Almost every country issues its own currency. Despite this, people around the world often use the U.S. dollar to make purchases, borrow, or save. In this way many countries are heavily "dollarized." However, dollarization may soon reach a new stage: some countries may abandon their currencies completely and adopt the U.S. dollar as their official currency. In particular, Argentina and El Salvador have shown a great deal of interest in official dollarization. Panama is already officially dollarized. Two subcommittees of the Senate Banking Committee have held two joint hearings on the issue (details below).
Official dollarization means a country eliminates its own currency and adopts the U.S. dollar as legal tender. Businesses could pay wages and settle contracts in dollars, consumers could make all purchases in dollars, and the government would accept dollars for debts and taxes and use dollars when making payments. For purposes of this guide, dollarization will mean official dollarization.
Interest in dollarization has risen for a number of reasons. Many emerging market countries have suffered high inflation for extended periods of time. Inflation has been such a problem in Latin America's recent past that even when countries keep prices relatively stable, businesses, banks, workers and investors expect this success will be short term and inflation will become a problem again. Fear of future inflation means banks charge high interest rates for loans in the local currency, businesses borrow in dollars to get lower interest rates, workers avoid saving in the local currency, and investors both offer less capital to local businesses and are quick to move their capital out when general economic conditions in emerging markets weaken.
Supporters of dollarization claim it offers the following benefits:
Lower Inflation: Countries would import the monetary policy of the United States, bringing inflation down toward U.S. levels.
Faster Growth: A decrease in inflation risk and the elimination of devaluation risk should increase local savings, reduce interest rates, and increase foreign investment. In turn, these should stimulate economic growth.
"Deeper" Financial Markets: In the eyes of many international investors, dollarization would make countries part of an overall "dollar bloc," including the United States. This should make them less vulnerable to capital outflows in times of crisis. Dollarization would also let people keep their savings in the local currency (the dollar) and make it easier to borrow long-term. Panama, which is already dollarized, is the only Latin American country with a highly liquid and competitive market for 30-year mortgages in the local currency — the dollar.
Budget Discipline: Countries that dollarize could not finance government spending by printing money. This would make them focus on programs that offer the best returns. Wasteful programs that are designed to buy votes will make it tougher to borrow.
Lower Interest Rates: Dollarization would reduce the inflation premium in interest rates toward U.S. levels. Interest rates would also fall as people no longer have to diversify away from local assets to hedge against general economic risks and lenders no longer have to charge a premium for local currency loans to compensate for having their assets and liabilities in different currencies.
Emergency Lending to Banks: Countries that have their own currency sometimes print extra money to try to bail out troubled banks. Dollarization would make this impossible. As a substitute for printing money, dollarized countries may want their banks to be able to borrow from the U.S. Federal Reserve. However, Treasury Secretary Lawrence Summers testified that the United States should not give other countries access to loans from the Federal Reserve. (See list of hearing witnesses below.)
Monetary Policy: A country that dollarizes would no longer be able to conduct an independent monetary policy; the monetary policy of the United States would become its own. A dollarized country may therefore put pressure on the Federal Reserve to consider its economic conditions when setting monetary policy. This could make the Federal Reserve less of a U.S. central bank and more of a "dollar bloc" central bank. However, Secretary Summers testified that the United States should not alter the procedures or orientation of U.S. monetary policy. Other witnesses downplayed the risk of foreign pressure influencing the Federal Reserve. Chairman Alan Greenspan testified that all of the policy stances the Federal Reserve would ordinarily take would be improvements for countries considering dollarization. Dr. Wayne Angell testified that as long as the Federal Reserve pursued U.S. price stability, U.S. monetary policy would be the best available policy for countries considering dollarization. Mr. Manuel Hinds testified that Latin American countries are already affected by U.S. monetary policy and it is the Federal Reserve's pursuit of U.S. price stability that makes dollarization worthwhile in the first place. Dr. Michael Gavin testified that by strengthening their economies, dollarization could actually decrease foreign pressure on the Federal Reserve.
