Comment & Debate
Official dollarization involves a country abandoning an independent currency. In dollarized countries, only a foreign currency is legal tender (though local coins may be produced).Countries that normally adopt such a radical change in monetary policy are often encountering instable economies, high levels of inflation and a very low competitive currency. Dollarization usually involves the US dollar, but may increasingly refer to conversion to other currencies such as the Euro.Worldwide, different countries have adopted different foreign currencies like the US dollar, the Euro or the Australian dollar. Panama, Ecuador and El Salvador are all currently “dollarized”, as are many small countries including East Timor, and dollarization was seriously suggested as a solution to Argentina’s recent crisis. Dollarization is different from monetary union because the US continues to set monetary policy in its own interest alone, whereas the European Central Bank (for example) is required to take all Eurozone countries’ interests into account.There are 13 euro countries as of January 1st 2007 and they include Belgium, Germany, Greece, Spain, France, Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland and from 1 January 2007: Slovenia. Unofficial dollarization is happening is Kosovo and Montenegro that currently use the Euro as a means of payment, replacing the “de facto” currency -the German Mark.Since most often it was mainly small, developing countries that have dollarized, numerous questions about the viability of such an action and its potential positive and negative effects arise.Its effects on the political and economic levels have split the specialists in advocates and opponents of such a policy, making it a contentious subject in international monetary and political studies.
Dollarized countries have been able to stabilize their economies and promote economic growth. Better integration into theinternational financial system and higher credibility among foreign investors, all have been effects of the dollarization policy.Cheaper international borrowing has lowered mortgage rates, spurred consumer credit and increased household consumption all leading to higher rates of economic growth.
The monetary union in Europe among EU members has shown that giving up domestic currencies and adopting the Euro has enhanced the financial integration among the member countries
Dolarization removes arbitrage within trade.Arbitrage is is the practice of taking advantage of a price differential between two or more markets.When this happens entrepreneurs in the dollarized country are faced with a large array of opportunities on how to better perform within international trade.This will make them focus on improving producion skills, developing niche businesses, invent and increase their competitiveness. Empirical examples from El Salvadaor prove this has been the case post dollarization and it has lead to even more economic growth.
Dollarization provides countries with access to the international financial systems.This competitive environment and the fact that there is no longer a monetary control agency both provide incentives to adopt a responsible borrowing behavior with a focus on repaying debts. This increases the credibility of that country internationally. Consequently they will have easier access to cheaper borrowing once they have restored their credibility as a sovereign borrower.
Dollarization significantly reduces transaction costs and eliminates currency conversion fees. It helps in this way enhance economic links between the dollarized country and the currency issuer country. From the perspective of the dollarized country , dollarization stabilizes their inflation and improves their credibility internationally.Hence they can extend their trade with the currency issuer country and gain more benefits as the transaction costs are lower. From the perspective of the currency issuer country,the elimination of a currency risk leads to more trust from the consumers in any of the dollarized countries’ products. Also the elimination of the currency conversion costs can provide incentives for tourists and business to go and invest in the dollarized country.
The United States often offers financial incentives to those countries that dollarize. Nations can benefit economically from such financial support from the United States.
The example of Ecuador proves that for a small independent country that was undergoing hyperinflation and a high levels of instability in the financial markets was able thanks to dollarization to stabilize inflation and improve its inetrantiona rankings in terms of financial credibility.
The fear of high inflation is a major factor inhibiting investment in developing countries. By dollarizing, these fears can be settled, and investments are likely to flow more freely.[1]
Even when a country dollarizes, the fundamentals of its debt do not change. If it unable to repay its now dollar-denominated debts, it will still have to default.
Countries with sound and stable economic policies do not really need the stabalizing effects of dollarization.
Dollarization is frequently considered a solution for countries that have poor economic policies. Yet, this essentially accepts these poor policies, puts a band-aid over them, and shirks the responsibility to improve the fundamentals of a country’s monetary policies. Such a band-aid approach is irresponsible, as it denies countries the opportunity to learn from their mistakes and develop sound monetary policies.
It is frequently important for countries to be able to adjust interests rates or the printing of money in order to respond to certain economic conditions, such as recession. But, by dollarizing, a country is forced to follow the monetary policies of the United States Federal Reserve. This puts countries in what is often called a monetary policy “straight jacket”, and can make it difficult to respond appropriately to economic conditions and avert such events as recessions.
Particularly as dollarization becomes more widespread, it becomes increasingly important that the United States be vigilant regarding the consequences of its monetary policies for other nations. If a particular US monetary policy adjustment is to have a negative impact on the majority of dollarized nations, for example, it will be more difficult the United States to implement such an adjustment. Such considerations will have a generally constraining impact on US monetary policy.
Dollarization combined with a financial integration provide the dollarized country with access to the large realm of international funds and liquidity.This means that there can be exchanges of funds between the dollarized country and the currency issuer country without any risk.This reduces the instability of foreign capital flows and also helps stabilize exchange rates. Ultimately, a more stable financial system in the dollarized country benefits consumers that will have access to internationally competitive international financial institutions.
