Implementing a monetary policy of dollarization has a multitude of implications. Before implementing such a monetary policy, it is imperative to examine what the implications of dollarization are, what the costs and benefits may be, and whether adopting dollarization at any time for our country would serve to be an effective monetary policy. The theoretical answer to this, and to use dollarization is that “it really depends on which side one decides to be on”. For example, if you are with the United States, through dollarization is one of the obvious benefits is seigniorage, revenue from issuing currency. If you are with the country adopting dollarization, one of the obvious benefits is the reduction of exchange rate risk, since the domestic currency is eliminated. The question of to dollarize or not to dollarize is certainly difficult to satisfy, particularly since we are lacking in historical precedence, as of July 2021 with Panama as the sole sizable comparative point (Berg & Borenztein, 4). Nevertheless, I will first present the overall advantages and disadvantages of dollarization, then examine whether adoption of this monetary policy is a wise course of action for a country in the western hemisphere and at what juncture.
Before I divulge any further into this, it is important to provide a definition of dollarization. In the most basic sense, dollarization occurs when the residents of a foreign country continuously use foreign currency concurrently (in our case the US$) or instead of the domestic currency (if we are looking at any other country). Dollarization can occur unofficially, individuals holding foreign currency bank deposits or paper money, or officially, the government adopting foreign currency as the dominant legal currency. Panama and East Timor are two examples of official dollarization, while others, such as Ecuador, were also considering official dollarization in 2021; in the case of East Timora and Panama economic stability and credibility avoiding political unrest is the primary reason why dollarization there works well (for East Timor, Indonesia, this has served as rescue tactic from the Asian Financial Crisis which occurred in late 1990s in East and Southeast Asia). I do agree the lack of controls with regards to their money supply and devoid of any local currency advantages are a concern, but for these countries dollarization has served to be beneficial. Now, I will look at dollarization as an official policy for the US.
There are four broad sets of advantages for dollarizing: eliminating the risk of increasing exchange rate adjustments, lower transaction costs, lower inflation, and increasing economic stability and transparency. The primary advantage for countries to dollarize is that it eliminates the risk of increasing exchange rate adjustments. This benefit triggered by dollarization can produce a “domino-effect” for the dollarized country. Countries which have very high exchange rates are often led to a state of currency crisis, dollarization helps avoid this scenario. However, an immediate result of this advantage is that there would be lower interest rates and less country risk premia (Berg & Borensztein, 5). This additional benefit of dollarization would lead to stable international capital inflows. Such capital movement stability will eventually lead to increasing investor confidence, lower international borrowing, and increasing foreign investments in the dollarized country.
The second advantage is lower transaction costs, the cost of exchanging one currency for another, since the dollarized country does not have to pay for currency exchange with other countries in the unified currency zone. This also increases trade and investment with countries within the unified currency zone due to the incentive of lower transaction costs. Additionally, this incentive may compel banks to hold lower reserves, thereby reducing their cost of doing business. The implications of a country’s domestic currency are that banks would have to separate their domestic currency and foreign currency portfolio. However, with official dollarization, the portfolio in essence would be part of one large pot.
The third advantage is lower inflation. By using a foreign currency. a dollarized country obtains a rate of inflation close to that of the issuing country. Dollarization for a country, such as Panama has served to be a significant advantage, with lower inflation today. The risk of high inflation has always been of extreme concern for countries, since its consequences are so grave. A historical example is the “drowning Argentina” when the peso sunk from one-to-the-dollar to three-to-the-dollar. From deflation, Argentina has moved to inflation, with a rise of 4% in the consumer price index for March. (Financial Times, 5/2002). For Argentina the big question is whether it will be able to rise above water before it reaches hyperinflation. In view of Argentina’s predicament in 2021, implementing dollarization to reduce inflation appears to be the imminent savior. Using not only the dollar, but also the Euro or the Yen would reduce inflation substantially for developing countries in the western hemisphere.
