Economic term generated by the "US dollar" when it is used as a country's currency in addition to the domestic currency or as a replacement.
It is an economic term generated by the "U.S. dollar" when it is used as a country's currency in addition to the domestic currency or as a replacement. It is an example of currency substitution taking the "U.S. dollar." It is often used with a weak domestic currency.
It means that the U.S. dollar is accepted within the market and performs the three tasks crucial for money: store of value, unit of account, and medium of exchange.
This usually occurs in a country where the domestic currency is weak and has an unstable economic situation. As a result, market participants tend to use the dollar since it is stronger and more stable than the domestic currency.
And sometimes, it is guaranteed by law as a means to pay public or private debt or tax payments which are called, in this case, "legal tender" in the country.
Moreover, people tend to use it to protect their wealth's value and purchasing power as it is seen as a stable currency relative to the domestic one.
In contrast, the government tends to lose some of its control over the market by adjusting its money supply. The dollarized country shifts its monetary policies to the U.S. Federal Reserve.
This aspect is considered a negative one since the U.S. Federal Reserve sets its policies according to the interest of the U.S. regardless of the dollarized countries.
However, it can benefit from the economy of scale or even moving the country to an optimal currency area, involving the country with more trades and acquiring a strong economic basis.
There are four forms, including:
- Full: This occurs when the U.S. dollar is considered the primary or exclusive legal tender. The U.S. dollar serves as the main currency in the region.
- Partial acceptance occurs when the country accepts the U.S. dollar in its transactions and keeps its domestic currency.
- Official (de jure): when the country's government accepts the dollar as its legal tender.
- Semi-official: foreign money is legal tender and may even outnumber local currency in bank deposits, but it serves a secondary role in paying wages, taxes, and everyday expenses such as grocery and utility bills.
As opposed to officially dollarized ones, semi-dollarized countries maintain a local central bank or other monetary authority and, as a result, have greater freedom to have an independent monetary policy.
Unofficially, the country's people believe that putting their savings in the U.S. dollar protects them from inflation. Holding any of the following can be considered unofficial Dollarization:
- Foreign bonds and other nonmonetary assets are held in a foreign country.
- Foreign currency deposits are held in a foreign country.
- Deposits in the domestic banking system in foreign currencies.
- Foreign notes (paper money) are stashed in wallets and mattresses.
How does it work?
In a fully dollarized economy, the money supply of the U.S. dollar functions similarly to the U.S. Nevertheless, prices and money supply are influenced by the country's macroeconomic situation and preferences.
In contrast, inflation rates might differ between the dollarized country and U.S., but they will tend to be similar most of the time. In countries experiencing high inflation, the dollar might be used frequently. Moreover, partial use of dollars is the result of economic instability.
For example, Panama and the United States can have different inflation rates despite having the same currency, much as Dallas and New York City might have different inflation rates while using the same currency.
On the other hand, the adoption of a single currency tends to maintain the prices of globally traded goods near the levels of the same items in the United States. As a result, while there are some price variations, inflation rates in the two nations will likely be comparable.
Complete or official use of the dollar:
Zimbabwe replaced its native currency with many distinct foreign currencies in 2009, following extended periods of hyperinflation and catastrophic economic crises that resulted in a total collapse.
Zimbabwe established a new currency known as the RTGS Dollar as recently as February 2019, and it became the only legal tender in Zimbabwe in June 2019.
In the case of Panama, USD was accepted in its constitution as the country's sole legal tender at the time of its inception.
Partial or unofficial acquisition of dollar:
Cambodia uses two currencies. The metropolitan economy is managed by the USD, while the rural economy is governed by its currency, the Riel.
It is unofficial since the government has never formally sanctioned it and is firmly opposed to de-dollarization; nonetheless, it is paradoxically one of the most dollarized economies in South-East Asia.
Factors affecting the acceptance of dollars:
The factors affecting are:
- The level of public support for the U.S. dollar influences the timing of its implementation. The more public acceptance and support, the shorter the period of the implementation process will be.
- The degree of macroeconomic stability affects the\ acceptance since the stability of a country is a key issue in this process.
- Institutional elements include the maturity of contracts involving both dollar and indigenous currency contracts.
Now the question arises - Why do countries use the dollar?
- Stability in value of the currency: increasing the stability by providing a more robust and more stable currency, the "dollar." This will result in a more secure climate for investment, encouraging the investors to enter the market.
- Reduce the country's risk by providing a strong currency and encouraging investors.
- Providing a secure economic climate.
- It is essential to mention that the "dollar" is the most traded currency in the world, providing power for its holders.
Cost and benefit analysis
The costs and benefits for the dollarized countries differ significantly from those of the United States. This is because dollarized countries accept the U.S. dollar without generating it. Instead, they use it as legal tender but cannot print dollars whenever they need them.
Based on this, and since dollarized countries acquire the U.S. dollar as a stable and strong currency, They will lose some control over their monetary policy while the U.S. will gain total control.
