives middle and low-income groups a mortgage interest subsidy of about 4 percentage points for 10 years” (Moreno-Villalaz, 130). In comparison to non-dollarized countries, interest rates in Panama are relatively low. Throughout Latin America, it is common to see interest rates as high as 15%, making it expensive for low-income consumers to finance even the most meager purchases, such as home appliances or computers. Dollarization in Panama, on the other hand, is an equalizer for low-income groups, because even though wages remain low in comparison to developed countries, individuals can finance their way out of underdevelopment.
As previously mentioned, dollarization occasionally causes a decline in the export sector because switching to the dollar creates a currency appreciation that can make goods more expensive for the importing country. However, currency substitution in Panama has not had this effect. Panama’s flexible labor market does not put it in danger of having to bargain with employees to reduce wages in case of a decrease in exports. Fortunately, the country functions under a system of labor contracts. If there is a sudden drop in exports, firms can easily shed excess production capacity and adjust to current demand conditions. Moreover, Panama is not as dependent on raw material exports as other Central American countries. Instead, Panama is a leader in the export of its service sector industries such as banking and insurance. All this is possible because of dollarization and the 100-year head start Panama has had in integrating with the world economy. In an extensive study performed by Kurt Schuler on approximately 100 countries who have used the U.S. dollar at one time or another, it is concluded that those that have switched between dollarization and fixed and floating rate regimes are worse off than if they had remained dollarized (Schuler, 124). Take the example of Bolivia, which dollarized in the early 1980s and then switched back to using a domestic currency. After the switch, Bolivia experienced an acute period of hyperinflation. The ensuing currency devaluation caused Bolivia to experience a foreign debt crisis. “Panama [on the other hand] has a long-term record of economic stability unusual for a country at its income level” (Schuler, 125).
As opposed to Panama, dollarization in Ecuador was implemented in a desperate move to halt the macroeconomic decay that gripped the country from 1998 to 2001. The devaluation of Ecuador’s currency, the Sucre, was a direct result of lax banking regulations that permitted lenders to make a series of bad loans throughout the preceding period. When Ecuador’s economy slowed down in the late 1990s and interest rates began to rise, Ecuador’s top banks, such as Banco del Pacifico and Banco del Progreso saw themselves in a bind and began to ask for assistance from the government to bail them out. In order to maintain the value of the Sucre and to prop up domestic banks, the government began to sell its foreign exchange reserves. “Meanwhile, exchange-rate depreciation led to further inflation. By the end of 1998, the sucre had depreciated by 30%. As a result, there was a growing quantity of dollars circulating as the sucre continued to lose its value relative to the dollar” (Berrios, 57). Eventually, Ecuador’s banks were put on lock down after citizens attempted to withdraw their domestic currency in order to exchange it for dollars. Instead of remedying the situation, freezing bank accounts exacerbated the devaluation of the Sucre. In the meantime, owners of banks and government officials were able to exchange their personal Sucre-denominated assets for U.S. dollar-denominated assets at a reasonable rate, but the majority of the population was left to watch powerlessly, as their personal savings transformed into a mere pittance. Once the decision to implement official dollarization was made, citizens were allowed convert their Sucre’s to U.S. dollars, however, it was too late for people to recover even a semblance of their previous savings. Ecuador’s banks were already insolvent, and the Sucre had fallen dramatically from January 2000 to 2001, reaching levels close to 26,000 to 1 versus the U.S. dollar. “Between 1998 and 2000, Ecuador was facing the highest inflation rate in Latin America. Consumer prices reached 60.7% in 1999 and 96.6% in 2000, respectively” (Berrios, 58). The out-migration of Ecuadorian citizens has been substantial, with 1 in every 10 Ecuadorians leaving the country. Among Ecuadorian cities, the third largest in terms of population, after Quito and Guayaquil, is New York City. The example of Ecuador’s dollarization experience should be a lesson to policymakers not to implement dollarization under conditions of severe macroeconomic instability. However, it would not be fair to blame currency substitution as the culprit of Ecuador’s current economic woes. The economic conditions under which official dollarization was initially implemented were much worse than present.
Dollarization has recently brought macroeconomic stability to Ecuador by putting downward pressure on inflation and interest rates and by changing the manner in which “supervisory and regulatory institutions manage liquidity and solvency risks” (Quispe-Agnoli and Whisler, 58). Dollarization brings the hope that banks improve their risk management capacity through their awareness that the central government can no longer bail them out in event of a crisis.
Economic output in Ecuador has recently improved, due to high oil prices on international markets, and under dollarization investor confidence in the domestic market has brought a continued inflow of foreign direct investment. Furthermore, dollarization has integrated the Ecuadorian economy with that of the United States, and remittances sent by Ecuadorians living in the abroad have come to be a dominant source of revenue for those in the home country. Some concerns for Ecuador to consider for the future are “how will Ecuador’s economy cope as the Federal Reserve increases interest rates? Interest rate hikes would discourage borrowing and, therefore, investment. Another issue Ecuador is now forced to deal with is the rapid weakening of the U.S. dollar relative to other major currencies. While it might help boost the country’s few exports, the main disadvantage is more expensive imported inputs the country needs” (Berrios, 63). The costs of imports from Spain and Colombia, Ecuador’s third country trading partners, are likely to become too expensive if the U.S. dollar continues losing ground. For now, Ecuador appears to be on track to further integration with the U.S. economy, now that the possibility of a free trade agreement is within reach. Yet, Ecuador’s political situation remains tumultuous regardless of dollarization. Sometime in the near future, Ecuador will be forced to choose sides between the United States, and countries such as Venezuela, Nicaragua, and Bolivia, who are now under Socialist influence. Recently, dollarization has become a source of discontent among Indigenous groups, who see it as a continuance of neo-liberal economic policies imposed by the IMF and World Bank. There have been numerous strikes and riots throughout the country, as well a sit-in’s at oil production facilities. Earlier this year, the central government deployed military personnel to stand guard over oil production facilities, after a three-day oil stoppage that cost the country millions of dollars. Events like these should encourage governments to be more deliberate before deciding to dollarize, because if the political backlash to currency substitution offsets the benefits, it might not be a worthwhile policy. For now, Ecuador must wait and see the results of the coming election to know if it will choose to embrace or reject the path to further economic integration with the United States. However, despite currency substitution, Ecuador’s leaders must remain committed to deeper economic reforms because “. . . dollarization has not been the solution to institutional flaws that led to the crisis in the first place” (Berrios, 66).