The Argentine and East Asian crises showed that partially fixed exchange rates expose countries to the risk of sharp falls in the exchange rate when speculators attack. Under dollarization there is no exchange rate to be attacked, so speculators have no role.[2]
When people are allowed to have bank deposits in foreign currencies, the risk of a devaluation of the domestic currency is lower causing also a lower risk of a bank run(that occurs when depositors all rush to the bank to withdraw their deposits causing the bank to be out of liquidities).
Studies have emiprically proved that countries that adopted dollarization when they were undergoing rampant hyperinflation have now been able to control inflation rates and become stable economies.
Dollarization has been proven to eliminate the posibility of currency crises. Thourgh the decision to give up one’s ability to conduct monetary policy , the dollarized country has no ability to appreciate or devalue their currency as to have an advantage in international trade. This inability coupled with the stability of the adopted currency mean the dollarized country cannot actually pursue any policy towards currency devaluations.
Governments, especially in developing countries, are very bad at controlling inflation. They always want to increase short term growth at the expense of long term stability. Governments should tie their own hands through dollarization to make their anti-inflation rhetoric credible.[3]
Countries are just as likely to abuse it and cause high inflation as they are likely to use it correctly. Developing countries never truly have independent monetary policy anyway, their economies are heavily affected by the United States’ policies even without dollarization, since changes in the US interest rate change demand for their exports.[4]
A lack of lender of last resort functions can promote a stronger, healthier banking system, and helps prevent the kind of “crony capitalism” that bedevilled South East Asia. Banks cannot take on risky loans, relying on the central bank to bail them out if necessary.[5]
If the government does not try to fix the exchange rate, then the rate will constantly adjust, with gradual falls instead of sharp crises.[6]
The announcement that a country is dollarizing often comes a year in advance of the initiation of the process. This can cause fears of a country’s economic instability or pending crisis, and can result in such things as capital flight, in which foreign money is rapidly withdrawn from the country.
While some respond to concerns about financial panic and damage during a long transition period to dollarization with the notion of “overnight dollarization”, there are reasons why this cannot be achieved.
It is frequently important for countries to be able to adjust interests rates or the printing of money in order to respond to certain economic conditions, such as recession. But, by dollarizing, a country is forced to follow the monetary policies of the United States Federal Reserve. This puts countries in what is often called a monetary policy “straight jacket”, and can make it difficult to respond appropriately to economic conditions and avert such events as recessions.
Particularly as dollarization becomes more widespread, it becomes increasingly important that the United States be vigilant regarding the consequences of its monetary policies for other nations. If a particular US monetary policy adjustment is to have a negative impact on the majority of dollarized nations, for example, it will be more difficult the United States to implement such an adjustment. Such considerations will have a generally constraining impact on US monetary policy.
Independent central banks are widely used in the developed world, and can work for developing countries if effort is put in to designing the institutions correctly. It is ridiculous to suggest governments should restrict their own ability to help their economies, just because some governments have sometimes misused this power.[7]
In order for money to perform its role it there is a “a priori” need or inflation not to occur. Inflation according to Austrian School Monetarist, Steven Horwitz, distorts monetary calculation and the ability of money to coordinate people . Out of the need for coordination and order people will look to other means or achieving order , more specifically through the political process. His argument is that inflation makes people more likely to desire totalitarian regimes and provides the example of now the inflationary periods of interwar Germany allowed for the rise of National Socialism.
Studies have emiprically proved that countries that adopted dollarization when they were undergoing rampant hyperinflation have now been able to control inflation rates and become stable economies.Stable economies allow entrepreneurs to specialize more, become more efficient and more competitive and in this way strengthening the prospects of that countries market economy to grow.
National currencies are often a powerful part of national identity. Replacing them with a symbol of another country’s national identity is often an affront to many citizens and their sense of nationalism and sovereignty.
It is concerning that a country would give up control of its sovereign monetary policies to the United States. The main problem is that this jeopardizes the democratic influence of a country’s population on monetary policy or democratic election of the leaders that control such policies. Dollarization undermines all of these democratic checks.
Dollarization is a maneuver that sees a significant degree of a country’s own image, in its currency, replaced by the image of the United States dollar. In nations where anti-Americanism is high, such a situation is not welcome, could lead to protests and violence, and may have political costs for national leaders that adopt such policies. It may also accentuate anti-Americanism and, subsequently, even terrorism.
Dollarization increases the influence and power of the United States and its markets in the world. Moves by the United States to dollarize other countries can be viewed as, in part, a self-interested move to increase the country’s economic influence and power. Such economic imperialism should be resisted.
Changing currencies is a painstaking process for a country. It is no different when de-dollarizing. But, there are some additional constraints revolving around the effects that such de-dollarization may have on relations with America and even American monetary policy.
Many contracts are made with the language of a particular currency. Dollarization requires the re-writing of these contracts in dollar terms. This is costly and can cause legal challenges.
This, in turn, promotes economic growth.[8]
“By reducing transaction costs, dollarization not only significantly increases bilateral US trade with dollarized countries but promotes trade among dollar-zone countries as well.”
Countries will become dependent on the good-will of US trade policies. This is not worth the sacrifices.
by countries who have retained their own currency, which may well devalue over time relative to the dollar, making their exports relatively cheaper
To access the second half of this Issue Report Login or Buy Issue Report
To access the second half of all Issue Reports Login or Subscribe Now
