EconSouth (Second Quarter 1999)

Responding to Global Crises:
Dollarization in Latin America

The Latin American region has been the subject of much conversation recently as financial crises spread across the globe. In an effort to provide stability to their economies, several Latin American countries have considered adopting the U.S. dollar as the official currency. While adopting the dollar has its benefits, it also has potential drawbacks.

A s economists struggle to explain the development and the spillover potential of financial crises, policymakers and economic advisers search for ways to protect their economies from the devastating effects these crises can cause. A number of proposals have been put forward. These include creating a new international financial architecture, instituting capital controls, applying stricter monetary and fiscal policy regimes, and implementing outright dollarization of an economy. Recently this last proposition has drawn significant attention as a potential scenario in certain Latin American countries. But there is much to consider before a country dollarizes its economy.

Dollarization is a process in which a country adopts — in whole or in part — the U.S. dollar as its official currency.

What is dollarization?
Dollarization is a process in which a country adopts — in whole or in part — the U.S. dollar as its official currency. In a totally dollarized economy, the U.S. dollar is made the only medium of exchange, store of value and unit of account; that country's national currency ceases to exist. Today, Panama is the only country in Latin America that is totally dollarized; it has been since 1904. A country that has totally dollarized has eliminated the monetary policymaking role of its central bank. Without a national currency to manage, the country's monetary policy is, in effect, put into the hands of the Federal Reserve in the United States.

Limited dollarization occurs when U.S. dollars circulate alongside a country's national currency. In this arrangement, the domestic currency continues to serve to some degree as a medium of exchange, store of value and unit of account. Limited dollarization exists in many countries throughout the world, notably in Latin America.

A recent International Monetary Fund study (Occasional Paper 171) estimated that in 1998 dollar deposits were at least 50 percent of domestic money supplies in seven countries around the world, between 30 percent and 50 percent in 12 countries, and between 15 percent and 20 percent in several other countries. Outside of Panama, Bolivia is the most significantly dollarized economy in Latin America, with a ratio of 82 percent; Argentina is next with a 44 percent ratio.

Paths to dollarization
There are two ways a country's economy can become dollarized. A de facto dollarization can occur when citizens lose faith in their national currency and turn away from it toward the dollar. This situation can develop for any number of reasons, including hyperinflation or a significantly negative outlook for inflation and suspicion that economic policies may not safeguard the national currency's value.

This course has occurred in many Latin American countries. Although most Latin economies are making significant attempts to institute and solidify policy credibility and have made impressive headway in limiting inflation, these initiatives are recent, most having been applied over the past decade. Thus, these beneficial policies simply do not have a long enough track record to wholly convince citizens in these countries that their national currencies' role as a store of value is permanent. In any of these countries, when economic conditions worsen or when the political outlook becomes more clouded, doubts may arise regarding the currency's future value. In other words, the probability of devaluation rises, and more citizens shun the national currency in favor of the historically more stable U.S. dollar.

Another path to dollarization occurs when a foreign government makes a conscious decision to re-place its own currency with the U.S. dollar. In a totally dollarized economy, this replacement affects all transactions. In a country with limited dollarization, this policy shift can take the form of allowing residents to hold dollar-denominated accounts.

The benefits of dollarization
Total dollarization nearly eliminates the possibility of a currency devaluation. The threat of devaluation has been a major concern for many people and businesses holding assets in Latin American currencies in the wake of recent international financial crises in Asia and Russia. The capital flight from many Latin countries in 1998 and early 1999 came about because asset holders there appeared to believe that these international crises threatened economic stability. Many of those with access to international financial markets moved to exchange national currencies for dollars or other foreign currencies.

Spreads Between Brady Discount Bonds and
Five-Year U.S. Treasury Notes

Chart 1

Source: BankBoston and Federal Reserve Bank of Atlanta's Latin America Research Group

Latin American Trading Partners*

Chart 2

*Percentages include imports and exports

Another reason for purposely dollarizing an economy is to limit the possibility of high inflation. By dollarizing, a country adopts U.S. monetary policy as its own. As long as U.S. monetary policy is prudently managed, the inflation environment in the dollarized economy should remain subdued.

A history of high inflation and policy volatility are often prevalent in countries that are partially dollarized and are main reasons behind their dollarization in the first place. The high interest rates in such countries reflect inflation expectations and, at the same time, restrain real economic activity. By importing benign U.S. inflation, dollarized economies also import lower interest rates that often closely track U.S. rates.