Contrary to the dollarization process in Ecuador, the dollarization in El Salvador has been a well-planned unilateral decision by the ARENA party to institutionalize liberalization and structural adjustment policies recommended by international financial institutions. Among scholars of Salvadorian economics, the consensus is that El Salvador was on the right track economically before dollarization; however, dollarization was a compliment to other reforms, which were intended to benefit the financial sector. In this sense, dollarization has not only been an economic decision but a political decision as well. Within El Salvador, there has been a split among the ARENA party between those representing old agricultural wealth and those representing financial wealth. Members of the financial sector generally support closer integration with the world economy. Francisco Flores, as the head of the ARENA party during dollarization, represented the financial sector; therefore, many speculate official dollarization was part a plan to make it difficult for another party to undo financial reforms made under the Flores government. (Towers and Borzutzky, 34). In El Salvador, this is certainly a real possibility, because after the Civil War in the 1980s, many of the congressional seats went to the radical leftist Faribundo Marti National Liberation party. In essence, dollarization has been a means to preserving the status quo and preventing a return to protectionist policies and chaos of the 1980s.
Taking into account that dollarization in El Salvador was not strictly an economic decision, was dollarization overall beneficial to the Salvadorian economy? “The [initial] costs of transition to dollarization include adapting bank accounts, cash registers, and accounting systems to the new currency. More important, the dollarizing country incurs a stock cost, or the cost of purchasing the first set of bills and coins needed for circulation. El Salvador’s stock cost was approximately 2.1 percent of GNP, or $330 million removed from the net international reserves” (Towers, and Borzutzky, 42). After dollarization, the stock cost should have been somewhat recovered because there was a “decline in interest rates, from 13.9% in 2000 to 9.6% in 2001. Lower interest payments directly transferred to savings on foreign debt obligations, but unfortunately, lower interest payments did not have a significant effect on the majority of the Salvadorian population who do not have access to formal credit lines (Towers and Borzutzky, 39). “. . .Because formal loans are not available to the majority of the population: their credit sources typically are NGOs or loan sharks in the informal market. Lower-income groups will benefit only if the low interest rates generate added investment which in turn will generate job creation and rising incomes. . .” (Towers and Borzutzky, 39). In Towers and Borzutzky’s study on the macroeconomic benefits of dollarization in El Salvador, findings show that foreign investment increased slightly after dollarization, but there is no way to prove causality, because FDI was increasing prior to dollarization as well (Towers and Borzutzky, 38). After dollarization, one would expect to see an increase in economic growth; however, El Salvador experienced a massive earthquake in 2001, which makes it impossible to determine whether currency substitution helped or hurt the economy (Towers and Borzutzky, 38).
The socioeconomic impact of dollarization in El Salvador has been negative for the majority of the rural poor because of a phenomenon known as rounding-up. When the Colon was still in circulation throughout the country, the cost of certain items may have been less than one dollar, however, “because the exchange rate was 8.75 colones to one dollar, a round number in colones does not translate into a round number in dollars” (Towers and Borzutzky, 48). Small shop owners, in order to simplify, began rounding up their prices, yet unfortunately, this had had a significant impact on the income of Salvadorians, where “the Gini coefficient is 52.3, the fifth highest in the world,” and more than 50% of the population lives in extreme poverty (Towers and Borzutzky, 32). Among some Salvadorians, there was a general tendency to reject U.S. dollars as a new currency source, consequently, in certain rural areas; the Colon remains in circulation. While in general, inflation declined throughout the country, it is important to note that inflation actually worsened for some groups. Aggregately, dollarization has had a beneficial impact for the Salvadorian economy, but for specific sectors of society, dollarization has caused increased hardship and resentment. Many in El Salvador, as in Ecuador, feel the political system is unresponsive to their needs and that dollarization was a decision undertaken without their input and consent. “As is the case with macroeconomic and trade liberalization, dollarisation’s benefits are not perceived to reach the poorest groups in society” (Hira and Dean, 476). To ensure legitimization and acceptance of government sponsored monetary policies, those in leadership positions may have to temporarily assist those suffering negative impacts.
Minimizing the Socioeconomic Impact of Currency Substitution
To minimize the psychological impact of dollarization, governments must assure citizens that using another country’s currency is not in any way an infringement upon the sovereignty of the nation. Circulating a currency that has the faces of national heroes who are not ones own can be difficult; especially when there is the perception that dollarization was not a choice but an imposition. One possibility for policymakers is to work out an arrangement with the U.S. Treasury, by where they can participate in the design of currency that will circulate within their country. This would allow the economy to retain the benefits of using a stable currency, while preserving a sense of national sovereignty for citizens. Since dollarization is normally followed by increased foreign investment, markets based on the export of agricultural commodities will have to cope with the transition to a more industrial or service-based economy. Another possibility for policymakers, to prevent the disproportionate socioeconomic impact of dollarization on any one group, is to focus foreign direct investment on regions that had previously depended on agricultural exports. Managing FDI in underdeveloped countries can be done by creating industrial parks in rural areas that are export free processing zones. Specifically, there should be no export or import tariffs on goods leaving or entering the special economic zone, as to encourage increased investment revenues. Groups such as the rural poor that previously worked in agriculture but are currently unemployed, can also be given government sponsored training and education to ensure a smooth transition to a modern work environment. Educational programs could also be used in conjunction with micro-lending programs and counseling for the responsible use of credit. This would spawn the growth of small businesses in rural areas that could provide employment.
Due to the asymmetrical relationship existing between dollarized countries and the United States, political opposition to dollarization is likely to remain. To smooth the transition in Latin America from underdevelopment to development, the U.S. must remain committed politically to Latin American countries. If currency substitution is not accompanied by some sort of political arrangement, the possibility for economic and monetary disintegration remains. In order to ensure the future stability of those countries in Latin America that are reform-oriented, the U.S. must also be willing to sacrifice some of its economic sovereignty, to secure Latin America’s cooperation and commitment to the dollar bloc in the 21st century.
Century: To Dollarize or Not?” Latin American Politics and Society, 43, 1-35.
Retrieved October 30, 2006, from JSTOR Full Text Database.
