Dollarization

Dollarization is the colloquial term for currency substitution. A country, either officially or unofficially, fully or partially accepts a foreign currency as its legal tender to enhance currency stability, reduce the costs of maintaining its currency, and boost investor and consumer confidence in its economy.

The United States dollar is one of the most popular currencies. Thus, currency substitution has become popularly known as 'Dollarization.' However, it doesn't mean that USD is the only currency used. This process might be adopted voluntarily or involuntarily and is used for controlling currency volatility, boosting international trade, etc.

• Dollarization is the process by which a country adopts the United States dollar (USD) or another foreign currency as its official currency or as a substitute for its domestic currency.
• Dollarization" and "currency replacement" are interchangeable.
• A country may accept all or part of a foreign currency as legal tender to enhance currency stability, reduce the expense of maintaining its currency, and boost investor and consumer confidence in its economy.
• There are four different kinds of dollarization. The results are cost-effectiveness, accelerated development, stability, and decreased interest rate premiums.

Currently, the world is running on a fiat money system in which an equivalent amount of gold does not back the paper currency or coins. This has been so since abolishing the Gold standard and its variants.

When gold-backed currencies, increasing the amount of a certain currency would require an equivalent amount of gold to be kept as a reserve. This created a limit on the increase in currency, as gold production has its limitations. However, under the fiat regime, an unlimited amount of money can be printed by countries if need be. This process is also known as Deficit financing.

A drawback is that the currency loses its value in the international market due to oversupply. In exchange for 1 unit of such a currency, lower and lower amounts of foreign currency are available. Ultimately, investors and consumers lose faith in the currency because of purchasing power.

To bring back the faith in the fiscal and economic structures of the dollarization countries, certain countries at different periods have officially or unofficially adopted a foreign currency as their legal tender. Such foreign currency has international acceptability, and therefore investors and consumers have greater faith in them.

The following image shows the degrees of flexibility of exchange rates:

• There is no separate legal tender under complete dollarization policy, also known as 'hard peg' or currency board system.
• Under a fixed-rate regime, the domestic currency exchange rate is fixed against a single or a basket of currencies to bring stability.
• Under soft peg or managed float, the domestic currency can freely float within a certain range, bound by its upper and lower limits.
• A fully floating exchange rate moves freely with the market movements of demand and supply without any political or monetary authority's intervention.

The following image shows the classification of dollarization policy based on degree and officiality:

• Complete dollarization implies that foreign currency is the only legal tender in the country.
• Partial dollarization implies that the foreign and local currencies are accepted as legal tender.
• Official dollarization implies that the country's government and monetary authorities have accepted a foreign currency as its legal tender.
• Unofficial dollarization occurs when the people in the country have their savings in foreign currency in the form of investment instruments because they consider that currency as a haven and protection against inflation which is one of the important reasons for dollarization.

The above are the various ways in which dollarization countries can adopt the method to bring back the economic stability and control economic unrest.

Now let us look at a few examples to understand the concept.

Example#1

• Zimbabwe completely replaced the domestic currency in 2009 with several different foreign currencies after stretched periods of hyperinflation and extreme economic crisis that led to a complete collapse. As recently as February 2019, Zimbabwe introduced a new currency known as RTGS Dollar, and in June 2019, it became the only legal tender in Zimbabwe.
• In the case of Panama, at the time of formation of the country, USD was adopted in its constitution as its only legal tender.
• Many Euro-zone countries except UK and Switzerland accepted Euro as the only legal tender replacing their currencies in 2002.

Example#2

• Cambodia has dual currencies. The urban economy is governed by USD and the rural economy by their domestic currency Riel. Dollarization is unofficial because the government has never officiated it and is also strongly in favor of de-dollarization; however, it is paradoxically one of the largest dollarized economies in South-East Asia.
• Nepal & Bhutan use Indian Rupee, and their domestic currencies follow a fixed currency peg.

