EconSouth (First Quarter 2001)
Will the Quick Fix Pay Off in the Long Run?
To dollarize or not to dollarize? That has been the question facing many Latin American countries in recent years. And while there are certainly some economic benefits associated with dollarization, foreign countries deciding to take the dollarization plunge should realize that adopting the U.S. dollar as their official legal tender is not a panacea for all economic ills, especially over the longer term.
ver the last few years, the idea of dollarization has surged to the forefront of policy alternatives for Latin American countries. By eliminating their national currencies and replacing them with the U.S. dollar, countries hope to achieve economic stability and growth. Is dollarization a remedy for economic stability in Latin America? The answer is yes — and no. Dollarization may promote economic stability in the short term, but structural and institutional problems must also be addressed if a dollarizing country is to achieve long-term economic benefits.
Several countries have already officially adopted the U.S. dollar as legal tender. Panama adopted the dollar in 1904, Ecuador dollarized in September 2000 and El Salvador dollarized in January 2001. In official dollarization, the U.S. dollar becomes the country’s legal tender and takes over all the former functions of domestic money: as a unit of account, as a medium of exchange and as a store of value. Unofficial dollarization, which is also widespread in Latin America, occurs when individuals substitute the dollar for domestic money to protect the purchasing power of their income.
Most countries that consider full dollarization have already experienced a high degree of unofficial dollarization. In Latin America, this process accelerated after the external debt crisis of the early 1980s. In that decade, many Latin American countries struggled with recession, inflation and unemployment as they witnessed the repeated failure of stabilization policies that resulted in higher inflation rates, larger fiscal deficits, deeper external imbalances and continuous capital flight.
Under such circumstances, these countries’ citizens initially used the dollar as the hard currency to protect their income from the detrimental effects of inflation. As the inflationary situation became chronic, the dollar was accepted first as the unit of account for contracts and large-denomination transactions. At the end of the 1980s, Latin American economies became more dollarized as both domestic and foreign currencies circulated as mediums of exchange. This wide acceptance was encouraged even further when some governments allowed deposit accounts and loans in foreign currency.
Even though unofficial dollarization was widespread among several Latin American countries, full dollarization was not a clear policy alternative. In the 1990s, Latin American governments switched dramatically from economic policies based on government intervention to market-oriented reforms. These reforms sought to control inflation and achieve economic stability through fiscal discipline, reduction of government intervention, privatization, tax reform, and trade and financial liberalization. The lowering and stabilizing of inflation and subsequent economic growth brought hope for the region’s sustained economic growth and development.
These optimistic developments changed with the financial turmoil brought on by the Mexican peso crisis in 1995 and the Asian, Russian and Brazilian financial crises in 1997 and 1998. Even though Latin American countries responded better to these financial crisis than to previous ones, these more recent events showed how vulnerable the region still was to the volatility of capital flows. Given the great uncertainty that followed the international monetary crisis, official dollarization became an attractive alternative for policymakers seeking monetary stability.
Dollarization pros and cons
Are the benefits of dollarizing greater than the costs? The decision of whether or not to dollarize brings to mind the statement “there is no free lunch.” Clearly, there are benefits associated with dollarization, but there are also certain costs.
By adopting the U.S. dollar as its own currency, a government gives up control of interest rates and the money supply. Given the past experience of Latin American countries with monetary policy, this lack of control might be seen as positive. Full dollarization would eliminate the possibility that the government could finance the fiscal deficit with seigniorage (the revenue associated with the printing of domestic currency) and exchange it for goods and services. Without this possibility of public financing, the government of the dollarizing country must look for alternative revenue sources or reduce government expenditures. By giving up control of its money supply, a fully dollarized government encourages fiscal discipline but also restricts the possibility of stabilizing fiscal policy’s response to a negative shock.
Another cost of full dollarization is the restriction it imposes on the monetary authority’s role as the lender of last resort to the domestic banking system. As lenders of last resort, central banks provide loans to banks facing liquidity problems. With full dollarization, printing money is no longer a feasible source of liquidity, and the central bank needs to look for alternatives to respond to financial emergencies. These solutions include external lines of credit with banks from foreign countries and reserve funds from tax revenues. Thus, paradoxically, even though full dollarization limits the central bank’s role as lender of last resort and monetary policy responses to financial crises, it might make bank runs less likely because consumers and businesses may have greater confidence in the domestic banking system.