Dollarization is when “a country adopts as legal tender another country’s currency [and] the adopted currency takes over all the functions of domestic currency: a unit of account, medium of exchange, and store of value” (Quispe-Agnoli and Whisler, 55). According to Hira and Dean, there exist two forms of dollarization. “De facto dollarisation is spontaneous adoption of the dollar (or any foreign currency) by the general public without supporting government legislation, a process which has been well underway in Latin America for many years . . . De jure dollarisation, by contrast, entails government legitimization, which may range from simply declaring the dollar to be legal tender, to withdrawing all domestic currency, to abolishing all other legal tender” (Hira and Dean, 462).
In 1904, Panama was the first Latin American country to implement official dollarization, however, more recently, Latin American policymakers have employed official dollarization as a policy tool to defuse exchange rate crisis, or as part of a larger policy package designed to compliment structural adjustment and other reforms. In Ecuador during 1999 and 2000, President Jamil Mahuad and his successor Gustavo Noboa implemented official dollarization to combat a severe bout of hyperinflation, which saw the Sucre drop 25,000 to 1 vs. the U.S. dollar. Shortly after during 2001, El Salvador’s President, Francisco Flores, replaced the Colon with the U.S. dollar to compliment a series of policy packages recommended by the International Monetary Fund. “While we normally think of monetary reform in terms of central bank engineered or supply-side reform, [unofficial] dollarization is a reform occurring from demand-side initiative. The failure of [Latin American] central [banks] to provide a high-confidence domestic money leads money demanders to substitute away from the domestic currency toward a more stable valued dollar” (Melvin, 551). Needless to say, the U.S. dollar has long been a medium of exchange throughout Latin American countries, but as can be expected, the prevalence of unofficial dollarization is unknown, because it is often difficult for monetary authorities to discern the amount of foreign currency in circulation. Depending on the extent of unofficial dollarization that occurs within an economy, it may make monetary sense for Latin American governments to implement de jure dollarization, rather than function under a system of de facto dollarization. In order to provide some guidance to Finance Ministers, Central Bank officials, and those within government possessing leadership roles, this selection will address the steps needed to implement dollarization, the macroeconomic effects and the cost and benefits of dollarization, and the circumstances under which currency substitution is a viable policy alternative. As to be anticipated, with any drastic changes in monetary policy, there will always be winners and losers, however, by outlining the experiences of countries that have dollarized, such as Panama, Ecuador, and El Salvador, it is expected that governments will make more informed policy decisions. This is with the hope that transition towards using a new currency will be more stable and free from economic shocks, thus minimizing the socioeconomic impact of currency substitution. Despite that dollarization is useful in bringing macroeconomic stability to some countries, it is important for governments to consider those groups at the margins of society, who argue that they have yet to reap the benefits of using a foreign currency. While dollarization is supported by some who are active participants in the formal economy and who are well connected to international financial and trade circles, there are those who stand to lose. Recognition of this problem is the first step governments can take to formulate policy initiatives to counter any widespread social discontent owing to dollarization. Consequently, this selection will also address specific actions that can be taken by governments to neutralize the negative effects of dollarization.
The Denomination Displacement Method: Approximations of Unofficial Dollarization
“The dollarization of Latin America has received only slight attention as a significant economic phenomenon. This lack of attention is probably due to the unavailability of data on dollar assets used in financing Latin American transactions” (Melvin, 544). For government officials, the inability to measure dollars in circulation is an impediment to pursuing official dollarization. Thus, being in charge of a Central Bank in a Latin American country, the first step necessary to implement dollarization is to research how much foreign currency is already in circulation. If there is a lack of information on the current amount of dollars in circulation, the Central Bank will be unaware of the correct number of dollars needed to replace the domestic money supply. Although unlikely, this could prompt a situation by where the Central Bank ends up releasing more dollars than necessary into the economy, prompting an inflationary crisis. In addition, the Central Bank can inadvertently purchase more dollars than it needs from the U.S. government and increase its dollar-denominated liabilities. According to Feige, Faulend, Sonje, and Sosic, the IMF looks at the “. . .foreign currency deposits held with domestic banks,” to determine the extent of unofficial dollarization, but unfortunately, there is still a lack of information regarding “foreign currency (cash) in circulation outside the banking system (FCC)” (Feige, Faulend, Sonje, and Sosic, 220). Some estimates put the number of dollars in circulation outside the U.S. to be 40% to 60% of the entire U.S. currency supply, however, to acquire more exact data, foreign governments can check with the U.S. Customs Service to obtain the sum of U.S. dollars that have crossed into their border (Feige, Faulend, Sonje, and Sosic, 224). As mandated by the Bank Secrecy Act, “persons or institutions importing or exporting currency. . .” in excess of $10,000 U.S. dollars are required since 1980 to file a Report of International Transportation of Currency or Monetary Instruments (Feige, Faulend, Sonje, Sosic, 224). “The largest component of cross-border currency flows is wholesale bulk shipments of U.S. currency by large financial institutions that specialize in the international transport of currency” (Feige, Faulend, Sonje, and Sosic, 225). Additional ways by which U.S. dollars reach foreign nations is via multinational firms, individual tourists carrying less than $ 10,000 U.S. dollars, and illegal transfers stemming from money laundering and drug-related activities (Feige, Faulend, Sonje, and Sosic, 225).
