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FEDERALRESERVE Dollarization Explained

BY STEPHEN SLIVINSKI

In some developing o understand the power of government’s reserve of dollars from to decide the fate of falling lower due to increased demand countries, monetary Tnations — developing nations, by citizens for the sounder currency. in particular — Manuel Hinds, But it also scares international stability might best the former finance minister of El investors afraid of another Salvador, says it helps to know the and suddenly the country faces higher be achieved by fable of Dema Gogo. interest rates in international capital Gogo is the president of a fictional, markets. officially adopting poor developing nation. Shortly after The vicious spiral continues. More he assumes office, he has a conversa- political pressure from labor unions a stable foreign tion with the devil, who passes along spurs the president to order the print- an idea he got from a recently ing of more gogos to pay wages. Then currency. deceased macroeconomist: Create his advisors tell him that he has lost your own currency, make it the legal all credibility with foreign creditors tender, and force citizens to relinquish and many voters. Soon, the president their dollars in exchange for the new finds himself running from an angry currency. This appeals to Gogo since it mob of citizens and during the pursuit would allow the government to create falls off a cliff to his death. as much as it wants and still This fable provides insight to the receive interest from placing the very real havoc created by political newly acquired dollars in a control over in the U.S. savings account. It’s developing world, particularly in Latin called , America. As a response to those eco- says the devil. A per- nomically dangerous impulses, some fect solution, it economists have suggested that a way seems, for a new for these economies to break out of ruler who wants to the trap is to hitch their currency to finance all the pub- the U.S. dollar — an action known as lic works projects he “dollarization.” Yet there are a variety was sure would of ways of achieving this, and the secure his continued distinctions between them could incumbency. He even have important consequences for gives the currency the economic growth. name “gogo.” But as is always the The How and Why case with Faustian of Dollarization bargains, there are The term “dollarization” describes a unexpected consequences. shift away from a country’s domestic instituted a “currency Oversupply of the currency creates toward a foreign ” system in 1991, but . That’s a nice thing for — typically the U.S. dollar, but not never adopted a policy of full exporters who can sell to overseas always — as a , unit of dollarization. Argentine pesos consumers in exchange for more-valu- account, and medium of exchange. like those pictured are still able dollars but bad for laborers who Official dollarization occurs when a in circulation today. have begun to protest the increased country explicitly makes a foreign cur- prices of imports. rency the preferred . So the devil suggests devaluing the There are a few countries that have currency by raising the official taken this direct route. The two of the dollar from one biggest economies in this category are to two gogos. That protects the and . The former

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has been dollarized since 2001, Dollarization also reverses the the latter since 2000. The main benefit of official isolation that results from having dollarized in 1904. There are four an unstable currency: The newly other smaller countries that have dollarization would come dollarized economy will soon find fully dollarized: the Marshall itself more integrated with inter- Islands, Micronesia, , and the from the monetary stability national capital markets. And the . Puerto ability of businesses to make long- Rico, the Northern Mariana that follows from the divorce term plans becomes more viable Islands, American Samoa, Guam, with the stability of the newfound and the U.S. Virgin Islands are dol- of politics and currency. larized, too, as a result of being There are trade benefits, too, U.S. territories. monetary policy. which are especially important to But the shift toward a foreign developing countries for which currency can occur in countries in exports compose a large share of which it is not considered legal tender. In fact, this form of the economy. Dollarization reduces the transaction cost of “unofficial” dollarization in which citizens prefer other cur- exchanging one currency for another. This may not seem like rencies in domestic transactions or as a means to safeguard a big problem, but it certainly can have real effects. Take the value of their bank savings is more common than the trade between Canada and the United States, for instance. official form. Various studies have concluded that Canadian provinces While data on the scope of unofficial dollarization world- tend to trade more with each other than with states in the wide are hard to come by, the most recent figures from United States to which they are closer geographically. Even economist Edgar Feige of the University of Wisconsin- with lower trade barriers between the two countries since Madison are illustrative. The countries with the highest NAFTA, it appears that the transaction cost of trading out degree of unofficial dollarization — the amount of foreign currencies has been a contributor to lower trade volume currency in circulation in each country as fraction of the than one would otherwise expect. effective money supply — were Bolivia, Nicaragua, , But there is another side of this coin, so to speak. From Croatia, and Russia (see table on page 4). the perspective of policymakers, there are indeed downsides The holders of foreign currency in these economies are to getting rid of the government’s control over monetary investing in a hedge against the (often very high) inflation of policy. It eliminates the ability of a central bank to serve as a their domestic currency. So the main benefit of official dol- and pursue other actions that can pro- larization — especially when coupled with an elimination of vide stability to the macroeconomy in the face of aggregate the central bank functions of the government — would supply or demand shocks. The government would also lose come from the monetary stability that follows from the the revenue generated by seigniorage. divorce of politics and monetary policy. The transaction Others have argued that the incentives of the anchor costs from shifting to such an arrangement could also be low country could be altered by widespread dollarization of in the countries listed here since so many citizens already use developing economies. Because the anchor country presum- the sounder currency. ably already has a central bank with the ability to adjust to There are other ways of dollarizing an economy. Instead economic shocks, the policymakers there might have to con- of eliminating the central bank function, a government can sider how their actions will affect the smaller countries that replace it with a “currency board.” This board would be rely on their monetary stability This won’t be a problem if responsible only for maintaining a specific exchange rate the anchor country is likely to experience the same sorts of between the domestic currency and the foreign currency of simultaneous shocks as the dollarized country. But if the dol- choice. Another solution would be to keep the country’s larized countries are subject to idiosyncratic shocks that are central bank in its old form and task it with the exchange foreign to the anchor country, there may be international rate stability role. These forms of “soft” dollarization, how- pressure on the latter to take a policy stance that benefits ever, could tempt policymakers to use the monetary tools the former. that are still available to them and weaken the currency Dollarization could also deal a blow to “national pride” in again. (As we’ll see later, that’s the problem that afflicted a country that adopts it. Few politicians are likely to want to Argentina.) admit that their country’s currency is troubled. Indeed, such The textbook version of any of these forms of dollariza- a concern among policymakers in the developing world is tion would lead to a more hospitable environment for often pointed to by economists like Nobel laureate Robert economic growth. In a predollarized scenario, the risk Mundell as a reason for why more countries don’t dollarize. premiums — and, therefore, interest rates — charged by Perhaps most fundamentally, dollarization will achieve its overseas lenders would be high. In a dollarized scenario, desired goal only if the anchor country pursues wise mone- lower real interest rates for those borrowing from interna- tary policies that result in price stability. For instance, that tional capital markets follow when the risk premiums fall. has generally been the case in the United States for more

