Subcommittee on Economic Policy
Subcommittee on International Trade and Finance


Hearing on Official Dollarization in Emerging-Market Countries


Prepared Testimony of the Honorable Manuel E. Hinds
Former Minister of Finance
Republic of El Salvador


9:00 a.m., Thursday, July 15, 1999

EXECUTIVE SUMMARY

I maintain in this document that dollarization would be beneficial for both the dollarizing countries - because it would bring predictability to their economies and the United States - because it would result in a more stable international financial environment. I argue that some of the objections that are commonly raised against the idea - such as the impossibility of exercising exchange rate and monetary policies - are in fact part of the benefits of a dollarization for the dollarizing economies. I also argue that some of the costs attributed to dollarization - such as the supposedly negative impact of a strong currency on employment and exports - do not exist in reality. Finally, I argue that the benefits of dollarization far outweigh its true costs and risks.


INTRODUCTION

THE MEANING OF DOLLARIZATION

I mean by dollarization the formal adoption of the US Dollar as the official currency in one country - directly or as in Panama, where the official currency is the Balboa but does not circulate. This eliminates the exchange rate of the local currency with the US Dollar altogether and eliminates the possibility of conducting monetary policy in the dollarized country. These are two of the main objectives of dollarizing. This is an all-or-nothing definition. One country with 90% of its deposits in US Dollars is not dollarized if its official currency is not the US Dollar because an exchange rate risk and the possibility of conducting monetary policy still exist in such a country. As long as the exchange rate exists, local banks run foreign exchange risks when lending in Dollars to domestic residents whose earnings are denominated in local currency. This prevents the economy from reaping all the benefits of operating in Dollars.

THE MODEL OF DOLLARIZATION

I assume in this document that the dollarization would be unilateral - that is, the result of a decision of the dollarizing country exclusively, involving no actions by the government of the United States excepting technical advice if needed. This assumption does not preclude the extension of the arguments presented here in Dollarization favor of dollarization to bilateral or multilateral arrangements of dollarization.

THE ORGANIZATION OF THE PAPER

I have organized the paper in six Sections, including this introduction. In the second section I discuss the problems posed by cross-currency risks in Latin America. In Section III I discuss the pros and cons of dollarization from the point of view of the dollarizing countries. Section IV analyzes the main issues that have to be dealt with to dollarize an economy. Section V deals with the pros and cons of dollarization from the point of. view of the United States. Section VI summarizes the findings of this paper.

THE PROBLEMS OF CROSS-CURRENCY RISKS

THE DOMESTIC DIMENSION

The US Dollar is the standard of value throughout Latin America. People think in terms of Dollars when making decisions about salaries, savings and investments and, in general, whenever an economic decision involves the passage of time. For this reason, Latin Americans are quite sensitive to shifts in the rate of exchange with the US Dollar and make adjustments in local currency prices - through the market or through trade union actions - whenever there is a devaluation of the local currency.

Savers and investors make their adjustments in advance. They demand the payment of a premium over the Dollar rate to deposit their funds in local currency and they are likely to move quickly into Dollars - domestically if the banking system receives deposits in Dollars, in the United States if not- whenever the risk of devaluation increases. Suspicions about the imminence of a devaluation are high both when devaluations have been frequent in the recent past. They are also high when there has been none. People think that for this reason, the devaluation is imminent. Consequently, the rate of interest tends to be very high in Latin America regardless of the exchange rate regime.

For the same reason, the maturity of loans and the business time horizon in general tend to be very short in Latin America. There is no rate of interest that could compensate for the risk of depositing in a weak currency for, say, five, ten or twenty years. The combined impact of high interest rates and short-term loans kills investment, and, with it, the possibility of creating jobs and growing at an accelerated pace. This, in turn, results in social problems and political instability. A private sector working only in the short term loses legitimacy with the population. The appeal of populist politicians increases. Populist policies lead to huge devaluations, enormous capital flights and financial crises. Through these mechanisms, the expectations of instability that lurk beneath the fear of devaluations become a self-fulfilling prophecy.