An expected benefit from full dollarization is a reduction in the cost of borrowing funds. Using the U.S. dollar eliminates the risk of devaluation and in turn should reduce the interest rates for credit that was denominated in domestic currency. In the case of public debt, this decline represents a reduction of debt service. In the private sector, the elimination of devaluation risk might bring stable capital flows and increase the confidence of foreign investors and therefore promote investment and growth. However, sovereign or default risk is still present, and investors still respond to financial crises, whether prompted by economic shocks or political and social conditions. So the effect of full dollarization on reducing the risk premium embedded in domestic interest rates is limited.
Full dollarization is also perceived to enhance the credibility of economic policy because it shows policymakers’ long-term commitment to stabilizing prices, output and employment.
All things considered, dollarization promotes, but does not guarantee, fiscal discipline, an efficient financial system, the adoption of institutional reforms, or financial and trade integration with international markets. On the other hand, the restrictions that full dollarization imposes on policymakers make a dollarized country more vulnerable to real shocks (such as oil supply shocks or natural disasters) and financial shocks.
Why, then, is full dollarization an attractive solution? Are the gains from improving policy credibility and economic stability and reducing borrowing expenses greater than the costs? The experiences of Panama and Ecuador help answer these questions.
Panama became the first fully dollarized economy in Latin America in 1904 after gaining independence from Colombia. The U.S. dollar became the legal tender for transactions, and the balboa (one balboa equals one U.S. dollar) was also used for small transactions as well as a unit of account. Panama’s decision to adopt full dollarization was based on political and historical considerations rather than economic ones. Because of its geographical location, Panama was a natural trade route and thus the logical site for the construction of the Panama Canal at the beginning of the 20th century. The opening of the Colon Free Trade Zone, a tax- and import duty–free facility for business operations, confirmed the importance of international goods and financial markets in Panama in 1948.
Panama seems to have gained one of the expected benefits of dollarization — stability in output and prices. Between 1980 and 1999, the country’s economy has had an average growth rate of 3.6 percent, exceeding the averages of Central American countries (2.9 percent), and an average inflation rate of 3 percent — 1 percent less than the average inflation rate in the United States.
Panama’s financial system also seems to have adjusted smoothly to the limitations dollarization has placed on its central bank as the lender of last resort. In 1970, the liberalization of the financial system in Panama involved the entry of foreign banks. The economy became financially integrated, with complete capital mobility and freedom for banks to invest excess funds in Panama or abroad. Foreign banks performed the role of lender of last resort by increasing their exposure to the domestic economy when economic conditions were weak. Domestic banks also established lines of credit with foreign banks with branches in Panama to help resolve liquidity problems.
In Panama’s case, dollarization’s potential to promote fiscal discipline has not been fully achieved. Fiscal deficits have at times been large despite the limitation of domestic financing (see chart 1). This trend was reversed between 1990 and 1995 in an effort to improve fiscal management. Public debt — 75 percent of it foreign debt — financed the fiscal deficit. But Panama has experienced some bumps in the road. The country’s reputation was damaged in 1987 and 1988 when external debt payments were suspended. Panama has also agreed to 13 adjustment programs with the International Monetary Fund (IMF) in exchange for funding since 1963, more than any other Latin American country. In 1996, foreign debt started declining as a result of an external bond exchange and a debt reduction operation.
Full dollarization has at least to some degree increased Panama’s vulnerability to external and internal shocks and reduced its flexibility in adjusting to these events. In the 1960s, political conflicts over the Canal Zone resulted in the massive withdrawal of domestic deposits, but this withdrawal was offset by an increase in domestic lending. The upturn in international oil prices in 1973 and 1978 raised domestic prices, resulting in high inflation rates. These shocks had a mild effect on Panama’s economy.
But a major economic crisis erupted between 1987 and 1989 as a result of political tensions between the governments of Panama and the United States. In 1987, 11 percent of local deposits were withdrawn from the banking system. Banks, as in previous years, borrowed abroad and reduced their liquid assets to compensate for the loss in domestic resources but also reduced lending. In 1988, a U.S. court indicted Manuel Noriega, Panama’s military leader, and imposed economic sanctions on Panama. As a result, real gross domestic product (GDP) decreased approximately 16 percent in 1988 and 0.4 percent in 1989, and there was large-scale capital flight.
The reaction of Panama to the Asian and Russian financial crises in 1997 and 1998 was relatively mild in comparison. In 1997, Panama’s growth rate was lower than average for the region, but in 1998 its growth rate was higher than the region’s average. Also, Panama’s inflation rates were lower than the U.S. rate. The effect of these crises was more pronounced in Panama’s dollarized economy because of the increase in interest rates.
