Extra Credit (Fall 2007)

Economically Speaking

Understanding dollarization

coin from El Salvador and globeDollarization—many of us have heard the term, but do we fully understand what it means? Dollarization occurs when a country uses U.S. currency in place of or in parallel with its domestic currency. Three foreign countries and a few territories are now completely "dollarized," using the U.S. dollar as their official currency in lieu of a local currency. In addition, a number of countries, including many in Latin America, use a mix of their local currency and the U.S. dollar for savings and transactions. In fact, two-thirds of U.S. currency is held outside the United States.

Seeking stability
Why do countries choose to dollarize? Generally, the fundamental reason is to promote financial stability. In some countries, high inflation or a weakening currency can reduce the local currency's value, making it harder for citizens to pay rent or buy necessities. The U.S. dollar's history of low inflation and relative stability makes it seem more secure than local currency.

Panama, Ecuador, and El Salvador are officially dollarized and no longer have their own currency. For these dollarized countries and for other countries that operate with a mix of local and U.S. currency, the Federal Reserve provides U.S. notes either through a correspondent bank or directly to the countries' central banks. In this relationship, funds from foreign reserves or a current account surplus are used to convert a country's currency to dollars.

Related Links
"Dollarization in Latin America"
"Dollarization: Will the Quick Fix Pay Off in the Long Run?" (EconSouth, Q1 2001)
"Official Dollarization and the Banking System in Ecuador and El Salvador" (Economic Review, Q3 2006)

Costs versus benefits
While dollarization can benefit the dollarized country, it also has a downside. In officially dollarized countries, the government loses the ability to create more money—an action that might be needed to cover a credit crisis or otherwise increase the money supply to support reasonable economic growth.

Given this potential financial risk, why would a country's leaders knowingly give up that control? Although simply printing more local currency could allow leaders to achieve short-term economic and employment gains, doing so could also create significant negative long-term consequences—high inflation or damaged market credibility. Thus, the inability to print additional money, combined with the dollar's relative stability can help the government gain credibility in international credit markets. This credibility in turn often helps governments obtain loans at significantly lower interest rates, making borrowing money less expensive.

In partially dollarized countries, citizens may also turn more of their deposits and borrowing (loans) into U.S. dollar transactions because of various factors, including political instability. Lack of confidence in incumbent or new leaders can lead to rapid depreciation of a local currency and to high interest rates, potentially costing savers and borrowers large sums. In these economies, borrowing in a foreign currency adds a degree of risk, especially in countries with volatile exchange rates, because repayment in U.S. dollars or some other currency could suddenly become more expensive if the exchange rate falls.

In summary, dollarization has both risks and rewards. A country considering dollarizing has to evaluate what system works best for its economy.

For more information on understanding dollarization, check out the related links.

Sarah Dougherty, economic and financial education specialist, Atlanta