Frequently, people think that the high rates of interest and short lending terms are the result of the country risk rather than of the currency risk. Facts, however, do not support this idea. Loans in US Dollars in Latin America carry much lower interest rates and much longer maturity terms. Only a few enterprises - the big ones with Dollar-denominated revenues and collateral - have access to such loans, however. Small entrepreneur's and common citizens wanting to buy houses and other durables are trapped within the high interest rates and short maturity characteristic of the region. Also, affluent people have access to pensions and insurance denominated in Dollars. The rest of the population is forced to save for their retirement in the weak local currencies. A simple calculation shows that, over the last thirty or forty years - the working life of a normal person - savings in Latin America have been reduced to a minor fraction of what the savers thought they would get to have a dignified retirement. Thus, the exchange rate problem has not only economic but also social implications.

This discrimination cannot be avoided because lending in Dollars to people whose earnings are denominated in the local currency is too dangerous for the banks. The danger is not in the Dollar denomination but in the risk of devaluation. Banks, however, cannot avoid the sweepingly destructive effects of devaluations, even if they lend only in local currency. In normal times, banks are structurally weak because the high interest rates substantially increase the risks of lending. When catastrophic devaluations occur, the disruption of the economy is so pronounced and the interest rates in the local currency go up so drastically that people cannot possibly repay their debts. In recent cases in Latin America, mortgage installments have become higher than the salary of the homeowners. Banks become insolvent. A conspicuous exception to these problems is Panama, where mortgages, for example, are 30 years at 9%. Their local currency is the US Dollar.

THE INTERNATIONAL DIMENSION

The existence of local currencies within this unstable environment also creates grave dangers to the Latin American banking system in the international dimension. Such risks are associated with what is commonly called 'hot money." Investors bring money to a country when they expect that the rate of devaluation will be lower than the difference between the Dollar and the local currency interest rates for a period long enough to make good profits. They convert the Dollars into local currency and deposit the latter in short-term instruments. When the investors suspect that the relationship between the rates of devaluation and domestic interest rates will reverse itself, they convert their local currency into Dollars and leave the place. Classically, a good portion of these funds return to the country after the catastrophic devaluation has taken place, showing beyond doubt that these funds were fleeing not because the country risk has increased but because of sheer fear of devaluation. In some cases, it has been proved that the money leaving the country in panic was primarily local. This story has repeated itself in many countries in the region. In fact, all money is hot in Latin America.

These events have terrible effects in the domestic financial system. They also have an extremely negative effect in the international financial system, as the recent financial crises have shown. There is a controversy raging on whether the ultimate source of these cataclysmic events is irresponsible monetary, exchange rate and fiscal policies of local governments or the voracity of the owners of the hot money. Both sides have strong arguments. What is clear is that these problems exist only because there is a local currency and, therefore, the possibility of making a profit from the large interest rate differences that local currencies make possible. Interest rates do not fluctuate that wildly in Panama. Consequently, there no are sudden rushes of money to and from Panama.

BETWEEN A ROCK AND A HARD PLACE

Given the prevalence of the US Dollar as the standard of value in Latin America, countries in the region find themselves in a very difficult situation regarding the choice of an exchange rate regime. No matter what they do, people keep on thinking in US Dollar terms and reacting quickly to any shifts in the relationship between the Dollars and the local currency. The situation of governments is like this.

Thus, you either suffocate the private sector with high interest rates or run the risk of destroying it with a catastrophic devaluation some time in the future.

Frequently, people say that these problems would not exist if fiscal and monetary policies were reasonable. This is true but misses the point of the term of the expectations we are discussing here. A 30-year loan spans between six to seven presidential periods in most Latin American countries. This is what people see when deciding to deposit their money, preferring to carry out their businesses in the short term exclusively.

So, what do you do? How do you convince people that stability will last, that they can put their money on the line for twenty to thirty years at reasonable interest rates?

I find only one answer to these questions. Give a total credibility to the domestic currency by using the services of a strong currency from abroad.

DOLLARIZATION FROM THE POINT OF VIEW OF THE DOLLARIZING COUNTRIES

BENEFITS

Economic Benefits
Social Benefits

ARGUMENTS AGAINST DOLLARIZATION

a) DOLLARIZATION WOULD PREVENT THE EXERCISE OF AN INDEPENDENT MONETARY POLICY

This point has two dimensions.

