Senate Banking, Housing and Urban Affairs Committee

Subcommittee on Economic Policy
Subcommittee on International Trade and Finance

Hearing on Official Dollarization in Emerging-Market Countries

Prepared Testimony of Mr. David Malpass
Director for International Economics
Bear, Stearns and Co., Inc.

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

Chairman Mack, Chairman Enzi, members of the subcommittees. Thank you for the invitation to this hearing on dollarization.


In my view, the post-Bretton Woods system in which countries constantly change the value of their money is unworkable. For developing countries, the exchange rate uncertainty raises the cost of capital, reduces investment, reduces growth rates, and leaves them poor. Already this year we've seen devastating exchange rate crises in Brazil, Ecuador and Colombia. Russia, Turkey and Venezuela have been failing economically, in large part due to their exchange rate systems. China and Argentina are battling virulent deflation.

Poor Economic Progress Abroad

I am saddened by the poor economic progress in many developing countries, in particular in those closely linked to U.S. policy influence. Many developing countries should be growing fast, yet per capita incomes remain stagnant. For example, even assuming a strong economic rebound in late 1999 and 2000, Latin America's per capita income will be substantially less in 2000 than it was in 1997. For Southeast Asia and South Korea, per capita incomes in 2000 will be well below their 1995 level, a huge setback. If data were available for median income, it would show even more severe declines, because most of the economic losses are falling on poor people. Poverty is on the rise, especially in areas such as Southeast Asia which had made significant gains in the years before the Asian financial crisis. In Indonesia, the World Bank estimates that 20 million more people are now living below the poverty line than in 1997. The World Bank estimates that worldwide there could be 1.5 billion people living in abject poverty, that is living on less than $1 per day. Given strong U.S. growth, low unemployment, and technology advances, these should be the best of times for developing countries. Yet many have moved sharply backward.

U.S. Is Responsible for the Dollar and the IMF

I think U.S. economic policy bears substantial blame for the poor economic performance of many developing countries. It is not our responsibility to create growth abroad. But it is our responsibility to provide a stable value for the U.S. dollar, because the dollar has become the global store of value and because its stability is in our self-interest. And it is our responsibility as the most influential member of the IMF to have it do no harm. In this regard, the U.S. and IMF are not providing economic leadership to the world and are actually blocking growth in many cases. As the U.S. becomes more isolated in its full employment and wealth, poor economic conditions abroad raise major issues for our national security, immigration policy and future growth, not to mention morality.

The U.S. needs a wholly new international economic policy focused on the global exchange rate system, not the facelift in financial "architecture" proposed by the Administration. A proper policy should be built on our country's economic beliefs -- sound money, limited government, free trade and a belief that people at the bottom of the economic ladder should be able to move up. Instead, in foreign countries, the U.S. and its related institutions promote centralized, non-democratic power through the IMF, weak currencies, high taxes, stagnation in class structures, legalisms rather than a constitutional rule of law, and a "limits to growth" mentality. The result is much slower growth in developing countries than what should be achieved.

We Should Focus on Stable Money

In its domestic and international economic policies, the U.S. should put immense emphasis on money as a store of value and an enabler of economic and political development. This clearly did not happen in 1997, when the dollar gained substantial value against gold, almost all commodities, and almost all world currencies.

The sudden change in the value of the dollar put immense pressure on dollar debtors and commodity producers around the world, distorting the global economy and harming developing countries. It culminated in the flight to quality crisis of August 1998. Three Fed rate cuts ended the immediate crisis. But the fluctuation in the value of the dollar will leave lasting costs in both the U.S. and globally.

When the dollar revalues, the dollar price of commodities falls. One example of the pressure on the global economy is the difficulty facing farmers in the U.S., China, Poland, Argentina, Mexico and elsewhere.

The U.S. should state clearly and repeatedly that our own economic policy depends on achieving a stable value for the dollar over both short and long periods of time. We should debate and implement mechanisms to accomplish this. We should actively promote stable money for other countries. Instead, we back policies and economic concepts guaranteed to force poor people abroad to use bad money. After clearly stating our own stable money policy, the U.S. should use the IMF, if it must exist, to promote sound money elsewhere.

  • The U.S. could ask for a provision in the IMF's charter making the IMF's primary mission to help create stable money in member countries.

  • The U.S. could use its voice and vote in the IMF to drastically alter and scale down the IMF so that it has a focused mission to help create sound money for people around the world.