Although studying the data collected by the U.S. Customs Service is one way to obtain an approximation of the number of U.S. dollars in circulation, there are other means by which U.S. dollars can enter a country that cannot be accounted for by reviewing Customs reports. For instance, if there was a dollar outflow from the U.S. to Mexico and then a dollar outflow from Mexico to El Salvador, there is no way to determine the number of dollars in El Salvador by simply looking at Customs reports. The U.S. Customs Service may perhaps underreport the extent of unofficial dollarization in El Salvador, due to imperfect information regarding the inflow of U.S. dollars to El Salvador through a third country. For this reason Feige, Faulend, Sonje, and Sosic have proposed denomination displacement as a method by which policymakers considering dollarization can determine the number of dollars already in circulation. The denomination displacement method is based on the hypothesis that as the extent of unofficial dollarization increases within a country, people will tend to use higher denomination foreign currency bills for their larger transactions (Feige, Faulend, Sonje, and Sosic, 230). This is particularly the case in a country where prices are increasing as well. Specifically, “. . . countries that are heavily (unofficially) dollarized with large-denomination foreign bills will have domestic currency (LCC) [local currency in circulation outside the banking system] denomination structures that are unusually skewed away from higher denomination domestic bills” (Feige, Faulend, Sonje, and Sosic, 230). “Denomination displacement occurs as higher denomination [foreign] bills substitute for the high-denomination [domestic] bills” (Feige, Faulend, Sonje, and Sosic, 230). By looking at the shifts in the denomination structure of those countries for which there is accurate information regarding the number of dollars (Argentina) and comparing them to those countries where there is insufficient data, it is possible to determine the number of dollars in circulation. The use of economists and finance specialist well versed in monetary policy is recommended throughout this process, because solving of mathematical equations and complex use of regression analysis is required. “. . . It is possible to obtain an estimate of the unknown amount of foreign currency in circulation in by substituting the known values of the independent variables [for a particular country] and solving the equation for the unknown quantity of FCC [(foreign currency in circulation)]” (Feige, Faulend, Sonje, and Sosic, 236). The known values in this case would be the domestic currency in circulation and the amount of domestic currency deposited in local banks (Feige, Faulend, Sonje, and Sosic, 220).
Dollarization: A Catalyst for Deeper Economic Reforms?
Now that the initial phases of the dollarization process have been dealt with, officials must be forced to think about why they are carrying out dollarization. If they expect dollarization to be a panacea for their economy, they are mistaken; however, if they deem currency substitution to be only one element of an integral program of numerous structural reforms, then it may help the economy in the long-term. Hira and Dean suggest, “because of the political difficulties of developing second generation reforms, dollarisation is being sold politically in Latin America as a substitute for tough reforms (Hira and Dean, 478). As in the case of Ecuador, monetary officials saw dollarization as a means by which to give “shock therapy” and accelerate transformations in other sectors of the economy; however, currency substitution is no replacement for making politically unpopular decisions. Dollarization must be an adjunct to deeper reforms, such as improving labor flexibility, reducing government spending, balancing the budget, and cutting populist social programs.
In the dispute that occurred in the European Union between the monetarists and the economists at the start of eurorization, the debate concerning the outlook for economic reforms under a currency substitution arrangement is illustrated (Eichengreen, 2). “The “economists,” German officials for present purposes, argued that economic policies and performance had to converge and institutions had to be harmonized before Europe could proceed to monetary union” (Eichengreen, 2). The “monetarists” (French officials), on the other hand, argued that eurorization itself would bring about convergence between newly eurorized and previously eurorized countries (Eichengreen, 2). Convergence entailed the lowering of inflation rates, capital mobility, elimination of the fiscal deficit, and in general, harmonization of economic policies with the wider EU. In the end, the “economists” won out and it was required that before countries joined the EU, they follow a strict set of macroeconomic restructuring programs to bring their economic houses in order. It is essential to bring focus to the eurorization debate because Latin American officials need to be aware that official dollarization requires economic policies to synchronize and converge with those in the United States. If stark macroeconomic disparities between the U.S. and the dollarized country are existent, the decisions made at the Federal Reserve will not be effective in jumpstarting or cooling the economy of the dollarizer. “Monetary policy is optimally used differently where unemployment and business conditions fluctuate differently. The interest rate cuts needed to moderate increases in unemployment and the interest rate increases needed to counter increases in inflation will occur at different times in countries across which conditions differ” (Eichengreen, 16). Therefore, it is imperative that politicians make reforms accordingly to tie their economy to that of the country whose currency they are using.
Barry Eichengreen, who looked at whether dollarization alone would accelerate the pace of labor market reform, fiscal reform, and financial sector reform, found that dollarization alone is not enough. In the case of Argentina, “observers of Argentine convertibility will be skeptical that a hard exchange rate constraint guarantees labor market reform [because] bargaining in Argentina remains centralized, encouraging wage compression and limiting flexibility. . .” (Eichengreen, 5). Unemployment remains high in Ecuador, El Salvador, and Argentina, hence, this is “hardly evidence of adequate labor market flexibility” (Eichengreen, 5). Granted, Argentina has yet to officially dollarize, however, it has maintained a hard peg of 1:1 to the U.S. dollar since the early 1990’s. In regards to fiscal discipline, those in favor of early dollarization argue that limiting the ability of the government to print money to finance budget deficits will prevent overspending. As has occurred in the past in Latin America, “if an irresponsible central bank is given freedom to issue pesos without worrying about the consequences for the exchange rate, it will simply print pesos to its heart’s content to fund a large budget deficit or to provide cheap credits to the banking system” (Sachs and Larrain, 81). Dollarization will surely prevent this type of self-destructive behavior. Yet, one could argue that the increased availability of commercial credit lines from private banks after official dollarization will encourage governments to get into debt instead of printing money to finance their spending. Essentially, they will have debt-led economic growth and will be swapping one destructive economic policy for another. The point is then made that if government’s in Latin America simply attempt to use dollarization as a temporary patch to boost their economy, their intentions will quickly become evident throughout the international economic community. International investors will quickly lose confidence, and the country’s credit rating will drop, making it difficult to acquire capital in international financial markets. Policymakers must be wholly committed to solving the deeper structural issues facing their economy, if they have the desire to make constructive reforms under a dollarized regime.
Macro and Microeconomic Effects of Dollarization
Once a Latin American government has decided to dollarize and has in essence tossed the key to the central bank, what can the country expect in terms of macroeconomic effects of dollarization? (Eichengreen, 3). “The main benefit [of dollarization] is increased efficiency in transactions between countries and thus, increased trade. . . A second benefit to a country that gives up full control over its currency is an increase in the stability and credibility of its macroeconomic policy” (Jameson, 6). One significant effect of dollarization is that interest rates in the foreign country will tend to converge with U.S. interest rates. This can help the country in several ways, one being that interest paid on debts held with the IMF or foreign sector banks will dramatically decrease, freeing up government revenues (Eichengreen, 2). Clearly, international financial institutions will charge higher interest if they are loaning in a currency not renowned for stability. “Banks and firms seeking funding abroad find themselves unable to borrow in the domestic currency. Since this leaves them saddled with mismatched dollar liabilities and domestic-currency-denomination assets, they get smashed whenever the currency depreciates” (Eichengreen, 8). However, loaning money to a country that is officially dollarized puts downward pressure on interest rates because loans are made in a stable currency. Specifically, “dollarization will enable the government to lengthen the term structure of its debt by removing the currency risk that causes investors to prefer short maturities. [Furthermore, dollarization will increase] the government’s access to commercial credit lines, arming it with the resources to provide at least limited lender-of-last-resort services” (Eichengreen, 2). Additional revenues available, as a result of not having to pay high debt servicing costs can be spent on infrastructure projects or education. An alternative option is to place funds in an interest bearing account to be used at a future date.
