Introduction
The policy of dollarization is widely used around the world as the main tool to reduce inflation rates, stabilize local currency and the elimination of exchange rate risk. The process of dollarization is connected with stabilization which precedes structural policies aimed at increasing the efficiency of the economy. In many emerging economies, in the absence of a government which has the political strength to stabilize, the legalization of dollarization is advocated, as this limits the authorities’ ability to fix prices administratively or to obtain purchasing power through the printing press.
In general, ‘dollarization’ means the substitution of hard currency for the domestic currency as the medium of exchange, and above all as the store of value, in a large part of the domestic economy, so that the country effectively adopts a dual currency system. The term ‘dollarization’ is applied to any foreign currency used as the national currency. Following Schmitt-Grohe et al (2001): Proponents of dollarization argue that, by eliminating devaluation risk, dollarization will go a long way toward reducing country risk premia, thus lowering aggregate volatility” (p. 482). Dollarization means a currency union in which countries create a new currency supported by new institutions. The examples of this process are euro currency and the European Central Bank (Hinds 2006).
The process of dollarization
The process of dollarization can be unofficial, semiofficial and official (Levy and Sturzenegger 2002). “Full dollarization is a complete monetary union with a foreign country from which a country “imports” a currency by making the foreign currency full legal tender and reducing its own currency, if any, to a subsidiary role” (Bogetic 2000, p. 17). The main countries which follow official dollarization policy are Ecuador, El Salvador, and Panama (US dollar).
Also, euro dollarization is typical for Kosovo, Monaco, Andorra, etc. The New Zealand dollar circulates in Cook Islands, Nine, Tokelan and Pitcarn Island. The Australian dollar is an official currency in Kiribati, Nauru and Tuvalu (Levy and Sturzenegger 2002).
Positive sides of dollarization
The advantages of ‘dollarization’ are, first, that enterprises and individuals are provided with a currency (or currencies) whose value is more or less constant, thus reducing the degree of risk involved in economic calculations. In this way one of the main real costs of inflation, and one which probably increases the natural rate of unemployment, is avoided. Second, enterprises (both socialized and private) are able to import what they need directly from the outside world, without having to go through the lengthy process of obtaining approval for hard currency from the central authorities (usually the central bank) (Eichengreen, 2002). Not only are such decisions taken slowly, but their quality is likely to be lower than that of decisions taken by the enterprises directly affected. Following Edwards and Magendzo (2006):
Dollarization will positively affect growth through two channels: first, Dollarization will tend to result in lower interest rates, higher investment, and faster growth. And second, by eliminating currency risk, a common currency will encourage international trade; this, in turn, will result in faster growth (p. 269).
‘Dollarization’ is usually introduced in countries suffering from hyperinflation. The benefits of this are that individuals and enterprises (both private and socialized) have access to currencies that retain their value and which allow them to compare domestic costs with those on world markets. Eichengreen (2002) underlines that dollarization “strengthen the financial sector, … improve the fiscal balance, harden the government’s budget constraint,.. and enable the government to lengthen the term structure of its debt” (1).
‘Dollarization’ would also make inflation self-limiting to some degree. The higher the rate of inflation, the larger the sphere of activity that actors would choose to carry on in hard currency, and thus the less the impact of inflation on the real economy. This would be an accelerating process (Eichengreen, 2002). As the number of activities affected by inflation declined, the ‘inflation tax’ on these activities for a given budget deficit would have to increase, inducing activities to switch even more rapidly to the hard currency economy.
Economists speak about one more form of dollarization which can be used to stabilize economy and local currency rate. According to Broda and Yeyati (2006):
Financial dollarization can take several forms, including foreign borrowing (domestic banks or local firms borrowing directly from abroad as in the case of Thailand and Indonesia in the 1990s or Chile and Argentina in the early 1980s) and deposit dollarization (domestic asset holders saving locally in foreign-currency deposits as in Turkey and Argentina in the 1990s)” (p. 963).
What will accelerated inflation lead to?
Acceleration of inflation can be expected to lead more actors to opt out of the inflationary economy in a multi-currency system. In such an economy, if exchange rates between currencies are flexible, then Gresham’s law does not hold. Indeed, the better money (the one which is less inflation-ridden and whose purchasing power is less impaired by shortages of goods due to controls on prices which it is used to denominate) will displace the worse (Levy and Sturzenegger 2002).
A government which finances a budget deficit caused mainly by widespread subsidies to loss-making enterprises by printing money will find that people paid in the domestic currency are facing more and more transactions which have to be carried out in hard currency, and that the free-market value of the domestic currency is falling. Inflation thus becomes self-limiting. As more and more of the nonsubsidized activities switch into hard currency, the pool of profitable activities which take place in the domestic currency, and which are effectively taxed by the printing of money to pay for the subsidies to loss makers, will constantly decline (Eichengreen, 2002).