Dollarization or currency substitution has its merits and demerits, and the trade-off exists. However, as far as practical and real-world observations are concerned, the benefits of dollarization are more on the economic front while disadvantages are more on the political front. Let us look at its effects:

• Control on currency volatility – Th edomestic currency experiences lesser fluctuation since it is usually pegged with US dollars, which is highly stable.
• Boost to international trade – Since the US Dollars are accepted globally fro international trade, it becomes easy for the economy pegged to dollars to conduct trade with various countries worldwide.
• Investors gain confidence – Dollarization helps in boosting the confidence level of investors in case of those currencies that have a history of fluctuations or extremely high inflation rates.
• Lack of control on monetary policy – The country adopting this method has to give up its hold on the country’s monetary policies. This may sometimes lead to economic unrest because the dometic economy cannot use any kind of monetary policy tool to boost its economy.
• Vulnerable to fluctuations on the US – Since now the home currency is tied to US dollars, any fluctuation in US dollar will affect this currency, which may have a significant impact.

Choosing the appropriate degree of dollarization is important so that when a need arises, there should be ample exit options. Suppose the country can utilize this policy to its benefit. It can easily achieve development, but it may never recover from its ill fate if it becomes complacent and short-sighted.

There are a few dollarization benefits that a country gets if it adopts the dollarization process to bring stability in its economic conditions.

• Stability: The exchange rate risk reduces when the foreign currency is accepted as a legal tender. Due to this, the investor community and consumers have greater confidence in the economy as they have faith that the value of their wealth will not face sudden shocks or complete erosion.
• Faster Development: With greater stability comes greater FDI and FPI as investors do not face the challenges of speculating the movement of their investments. This leads to faster development of emerging economies as investors feel greater transparency.
• Lower interest rate premiums: Government and corporate debts can be issued at lower interest rates when denominated in the internationally acceptable currency because of the reduced premium associated with country risk, one of the components of the interest rate calculation. This leads to lower lending rates and stimulates capital investment.
• Cost-effectiveness: The cost of printing and maintaining the domestic currency is reduced or eliminated.

Thus, the above are some of the reasons for dollarization that are beneficial for an economy.

Along with the dollarization benefits, it is also necessary to understand the disadvantages. Only then will an economy be able to take an informed decision about the process. Let us go through the following points in detail.

• Loss of Seigniorage:
  • First, let's understand the meaning of Seigniorage. When a country issues or prints currency, it effectively borrows the same. If not backed by gold, it is backed by the government's full faith. Therefore, there is no interest charged on this loan.
  • The money thus saved is used by the government to fund its various expenses. When the country dollarizes, it loses its right to print its own money and therefore also loses current and future Seigniorage.
  • To dollarize, the country first reduces the amount of domestic currency by buying it back in the open market. It uses the accumulated Seigniorage to fund this activity, and the country doesn't accumulate in the future Seigniorage.
• Default risk: Even though the country issues debt in foreign currency, it all boils down to its capacity to pay back the debt. Suppose it cannot stimulate investment and achieve the required development. Its chances of defaulting increase. Had such debt been issued in the domestic currency, it would print more currency to pay back the debt, but that is not an option after dollarization.
• In tandem with the foreign economy: When dollarization occurs, the country is no longer immune to the macro-economic upheavals in the foreign country, which causes depreciation of the foreign currency.
• Loss of monetary autonomy: The central bank of the dollarized country loses its freedom to impact the policy rate and, in turn, the lending rate. This leads to a lack of control over the country's economic environment and money supply.

Both the above methods are two different ways to manage the currency of a country to avoid currency fluctuations and promote growth. However, let us lok at the basic differences between them.

• The former is just the method of adopting dollar as the official or unofficial currency of the economy whereas the latter means the country’s official currency is pegged to another foreign currency, which may be dollar, euro or any others.
• Adopting the former means the home country has to give up its control over the monetary policy of their own country since it is flowing the movement of dollar, but adopting the latter means some control on the monetary policy can be retained with regard to interest rate adjustment etc.
• The dollarization process gives less flexibility than currency board due to lack of power over the monetary policy of the economy. This is not the case with currency board.
• The former may make the currency of the country that has adopted dollar vulnerable to fluctuations because it is tied to the currency of the economy whose official currency they has taken.

However, both the methods helps in maintaining the stability in exchange rates inspite of lack of official control on the economy. The country will adopt it or not depends on the political and economic conditions.

This has been a guide to what is Dollarization. We explain the advantages, disadvantages, example, differences with currency board & types. You can learn more from the following economics articles –

• Full Form of RTGS
• Currency Market Examples
• Currency Depreciation Causes
• Currency Devaluation