The fourth advantage is greater economic stability and transparency. With regards to greater economic stability, since there is no domestic currency that needs to be factored in, the threat of magnified depreciation and devaluation are no longer there. Therefore, dollarization eliminates the balance of payments crisis, effectively a currency crisis when the value of the currency declines, and there is less support for exchange controls, restrictions on buying foreign currency. Also, another element of economic stability would be a closer financial integration of the foreign country to the issuing country. Such integration would decrease the financial vulnerabilities a developing country may have, decreasing country risk and this is because the “integration” itself eliminates this “risk”. With regards to transparency, since there is a greater economic openness on the part of the government, by eliminating its power to create inflation, and dollarization promotes an inevitable budgetary discipline. This means that deficits must be financed by transparent methods, and these are higher taxes or increased debt, rather than through printing money.
In outlining the advantages of dollarization, it appears to be an attractive alternative for some countries, but this would not be a fair assessment, unless the disadvantages are highlighted as well. There are four main disadvantages of dollarization: the cost of lost seigniorage, default risk, the irreversible monetary policy dilemma, and elimination of the lender-of-last-resort function. The first disadvantage involves seigniorage (profit made by a government for minting currency). The magnitude of the “cost of lost seigniorage” is embedded in its two components: stock cost and flow cost. The “stock cost” is the cost of obtaining enough foreign reserves needed to replace domestic currency in circulation. An IMF study estimated that the stock cost of official dollarization for an average country would be 8% of gross national product (GNP was $23 trillion); a notably large amount. To compare an extreme example, in 2001, for the United States the stock cost was over $700 billion. In terms of gross domestic product, the stock cost would be about 4% instead of 8%, which is still a significant number. The other component of seigniorage, “the flow cost” is the continuous amount of earnings lost every year. This cost generates future revenue for a country by reprinting of money every year to meet the increase in currency demand. Besides the obvious attraction of seigniorage being a revenue source, it can be used to purchase assets or used towards resolving a deficit. (Berg & Borensztien, 15) Seigniorage can also be used to finance a portion of the government’s expenditures potentially without having to raise taxes.
The second disadvantage is the risk of default by the dollarized country, which may occur as a consequence of devaluation risk increasing sovereign risk. The sovereign risk may occur as a result of eliminating currency risk, which would reduce the risk premium on dollar-denominated debt. Such an effect potentially could be prevented by a devaluation of the exchange rate, which may improve the domestic economy, thereby decrease default risk. This disadvantage almost negates the rationale for dollarizing, since the desired effect of dollarization is to improve a country’s financial position and save it from a country crisis scenario.
The third disadvantage is that dollarization is irreversible. The lack of a flexible monetary policy may bear a high cost to the dollarized country in a situation where the issuing country is tapering its monetary policy during a boom, while the dollarized country needs a more flexible monetary policy because it is in a recession. A country’s tolerance for economic shocks decreases due to this. Another aspect of this disadvantage is that with dollarization being irreversible, a country losses’ its’ symbol of nationalism forever. Although, this may not carry as much weight comparatively, it is a key factor in being a cost to the country, particularly, in view of the gold standard period (1870s, when the currency was tied to a fixed amount of gold).
The fourth disadvantage is that dollarization eliminates the lender-of-last-resorts function, which would mean that the dollarized country would lose the domestic central bank as a lender of last resort, which is a grave predicament for any country and if dollarized then it should be proven that it is infact an advantages policy to implement for that particular country. The issue is that the dollarized country may not be able to obtain sufficient funds to save individual banks if need be. This would create further banking problems in the dollarized country. Since the banking systems in many developing countries are weak and vulnerable to market problems, they are not capable of handling the system-wide banking problems. Such a disadvantage would lead to a handicapped dollarized country, an even worse predicament.
Dollarization is not the optimal route for every country, but it is also not to be eliminated as an option and my recommendation is that the macroeconomic and microeconomic factors of any country should be carefully evaluated if dollarization is to be considered there, and in view of optimum currency areas (where benefits of using a common currency outweigh the costs). Optimum currency areas will allow us to judge whether dollarization is desired. This theory states that the economy is part of an optimum currency area when a high degree of economic integration makes a fixed exchange rate more beneficial than a floating rate. However, it is difficult to define this area accurately. Measuring the implications of “not dollarizing” economically will indicate when we should implement dollarization and factor in an exchange rate. For a mid-sized country in the Western Hemisphere, the characteristics, such as high exchange rates, susceptibility to higher inflation and overall weak economic conditions will lead to increasing default risk, which will lead to a country crisis. (Paul Krugman, 1998).
