Dollarization and Foreign Countries That Have Dollarized To the U.S. Dollar

Table of Contents

Introduction

Definition of Dollarization

Motivation and Process

Pros and Cons

Examples of Dollarization

Dollarization in El Salvador

Dollarization in Ecuador

Future Directions for Research

Conclusion

References

Introduction

Dollarization is not a recent occurrence in the international community, but with the official adoption of the U.S. Dollar by several countries over the last decade, it has gained significant attention. Governments, international organizations such as the U.N., the World Bank, The International Monetary Fund, as well as economists and other scientists have all over the past ten years been paying far more attention than previously to dollarization.

First, a complete definition and brief history of dollarization will be presented followed by the motivating factors behind a nation’s decision to dollarize. One economist’s process for dollarization is also presented. Next, some Pros and Cons are summarized followed by an overview of the example nations that have dollarized will be given followed by the beginning of my focus on Latin America as a region apparently prone to dollarization and why.

The balance of the paper will be devoted to two case studies presenting in depth information about two Latin American countries that have officially adopted the U.S. Dollar, El Salvador, and Ecuador. Finally, directions for future research are presented.

Definition of Dollarization

In a staff report to the Joint Economic Committee of the United States Congress, International Economist Kurt Schuler, PhD defined dollarization as occurring, “when residents of a country extensively use the U.S. dollar or another foreign currency alongside or instead of the domestic currency.” The definition of dollarization has taken on new meaning as the practice has evolved. What once meant the official adoption of the U.S. Dollar as a country’s national currency has expanded to include the adoption of any foreign currency by a nation and to varying degrees of dollarization (official, partial, unofficial, etc) (Schuler, pg 2).

Unofficial dollarization occurs when people in a country commonly hold all or a large portion of their wealth in a foreign currency regardless of the fact that it has not been declared as legal tender by the government, in fact in some cases such actions may even be considered illegal by the government. The most common type of unofficial dollarization is a country’s people using the domestic currency for everyday transactions and perhaps even keep small bank deposits in that currency, but making large purchases (homes, vehicles, etc.) and keeping investments (stocks, bonds, etc.) where domestic or abroad in another country’s currency (Schuler, pg 3).

Official dollarization exists when a country’s government declares a foreign nation’s currency to be official legal tender. This can also be accompanied by a formal agreement between the country adopting the currency and the country that actually issues it, but not necessarily. Its existence is further confirmed by the government itself using the foreign currency for payments, collecting taxes, tariffs and other revenue in the foreign currency officially. While the foreign currency becomes the official currency, it is not uncommon for dollarized countries to permit the use of their previous domestic currency or even multiple foreign currencies and some also continue to issue a domestic currency. Officially dollarized countries do however in general discontinue their central bank and domestic monetary policy. The occurrence of a partial or semiofficial dollarization is more difficult to define. Generally, economists agree that this occurs when a country enforces both its domestic currency and a foreign one, maintains a domestic central bank and continues utilizing monetary policy (Schuler, pg 4-5).

In the simplest of definitions, dollarization has been unofficially occurring for many years with the use of a mother country’s currency by territories, protectorates and other non-nations. However the first case of official dollarization of an independent nation to the U.S. Dollar occurred in 1999 with Panama. Several other countries have followed. However far more prevalent are nations that have unofficially dollarized to the U.S. Dollar including Latin America, the Caribbean, Mexico, former Soviet Union nations, many Pacific Island nations, and even some Asian countries (Schuler, pg 5-6).

Clearly the definition of dollarization has evolved to mean the adoption by a country, territory, etc. of any foreign currency, to varying degrees of totality. However, the balance of this paper will focus on dollarization where a foreign nation adopts the U.S. Dollar officially as its national currency.

Motivation and Process

Official dollarization to the U.S. Dollar is generally more prevalent in Latin America and for a variety of reasons. Therefore this discussion for motivation and process and the following case studies will generally focus on Latin American countries that have dollarized to the U.S. Dollar.

One of the strongest motivating factors for a nation to officially dollarize to the U.S. Dollar is a reduction in transaction costs. If for example a domestic currency is weaker (in a sense of the exchange rate), consumers will have to pay more for goods or services in the U.S. by way of having to convert their money into U.S. Dollars. If however, they already held U.S. Dollars then those transactions costs would virtually disappear (except additional shipping for distances, surcharges for purchasing services from outside the U.S., etc.). This benefit does not stop there though. In general, a country considering dollarizing to the U.S. Dollar likely utilizes a domestic currency that is weak by comparison to the U.S. Dollar against other prevalent world currencies (such as the Euro, Yen, Canadian Dollar, British Pound, etc.). Therefore transaction costs with countries other than the U.S. would also be reduced if the consumers already held the U.S. Dollar (Schuler, pg 15).

Other potential benefits that tend to motivate countries to dollarize to the U.S. Dollar include lower current and potential future inflation rates. “Confidence exists that inflation in the (U.S.) dollar, euro, and yen will continue to be low, (and) they have low and relatively steady interest rates” . This can also translate into greater security for a nation’s lower income citizens to retain savings, retirement funds, etc. with a smaller risk of a loose of value compared to their own volatile domestic currency (Schuler, pg 15-16). Lastly another major motivational factor is a potential for greater openness and a reduction in monetarily irresponsible policies on the part of the government. It is not uncommon for the governments of many developing countries and ones with very weak domestic currencies to attempt to artificially prop up their currency or restrict the purchase of foreign currencies to fight large balance of payments deficits and other economic issues. While it is unlikely official dollarization to the U.S. Dollar will eliminate all of these economic problems, the monetary stability that comes from the conversion does generally assist (Schuler, pg 16).

Respected Economist, Harvard Alumni, Chairman of the Cato Institute and previous Economic Adviser to President Reagan, Dr. William A. Niskanen, PhD wrote an article in the Spring/Summer 2000 volume of the Cato Journal where he overviews his opinion of dollarization in Latin America. In his article, Niskanen outlines a process for which he feels countries; specifically those in Latin America should take in order if they intend to move toward official dollarization to the U.S. Dollar. However, Niskanen also points out that it possible for a Latin American country complete a step, see sufficient results and not continue in the process. I’ve developed a graphical representation of his four step process which also illustrates this escalation and only advance if necessary nature (Niskanen, pg 2-4).

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