A further observation is that Latin American countries are already affected by American monetary policy. Since the Dollar is the standard of value in Latin America, an increase in the American interest rates prompts immediate increases in the countries of the region, and vice-versa. Thus, depending on the American monetary policy would be nothing new for Latin American countries.

a) WOULD DOLLARIZATION INCREASE UNEMPLOYMENT?

This argument is based on the idea that, all other things equal, lower salaries lead to more employment. If successful, devaluations reduce wages denominated in local currency relative to the prices of agricultural and industrial goods - which maintain their value in Dollars because they can be traded internationally. Thus, devaluations are said to spur employment by lowering wages.

A devaluation, however, might fail to lower wages. As it has happened so frequently in Latin America, wages in local currency frequently jump upward with devaluations, so that the reduction of wages does not take place. Even if the devaluation is effective, however, a reduction in wages might result in higher employment only under some circumstances. In the short term, employment creation is restricted by the current availability of factors complementary to labor in production, mainly capital. Enterprises would not employ people in excess of what their existing machines would justify regardless of the salary levels. They would hire more people when wages go down only when they have unused machines and demand for their products is growing. In the long term, employment depends even more from investment because companies do not create overcapacity willingly.

Now, we can examine what happens in the wake of a devaluation. Since the US Dollar is the standard of value, interest rates go up immediately to compensate for the loss in acquisitive power of the local currency. Even more, to make the devaluation successful, the government has to restrict domestic demand, which it does by increasing interest rates further. Thus, devaluations in Latin America eliminate the two conditions necessary for a reduction in salaries to cause an increase in employment: investment and growing demand. In fact, by keeping interest rates low, a dollarized economy can create more jobs than an economy where wages are constantly lowered through devaluations.

Moreover, what kind of development can be achieved in an economy where employment is assured by continuously lowering wages?

b) WOULD IT Make Economies Less Competitive?

This is another version of the previous argument. It defines competitiveness as inversely proportional to the level of wages expressed in Dollar terms. This is actually a perversion of the concept of competitiveness. A country that can compete abroad only by cutting wages continuously cannot be called competitive. True competitiveness arises from increasing the productivity of all the factors of production. By guaranteeing stability in the long run, dollarization would help countries to become competitive more than any devaluation or series of them.

1) Balance

By creating a stable monetary environment for enterprises, government and citizens, dollarization would bring substantial social and economic benefits to the dollarizing countries. Losing the possibility of having an independent monetary policy would increase the confidence of markets. Rather than reducing employment and competitiveness, it would increase them.

II. MAIN ISSUES

There are two kinds of these issues. Some refer to the working of the system when in place and others to the transition to a dollarized economy.

1) THE COSTS OF DOLLARIZATION

a) LOSING THE LENDER OF LAST RESORT

Dollarized economies would lose the capacity to create money to finance banks with liquidity problems. I stress the term liquidity because banking solvency problems are not in the realm of central banks. They are fiscal in nature - resolving them needs an absorption of the losses incurred by the failing banks, which, if not burdened on the depositors of the failed banks, has to paid for with government resources. Liquidity problems, by contrast, can be resolved with central bank's credit. Without a central bank, dollarized countries would lose the main mechanism to deal with liquidity crises.

Central banks, however, are not the only possible sources of funds to keep banks liquid. There are two main mechanisms that could be used to substitute for the central bank in this respect.

a) Losing Seigniorage

There is no theoretical reason for the United States to share the seigniorage with the dollarized economies. The seigniorage paid to the United States would be the price of the services of a stable currency.