Thus, implementing it may benefit the economy, but in some cases, governments prefer not to do so. From the viewpoint of the United States, it is worth noting that about two-thirds of all dollar money is held outside the United States, which will strengthen its presence in the market.
Benefits for dollarized countries:
- Positive effect on international trade: This is due to the excessive use and acceptance in the alien world, in addition to having a strong value, stability, and less volatility than the domestic currency.
- Promoting businesses will hinder growth through the promotion of companies and investors.
- Helping the country to become a more prominent international participant by dollarizing the economy, especially in periods of reduced economic growth.
- Promoting Foreign Direct Investment (FDI) where the investors are encouraged to start businesses in the local country using foreign currency already accepted by it.
- Administrative costs are decreased: The government is no longer required to bear the cost of maintaining an infrastructure dedicated only to manufacturing and maintaining a distinct national currency.
Due to the diseconomies of small scale involved, such savings are likely to be most appealing to poorer or more tiny sovereignties. However, the potential savings would be significant for larger and wealthier countries.
- A stable financial sector entails more than just using a foreign currency. It also implies financial integration with the United States, which will compel domestic financial firms to enhance their efficiency and service quality.
Furthermore, it shows a long-term commitment to low inflation, budgetary restraint, and transparency.
This would be especially beneficial to countries with poor pricing or fiscal stability reputation.
- Reduction in the interest rate for local borrowers: it offers a steady association with a currency that already has a solid reputation.
Rather than spending considerably to increase market trust in its monetary policy, a government may gain rapid credibility by "hiring" the recognized Federal Reserve instead.
Fed policy becomes national policy. With luck, the interest rate cut will result in significantly greater levels of domestic investment and future economic development.
Costs for dollarized countries:
It has historically been a reaction to economic insecurity and rising inflation. To some extent, many emerging economies already employ the dollar. Many, however, have shied away from it since the economies that might consider complete Dollarization are still emerging.
- Losing partial control: relying on a foreign currency will make the monetary policy of the domestic currency dependent on the Federal Reserve. In turn, this will make the country lose some of its autonomy.
- Having to maintain a good political relationship with the U.S. since any change in it will result in a disaster for the developing country. Furthermore, it may be difficult for any country to succeed if it does not have control over its money supply and currency.
- Also, there always exists a risk that the Fed might prohibit the dollar from being used in dollarized countries, which will worsen the economic situation in countries that use the dollar.
However, for many nations, having an autonomous economic policy and the sense of individual statehood that comes with it is too valuable to give up in exchange for full Dollarization. This extreme choice is mostly irreversible.
Advantages for the United States
Advantages for the U.S. are;
- The power of seigniorage: Seigniorage is the revenue generated by issuing money. Net seigniorage is the difference between the cost of circulating capital and the value of the products that money can buy. It can be measured as a stock—a one-time gain.
Increased cross-border movement of a country's currency creates the equivalence of a subsidized or interest-free loan from outside. This indirect transfer reflects a real-resource benefit for the economy overall.
- The improved flexibility of macroeconomic policy comes with the ability to fund foreign deficits with one's own money.
The expansion of cross-border circulation, like any other kind of monetary union, decreases the cost of adjusting to unexpected payment shocks by internalizing through credit what would otherwise be external transactions requiring scarce foreign cash.
In effect, it eliminates the necessity to consider the balance of payments while developing and implementing domestic policy.
- Market dominance since it is widely used and accepted.
- The monetary dependence of other countries generates political power.
How to calculate?
Measuring it in 2 ways:
1. Deposit dollarization: the ratio of dollar deposits to total broad money deposits, and
2. Credit: the ratio of dollar loans to total loans.
Which countries are officially dollarized?
Some of the countries that are dollarized:
|Dollarized country||Geographic location|
|Commonwealth of Puerto Rico||North-eastern Caribbean|
|Ecuador||North-Western South America|
|Republic of El Salvador||Central America|
|Republic of Zimbabwe||South-east Africa|
|Guam||Western Pacific Ocean|
|Turks and Caicos||Caribbean|
Source: The World Bank, Long Reads CBS, World Population Review
When should a country use the dollar?
The first topic is whether particular preconditions should exist before implementing de jure Dollarization.
In this regard, there are two opposing viewpoints: one that believes that putting preconditions before introducing a foreign currency as legal tender will yield more benefits, and the other that it puts pressure on countries to adopt similar policies immediately.
These prerequisites imply, at a bare minimum, the following:
- A strong financial system and solid financial supervision reduce the possibility of banking crises in an environment with no or limited lender of last resort (LOLR) capabilities.
- Strong public finances give market investors appropriate guarantees regarding the fiscal policy's long-term viability.
- To promote macroeconomic adjustment in reaction to external shocks, labor markets must be flexible.
While some economists agree that these preconditions must exist to dollarize, others believe it creates pressure on countries to implement comparable measures immediately.
The problems are:
1. Institutional issues: it needs significant political backing. Countries should consider the costs and advantages of converting a foreign currency into a legal tender.
