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Economic Research & Data
Dollarization in Latin America

LARG Brief: Dollarization in Latin America

The economic crisis in Argentina has fostered renewed discussion of dollarization as a policy option for Latin American countries. By replacing their domestic currencies with the U.S. dollar, countries considering dollarization hope to achieve economic stability and growth. However, dollarization does nothing to resolve structural and institutional problems which, in many cases, give rise to crisis conditions in the first place. These problems must be addressed in order for countries to achieve long-term economic stability and growth. In short, dollarization is not a panacea for what troubles many Latin American economies.

Why the U.S. dollar? Since the United States is the main trading partner of most Latin American countries, the U.S. dollar is used extensively for international transactions. The process of dollarization in Latin America accelerated after the external debt crisis, when countries struggled with recession, inflation and unemployment. After a series of failed stabilization attempts, these countries faced higher inflation rates, larger fiscal deficits, deeper external imbalances and continuous capital flight. Under these circumstances, individuals initially used the dollar as the hard currency to protect their incomes from the detrimental effects of inflation. As inflation became chronic, the dollar became the unit of account for contracts and large denomination transactions. At the end of the 1980s, it became more common for U.S. currencies to circulate alongside domestic currency. This process was encouraged even further when some governments began to allow deposits and loans in U.S. dollars.

What is the definition of dollarization? Under official or full dollarization, the U.S. dollar is the legal tender for all transactions in the economy. Several countries have already officially dollarized. Panama adopted the U.S. dollar as its official currency in 1904, Ecuador dollarized in September 2000 and El Salvador dollarized in January 2001. Unofficial or partial dollarization, which is widespread in Latin America, refers to the process where individuals substitute domestic money with foreign money in order to conduct transactions and protect the purchasing power of their income. The table shows the degree of dollarization in several Latin American countries by calculating bank deposits in foreign currency as a percent of total liquidity. While dollarization is an observable process, it can only be measured accurately if financial transactions using foreign currency are permitted.

Why would a country adopt full dollarization? Countries initiating full dollarization seek policy credibility. Full dollarization requires a serious commitment to maintaining consistent economic policy, and governments must introduce a series of institutional and structural reforms. In the case of Ecuador, full dollarization helped to reduce inflation (and expectations of inflation) and to bring economic stability. In El Salvador, in contrast, the implementation of full dollarization was part of the process that included stabilization and structural reforms. Authorities there expect that full dollarization will promote foreign investment and integration with international markets.

What are the implications of full dollarization in the short run? Under full dollarization, the fact that money supply varies according to the net foreign reserves will have several implications for economic policy. First of all, the central bank is no longer the lender of last resort, meaning that it cannot provide funds to financial institutions in trouble. Its function instead is to maintain the soundness and efficiency of the financial system. Second, since the government can no longer print money, it can only finance fiscal deficits through alternative sources of revenue. These implications have both costs and benefits. The restrictions on changing the money supply can improve policy credibility given the fact that many countries in the region have a long history of hyperinflation that resulted from printing money to finance fiscal deficits.

However, if the government wants to counter a recession through countercyclical spending, economic agents could interpret it as a signal of a lack of commitment to maintaining a consistent economic policy. Another cost is the loss of seigniorage, which is the revenue that the government receives for creating money. Furthermore, in a fully dollarized economy, interest rates are expected to decline because there is no depreciation risk. This would lower the borrowing costs of the private sector and promote investment. However, this decline could be offset by an increase in the country risk or default risk. Default risk depends upon the country’s ability to pay for its debt, principal and services. Borrowing by issuing government debt is an alternative source of fiscal financing. Therefore, the government needs to demonstrate a commitment to fiscal discipline and debt repayment.

By adopting the U.S. dollar, the financial system also opens to capital flows. Capital mobility promotes financial intermediation, competition and efficiency among institutions, and helps restore confidence in the financial system. It also encourages integration of the financial system with the rest of the world. However, this openness to international markets also exposes a country to external shocks, and it can make coping with internal shocks more costly. For example, in the event of a natural disaster, a dollarized economy would be more dependent on external resources to finance reconstruction. Dollarized economies can no longer rely upon monetary and exchange rates policies to respond to the negative effects of these shocks on the economy.

Is full dollarization sustainable in the long run? A dollarized economy will become dependent on a continuous flow of international reserves or foreign currency and consequently on the conditions of international markets. In order to maintain satisfactory economic growth, a fully dollarized country needs to be competitive internationally and attract capital flows, either as foreign investment or net borrowing.

The sustainability of a fully dollarized economy will depend upon how successfully the government implements fiscal discipline, including tax and expenditure reforms. Improved supervision and regulation of the financial system can provide stability and promote confidence that the system can respond to financial crises and sudden capital outflows. Diversification of exports and the promotion of competitiveness is also important to encourage investment and economic growth. Consequently, dollarization does not stand alone as a remedy for economic maladies. It might buy some time in the short run; however, it must be accompanied by a series of structural reforms in order to achieve economic growth and development in the long term.

Deposits in Foreign Currency
as a Percentage of Money Supply
  1990 1995 1997 1999 2001
Argentina 33.7 45.1 47.3 48.2 62.8
Bolivia 66.2 67.3 79.9 82.7 84.8
Costa Rica 23.5 34.5 34.1 40.0 43.6
Guatemala         1.0**
Honduras 1.4 17.0 23.4 22.7 27.6
Mexico 10.0 17.5 9.7 7.3 5.5
Nicaragua 27.3 57.6 64.5 67.8 70.4*
Paraguay   27.6 37.6    
Peru 38.6 57.1 53.9 60.1 55.0
Uruguay 80.1 73.7 76.6 79.7 82.2*
Venezuela   3.4 2.3    
Source: Central Banks and IMF reports
* November 2001
** Law off Free Negotiation of Foreign Exchange, May 2001

Real Economic Growth Outlook
  2001 2002 2003
Argentina -3.9 -8.2 1.1
Bolivia 0.7 2.4 3.4
Brazil 1.7 2.1 3.6
Chile 3.0 3.0 4.4
Colombia 1.6 2.3 3.1
Costa Rica 0.0 1.4 2.9
Dominican Republic 2.3 3.3 4.3
Ecuador 4.7 3.5 4.1
El Salvador 1.7 2.5 NA
Guatemala 2.0 2.4 NA
Honduras 2.4 2.8 NA
Jamaica 0.7 1.2 NA
Mexico -0.3 1.3 NA
Nicaragua 2.2 2.2 NA
Panama 1.2 1.7 2.2
Paraguay 0.4 1.4 2.2
Peru -0.1 3.3 3.8
Uruguay -1.4 0.2 2.3
Venezuela 2.7 0.6 1.7
Total Latin America 0.5 0.3 3.2
Sources: IMF, Consensus Economics, LatinFocus, Economist Intelligence Unit, ECLAC
   Data represent average of forecasts.

The views expressed in this report are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Atlanta or the Federal Reserve System.
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