As mentioned previously, bilateral trade between the dollarized country and the United States will increase exponentially, once currency risk is removed from the equation. “. . . Dollarisation eliminates the transactions costs of exchanging one currency for another and [it] allows a country to make maximum use of the de facto dollars that are already part of the economy” (Hira and Dean, 463). Making use of the de facto dollars in circulation provides for greater transparency and can assist law enforcement agencies in combating money laundering and drug smuggling activities. Eradication of transaction costs enhances trade because firms save on the cost of currency insurance and they avoid having to engage in hedging, such as currency swapping and trading in forward markets. Foreign investors will not be as hesitant to invest their capital to purchase assets denominated in dollars, because the threat of massive currency devaluation is minimized. Above all, the capital account will flourish because of an increase in both portfolio investment and foreign direct investment. Domestic companies also have greater access to capital after dollarization, because they are able to list on international stock exchanges in New York, London, and Tokyo, to attract a diverse array of international investors. The ability of domestic companies to access long-term capital in international markets provides an incentive to undertake larger projects, thus contributing to economic growth and job creation for the entire economy. Firms eventually will move up on the experience curve and develop economies of scale, opening up the possibility of becoming internationally competitive. “. . . Dollarization, by downsizing the safety net, will force managers to reinforce their own precautionary measures and intensify their peer monitoring, or go out of business” (Eichengreen, 9).
At the microeconomic level, the opportunity for consumers to access affordable consumer credit becomes a reality. It has been confirmed repeatedly that giving consumers in developing countries access to credit is the surest way to improve the standard of living of the poorest sectors of the population. The Grameen Bank in Bangladesh and its micro-credit program that has a 99% repayment rate, is just one example of the difference credit can make in the lives of those working in the informal sector. In regards to creating more responsive government institutions, the best prescription to constrain irresponsible Central Banks and spendthrift government agencies is dollarization, because printing money is not available as a means to finance deficit spending. “No longer can [the] government influence the exchange rate, and limits are imposed on expansionary economic policy” (Jameson, 6). Historically, overspending has been a huge problem in Latin America because the government chooses to live beyond its means. Yet, under a dollarized regime, inflation is automatically brought into line with the U.S. inflation rate because politicians are cut off from the purse strings of the Central Bank. Dollarization then has the effect of insulating the citizenry from the bad decisions made by their government, and at the same time, political demagogues no longer exploit their spending power before election time to entice masses of voters. Currency substitution also creates greater transparency in the commercial and financial sectors; because banks and firms must conform to international standard practices and be open to scrutiny should shady dealings occur. As international scrutiny increases, risk management practices will be enhanced and banks will better screen their clientele to avoid making bad loans.
The Costs of Losing Monetary Sovereignty
At first glance, the benefits of dollarization would overwhelmingly convince government officials that it is preferable to operating under a fixed or floating exchange rate regime, but nevertheless, there exist many downsides to currency substitution that have yet to be discussed. An area where dollarization can have a negative impact, at least in the short term, is on the balance of trade. Under an arrangement where a country operates with a domestic currency, exports to the United States and other developed nations tend to thrive, since monetary authorities can use currency devaluations to make exports cheaper for consumers in the importing country. Exports are a particularly vital component of Latin American economies, which specialize in the production of raw materials or commodity products, such as cooper, petroleum, shrimp, sugar, coffee, and bananas. Unfortunately, once full dollarization becomes official, exports become more expensive and priced out of the reach of consumers in developed countries. The current account deficit can deteriorate if the U.S. dollar were to appreciate versus other major world currencies, i.e. the Euro, Yen, or British Pound. “Countries that have greater amounts of trade with third-party (non-US) countries stand to suffer from a reduction in export competitiveness should the dollar appreciate against these third-party currencies. Within countries, regions that have higher proportions of third-party trade may suffer recessionary effects” (Hira and Dean, 476). The only way then to make exports from Latin American countries more competitive is to lower production costs. This is what Sach’s describes as a monetary straitjacket. “If a country abandons its national currency in favor of the U.S. dollar, the result is very much like a pegged exchange rate, only with less room to maneuver. First, of course, there is no longer the “shock absorber” of exchange rate depreciation. The only alternative is a cut in wage levels, which is likely to be a long, drawn out affair, with lots of interim unemployment” (Sachs and Larrain, 86).
Another danger to the balance of trade is that if international investors and currency speculators lose confidence in the U.S. dollar as the international reserve currency, the price of imports from Latin America’s third country trading partners, such as the European Union and China, suddenly become quite expensive. As investors sell the dollar short in currency markets, dollar depreciation leads to a loss of purchasing power. Although most bilateral trade within dollarized countries occurs with the U.S., there are still a certain number of inputs for production and extraction of raw materials, which may be required from third countries. If Latin America cannot afford the necessary imports necessary for those industries in which it possesses a comparative advantage, the export sector will suffer leading to a recession or even a depression. On the other hand, one may argue that the risk of a devaluation of the U.S. dollar is too far fetched, and the immediate gains attained from the increased purchasing power of the dollar far outweigh the risk. “The reverse effect, that imported inputs should now be cheaper, could lead to gains in the manufacturing area, even where manufactures are exported. . .” (Hira and Dean, 465). Nonetheless, gains in the manufacturing sector in Latin America may not be as beneficial as presumed because “. . .these sectors tend to be highly limited in most Latin American countries. . .” (Hira and Dean, 465). As mentioned earlier, most Latin American exports are raw materials sent to the developed world, where most of the value is added after being converted into finished products. Only after value-added activities are completed, is it that these products are exported back to Latin America. In this instance, “dollarisation may perpetuate or even exacerbate the current account deficit by spurring increases in imports at a much faster rate than exports” (Hira and Dean, 469).