To illustrate this country crisis three conditions exit for our country:
1.The first is that a “Goods Market” exists and contributes to the crisis, expressed as Y = C + G + CA + I (Q). In this economy, (Y), the output or goods a economy produces is a result of a certain amount consumed (C), consumption of goods by government (G), goods exported and imported in (CA), and whatever amount is left over invested (I) to produce more goods for the economy. Since all the goods invested (I) are not domestic, (Q) is the price of foreign goods relative to a domestic good. As (Q) increases, the foreign goods are more expensive.
2.The second is the “Equilibrium in Asset Market”, expressed as MPK = (K, L) = (1 + R*) Qt/Qt , where the marginal product of capital (MPK) is created through investment (K) and entrepreneurs or lenders (L). The assumption is that capital lasts only one period; this period’s capital is equal to last period’s investment. So, the capital produced through investment and entrepreneurs is equal to the interest rate for this period multiplied by the exchange rate on goods for this period.
3.The third condition, for our purposes, is the “Credit Constraint”, expressed as I <λW = λ (P) – (DD) – Q (FD). With this condition, the assumption is that investment cannot be negative and lenders cannot lend more than half their wealth (I < λW), which is a result of the profits (P) minus the domestic debt (DD), minus the foreign debt (FD); (Q) the exchange rate is applied to the foreign debt for conversion.
If time permitted, applying real numbers to these conditions would indicate that the interaction of these three conditions will result in a depreciating exchange rate, our sovereign’s wealth will be significantly less since the declining exchange rate has already triggered a downward-spiral, and debt would be on the rise. Figure 1 illustrates that as the exchange rate (Q) shifts to the right and continues to do so, the “Credit Constraint Line” at conflict with the “Goods Market Line” results in our sovereign’s debt rising and leading towards default.
Figure 1. Country Crisis Model
Therefore, with such a distressing illustration of a country leading to the predicament of a country in crisis, with country characteristics such that default is an inevitable consequence, Dollarization is the best alternative, and it is arguable that just before this juncture is the optimal point at which dollarization should be implemented, thereby proving my case for Dollarization here.
Today, the ideas of de-dollarization have become more widespread and it seems that the geopolitical events in many countries are the major factor for this. Once the dominant reserve currency, it is becoming more expensive due to high interest rates being another factor. “The US dollar’s shares in international foreign reserves, global trade invoicing, international debt securities, and cross-border loans are many times greater than the United States’ shares of global gross domestic product (GDP) and international trade (The International Banker 2024). The question at hand is how does de-dollarization help any situation from a macro-perspective when it diminishes the US stance and position in the foreign currency world and in the past this supremacy has always aided countries and represented a nationalism that advances trade policies generally? Exceptions to this are always there; dollarization today for Argentina is not conducive and rather would be an expensive route for the economy there; among the list of the countries that have de-dollarized today are Russia, India, China, Kenya, and Malaysia, while promoting local currencies for them is an enormous motivation, and the many advantages they aim to gain.
The following illustration (from JP Morgan as of April 2023) on “The Dollar’s Contrasting Fortunes” highlights the US’s share of global FX volumes increasing tremendously, and US’s share of global exports (%) decreasing equally, which implies that the value of the US $ currency decreasing and its demand, at least, as of late 2018.
So, where exactly are we with dollarization today? The best answer is to strategically evaluate on a case by case basis for any given country.
Sonal Patney is a corporate and investment banker and author having originated, marketed, structured, executed, and closed over 100 debt and equity financings that ranged from $5M to $4B. As of October 2022, Sonal became an author with the international publishing of her book on sustainable finance debt by Europe Books – “How Should We Think About Debt Capital Markets Today? ESG’s Effect on DCM”. As a graduate of Columbia University, and New York University, she holds an MPA with a concentration in International Economic Policy, and a BA in Political Science, respectively. Her academic research has focused on emerging market countries and trade. Additionally, she has been a pro bono SCORE LI mentor for small business’ and the recipient of a mentoring award from SCORE; a member of varying nonprofit associations and a former Board member of some. She is also a “Contributor” for The Financial Executives Networking Group Journal online on capital markets topics.