  • The IMF should construct economic programs based on currency stability, economic growth and increased purchasing power. This would be a dramatic change of direction from past and current IMF programs based on demand reduction, austerity, and currency uncertainty.

  • The core of an IMF agreement with a country should be a statement of the responsibility of the central bank to change the quantity of money in the event the value of the country's money begins to change. By matching the supply of money with the demand for it, countries would be able to keep the value of their money stable, building confidence in their central banks and quickly lowering their cost of capital.

    Cost of Capital

    The cost of capital is very high for governments in many emerging markets. This is almost entirely due to uncertainty over the future exchange rate.

    Capital is even more expensive for the private sector, if it is available at all. For example, while the Peruvian government can borrow in the local market at 13%, a Peruvian company has to pay almost three times as much, 36%, to obtain a loan. In Brazil and Mexico, private sector interest rates are a multiple of the governments' 20% borrowing rates, generating a prohibitively high cost of capital for the private sector.

    The high cost of capital reduces investment. It penalizes the private sector and stunts its development. The result is slower growth, fewer jobs, and more poverty. For the U.S., this means lost exports, increased national security concerns, and less global attention to environmental progress.

    Currency Boards Under Attack

    The graph below shows that Hong Kong's interest rates were practically the same as U.S. interest rates in 1996. They now stand 104 basis points higher than in the U.S.

    Argentina's interest rates remained stubbornly above U.S. interest rates even during the calm period in 1996. They now stand at 287 basis points above U.S. rates, a huge cost to the Argentine economy for the option of using pesos.

    Dollarization Would Work

    Countries which have given up their own currencies have seen their cost of capital fall. Even before the official introduction of the euro, the European countries reaped massive financial benefits as their currencies and interest rates converged. Bond yields in Italy, historically the highest of the major EMU countries, fell from nearly 14% in 1995 to below U.S. levels by late 1997. The Italian government can now borrow 10-year money at 4.9%, versus 5.7% for the U.S. government.

    By adopting the euro, even heavily indebted countries got a low cost of capital. This won't solve their structural problems, but it will give them the chance to improve. There is every reason to think that this same convergence process would occur for developing countries if they adopted the dollar or euro.

    Objections Addressed

    Don't countries need to harmonize their growth rates, fiscal deficits, and inflation rates with the U.S. before they contemplate dollarization? No. In the creation of the euro, much attention was focused on the Maastricht Treaty. However, most of the convergence of European economic indicators occurred as a result of the euro announcement itself, not the treaty. For example, fiscal deficits came down sharply when exchange rate convergence brought cheaper borrowing costs. Argentina's government would quickly move from fiscal deficit to surplus if it announced a dollarization timetable.

    Could dollarized countries alter U.S. monetary policy? No. Fed Chairman Greenspan has addressed this issue carefully. The U.S. would have control over its own monetary policy. Many countries already rely on U.S. monetary policy - Argentina, Hong Kong, Panama - without being able to affect it.

    Who would be the lender of last resort? Countries which dollarize will address this in various ways. Heavy bank capitalization requirements. Private sector insurance and lines of credit. Active involvement of foreign banks.

    Is seigniorage an important economic issue? No. In rough terms, a central bank earns 5% annually on the currency portion of its monetary base, which might be 5% of its GDP. So seigniorage is worth 0.25% of GDP. Dollarization would likely add 2% to GDP growth, 10 times the forgone seigniorage. The same type of calculation applies to the fiscal effect of forgone seigniorage, where extra growth more than makes up for lost seigniorage.

    Can countries do without a monetary policy? Yes. Discretionary monetary policy causes immense problems for developing countries. Uncertainty over monetary policy causes a high cost of capital. Monetary policy is often politicized. Arguments for an activist monetary policy rest on the false premise that controlling interest rates is more important than keeping the value of money stable.

    Do countries have the resources to dollarize? Yes. They start with their own international reserves and the dollar resources of their private sectors. Add to that, the huge capital inflow that would greet a decision to dollarize.


    In conclusion, I want to thank the Committee for inviting me to this hearing. In my view, the post-Bretton Woods system in which countries constantly change the value of their money is unworkable. Current U.S. policy makes it difficult for countries to adopt better exchange rate systems. U.S. policy should be changed. Dollarization is a viable approach for many developing countries. The U.S. should actively support this development by: 1) committing to keep the value of the dollar stable; 2) supplying technical support to interested countries; 3) quickly assessing the feasibility of seigniorage sharing arrangements; and 4) either offering seigniorage sharing or allowing countries to dollarize unilaterally.

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