Previously, the benefits of being able to list a firm on an international stock exchange were discussed; however, the positive aspects of being able to raise equity in international capital markets are accompanied by costs borne by small-scale Latin American companies. If a firm is to list itself in New York, it will tend to forget about local equities markets in Mexico City or Bogotá. “While de-listing may improve access to international capital for the top Latin American companies, it also underscores and may increase the weakness of local equity markets. De-listing thus may weaken access to capital for local companies not able to list on US exchanges” (Hira and Dean, 476).
In terms of monetary costs of dollarization, it is far from being free. Another expense that must be considered is that the dollarizer must purchase the U.S. dollars needed to replace the domestic currency from the U.S. Federal Reserve. Most countries hold diverse types of foreign currency that they place into interest bearing accounts, however, to initialize official dollarization, it is required that reserves be sold off in exchange for U.S. dollars. There is a tremendous cost to bear in terms of interest proceeds lost after selling previously held foreign exchange reserves. “Argentina, for example, would have to spend $15 billion initially to swap its peso currency notes for U.S. dollars. As the economy grows and needs more greenbacks, there would be a continuing price to pay” (Sachs and Larrain, 86). The loss of seigniorage is another negative aspect of dollarization. “When a small country dollarizes, the U.S. collects seigniorage equal to the difference between the amount of dollars that the country holds in the new steady state and the amount it had before the dollarization” (Lamdany and Dorlhiac, 97). Seigniorage is “the ability [of a nation] to increase its resources from minting or printing the domestic currency” (Jameson, 531. In other words, seigniorage is an inflation tax that the government exacts from its citizens by printing currency at the mint. Since it takes some time before the additional money printed at the mint passes through the economy and becomes inflationary, the government can temporarily take advantage of this revenue stream. In Argentina and Bolivia, the total amount of seigniorage collected has been close to 70% of revenue at certain times, while in other countries, it has been close to 20% of total earnings (Melvin, 552). Under a dollarization regime, however, all seigniorage revenues would go directly to the U.S. treasury, unless the United States chose to share seigniorage revenues among dollarized countries. In the words of Lamdany and Dorlhiac, the possibility of collecting seigniorage revenues “creates an incentive for the U.S. to “bribe” the small country into switching currency” (Lamdany and Dorlhiac, 97). However, the possibility that the U.S. would share seigniorage revenues “seems a particularly distant political prospect” according to Sachs and Larrian (Sachs and Larrian, 97). “Since Latin American nations have used the seigniorage from money creation as an important source of government revenue, they have a large stake in controlling [or even preventing] the dollarization process” (Melvin, 552).
Another risk of official dollarization is the loss of ability by the Central Bank to be the lender-of-last-resort to the domestic banking system. Loss of lender-of-last- resort privileges occurs due to the abolition of the entire Central Bank, which could previously print money on-demand in case of an emergency, should the government request it. Regrettably, under an official dollarization regime, citizens will distrust domestic banks because they know there is a lack of liquidity to effectively counter a run on the banking system. The loss of faith in the ability of banks to pay depositors their money under official dollarization underscores the fragility of domestic banks and will hurt their international competitiveness in the long-term. Once the newly dollarized nation liberalizes the financial sector and foreign banks compete directly with domestic banks, the general public, and the business sector, is likely to shun domestic banks in favor of foreign banking conglomerates such as Bank of America, Chase Manhattan, and Citibank. Citizens and businesses will be aware that foreign banks are a safe haven supported by the U.S. Treasury, while domestic banks are buttressed only to the extent that they can access loans on international capital markets.
Needless to say, what typically occurs in a situation when a country asks to borrow money to deter a run on the banking system is that its ability to access liquidity is limited because its international credit rating has already fallen, and “producing adequate collateral [to put creditors at ease] could prove difficult” (Sachs, and Larrain, 87). As is evident from U.S. Senator Connie Mack’s recent proposal titled, International Monetary and Stability Act. “. . .a Latin American dollarizer that experienced a debt crisis would be left by the Fed to stew in its own juices. . .” (Eichengreen, 15). The International Monetary and Stability Act, which is a law, intended to encourage dollarization gives the “U.S. Secretary of the Treasury the discretion to encourage official dollarization by offering to rebate quarterly to any country that dollarizes 85 percent of the resulting increase in U.S. seigniorage revenues. The law makes clear, however, that the United States would have no obligation to serve as lender of last resort to dollarized countries, to consider their economic conditions when setting monetary policy, or to supervise their banks” (Kehoe, 595). Evidently, before policymakers settle on dollarization as the best solution to their nation’s economic woes, it is recommended they consider whether they have sufficient credit available to prop up their domestic financial sector, should a crisis ensue.
Dollarization Case Studies: Panama, Ecuador, and El Salvador
Up until present, we have discussed the steps necessary to implement dollarization and the macroeconomic effects of currency substitution (both positive and negative); however, we have yet to discuss case studies of dollarized countries. For purposes of this selection, we will examine three countries, Panama, Ecuador, and El Salvador, and discuss how they have managed under a dollarized economy.
Dollarization in Panama has produced a vital transformation of the economy, because it has generated a thriving service sector and allowed the country to become fully integrated with international financial markets. Panama, as a tiny Central American country, would under normal circumstances, be ignored by foreign investors, but because of the Panama Canal and the countries strategic importance as a trade route, Panama attracts abundant foreign investment. Panama does not face any of the above-mentioned dilemmas that are normally associated with currency substitution, such as a loss of liquidity or poor export performance. Namely, this is because it has a well-established history of stability and commitment to the norms of the international financial system. In Panama, for instance, the “stability of export prices tends to preempt terms-of-trade shocks: the unified currency removes any exchange risk, transfer risk, or currency mismatch associated with devaluation. No financial or banking crises take place because of financial integration with world-connected banking. Domestic inflation or fiscal crises have not occurred because the government cannot monetize its deficits. Inflation in Panama is systematically lower than in the United States due to the Balassa-Samuelson effect, thereby providing stability to the real exchange rate” (Moreno-Villalaz, 132).