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than two decades, but there have also Unofficial Dollarization grated with international financial mar- been missteps along the way, such as in Index: Reported Ratios of kets, particularly after banking laws were the 1970s, when inflation reached double Dollar Holdings in Foreign liberalized in 1970. digits. Under such circumstances, it’s Economies (2003-2004) Juan Luis Moreno-Villalaz explained it unclear that dollarization is preferable to this way in a 1999 article, authored when maintaining an independent currency Country he was an advisor to the Ministry of and central bank. Argentina 68.8 Economy and Finance in Panama: Still, from the perspective of most of “Panama’s monetary system operates as if the citizens who hold the currency, only Armenia 45.3 it were a competitive macroeconomy, the last of these concerns is likely to be Belarus 58.9 since monetary equilibrium is the result seen as an actual downside. And there Bolivia 83.5 of private-sector decisions without gov- have been solutions proposed to over- Bulgaria 55.6 ernment intervention or distortions.” come some of these shortcomings 47.5 Not all dollarization experiments have perceived by policymakers. Take the loss begun as peacefully as Panama’s. An of seigniorage, for example. The anchor Croatia 72.7 example of a more recently dollarized countries could easily share the seignior- Czech 25.9 economy is Ecuador, which adopted age revenue with the countries that adopt Estonia 17.4 the U.S. dollar as the official currency its currency. Such a revenue-sharing Hungary 20.6 in 2000. arrangement existed between the British Kyrgyzstan 41.4 Ecuador’s economic growth was stag- government and some of its colonies nating in the 1990s because of a heavy before the 1950s. There also exists a Latvia 48.7 government presence in the economy. seigniorage-sharing agreement between Lithuania 31.5 Policymakers attempted and failed to the European Central Bank and the Mexico 25.8 open the country to international trade countries that have adopted the . Nicaragua 76.4 and capital markets. Meanwhile, political Still, the opposition among policy- 57.5 unrest began to build as the large concen- makers in developing countries to tration of business involved in oil dollarization is probably the most robust Poland 18.0 exporting took a hit when oil prices fell, barrier to such policy changes. Exploring Romania 36.1 taking sections of the economy down the successful experiments with dollar- Russia 72.6 with it. A collapse of the banking system ization in Latin America can help us Turkey 46.7 followed in the late 1990s around the time understand the circumstances under Ukraine 44.9 that the atmospheric phenomenon which a developing country might adopt El Niño had a devastating impact on such a policy. Uruguay 74.1 production and infrastructure. Runaway 18.0 inflation, the result of an overly permis- Successful Dollarization sive and politicized central bank prior to in the Real World SOURCE: Edgar L. Fiege, University of the crisis, was also a factor. To see how a small country can function Wisconsin-Madison So, dollarization was adopted as part as a dollarized economy, you don’t have to of the solution, along with the privatiza- look any farther south than Panama, which adopted the U.S. tion of some state-owned enterprises, and liberalization in dollar as the official domestic note in 1904. (Panama does labor markets. But it was done in the midst of a political cri- circulate a domestic coin — the “balboa” — but it is fully sis that accompanied the economic downturn. Ecuador had convertible at a rate of one coin for one U.S. dollar.) gone through four presidents between 1996 and 1998. When The dollarization of Panama did not occur in a political the sitting president, Jamil Mahuad, announced the dollar- vacuum. The U.S. government had a specific interest in ization policy in January 2000, he was deposed days later. building a canal there as the 20th century dawned and was His successor, Vice President Gustavo Noboa, stuck to the encouraging the Panamanian government to declare inde- policy and by 2003, his last year in office, the inflation rate pendence from Colombia. When it did so in 1904 and new was 7.9 percent — down from close to 100 percent in 2000 independent governmental institutions were established, no — making it the first year since 1972 to see a single-digit central bank was created and the U.S. dollar became the de inflation rate. facto official currency. The absence of a central bank, however, does not mean The Perils of Soft Dollarization there are no options for the private banking system looking The Ecuador example shows how dollarization can follow for a lender of last resort in an economic tumult. massive economic dislocation and political unrest. Yet it also Panamanian banks have established lines of credit with for- hints at how the form that dollarization takes can affect the eign banks that have branches in Panama and can draw on outcome. The Ecuadorian government opted for a soft form those in a liquidity crunch. In fact, Panama is very well-inte- of dollarization — it retained the central bank and allowed

