Full dollarization of the economy is widely discussed as a way of enabling
developing countries to overcome monetary and exchange rate instability. What are the
costs and benefits of dollarizing, and which developing countries are most likely to
benefit?
There is an old joke that says that the exam questions in economics remain the same
every year—only the answers change. Certainly, the debate about the best exchange
rate regime has been with us forever, but new answers keep appearing. The newest answer to
the question of what exchange rate regime countries should choose is "none."
That is, countries should forgo using their own currencies entirely and adopt as legal
tender a stable foreign currency, most commonly the U.S. dollar. Last year, the Argentine
government gave serious consideration to dollarization, and some prominent economists have
begun to argue that essentially all developing countries should dollarize. Not only
developing countries, however, are considering dollarization. Prompted partly by the
adoption of the euro this year, some have suggested that Canada should adopt the U.S.
dollar. (Dollarization is also used to describe the spontaneous use of the U.S. dollar
alongside a country's domestic currency in transactions. As used here, however, the term
refers to the dollar's total replacement of the domestic currency—that is,
"full" dollarization.)
New answers to the exchange rate question appear because the world continually presents
new problems to policymakers. During the 1980s, much of the debate about exchange rate
regimes for developing countries centered on the role of exchange rate pegs in
inflation-stabilization programs. Two distinguishing features of the 1990s have changed
the terms of the discussion. First, the inflation problem has receded considerably.
Second, as the degree of capital mobility and the scale of capital flows have increased
sharply, so have the apparent frequency and severity of currency crises. And many of the
targets of these fierce speculative attacks were maintaining some sort of pegged exchange
rate regime.
Because of those crises, the idea of full dollarization has elicited considerable
interest. The view has emerged that in a world of high capital mobility, exchange rate
pegs are an invitation to speculative attacks and that only extreme choices—a firm
peg such as a currency board or a free float—are viable. Advocates of dollarization
have attacked both of these alternatives. Free floats, they argue, are not viable for many
countries because they result in excessive exchange rate volatility or a de facto
"soft peg" if the authorities resist exchange rate movements. Meanwhile, it has
become clear that even currency boards are not immune to costly speculative attacks: for
example, Argentina and Hong Kong SAR suffered from episodes of financial contagion in
recent years that resulted in sharp increases in interest rates and recessions.
Full dollarization promises a way of avoiding currency and balance of payments crises.
Without a domestic currency, there is no possibility of a sharp depreciation, and sudden
capital outflows motivated by fears of devaluation are ruled out. Dollarization may also
bring other benefits: closer integration with both the United States and the global
economy would be promoted by lower transaction costs and an assured stability of prices in
dollar terms. By definitively rejecting the possibility of inflationary finance,
dollarization might also strengthen institutions and boost investment.
Yet countries may be reluctant to abandon their own currencies. For one thing, the
currency is a national symbol, and proposals to join a monetary union (or directly adopt
the U.S. dollar) may draw criticism from some political quarters. From an economic point
of view, the right to issue currency provides the government with seigniorage revenues
(resulting essentially from the difference between the cost of producing and distributing
paper money and coins and their (greater) purchasing power). The central bank can use
currency, which does not bear interest, to purchase interest-bearing assets, such as
foreign reserves. These seigniorage revenues show up as central bank profits and are
transferred to the government. Countries that dollarized their economies would lose these
revenues unless the United States decided to share part of the extra seigniorage it would
obtain. In addition, a dollarizing country would be relinquishing any possibility of
having an autonomous monetary and exchange rate policy, including the use of central bank
credit to provide liquidity support to its banking system.
Is dollarization, then, a better exchange rate regime for developing countries? To
simplify the discussion, we com- pare the merits of dollarization to those of its nearest
"competitor"—the currency board. Under a currency board arrangement, the
monetary authorities commit to trade foreign exchange for domestic currency on demand at a
fixed rate of exchange. This is the only mechanism the central bank can use to increase
the base money supply—there is no extension of domestic credit to the government or
banks, for example. Thus, the domestic currency is fully backed by a corresponding stock
of foreign exchange. A focus on comparing dollarization to currency boards captures the
main implications of dollarization and how its effects differ from those of adopting a
firm peg. Furthermore, much of the current discussion about dollarization has been
motivated by suggestions that Argentina should take the next step: moving from its
currency board, with a one-to-one fix between the peso and the dollar, to full
dollarization.
Currency board and dollarization arrangements are quite similar, but a comparison is
nonetheless revealing. To begin with, dollarization implies the loss of seigniorage
revenue for the government. But dollarization's key distinguishing feature is that it
would be permanent, or nearly so. It would presumably be much more difficult to reverse
dollarization than to modify or abandon a currency board arrangement.
With few recent exceptions, countries introducing their own currencies have done so in
the context of newly gained national independence, as, for example, have the countries of
the former Soviet Union. These currencies have, moreover, almost always replaced a weak
and inconvertible currency. In fact, the largest benefits such countries might obtain by
pursuing the alternative of dollarization derive from the credibility attached to it,
precisely because it is nearly irreversible. We now take a closer look at the benefits and
costs of full dollarization.
