Dissertation on Dollarization

Dollarization Dissertation

Recently, Ecuador announced that it would replace it's local currency, the sucre with the US Dollar for all purposes. This change was intended to help return the country to growth and prosperity. This "Dollarization" has become a popular topic and has been considered by many developing nations in Latin America and other regions.

By implementing dollarization, a developing country would accept the following consequences:

1. It's government would give up the revenue and benefits it enjoys from creating it's own money. This is typically referred to seignorage meaning that the country can print currency at very little cost to purchase what it needs. In a dollarization situation, the country would give up its seignorage revenues to the US government. 

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Seignorage revenues have typically amount to 0.3-1.3% of GDP for Argentina and Brazil, respectively. The level of seignorage indicates the degree to which the government relies to finance their budgets. Therefore, it would be much easier for a country with lower seignorage revenue to implement a dollarization policy. In addition to the revolving seignorage revenues which would be lost, a dollarizing country would also be subject to the one-time start up cost of trading the local currency in circulation for dollars.

2. It's central bank would no longer serve as a lender of last resort to domestic banks. The lender of last resort is a crucial component to reassure creditors and depositors of the banks such as the assurance provided by the FDIC in the US. Since the ability to print local currency would no longer be in the control of the country, they would lose this ability to provide an influx of cash to bail out struggling banks. If there is no lender of last resort, confidence weakens and bank runs (increase of withdrawals) becomes more likely and more damaging when they occur. However, the cost of this impact is hard to quantify depending on the type of system it is replacing (i.e. currency board with fixed exchange rats vs. floating exchange rates). Options to ensuring backing of the banking system include: setting aside a liquid fund to be lent to banks in a crisis or securing a line of credit from abroad.

3. It would no longer control domestic monetary policy. Therefore the government would be forced to accept the decision of Federal Reserve. By controlling the monetary base, a central bank can have an impact on inflation. With dollarization, the country would lose this control. The "cost" of this impact is questionable depending on the level to which the country has used monetary policy in the past; may countries in Latin American have only used interest adjustment sparingly, therefore the "cost" would be minimal. In the end, the "cost" will depend on the value that a more stable currency brings relative to the more standard behavior of output and employment typical of standard flexible exchange rates.

Benefits of dollarization include:

Dollarization may lower the country's cost of foreign credit. The risk of currency devaluation would not exist because the domestic currency would disappear, therefore the cost of foreign credit would come down due to the elimination of default risk or sovereign risk, stimulating investment and economic growth. However, there is the countering concern that the elimination of a lender of last resort will result in an increase of risk.

It may enhance the credibility of government policy. The background of this statement is that dollarization would be more difficult to reverse than another fixed exchange system. The problem is putting a value on this benefit. Three (3) benefits can be stated based on the irreversible nature of dollarization: 1) elimination of possibility of devaluation, 2) monetary policy removed from central bank which is often unreliable, and 3) enhance fiscal discipline.

The conclusion reached by many economists is that dollarization is a desirable reform in spite of widespread uncertainty about its economic benefits. Most of the costs can be identified and quantified, however the benefits remain to be demonstrated.

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