Chart 1 shows that interest rates in Latin America skyrocketed in the wake of the Asian financial crisis in the fall of 1997, again following the Russian default in August 1998, and again in January 1999 as Brazil devalued its currency. The chart shows the spread between selected Latin American Brady bond yields and comparable yields on U.S. instruments. An increase in the spread indicates that investors allotted an increased risk to holding Latin American debt. Dollarization arguably could reduce this spread to nearly zero because the threat of devaluation and the resulting pressure on international payments would be significantly diminished.

In addition to deterring devaluation and inflation, dollarization reduces the transaction costs associated with international trade and finance with the United States, which is the most important trading partner for Latin America as a whole (see Chart 2). Eliminating currency conversion would allow trade to flow more easily.

Dollarization should not be viewed as a panacea for an environment created by economic mismanagement, however. Developing policy credibility to a point at which residents have sufficient confidence in the currency takes decades of prudent fiscal and monetary policies, uninterrupted over many administrations and supported by major political parties. Since most Latin American nations are in their first decade of real and sustained economic reform, their policy credibility is still being built. Dollarization in this environment should be viewed on a case-by-case basis.

The costs of dollarization
Dollarization also implies some costs to the economy of a country that adopts it. A dollarizing country relinquishes several important policy instruments. For one, monetary policy in a dollarized economy is made by the Federal Reserve in the United States. The Federal Reserve's policy mandate is domestic, and the U.S. economic outlook chiefly dictates its policy decisions.


Jack Guynn, president and chief executive officer of the Federal Reserve Bank of Atlanta, discussed the Federal Open Market Committee's policy mandate in a speech to the Money Marketeers of New York University in September 1998.

Guynn said, "The mandate of the FOMC is chiefly domestic. We're charged with delivering the best economic conditions we can as defined by, among other things, the inflation rate, GDP growth, the unemployment rate and the safety and soundness of the banking system in the United States. But the policy environment in which we attempt to achieve this mandate is global. No economic condition in any part of the world can be considered exogenous. And any action intended to produce a strictly domestic result is almost instantly transmitted around the globe and may or may not be countervailed by a concomitant change in international economic conditions.

"Globalization complicates the policy environment," he said. "It presents enormous opportunities for capital. But it also presents equally formidable challenges for those of us whose job it is to sort it all out, to take advantage of it or to understand where the policy action is. In the global economy, our policies are more influential than ever, although the equation through which we calculate them is more complex. Understanding that equation is the challenge."

Of course, the United States is not a closed economy. The Federal Open Market Committee (FOMC), the Federal Reserve's policymaking body, cannot ignore developments in the global economy that may affect the United States. But the FOMC bases its decisions on considerations about the welfare of the United States and its citizens, not about the welfare of countries that have dollarized. The role of the Federal Reserve and its domestic mandate in a highly globalized economy remain important issues, issues that Jack Guynn, president and chief executive officer of the Federal Reserve Bank of Atlanta, noted in a speech last year (see the sidebar on page 17).

A country's decision to dollarize its economy does not require the permission of the U.S. government or the Federal Reserve. But chief policymakers at both the Fed and U.S. Department of the Treasury have stated that the policies of the United States will not be altered to adapt to the economic considerations of countries that choose to dollarize. So foreign governments that may be considering full dollarization must do so with the understanding that U.S. monetary policy will remain focused on domestic issues.

Countries debating whether to dollarize should also consider how reversible that policy would be. Although a government can always choose to end its dollarization policies, the risk of financial instability from this move would be a powerful force working against reversing dollarization.

There is also a measurable monetary cost, called lost seigniorage, involved with forgoing a national currency. Seigniorage is the revenue gained by issuing currency. Governments that dollarize will give up the benefits of seigniorage, although this total benefit is estimated to be less than 1 percent of gross domestic product (GDP) in most countries.

Adopting the dollar as the official currency has both political and economic ramifications for a nation. The loss of sovereignty that accompanies the surrender of monetary policy control, the national currency and the central bank is likely to spark opposition within a country. Such opposition is evident in some Latin American countries where the dollarization debate is under way.

Although the business community in many of these nations appears to back dollarization, other segments of society may view the loss of sovereignty as too great a price despite the economic benefits. The outcome of this debate will be one of the most important economic developments in Latin America in the near term.

Dollarization also implies some costs to the economy of a country that adopts it. A dollarizing country relinquishes several important policy instruments. For one, monetary policy in a dollarized economy is made by the Federal Reserve in the United States. The Federal Reserve's policy mandate is domestic, and the U.S. economic outlook chiefly dictates its policy decisions.