As the ‘inflation-tax base’ declines, the ‘inflation-tax rate’ increases, speeding up the process by which profitable activities switch to the hard currency economy. In the end only loss-making activities would be financed in the domestic currency. Once this situation was reached the domestic currency would have literally no value. The authorities could therefore be expected either to pursue a less expansionary monetary policy before this stage was reached, or to prevent certain profitable activities from switching to the hard currency economy by administrative decree, which would be a form of direct impost upon them. “dollarization levels can remain high, in spite of disinflationary policies, if the expected volatility of the inflation rate is high in relation to the volatility of the real exchange rate” (Duffy et al 2006, p. 2073).
As long as most of the profitable part of the economy used hard currency, it would be fairly visible who was paying the inflation tax. This might lead to countervailing political pressure, or to the profitable domestic currency sector simply being smaller than it otherwise would have been (Jameson, 2003).
The sources of costs associated with dollarization involve:
- the loss of seigniorage revenue,
- the lack of a lender of last resort,
- the country loses its ability to conduct cyclical monetary policy.
Following Schmitt-Grohe et al (2001): when a country adopts the U.S. dollar as the sole legal tender, the stream of its seigniorage revenue begins to flow to the U.S. central bank. Clearly, the magnitude of the cost of dollarization stemming from the loss of seigniorage revenue for emerging market economies depends on their ability to negotiate a seigniorage sharing agreement with the United States” (p. 482).
Dollarization of necessity involves a cost: the ‘seigniorage’, which is paid to the suppliers of the hard currencies. The example of economic policy in Poland and Yugoslavia during 1990s vividly portrays the process of dollarization. To circulate in Poland and Yugoslavia US dollars have to be obtained, ultimately from the central banks of the United States. They can only be obtained in exchange for goods and services, yet they are then used for exchange, and as stores of value, by Polish or Yugoslav residents, so that they are not used to purchase US goods.
Naturally, a single dollar may circulate many times a year, thus facilitating transactions worth several times its value in that period (Levy and Sturzenegger 2002). Nevertheless, the cost of seigniorage remains, whereas countries whose governments are capable of providing their citizens with a stable currency do not have to pay it. Seigniorage costs already represent a significant amount. In Poland probably some $7 billion are held by the population in hard currency bank accounts and cash, an increase of some $5 billion since 1982, or $700 million per annum, which is between 0.5 per cent and 1 per cent of GNP per annum in purchasing power parity terms (Levy and Sturzenegger 2002).
However, in the absence of a successful anti-inflationary policy, the attempt to do without a second, ‘hard’ currency would lead to even higher costs due to the disruption of economic activity which would be caused by a hyperinflation from which there was no easy shelter. For instance, the case of Panama shows that
Official dollarization may have favorable distributional benefits. In the environment of a weak national currency, the young, financially sophisticated, and wealthy are often better able to preserve and expand their wealth during periods of high inflation than are the old (such as pensioners), the poor, and, generally, people living on fixed incomes” (Bogetic 2000, p. 17).
The process of dollarization is known from many countries suffering from hyperinflation, Argentina at present and Israel in the early 1980s being examples. Dollarization is, at present, only relevant to the two market socialist countries. which are affected by hyperinflation (Bogetic, 2000). China and Hungary have the possibility of bringing inflation and excess demand under control, and then moving on to convertibility of the domestic currency.
Although the present author is not optimistic as to their likely success, dollarization is very much a cure of last resort. Dollarization is made easier in Poland and Yugoslavia by the fact that both countries have large numbers of their nationals working abroad (Levy and Sturzenegger 2002). These send home remittances if they are permanently domiciled abroad, or return home with their accumulated hard currency earnings after periods of temporary, often illegal, work in the West (Hinds 2006).
By 1987 in Poland the majority of savings deposits and cash held by the population were in hard currency (valued at the black market rate of exchange). If inflation continues to gather pace, this proportion will increase further, as individuals and private businesses switch to currencies which devalue far less, for use as stores of value and even media of exchange for larger transactions (such as house, car or machinery purchases). Many private businesses have used hard currency as their unit of account for years (Levy and Sturzenegger 2002). Current inflation and shortages, due to repressed inflation, have also led many socialized enterprises to insist on part payment in hard currency in both Poland and China, and such practices can be expected to expand if inflation accelerates further (Bogetic, 2000).
Unofficial dollarization has a great impact on exchange rate of the local country. Following Jameson (2003), unofficial dollarization occurs under three circumstances:
“When there is ample availability of dollars to the domestic economy. When domestic instability affects the health of the financial system and the confidence of domestic economic actors. When government policy allows a dollarized sector to exist within the domestic economy” (p. 643).
In this case, a central concern for economists analyzing forex black markets has been to determine the impact of these markets on national governments’ ability to carry out monetary policies such as money supply and aggregate credit management, as well as exchange rate policy (Eichengreen, 2002). The primary focus has been on the black market’s relationship with domestic inflation. Following Duffy et al (2006): “Unofficial ” dollarization ” has become a pervasive phenomenon in many emerging market economies. … [It means] unofficial currency substitution, i.e. the competition between U.S. dollars and the domestic currency as a medium of exchange” (2073).
