Dollarization Explained

Since the abandonment of the gold standard at the outbreak of WWI and the Bretton Woods Conference following WWII, some countries have been desperately seeking ways to promote global economic stability and hence their own prosperity. For the majority of these countries, the optimal way to obtain currency stability has been to peg the local currency to a major convertible currency. However, another option is to abandon the local currency in favor of the exclusive use of the U.S. dollar (or another major international currency, such as the euro). This is known as full dollarization.

How Pegging Works
The extreme method of pegging lies in a currency board, by which countries "anchor" their local currencies to a convertible currency (often the U.S. dollar). (To learn more about this, see What Is A Currency Board? and Floating And Fixed Exchange Rates.) The result is that the local currency has the same value and stability as the foreign currency. Pegging has typically been a way to substantiate the value of a local currency against the world's convertible currencies and to stabilize the exchange rate.

The Dollarization Alternative
As an alternative to maintaining a floating currency or a peg, a country may decide to implement full dollarization. The main reason a country would do this is to reduce its country risk, thereby providing a stable and secure economic and investment climate. Countries seeking full dollarization tend to be developing or transitional economies, particularly those with high inflation.

Many of the economies opting for dollarization already informally use foreign tender in private and public transactions, contracts, and bank accounts; however, this use is not yet official policy, and the local currency is still considered the primary legal tender. By deciding to use the foreign tender, individuals and institutions are protecting against possible devaluation of the local exchange rate. Full dollarization, however, is an almost permanent resolution: the country's economic climate becomes more credible as the possibility of speculative attacks on the local currency and capital market virtually disappears.

The diminished risk encourages both local and foreign investors to invest money into the country and the capital market. And the fact that an exchange rate differential is no longer an issue helps reduce interest rates on foreign borrowing.

Disadvantages of Dollarization
There are some substantial drawbacks to adopting a foreign currency. When a country gives up the option to print its own money, it loses its ability to directly influence its economy, including its right to administer monetary policy and any form of exchange rate regime.

The central bank loses its ability to collect 'seigniorage', the profit gained from issuing coinage (the minting of monies costs less than the actual value of the coinage). Instead, the U.S. Federal Reserve collects the seigniorage, and the local government and gross domestic product (GDP) as a whole thus suffer a loss of income.

In a fully dollarized economy, the central bank also loses its role as the lender of last resort for its banking system. While it may still be able to provide short-term emergency funds from held reserves to banks in distress, it would not necessarily be able to provide enough funds to cover the withdrawals in the case of a run on deposits.

Another disadvantage for a country that opts for full dollarization is that its securities must be bought back in U.S. dollars. If the country does not have a sufficient amount of reserves, it will either have to borrow the money by running a current account deficit or find a means to accumulate a current account surplus.

Finally, because a local currency is a symbol of a sovereign state, the use of foreign currency instead of the local one may damage a nation's sense of pride.

Advantages of Dollarization

Besides reducing risk and protecting against inflation and devaluation, there are some compelling reasons for a country to decide to give up so much control over its economy.

As we mentioned above, full dollarization creates positive investor sentiment, almost extinguishing speculative attacks on the local currency and the exchange rate. The result is a more stable capital market, the end of sudden capital outflows, and a balance of payments that is less prone to crises. (You can read more about the BOP in What Is The Balance Of Payments?)

Last but not least, full dollarization can improve the global economy by allowing for easier integration of economies into the world's market.

Many emerging economies already use dollarization to some extent or another. However, many have shied away from it because economies that would consider full dollarization are those that are still developing. For many countries, having an autonomous economic policy and the sense of individual statehood that comes with it is too much to give up for full dollarization, an extreme option that is for the most part irreversible.