Specifically, one sector that has thrived in Panama because of dollarization is the home mortgage industry. Since there is heavy competition among the banking sector and there is a system by where home mortgage payments and other debts are automatically deducted from payroll checks, there is less credit risk for banks (Moreno-Villalaz, 131). “The bank and the borrower sign an irrevocable contract, accepted by the employer, to discount loan payments from wages, which effectively gives mortgage loans a senior debt status” (Moreno-Villalaz, 131). This enables banks to charge lower interest rates than normal, providing an end benefit to consumers. “For example, banks routinely offer 30-year mortgages at 5 to 6 percent variable interest rates, with a down-payment requirement of 0 to 2 percent. . . In addition, the government gives middle and low-income groups a mortgage interest subsidy of about 4 percentage points for 10 years” (Moreno-Villalaz, 130). In comparison to non-dollarized countries, interest rates in Panama are relatively low. Throughout Latin America, it is common to see interest rates as high as 15%, making it expensive for low-income consumers to finance even the most meager purchases, such as home appliances or computers. Dollarization in Panama, on the other hand, is an equalizer for low-income groups, because even though wages remain low in comparison to developed countries, individuals can finance their way out of underdevelopment.
As previously mentioned, dollarization occasionally causes a decline in the export sector because switching to the dollar creates a currency appreciation that can make goods more expensive for the importing country. However, currency substitution in Panama has not had this effect. Panama’s flexible labor market does not put it in danger of having to bargain with employees to reduce wages in case of a decrease in exports. Fortunately, the country functions under a system of labor contracts. If there is a sudden drop in exports, firms can easily shed excess production capacity and adjust to current demand conditions. Moreover, Panama is not as dependent on raw material exports as other Central American countries. Instead, Panama is a leader in the export of its service sector industries such as banking and insurance. All this is possible because of dollarization and the 100-year head start Panama has had in integrating with the world economy. In an extensive study performed by Kurt Schuler on approximately 100 countries who have used the U.S. dollar at one time or another, it is concluded that those that have switched between dollarization and fixed and floating rate regimes are worse off than if they had remained dollarized (Schuler, 124). Take the example of Bolivia, which dollarized in the early 1980s and then switched back to using a domestic currency. After the switch, Bolivia experienced an acute period of hyperinflation. The ensuing currency devaluation caused Bolivia to experience a foreign debt crisis. “Panama [on the other hand] has a long-term record of economic stability unusual for a country at its income level” (Schuler, 125).
As opposed to Panama, dollarization in Ecuador was implemented in a desperate move to halt the macroeconomic decay that gripped the country from 1998 to 2001. The devaluation of Ecuador’s currency, the Sucre, was a direct result of lax banking regulations that permitted lenders to make a series of bad loans throughout the preceding period. When Ecuador’s economy slowed down in the late 1990s and interest rates began to rise, Ecuador’s top banks, such as Banco del Pacifico and Banco del Progreso saw themselves in a bind and began to ask for assistance from the government to bail them out. In order to maintain the value of the Sucre and to prop up domestic banks, the government began to sell its foreign exchange reserves. “Meanwhile, exchange-rate depreciation led to further inflation. By the end of 1998, the sucre had depreciated by 30%. As a result, there was a growing quantity of dollars circulating as the sucre continued to lose its value relative to the dollar” (Berrios, 57). Eventually, Ecuador’s banks were put on lock down after citizens attempted to withdraw their domestic currency in order to exchange it for dollars. Instead of remedying the situation, freezing bank accounts exacerbated the devaluation of the Sucre. In the meantime, owners of banks and government officials were able to exchange their personal Sucre-denominated assets for U.S. dollar-denominated assets at a reasonable rate, but the majority of the population was left to watch powerlessly, as their personal savings transformed into a mere pittance. Once the decision to implement official dollarization was made, citizens were allowed convert their Sucre’s to U.S. dollars, however, it was too late for people to recover even a semblance of their previous savings. Ecuador’s banks were already insolvent, and the Sucre had fallen dramatically from January 2000 to 2001, reaching levels close to 26,000 to 1 versus the U.S. dollar. “Between 1998 and 2000, Ecuador was facing the highest inflation rate in Latin America. Consumer prices reached 60.7% in 1999 and 96.6% in 2000, respectively” (Berrios, 58). The out-migration of Ecuadorian citizens has been substantial, with 1 in every 10 Ecuadorians leaving the country. Among Ecuadorian cities, the third largest in terms of population, after Quito and Guayaquil, is New York City. The example of Ecuador’s dollarization experience should be a lesson to policymakers not to implement dollarization under conditions of severe macroeconomic instability. However, it would not be fair to blame currency substitution as the culprit of Ecuador’s current economic woes. The economic conditions under which official dollarization was initially implemented were much worse than present.
Dollarization has recently brought macroeconomic stability to Ecuador by putting downward pressure on inflation and interest rates and by changing the manner in which “supervisory and regulatory institutions manage liquidity and solvency risks” (Quispe-Agnoli and Whisler, 58). Dollarization brings the hope that banks improve their risk management capacity through their awareness that the central government can no longer bail them out in event of a crisis.
Economic output in Ecuador has recently improved, due to high oil prices on international markets, and under dollarization investor confidence in the domestic market has brought a continued inflow of foreign direct investment. Furthermore, dollarization has integrated the Ecuadorian economy with that of the United States, and remittances sent by Ecuadorians living in the abroad have come to be a dominant source of revenue for those in the home country. Some concerns for Ecuador to consider for the future are “how will Ecuador’s economy cope as the Federal Reserve increases interest rates? Interest rate hikes would discourage borrowing and, therefore, investment. Another issue Ecuador is now forced to deal with is the rapid weakening of the U.S. dollar relative to other major currencies. While it might help boost the country’s few exports, the main disadvantage is more expensive imported inputs the country needs” (Berrios, 63). The costs of imports from Spain and Colombia, Ecuador’s third country trading partners, are likely to become too expensive if the U.S. dollar continues losing ground. For now, Ecuador appears to be on track to further integration with the U.S. economy, now that the possibility of a free trade agreement is within reach. Yet, Ecuador’s political situation remains tumultuous regardless of dollarization. Sometime in the near future, Ecuador will be forced to choose sides between the United States, and countries such as Venezuela, Nicaragua, and Bolivia, who are now under Socialist influence. Recently, dollarization has become a source of discontent among Indigenous groups, who see it as a continuance of neo-liberal economic policies imposed by the IMF and World Bank. There have been numerous strikes and riots throughout the country, as well a sit-in’s at oil production facilities. Earlier this year, the central government deployed military personnel to stand guard over oil production facilities, after a three-day oil stoppage that cost the country millions of dollars. Events like these should encourage governments to be more deliberate before deciding to dollarize, because if the political backlash to currency substitution offsets the benefits, it might not be a worthwhile policy. For now, Ecuador must wait and see the results of the coming election to know if it will choose to embrace or reject the path to further economic integration with the United States. However, despite currency substitution, Ecuador’s leaders must remain committed to deeper economic reforms because “. . . dollarization has not been the solution to institutional flaws that led to the crisis in the first place” (Berrios, 66).