Once the choice to legally dollarize is made, it is necessary to create a clear legal framework, which ideally should be supported by society. It necessitates the passage of laws establishing the legal framework for the new monetary arrangement.
2. Operational issues: The conversion rate is the rate at which the native currency is transformed into the new legal tender and is the most significant operational issue to define as a country dollarizes. This may not be a concern if the country has a fixed exchange rate system or a stable economy.
However, determining the precise exchange rate is difficult in an atmosphere of macroeconomic insecurity.
Two factors must be considered before jumping to a conclusion. First, find the closest value to the market rate, allowing economic agents to convert the two currencies quickly and easily.
Second, the conversion rate necessitates that significant central bank liabilities be funded by the current stock of net international reserves. Another essential option is establishing a backing rule that permits specified central bank obligations to be covered with overseas reserves.
3. Interest rate conversion: When a country dollarizes under stable macroeconomic conditions, there is no need to amend the specifications of contracts maturing after the country's Dollarization; however, renegotiation may be permitted.
Typically, interest rates fall when the economy is officially dollarized. The lower risk due to implementing a foreign currency attracts domestic and foreign investors to participate in the country and its capital market. Furthermore, the absence of an exchange rate disparity helps to cut interest rates on overseas borrowing.
In a macroeconomically stable context, the least disruptive method of converting local currency interest rates to dollar-denominated interest rates is to keep the original contract terms and conditions unchanged and apply them at the conversion rate.
The case of Zimbabwe
Zimbabwe conducted a dollarization experiment to explore if using foreign money might prevent severe inflation and stabilize the economy. In July 2008, Zimbabwean currency inflation hit an estimated yearly rate of 250 million percent.
Zimbabwe's currency had depreciated to the point where it was frequently used as insulation and furniture stuffing. As a result, many Zimbabweans had begun to use foreign currencies for commercial transactions or just barter.
The interim finance minister declared that the United States dollar would be recognized as legal money by a limited number of merchandisers and shops.
Following the trial, the finance minister stated that the government would adopt the U.S. dollar, allowing its widespread usage in 2009 and discontinuing the use of the Zimbabwe dollar later in 2015.
In Zimbabwe, the acceptance of dollars immediately reduced inflation. This lowered the country's overall economic volatility, allowing it to boost its inhabitants' purchasing power and achieve higher economic growth.
Furthermore, the country's long-term economic planning became easier because the stable currency attracted international investment. However, the country's journey was not without complications.
Dollarization, fixed exchange rate, and currency board system.
The comparison is:
- There is no exchange rate under a dollarization system since the indigenous currency ceases to exist. When a country accepts this regime, it loses its monetary policy autonomy.
- A currency board is a fixed exchange rate at its most severe. If it has one, the nation's central bank is stripped of control over the exchange rate and the money supply. A currency board is often obliged to have reserves of the underlying foreign currency and a set exchange rate.
- A currency board is a fixed exchange rate at its most severe. At the same time, Dollarization occurs when a state starts to acknowledge the U.S. dollar as a means of exchange or legal tender alongside or instead of its currency.
- In the event of a fixed exchange rate or currency board, the nation to which the local currency is attached, or the country that issues the currency used in the case of Dollarization, sovereignly controls its monetary policy, leaving the domestic country at its mercy.
What is de-dollarization?
De-dollarization is not a new occurrence but a difficult policy to implement. To be successful, de-dollarisation necessitates a variety of precisely calibrated economic, legal, regulatory, fiscal, and political implementation mechanisms.
The de-dollarization movements in Chile and Israel demonstrate the complexity.
De-dollarisation replaces the U.S. dollar as the currency for trading oil and/or other commodities, purchasing U.S. dollars for forex reserves, bilateral trade agreements, and dollar-denominated assets.
Therefore, De-dollarisation refers to a shift from this global order to one in which nations sell their U.S. treasuries to keep reserves in other currencies or gold and attempt to utilize their currencies for dealings with their most significant trading partners.
Example: China and Russia have attempted to lessen their reliance on the U.S. dollar or 'de-dollarize' their economies to protect their economy from U.S. sanctions, limit vulnerability to the consequences of U.S. economic and monetary policies and express their brand of global economic leadership.
- When a country begins recognizing the U.S. dollar as a means of exchange or legal tender alongside or in place of its currency, this is called Dollarization.
- It can take four forms: full, partial, official, and semi-official.
- Interest rates tend to be similar in dollarized countries to the U.S. in contrast to the money supply and prices.
- The purpose is to reduce the country's risk and enhance its macroeconomic situation.
- It has benefits, such as enhancing international trade, while on the other hand, the country may lose partial control over its economy.
- The United States has some advantages, such as the power of seigniorage and having complete control over the market.
- It can be estimated in 2 ways: deposit and credit dollarization.
- Many countries are officially dollarized, such as Puerto Rico and Zimbabwe.
- The process of substituting the U.S. dollar as the currency for trading oil and/or other commodities, purchasing U.S. dollars for forex reserves, bilateral trade agreements, and dollar-denominated assets is known as de-dollarisation.