4 Region Focus • Fall 2008 it to function as a lender of last resort. Today, some international and internal debt it had racked up over the pre- observers suggest that the future of dollarization remains ceding decades. In addition, skepticism of the government’s uncertain in the face of recent stresses to that country’s commitment to convertibility spooked the markets and banking system. began a “silent run” on bank deposits. A country that most vividly illustrates the perils of soft By this time, the government was led by officials who dollarization is Argentina. President Carlos Menem came to were known to be less fond of the currency board structure. office in 1989 during a period of economic stagnation. The By the middle of 2001, the government was well on its way next year, the inflation rate topped 20,000 percent. to devaluing the peso by violating the convertibility rule. Dollarization of the economy began in 1991 and was They also announced a separate set of exchange rates for relatively painless since most citizens preferred dollars any- various export transactions. Thus, the currency board way, and had large holdings of them. (Dollar notes were ceased to be a rules-based institution that bound the hands estimated to exceed domestic currency notes and bank of policymakers. deposits combined.) Advocates of hard dollarization argue that Argentina The form that dollarization took here was soft too. The would be in better shape if the discretionary power of the mechanism used was widely called a “currency board.” It was currency board was taken away completely. They arguably tasked with overseeing the convertibility of the currency have a point: When the Argentine peso faced inflationary and offered anyone who wanted to trade in their pesos for pressure from speculators in 1995, the government was able dollars a 1-to-1 exchange rate. It was a credible commitment to reduce that pressure by threatening to shift to because the board was required to hold dollars in reserve as hard dollarization and to get rid of the peso means to make good on the exchange and was presumably altogether. By threatening a less discre- bound by the expectation that they would not embark on a tionary policy, they were able to protect discretionary monetary policy. their currency. This arrangement was in some ways a concession to the Over time the allure of monetary sovereignty concern. At the time, pesos were still in circula- sovereignty and political pressure pre- tion and considered legal tender, but the convertibility of vailed. Economist Kurt Schuler, them to dollars made the U.S. currency the de facto medium currently with the U.S. Treasury of exchange. Yet it was indeed successful in reducing infla- Department, has tallied up the costs to tion to single digits by 1993. these sorts of political preferences and dis- But the currency board deviated from the textbook covered that they are steep. Between 1971 and definition. There were some loopholes in the reserve 2000, developing countries without central banks had requirements. The Argentina currency board was able to about as much inflation as developed countries with central hold a certain percentage of government-issued bonds banks. Presumably the latter learned very important lessons instead of foreign currency. And the government was quite from the period of high inflation in the 1970s. But develop- eager to run up debt in the years after the currency board ing countries with central banks have far less success: was created. Average annual inflation was about 10 times higher in those International investment in the region slowed after inter- countries. national shocks, like the East Asian and Russian currency Sometimes truth and fiction look disturbingly similar. crises, and local ones, like the devaluation of the Brazilian The story of Dema Gogo provides us with insight on mone- currency. A recession resulted, but that alone wasn’t tary experiments in the developing world. Unfortunately, for enough to threaten the currency board structure. Instead, many of those countries the fable continues to be closer to Argentina’s government had trouble paying interest on the reality than myth. RF

R EADINGS Bogeti , Zeljkˇ o. “Official Dollarization: Current Experiences and Hinds, Manuel. Playing Monopoly with the Devil: Dollarization and c´ Issues.” Cato Journal, Fall 2000, vol. 20, no. 2, pp. 179-223. Domestic Currencies in Developing Countries. New Haven, CT: Yale Feige, Edgar L., and James W. Dean. “Dollarization and Euroization University Press, 2006. in Transition Countries: Currency Substitution, Asset Substitution, Salvatore, Dominick, James W. Dean, and Thomas D. Willett, eds. Network Externalities, and Irreversibility,” in Monetary Unions and The Dollarization Debate. New York: Oxford University Press, 2003. Hard Pegs, eds. Volbert Alexander, Jacques Mélitz, and George M. von Furstenberg. New York: Oxford University Press: 2004, pp. 303-321.

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