Contrary to the dollarization process in Ecuador, the dollarization in El Salvador has been a well-planned unilateral decision by the ARENA party to institutionalize liberalization and structural adjustment policies recommended by international financial institutions. Among scholars of Salvadorian economics, the consensus is that El Salvador was on the right track economically before dollarization; however, dollarization was a compliment to other reforms, which were intended to benefit the financial sector. In this sense, dollarization has not only been an economic decision but a political decision as well. Within El Salvador, there has been a split among the ARENA party between those representing old agricultural wealth and those representing financial wealth. Members of the financial sector generally support closer integration with the world economy. Francisco Flores, as the head of the ARENA party during dollarization, represented the financial sector; therefore, many speculate official dollarization was part a plan to make it difficult for another party to undo financial reforms made under the Flores government. (Towers and Borzutzky, 34). In El Salvador, this is certainly a real possibility, because after the Civil War in the 1980s, many of the congressional seats went to the radical leftist Faribundo Marti National Liberation party. In essence, dollarization has been a means to preserving the status quo and preventing a return to protectionist policies and chaos of the 1980s.
Taking into account that dollarization in El Salvador was not strictly an economic decision, was dollarization overall beneficial to the Salvadorian economy? “The [initial] costs of transition to dollarization include adapting bank accounts, cash registers, and accounting systems to the new currency. More important, the dollarizing country incurs a stock cost, or the cost of purchasing the first set of bills and coins needed for circulation. El Salvador’s stock cost was approximately 2.1 percent of GNP, or $330 million removed from the net international reserves” (Towers, and Borzutzky, 42). After dollarization, the stock cost should have been somewhat recovered because there was a “decline in interest rates, from 13.9% in 2000 to 9.6% in 2001. Lower interest payments directly transferred to savings on foreign debt obligations, but unfortunately, lower interest payments did not have a significant effect on the majority of the Salvadorian population who do not have access to formal credit lines (Towers and Borzutzky, 39). “. . .Because formal loans are not available to the majority of the population: their credit sources typically are NGOs or loan sharks in the informal market. Lower-income groups will benefit only if the low interest rates generate added investment which in turn will generate job creation and rising incomes. . .” (Towers and Borzutzky, 39). In Towers and Borzutzky’s study on the macroeconomic benefits of dollarization in El Salvador, findings show that foreign investment increased slightly after dollarization, but there is no way to prove causality, because FDI was increasing prior to dollarization as well (Towers and Borzutzky, 38). After dollarization, one would expect to see an increase in economic growth; however, El Salvador experienced a massive earthquake in 2001, which makes it impossible to determine whether currency substitution helped or hurt the economy (Towers and Borzutzky, 38).
The socioeconomic impact of dollarization in El Salvador has been negative for the majority of the rural poor because of a phenomenon known as rounding-up. When the Colon was still in circulation throughout the country, the cost of certain items may have been less than one dollar, however, “because the exchange rate was 8.75 colones to one dollar, a round number in colones does not translate into a round number in dollars” (Towers and Borzutzky, 48). Small shop owners, in order to simplify, began rounding up their prices, yet unfortunately, this had had a significant impact on the income of Salvadorians, where “the Gini coefficient is 52.3, the fifth highest in the world,” and more than 50% of the population lives in extreme poverty (Towers and Borzutzky, 32). Among some Salvadorians, there was a general tendency to reject U.S. dollars as a new currency source, consequently, in certain rural areas; the Colon remains in circulation. While in general, inflation declined throughout the country, it is important to note that inflation actually worsened for some groups. Aggregately, dollarization has had a beneficial impact for the Salvadorian economy, but for specific sectors of society, dollarization has caused increased hardship and resentment. Many in El Salvador, as in Ecuador, feel the political system is unresponsive to their needs and that dollarization was a decision undertaken without their input and consent. “As is the case with macroeconomic and trade liberalization, dollarisation’s benefits are not perceived to reach the poorest groups in society” (Hira and Dean, 476). To ensure legitimization and acceptance of government sponsored monetary policies, those in leadership positions may have to temporarily assist those suffering negative impacts.
Minimizing the Socioeconomic Impact of Currency Substitution
To minimize the psychological impact of dollarization, governments must assure citizens that using another country’s currency is not in any way an infringement upon the sovereignty of the nation. Circulating a currency that has the faces of national heroes who are not ones own can be difficult; especially when there is the perception that dollarization was not a choice but an imposition. One possibility for policymakers is to work out an arrangement with the U.S. Treasury, by where they can participate in the design of currency that will circulate within their country. This would allow the economy to retain the benefits of using a stable currency, while preserving a sense of national sovereignty for citizens. Since dollarization is normally followed by increased foreign investment, markets based on the export of agricultural commodities will have to cope with the transition to a more industrial or service-based economy. Another possibility for policymakers, to prevent the disproportionate socioeconomic impact of dollarization on any one group, is to focus foreign direct investment on regions that had previously depended on agricultural exports. Managing FDI in underdeveloped countries can be done by creating industrial parks in rural areas that are export free processing zones. Specifically, there should be no export or import tariffs on goods leaving or entering the special economic zone, as to encourage increased investment revenues. Groups such as the rural poor that previously worked in agriculture but are currently unemployed, can also be given government sponsored training and education to ensure a smooth transition to a modern work environment. Educational programs could also be used in conjunction with micro-lending programs and counseling for the responsible use of credit. This would spawn the growth of small businesses in rural areas that could provide employment.
Due to the asymmetrical relationship existing between dollarized countries and the United States, political opposition to dollarization is likely to remain. To smooth the transition in Latin America from underdevelopment to development, the U.S. must remain committed politically to Latin American countries. If currency substitution is not accompanied by some sort of political arrangement, the possibility for economic and monetary disintegration remains. In order to ensure the future stability of those countries in Latin America that are reform-oriented, the U.S. must also be willing to sacrifice some of its economic sovereignty, to secure Latin America’s cooperation and commitment to the dollar bloc in the 21st century.
References
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