Risk premiums
An expected benefit from the elimination of the risk of devaluation would be a
reduction of country risk premiums, and thus lower interest rates, which would result in a
lower cost of servicing the public debt and also in increased investment and faster
economic growth. Interest rates on dollar-denominated securities issued by the Argentine
government, for example, exceed those on advanced countries' debt, reflecting the greater
sovereign, or default, risk on the former. With dollarization, the interest premiums owing
to devaluation risk would disappear but sovereign risk would not. The key question, then,
is what effect dollarization would have on the cost of dollar-denominated borrowing.
Devaluation risk might increase default risk for several reasons. First, governments
attempting to avoid a currency crisis may impose currency controls that force a suspension
of payments on foreign debt. Second, default risks could rise with a devaluation owing to
the higher cost of servicing dollar-denominated debt. And third, a devaluation could cause
heavy losses in the financial sector, and governments might end up bearing most of the
cost.
Not all default risks arise from the risk of currency crises, however.
Sovereign defaults may result from an unsustainable fiscal position or political turmoil,
and dollarization cannot prevent this sort of crisis. Although data show that sovereign
risk and devaluation risk move together (see the Argentine data shown in the chart below),
this does not establish a causal link from devaluation risk to sovereign risk, or vice
versa. For example, a general "flight to quality" by investors (originally
unrelated to fears of devaluation) would raise both the measured risk of default and the
risk of devaluation. Evidence from Panama suggests that, indeed, the observed parallel
movements in sovereign risk and devaluation risk reflect common factors. The chart
suggests that the interest rate spreads over U.S. treasury bills of Argentine and
Panamanian Brady bonds are, in large measure, driven by common factors. Thus, the absence
of currency risk in Panama does not isolate that country from swings in market views of
emerging markets. Dollarization can help reduce risk premiums, but only to a limited
extent.
Stability and integration
Looking just at interest rates, however, provides too narrow a perspective. Important
as reducing risk spreads is, dollarization may offer other gains that, although not
immediately observable, may prove more beneficial over time. To begin with, speculative
attacks and currency crises are costly not only because their possible emergence widens
risk premiums but also because they have dire consequences for the domestic economy. Of
course, dollarization would not completely eliminate the risk of external crises; indeed,
Panama has had several crises and consequently entered into a large number of IMF
programs. Nevertheless, dollarization holds the promise of at least reducing the frequency
and scale of crises and incidences of contagion.
In addition to promoting financial integration, dollarization may contribute to trade
integration with the United States to an extent that would not be possible otherwise. The
volume of trade among Canadian provinces is more than 20 times that of their trade with
U.S. states, after corrections are made for other variables that explain trade across
provinces or states. The use of a common currency may be an important factor in explaining
this pattern of national market integration, given the fairly low transaction costs and
restrictions to trade across the Canadian-U.S. border.
Seigniorage
A country adopting a foreign currency as its legal tender would lose the income from
seigniorage. First, the country would have to purchase the stock of domestic currency held
by the public (and banks) with dollars from the country's international reserves or with
borrowed funds. Second, the country would give up future seigniorage earnings stemming
from the flow of new currency printed every year to satisfy the increase in the demand for
money. These increases are likely to become smaller over time, however, as financial
development results in a reduced need for currency to effect transactions.
Seigniorage costs can be significant. For Argentina, domestic currency in circulation
is equivalent to roughly $15 billion (5 percent of GDP), and the annual increase in
currency demand has averaged roughly $1 billion (0.3 percent of GDP) in recent years.
About $0.7 billion (0.2 percent of GDP) a year in interest on the existing stock of
currency would be lost because of dollarization. These forgone interest earnings would
grow over time with the increase in money demand. Argentina's seigniorage loss would be
the United States' gain. For this reason, it has been suggested that the United States
share this seigniorage with dollarizing countries according to some agreed-upon formula
(as is done in the euro and the South African rand areas).
Exit option
Suppose that the real exchange rate in a dollarized country becomes overvalued. This
may result from excessive wage increases, a sharp deterioration in its terms of trade, or
the dollar itself becoming overvalued relative to the currencies of other important
trading partners. Countries with flexible exchange rate regimes can adjust by allowing
depreciation to occur in, one hopes, a gradual and nontraumatic way. With dollarization or
fixed rates, the real devaluation must be achieved through a fall in nominal wages and
prices. Experience has shown that these declines are often achieved only at the cost of
economic recessions, because resistance to nominal wage and price reductions can be
strong. Countries with currency boards have, of course, already eliminated much of their
choice with regard to the exchange rate. But what distinguishes such countries from
dollarized economies is that, in extreme cases, the former can devalue more easily.
