Dollarization

What Is Dollarization?

Dollarization is an economic term generated by the "U.S. dollar" when used as a country's currency in addition to the domestic currency or as a replacement. It is an example of currency substitution involving the adoption of 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 often occurs in a country where the domestic currency is weak and may be experiencing 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. 

Sometimes, it is guaranteed by law as a means to pay public or private debt or tax payments, making it 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, particularly in its ability to conduct independent monetary policy. 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 the country by facilitating increased trade and strengthening its economic foundation.

Forms of Dollarization

 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 dollarization occurs when the country uses the U.S. dollar alongside its domestic currency in transactions
• Official (de jure) dollarization occurs when the country's government adopts the U.S. 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

Unlike officially dollarized countries, semi-dollarized countries maintain a local central bank and retain greater control over their monetary policy.

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:

1. Foreign bonds and other nonmonetary assets are held in a foreign country
2. Foreign currency deposits are held in a foreign country
3. Deposits in the domestic banking system in foreign currencies
4. Foreign notes (paper money) are stashed in wallets and mattresses

How does dollarization 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 the U.S., but they will tend to be similar most of the time. In countries experiencing high inflation, the U.S. dollar might see increased circulation or usage. Moreover, the 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, adopting a single currency may contribute to stability in the prices of globally traded goods, helping to align them with levels observed in the United States. As a result, despite occasional price variations, inflation rates in the two nations will likely be comparable.

Examples of Dollarization

Let us take a look at some of the examples of dollarization.

1. 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, alongside a multi-currency system, and it became one of the legal tenders in Zimbabwe in June 2019. 

In the case of Panama, the USD is widely used and accepted, and it is recognized as legal tender alongside the official currency, the Panamanian Balboa, with both having parity.

2. Partial or unofficial acquisition of dollar

Cambodia uses two currencies. The USD manages the metropolitan economy, 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 moving away from using the U.S. dollar; nonetheless, it is paradoxically one of the most dollarized economies in Southeast Asia.

Factors Affecting Dollarization Acceptance

The factors affecting are:

• The level of public support for the U.S. dollar can influence the decision to implement dollarization. Higher public acceptance and support may contribute to a smoother implementation process.  
• The degree of macroeconomic stability significantly influences the acceptance of dollarization, a crucial factor in this process.
• Institutional elements include the maturity of contracts involving both dollar and indigenous currency contracts. 

Dollarization 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 the authority to print it. Instead, they use it as legal tender for transactions and economic activities.

Instead, they use it as legal tender but cannot print dollars whenever needed. 

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 influence.

Thus, implementing it may benefit the economy, but governments may choose not to do so for various reasons, which should be carefully considered.

From the viewpoint of the United States, it is worth noting that about two-thirds of all dollars are held outside the United States, strengthening its presence in the market.

The dollarization calculation can be measured in 2 ways:

1. Deposit dollarization: the ratio of dollar deposits to total broad money deposits

2. Credit: the ratio of dollar loans to total loans

Benefits for dollarized countries

Some of the benefits are:

• There is a positive effect on international trade. This is due to the excessive use and acceptance in the alien world and having a strong value, stability, and less volatility than the domestic currency.
• Promoting businesses will enhance growth through the encouragement of companies and investors. 
• Helping the country become a more prominent international participant by dollarizing the economy and fostering stability.
• Promoting Foreign Direct Investment (FDI) is 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 to printing and maintaining a distinct national currency.

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. 

Some costs are:

• Countries lose 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 is always a risk that changes in U.S. policies or international agreements may impact the economic situation in countries that use the dollar.

Which countries are officially dollarized? 

Some of the countries that are dollarized:

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 believes that establishing preconditions before introducing a foreign currency as legal tender will yield more benefits, while the other argues that it may pressure countries to adopt similar policies immediately.

These prerequisites imply, among other considerations, 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.
• Labor markets must be flexible to promote macroeconomic adjustment in reaction to external shocks.

While some economists argue that having these preconditions can benefit dollarization, others contend against immediately imposing comparable measures, stating that it may create unnecessary pressure on countries.

Advantages of Dollarization for the United States

Advantages for the U.S. are:

• The power of seigniorage: Seigniorage is the revenue generated by issuing money. It represents the difference between the face value of money and the cost of producing or issuing it.
• Increased cross-border movement of a country's currency can create benefits similar to 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, can decrease 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 may reduce the necessity to consider the balance of payments while developing and implementing domestic policy.
• Market dominance achieved through the widespread use and acceptance of the U.S. dollar can provide economic advantages and influence international trade and finance.
• The monetary dependence of other countries on the U.S. dollar can contribute to the generation of political power for the United States, influencing diplomatic and economic relations.

Problems of Dollarization

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 adopt a foreign currency as the official legal tender 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, alternatively, a stable economy. However, determining the precise exchange rate is difficult in an atmosphere of macroeconomic insecurity. 

Two factors must be considered before reaching a decision:

• 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, a commonly employed 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 have begun to use foreign currencies for commercial transactions or just barter. 

The interim finance minister declared that a limited number of merchants and shops would recognize the United States dollar as legal money.

Following the decision, the finance minister stated that the government would adopt the U.S. dollar, allowing its widespread usage in 2009 and discontinuing using the Zimbabwe dollar later in 2015.

In Zimbabwe, the acceptance of dollars contributed to reducing 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 Vs. Fixed exchange rate Vs. currency board system

The comparison is:

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 involves reducing reliance on the U.S. dollar in 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.

For example, China and Russia have attempted to lessen their reliance on the U.S. dollar or 'de-dollarize' their economies.

This move aims to protect their economies from U.S. sanctions, reduce vulnerability to the consequences of U.S. economic and monetary policies, and express their brand of global economic leadership.

Researched and Authored by Jessica Yarak

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