Seigniorage: Seigniorage (pronounced, CEE-nyer-rij) is the profit a country earns when it issues a currency. It's the difference between the products currency can buy and the cost of printing that currency. For example, a $100 dollar bill is worth $100, but it only costs 4¢ to print. The United States earns about $25 billion per year in seigniorage; Argentina earns about $750 million per year. If a country dollarizes it would no longer earn seigniorage. Meanwhile, because more people would use the U.S. dollar, the United States would earn more. If the United States wants to encourage dollarization, it could arrange to repay some of this extra seigniorage. Theoretically, this could be a "win-win" situation for both the United States and the dollarized country. The United States would keep a portion of its increased seigniorage; the dollarized country would get the presumed overall benefits of dollarization and get to keep most of its seigniorage. Dr. Angell, Dr. Guillermo Calvo, and Dr. Gavin testified in favor of sharing seigniorage with countries that dollarized. Mr. David Malpass testified that the United States should quickly assess the feasibility of sharing seigniorage.
The Subcommittee on Economic Policy and the Subcommittee on International Trade and Finance — both of the U.S. Senate Committee on Banking, Housing and Urban Affairs — have held two joint hearings on dollarization. The first hearing was held on April 22, 1999. It explored dollarization in general, including economic implications for countries that dollarize. The second hearing was held on July 15, 1999. It explored whether dollarization would benefit countries in Latin America. Both hearings discussed what the appropriate U.S. policy should be toward dollarization.
Witnesses at the first hearing were:
Hearing on Official Dollarization in Emerging-Market Countries, Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Economic Policy and Subcommittee on International Trade and Finance, April 1999.
Hearing on Official Dollarization in Latin America, Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Economic Policy and Subcommittee on International Trade and Finance, July 1999.
Robert Stein, "Issues Regarding Dollarization," Staff Report, Subcommittee on Economic Policy, U.S. Senate Committee on Banking, Housing and Urban Affairs, July 1999.
Kurt Schuler, "Encouraging Official Dollarization in Emerging Markets," Staff Report, Joint Economic Committee (Office of the Chairman), U.S. Congress, April 1999.
Kurt Schuler, " Basics of Dollarization," Staff Report, Joint Economic Committee (Office of the Chairman), U.S. Congress, July 1999.
eljko Bogeti , "Official or 'Full' Dollarization: Recent Issues and Experiences," (unpublished paper) International Monetary Fund, June 1999.
Guillermo Calvo, "Argentina's Dollarization Project: A Primer," February 1999.
Guillermo Calvo, "On Dollarization," April 1999.
Ricardo Hausmann, "Currencies: Should There Be Five or One Hundred and Five?" Inter-American Development Bank, July 1999.
Ricardo Hausmann, Michael Gavin, Carmen Pages-Serra and Ernesto Stein, "Financial Turmoil and the Choice of Exchange Rate Regime," Inter-American Development Bank, March 1999.
Ricardo Hausmann and Andrew Powell, "Dollarization: Issues of Implementation," Inter-American Development Bank, July 1999.
IMF Economic Forum, Dollarization: Fad or Future for Latin America?, International Monetary Fund, June 1999.
Juan Luis Moreno-Villalaz, "Lessons from the Monetary Experience of Panama: A Dollar Economy with Financial Integration," Cato Journal, Volume 18, Number 3, Winter 1999, pp. 421-39.
Stephanie Schmitt-Grohé and Martín Uribe, "Dollarization and Seigniorage: How Much is at Stake," July 1999.
Stephanie Schmitt-Grohé and Martín Uribe, "Asymmetric Shocks and the Costs of Dollarization," July 1999 (in progress).
Francois R. Velde and Marcelo Veracierto, "Dollarization in Argentina," Chicago Fed Letter, Number 142, Federal Reserve Bank of Chicago, June 1999. _____________________________________________________________________________________
Prepared by Robert Stein, Staff Director, Subcommittee on Economic Policy, U.S. Senate Committee on Banking, Housing and Urban Affairs, (202) 224-2336
This staff report expresses the views of the author only. These views do not necessarily reflect those of the Subcommittee on Economic Policy, its Chairman, or any of its Members.