If the black market allows excess demand for foreign exchange to move out of the official market, then it may also permit the pricing of imports to reflect their black market cost rather than their official market cost (in local currency). This condition greatly lessens the government’s ability to deal with inflation through exchange rate policy. The larger the country’s international sector, the more serious is this concern.
Impact on credit policy by dollarization
The dollarization processes have a crucial influence on credit policy because in addition to the direct exchange rate effects of black markets, and the subsequent effects on inflation, there are key monetary policy effects through alteration in the availability of credit. When the black market is used to bring added foreign exchange into the country, and when that foreign exchange is partially used as domestic currency (dollarization), then the money supply has effectively increased (Eichengreen, 2002). For instance, in Argentina despite the number of pesos remaining constant, the full money supply available to the public rises with the added dollars.
This implies an inflationary pressure in the local economy, unless the central bank intervenes to take currency out of circulation (Velde and Veracierto 2000; Hinds 2006). To complicate matters further, the money supply becomes less manageable as the dollars grow in proportion of total money, since the central bank cannot control the amount of dollars in circulation. For instance, “In order to dollarize, Argentina has to buy noninterest-bearing dollars with the interest-bearing reserves it has accumulated. These reserves bear interest at present, and therefore are a source of income for Argentina (seigniorage)” (Velde and Veracierto 2000, p. 24).
Dollarization has been observed throughout Latin America from 1970 to 1990. In cases such as Peru and Bolivia, estimates of annual cash U.S. dollar inflows during the late 1980s in each country exceed $US 1 billion. In relation to domestic money supplies, these figures are substantial amounts. These problems are compounded by the common phenomenon of capital flight, which takes local wealth out of the country (often through the black market) and places it in overseas safe havens. In this way, dollars are leaked out of the country in exchange for financial claim, such as bank deposits (Velde and Veracierto 2000; Jameson, 2003).
Likewise, further down in the credit chain, black market dollar holdings overseas may expand the availability of dollar credit to those holders. Thus, a local resident with an overseas dollar deposit account may be able to secure credit for use in the local economy, again outside of the control of the local monetary authority. None of the macro models available is able to handle these multiple complications together, although some models do treat some of them (Hinds 2006).
The high and hyperinflation that market socialist economies are experiencing does matter economically and politically. Inflation is destructive of enterprises’ and individuals’ ability to make economic calculations, so that its disruptive effects become more severe as the economy is reformed in a market direction and relies less on administrative control (Hinds 2006). Western evidence, limited as its use inevitably is, suggests that whatever the proximate causes of inflation in the market socialist countries (e.g. government policy to raise consumer goods prices so as to reduce consumption for international payments reasons in Hungary), the underlying reason is the maintenance of the actual rate of unemployment far below the natural rate (Eichengreen, 2002).
Given the extremely high degree of rigidity in these economies the natural rate of unemployment could well lie in the range of 20-30 per cent. Since it is far from certain whether inflation can be stabilized at rates of 60-195 per cent, the actual rates of unemployment required in these two countries to bring inflation under control could be considerably higher. Unemployment at these levels may be politically unacceptable in countries which have had very little experience of unemployment over the past four decades (excepting Yugoslavia) (Schmitt-Grohe et al 2001, Levy and Sturzenegger 2002).
The main problem for local economies is that the extensive dollarization has prompted even greater interest in the forex black market. As local currencies have devalued, sometimes drastically, many Latin American individuals and institutions have searched for a safer store of value (Hinds 2006). The U.S. dollar, though not wholly stable or able to maintain its purchasing power relative to European and Asian currencies in recent years, has generally maintained its value in terms of Latin American currencies from 1960 to 1990 (Levy and Sturzenegger 2002).
By holding some of their wealth in dollars and/or dollar-denominated financial instruments, Latin Americans have been able to preserve that value in contrast to holding local currency instruments. Because access to dollars in the official market has been frequently restricted, the black market has served the function of providing this access (and also providing the service of transferring funds overseas to “safe” havens such as the United States) (Levy and Sturzenegger 2002)..
This is a complex issue, since in many of the countries, dollarization of the economy has led in past decades to use of U.S. dollars as an acceptable or even preferred means of settling domestic financial claims. Thus, the de facto money supply includes both dollars as well as local currency in circulation in many instances (Hinds 2006).
Conclusion
In sum, dollarization is widely used in emerging economies as the main method to reduce inflation rates and stabilize local currency. This policy proposes both benefits and threats for local economies including low inflation rates but lack of financial and monitory control over the local currency. Thus, dollarization is considered vital to eliminate the monetary financing of the budget deficit, while a significant degree of discretion is usually maintained in the creation of credit for non-government (CNG) by the banking system.
References
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