Who should dollarize?
Although dollarization may not be feasible for all economies, it would seem to benefit some. Small, open economies that are particularly vulnerable to international shocks may find that adopting a high level of dollarization or pegging their currency to the U.S. dollar can help prevent extreme exchange-rate variations that can harm their economies.

Countries with strong international trade and financial ties to the United States are also among those better equipped to seriously consider dollarization. Transaction costs between such countries and the United States should be reduced by dollarization, and this reduction could help develop even stronger ties through other economic arrangements.

This advantage is particularly important for Latin America, which has a stronger trade relationship with the United States than with any other country or region. The move toward a Free Trade Area of the Americas has dropped from the headlines because of international financial crises and political developments in the United States. Dollarization could lead to the deepening of trade relationships that may integrate the hemisphere. Latin American countries stand to gain the most from such a development.

In Latin America, the cases of Argentina, Mexico and Brazil highlight the current dollarization debate. Argentina has stated officially that it would like to totally dollarize its economy. The country instituted a currency board in 1991 in response to hyperinflation and a lack of policy credibility. Despite its fixed exchange rate and constitutionally self-imposed restrictions on issuing currency, Argentina still finds itself buffeted by international shocks.

Because the Argentine peso circulates along with the dollar, the chance of devaluation remains a possibility in spite of Argentine policymakers' hard work to assure investors and peso holders that such a currency realignment would never happen. Therefore, the country's interest rates maintain a notable spread over comparable U.S. instruments (see Chart 1). Argentina's economy is not small, nor does it have extensive ties with the United States. The fact that it has successfully operated a currency board arrangement for much of the last decade, however, goes a long way toward enhancing Argentina's drive toward full dollarization.


Currency Boards

  • Domestic currency is converted to the reserve currency on demand at a fixed exchange rate.
  • Monetary policy is automatic. If investors switch out of domestic currency into dollars, the supply of domestic currency will automatically shrink. This decline will cause interest rates to rise until it becomes attractive for investors to hold local currency again.

Total Dollarization

  • The process involves adopting the U.S. dollar as the official currency. The national currency unit ceases to exist.
  • Monetary policy is made by the Federal Reserve in the United States with no formal input from officials in the dollarized economy.

Monetary Union

  • Members of a monetary union agree on a common currency, either by adopting an existing one or issuing a new currency altogether.
  • Monetary policy is made collectively, with input from each member of the union.

In Mexico, business leaders recently petitioned President Zedillo to move toward fully dollarizing the nation's economy. The continuing effects of Mexico's peso crisis in 1994 and 1995, coupled with the strong economic ties between the United States and Mexico, make the dollarization debate there more lively. The loss of sovereignty that accompanies dollarization is a difficult political hurdle in Mexico at present. Despite Mexico's apparent hesitancy, Central American countries are actively considering a move toward dollarization, and their leaders plan to meet in July to formally discuss the idea.

Brazil shows no interest in pursuing official dollarization despite its recent economic troubles and hyperinflationary bouts in the 1980s and early 1990s. Brazil's economy is the largest in Latin America. Its trade and financial ties with the United States are as strong as those of many other South American economies, but its economy remains comparatively closed, with total exports accounting for roughly 7 percent of GDP.

Dollarization and U.S. business
Businesses in the United States could benefit from dollarization in countries that are trade partners. Like the dollarizing countries, U.S. companies doing business in these countries would see transaction costs decrease. Currency conversion could be eliminated, and the administrative costs associated with international trade and investment would decrease. As long as the U.S. economy is stable, full dollarization should diminish the kind of currency volatility that restricts investment and curtails deeper economic ties.

Businesses in the United States would also benefit from the expected fall in inflation and interest rates in dollarized economies because these developments should, in turn, lead to faster rates of economic growth in these countries. The stronger consumption and increased sales this growth would spark could improve the performance of U.S. businesses that export to the dollarized markets.

To dollarize or not to dollarize
Dollarization is one proposition currently under consideration as a means to prevent, limit or contain the kinds of financial crises that have swept the globe during the past two years. Countries considering dollarization need to undertake a careful cost-benefit debate, weighing the benefits against the resulting loss of sovereignty and the realization that monetary policymakers in the United States have a domestic focus, considering international issues only insofar as they affect U.S. economic conditions.

Not all countries appear suited for dollarization. The current debate in Argentina about dollarization deserves attention, as do increasing discussions in several other Latin American countries. The immediate implications for the U.S. economy are not profound, although widespread dollarization throughout the hemisphere would focus attention on the appropriateness of the Federal Reserve's domestic mandate in such an environment.

This article was researched and written by analysts in the Atlanta Fed's Latin America Research Group.

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