Thus, Panama’s fully dollarized economy has had low and stable inflation rates along with solid economic growth. But the rigidities imposed by the restrictions in monetary and exchange rate policies have made Panama vulnerable to real, financial and political shocks that affected economic growth. Full dollarization enhanced Panama’s policy credibility but did not guarantee fiscal discipline.
Ecuador’s incipient dollarization
During the 1990s, attempts to open the Ecuadorian economy to international trade and capital markets failed for the most part. Large fiscal deficits and increasing external debt led to imbalances that became unsustainable with the decline of world oil prices and the devastating impact of El Niño in 1998. These external shocks resulted in low growth, inflation and liquidity problems in an already fragile banking sector. The country’s dependency on oil and agricultural products, whose prices were declining, to generate export revenues became evident and limited the country’s ability to service foreign debt.
Several developments contributed to Ecuador’s economic collapse in 1999 — the devaluation of the sucre in February, the freeze on bank deposits in March, the default on external debt payments in September, and the country’s overall political uncertainty and lack of policy direction. As a result, in 1999 Ecuador’s real GDP declined by 7 percent, the inflation rate was more than 50 percent and the currency depreciated by 200 percent. In January 2000, in an environment of social unrest and lacking congressional support for implementing structural reform, then President Jamil Mahuad called for full dollarization to avoid a banking system collapse. Days later, President Mahuad was deposed, and the Ecuadorian Congress confirmed Gustavo Noboa, the elected vice president, as the new president.
President Noboa continued with full dollarization, hoping to promote a return to economic stability. In this already dollarized economy, the conversion rate was set at 25,000 sucres per U.S. dollar. Along with full dollarization, a new economic program provided incentives to private investment in the energy sector, encouraged privatization of state enterprises and included legislation that makes labor markets more flexible. In addition, the IMF signed a standby agreement with the Ecuadorian government to support economic stability and recovery. This agreement helped to attract additional funding from other multilateral institutions.
Ecuador started enjoying the expected benefits of full dollarization before the legal adoption of the U.S. dollar on Sept. 9, 2000. As a signal of the enhanced credibility full dollarization lends to a country’s financial system, a bank run did not ensue upon the release of previously frozen bank deposits in March. The drop in the inflation rate in July and economic recovery in the first quarter of 2000 supported full dollarization’s stabilizing effects. In addition, Ecuador restructured its external debt in August 2000, reducing the public external debt ratio from 105 percent of GDP at the end of 1999 to around 94 percent in 2000. Full dollarization also eliminated devaluation risk; chart 2 shows the reduction in the volatility of the interest rate spread. A risk premium, however, still exists that responds to the uncertainties surrounding Ecuador’s economic performance in the long term.
Even though Ecuador has realized some immediate benefits from dollarization, the country’s dependency on revenues from oil and external financing still leave it vulnerable to external economic shocks. Full dollarization adds to this vulnerability by limiting economic policies’ flexibility in responding to real, financial and political shocks. To overcome these limitations, banks may need to establish credit lines with international institutions and private deposit insurance programs to respond to liquidity problems. Dollarization also does not guarantee fiscal discipline, and Ecuador depends on sometimes unpredictable oil revenues to finance a large share of government expenditures. Tax reform and the restructuring of fiscal accounts are necessary to show the government’s commitment to consistent and sustainable policies to attract foreign investment.
Political consensus will perhaps be the greatest challenge for Ecuador’s structural reform. President Noboa is negotiating with indigenous groups whose widespread protests against the increases in fuel and transportation prices limited the passage of further reforms. An additional challenge to the country’s dollarization process is the circulation of counterfeit currency. To prepare the population for the transition to the U.S. dollar, the government printed guidebooks with information on how to identify counterfeits.
On Jan. 1, 2001, the U.S. dollar became official legal tender in El Salvador. The domestic currency, the colon, continues to circulate along with the U.S. dollar at an exchange rate of 8.75 colons per U.S. dollar. Unlike Ecuador, which adopted the U.S. dollar as a policy alternative to bring economic stability, El Salvador has enjoyed economic stability and low inflation rates during the last few years. Consequently, full dollarization should reduce interest rates in El Salvador and improve investor’s confidence and ultimately promote economic growth.
Not all the answers
The experiences of these Latin American countries show that full dollarization can bring several benefits that help to achieve sustainable economic growth. Full dollarization enhances policy credibility, encouraging foreign investment. Dollarization also promotes fiscal discipline, a competitive financial system and economic integration with international markets. But dollarizing countries need to establish structural programs and institutional reforms to ensure that short-term stabilization develops into long-term economic growth.
This article was written by Myriam Quispe-Agnoli, a senior economic analyst in the Atlanta Fed’s Latin America Research Group.