SUNNY SIDE OF THE STREET: ANALYSIS OF THE FINANCIAL SYSTEM & THE ECONOMY (part 49)

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Dollarization and Currency Boards

by

Charles Lamson

Full dollarization occurs when a country abandons its own currency in order to adopt another country's currency as its official currency. The adopted currency becomes the medium of exchange and unit of account. The U.S. dollar is the currency that has been most widely adopted and used by other countries. Although the U.S. dollar is the most widely dollarized currency, the term dollarization is generic and in many cases, has little to do with the United States or the U.S. dollar. For example, Greenland has adopted the Danish krone; the Vatican City, the Italian lira; Tuvalu, the Australian dollar, and so on.

Since 1999, El Salvador, Ecuador, and Guatemala have dollarized by adopting the U.S. dollar and abolishing their domestic currencies. Argentina has seriously considered full dollarization (Panama dollarized in the early twentieth century.) Full dollarization with the U.S. dollar is discussed as a way to help developing countries, particularly those in South and Latin America, to overcome monetary and exchange rate volatility and to stabilize prices.

There are both benefits and costs to full dollarization. On the benefits side, there can be no balance of payment crises or speculative attacks on the domestic currency if the currency does not exist. The increased stability should lead to increased capital inflows, lower interest rates, and greater investment and growth. Lower interest rates also reduce the government's cost of financing the public debt. Another possibility is greater trade and financial integration with the United States and reduced inflationary expectations.

The costs of full dollarization include the loss of the identity associated with one's national currency. Many of the European countries that participated in the euro had a difficult time giving up their domestic currencies. A more direct cost is seigniorage. Seigniorage is the difference between the cost of producing and distributing currencies and any revenues earned through the distribution. For example, the Fed issues currency by purchasing government securities that earn interest. The interest goes to the fed and eventually to the government. On the other hand, the currency issued by the Fed does not pay the interest. The amount of interest earned on the government securities less the cost of producing the Federal Reserve notes is seigniorage. If a country fully dollarizes with U.S. dollars, that country forgoes earning seigniorage and the United States earns additional seigniorage that is related to the amount of U.S. dollars circulating in the foreign country. If electronic payments reduce the risk of currency in the future, the amount of seigniorage will be reduced.

Another cost of full dollarization is that the country that the country that dollarizes loses the ability to pursue an autonomous monetary policy. Small countries that wish to become more integrated with larger economies to increase trade and attract capital inflows have limited ability to pursue an independent monetary policy anyway.

A close alternative to full dollarization is the creation of a currency board. A currency board is an organized body within a country with the sole responsibility and power to defend the value of a country's currency. The currency board pegs or fixes the currency value to the value of the currency of the dominant trading partner. The country commits to a fixed exchange rate and the currency is fully convertable with the pegged currency. The government cannot print money unless it is backed by reserves of the currency to which it is pegged. Finally, the currency board has the power to force the government to eliminate a budget deficit that may be inflationary.

A currency board can achieve many of the benefits of full dollarization. Also, the value of the seigniorage from issuing one's own currency is not lost. The problem is that the currency board may not be perceived to be as permanent as full dollarization. Given the perception that the currency board could be abolished or modified, the full benefits of greater trade and investment and lower interest rates would not be realized. The currency could still be subject to speculate attacks if speculators sold the currency at the present price, putting tremendous pressure on the currency board to devalue. Argentina established a currency board in 1991 that fixed the Argentina peso with the U.S. dollar. Despite the presence of the currency board, there is less certainty with a currency board than with full and slower growth than what would be otherwise. Argentina, Bulgaria, Bosnia, and Hong Kong have had successful currency boards.

Finally, it should be noted that dollars already circulate and are widely used in many of the countries that could benefit from full dollarization. To the extent that the dollar displaces the national currency, seigniorage is already reduced.

*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 665-666*

END