Departures from the gold standard in the interwar years and the devaluation of the CFA
franc in 1994 suggest that an exit option may indeed have some real value in the presence
of extreme shocks. During the Great Depression, countries abandoned the gold
standard—the fixed exchange regime of that time. Argentina suspended convertibility
in 1929 and followed an active monetary policy to sterilize the impact of capital
outflows, which helped to minimize the impact of the Great Depression. More recently, in
1994, when countries of the CFA franc zone in West and Central Africa faced a prolonged
deterioration of their terms of trade and a steep rise in their labor costs, combined with
a nominal appreciation of the French franc against the U.S. dollar, they decided to adjust
their firm-peg regime, which had been in place since 1948, and devalue the CFA franc. This
exchange rate realignment led to a significant economic turnaround during 1994-97 and had
little inflationary impact on their economies. Had they "French franc-ized"
instead, making the necessary adjustment would have been more difficult.
Despite those experiences, many countries might not profit from an exit option even
when the currency is overvalued. Where policymakers have little credibility, or where the
dollar is already the unit of account, a nominal devaluation may rapidly lead to enough
inflation to undo the devaluation's positive effects. As we have observed in a variety of
recent currency crises, devaluations undertaken in a context of weak banking systems and
large foreign exchange exposure in the private sector damage the financial health of banks
and businesses, sharply disrupting economic activity. This implies that devaluation may be
a prohibitively costly policy option in some cases and that moving to full dollarization
would not entail the loss of an important policy tool.
Lender-of-last-resort function
As lenders of last resort, central banks stand ready to provide liquidity to the
banking system in the event of a systemic bank run. The central bank does this essentially
by using its ability to create liquidity—something that it would not have in a
dollarized system. Currency boards face a similar constraint, because they can create base
money only to the extent that they accumulate reserves. Countries with currency board
arrangements can, however, retain some flexibility to create money that is not fully
backed by reserves, so as to be able to deal with the risk of banking crises. During the
1995 Tequila crisis, the central bank of Argentina was able partially to accommodate the
run on domestic deposits by temporarily reducing the reserve coverage of the monetary
base. In the wake of the 1997 speculative attacks, the Hong Kong Monetary Authority
introduced a discount window to provide short-term liquidity to banks and may have moved
closer to taking advantage of the flexibility granted by a currency board arrangement. In
a dollarized economy, as in an economy with a currency board, the authorities have the
option of obtaining lines of credit from external sources that might be used in the event
of a crisis. Experience so far with such lines of credit suggests, however, that they may
not be very useful precisely when they are needed, because foreign banks have many ways to
reduce their exposures to a country experiencing a serious crisis. Alternatively, the
authorities might build up a reserve fund from tax revenues in anticipation of financial
sector emergencies if they have sufficient room for maneuver on fiscal policy.
In any case, the importance of a curtailment of the lender-of-last-resort function
should not be exaggerated, because the ability of a central bank to deal with a financial
crisis solely by printing money is inevitably limited. Dollarization may, moreover, make a
bank run less likely. If there are not significant currency mismatches in the banks'
positions, depositors may have more confidence in the domestic banking system. If large
foreign banks play a dominant role in the banking system, which would presumably be
encouraged by dollarization, this would also reduce the danger of a bank run.
Conclusion
What is the balance of costs and benefits of full dollarization? Our discussion has
perhaps been frustratingly inconclusive. In our view, this is inevitable, given the
complexity of the issue and the current state of knowledge about it. We can at least
estimate the potential benefits of lower interest rates and the cost of forgone
seigniorage revenues. But many of the most important considerations, such as the value of
keeping an exit option, are the least quantifiable.
Which countries are likely to benefit from dollarization? The first group of candidates
consists of countries that are highly integrated with the United States in trade and
financial relations (and that are candidates to form what the economics literature calls
an optimal currency area). Yet most countries in Latin America are quite different from
the United States in their economic structure and would probably not benefit greatly from
dollarization unless it took place in the context of a deep market integration (carried
out in European Union style). The current discussion (and this article) centers on a
different group of candidates: emerging market economies exposed to volatile capital flows
but not necessarily close, in an economic sense, to the United States. For these
countries, the more the U.S. dollar is already used in their domestic goods and financial
markets, the smaller the advantage of keeping their national currencies. For an economy
that is already extremely dollarized, seigniorage revenues would be small (and the cost of
purchasing the remaining stock of domestic currency also would be small), the exposures of
banks and businesses would make devaluation financially risky, and the exchange rate would
not serve as a policy instrument because prices would be "sticky" in dollar
terms. In such cases, dollarization may offer more benefits than costs.
Postscript
On January 9, 2000, the President of Ecuador announced a decision to adopt the U.S.
dollar as the country's legal tender. The sucre would retain a minor role, perhaps
circulating only in denominations smaller than the equivalent of US$1. The measure was a
response to a complete loss of confidence in Ecuador's economic policy and the
authorities' inability to stem pressure on the sucre.