From the point of view of the dollarizing economies, the loss of the seigniorage has to be compared with the benefits of the dollarization. The loss depends on the demand for the non-interest bearing obligations of the central bank - which include cash in circulation and, in some cases, deposits of the banks in the central bank as legal reserve requirements. In some countries, seigniorage is negative because the central bank pays more in Dollar equivalent terms for the legal reserve requirements of the banks than what it receives for the reserves backing such deposits and the currency in circulation. In these cases, losing the seigniorage would be a benefit. In other cases, the benefits of dollarization are larger than the loss of the seigniorage. In the case of El Salvador, the central bank pays 7% for most of the banks' deposits and receives 5% from international banks for the reserves backing them - so that the seigniorage is negative in that portion of the central bank obligations. For cash in circulation, the central bank receives 0.16% of GDP. When the two components are netted out, seigniorage is negligible. The case is representative. Because of its stable economic environment, El Salvador is one of the countries with stronger demand for monetary and financial assets in the region (currency plus deposits in the consolidated banking system are about 40% of GDP and Dollar deposits are less than 6% of GDP). A reduction of 6 points in the interest rate - the expected reduction in a dollarization -would represent 2.2% of GDP. Spending less than 0. 16% of GDP in reducing interest rates 6 points and obtaining long-term economic stability would be a good investment even if the United States does not share the seigniorage with the dollarized countries.

1) ISSUES OF THE TRANSITION

a) SHOULD COUNTRIES STRENGTHEN THEIR BANKS BEFORE DOLLARIZING THEIR ECONOMIES?

The question here is: if banks are in bad condition in one country, is it cheaper to restructure and recapitalize them with the current exchange rate regime or in a dollarized economy? This is a question that has to be analyzed in each country. In most cases, the answer is that it is cheaper to resolve the problem of the ailing

banks within a dollarized economy. This is so because the best practice to cover losses of banks is to buy their bad portfolio at face value with interest-bearing government bonds. The rates of these instruments must generate enough revenue to make the bank profitable in combination with the revenue coming from other remaining good assets. The lower the rate of interest paid on these bonds, the cheaper the solution of the problem. To the extent that interest rates in dollars are substantially lower in real terms than those in local currency instruments, restructuring would be cheaper in the dollarized economy. In addition, restructuring in a dollarized economy would take place in a stable economic environment, with reasonable interest rates, which would spur a faster recovery.

b) ACCUMULATING the NECESSARY DOLLAR RESERVES

This is the main obstacle to dollarization. To dollarize its economy, a country needs to buy with cash denominated in Dollars its reserve money - that is, all the cash in circulation plus the deposits of the banks in the central bank. This is not a trivial quantity. Few countries in Latin America have enough reserves to do it.

THE IMPACT ON THE UNITED STATES

1) Implications for American Monetary Policy

In the model I discuss in this paper - unilateral dollarization - dollarization would have no impact on the monetary policy of the United States. The whole idea of dollarization from the point of view of the dollarizing countries is to acquire the stability of the Dollar. Thus, as long as the policy of the Federal Reserve is to keep price stability in the United States, dollarization would be convenient for Latin American countries. The pressures arising from Latin America on the American monetary decisions would in fact decline as more countries become dollarized because the main source of those pressures, currency crises, would disappear.

2) BENEFITS

The United States would obtain the following benefits from the dollarization of Latin American countries:

1) COSTS

There are no costs for the United States in the model of unilateral dollarization discussed here.

2) HOW COULD THE UNITED STATES HELP THE PROCESS?

In my opinion, countries opting for dollarization should do it as a means to ensure their own stability and get access to a large financial and trading block. They should not do it hoping that the United States would modify their own monetary policy for the sake of them. If the United States did that, such action would reduce the appeal of the Dollar as a currency of choice. The United States could help the process by recognizing publicly that dollarization would be beneficial for all parties involved and cooperating technically with the dollarizing countries to carry out the process.



SUMMARY

Dollarization would remove one of the most daunting obstacles for the development of Latin American economies: their protracted instability and propension to exchange rate crises. By doing that, it would not just improve the growth prospects of the region. It would also provide substantial benefits to the United States in the shape of lower risks for American banks operating in the region, lower transactions costs for American banks and enterprises, and increased political stability in the hemisphere. Dollarization is attractive even if seigniorage is not shared with the dollarizing countries. The loss of the lender of last resort in the dollarized economies can be compensated with liquidity requirements and contingent credit lines. Regarding the transition to a dollarized economy, the main obstacle is the lack of Dollar reserves large enough to carry out the process in many countries in the area. Regarding restructuring weak Latin American banks, doing it would be cheaper if conducted within an already dollarized economy. The United States could help the dollarization process by recognizing that it would be beneficial for all the parties involved through the creation of a stable monetary and trading block in the Americas.


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