Pros and cons of dollarization

Numerous countries around the world either peg their own currency to one of the main currencies or adopt the main currency outright. This occurs around the world with the US$ and with the Euro for countries whose trade is redominantly in Euros.

There are arguments for and against the adoption of one of the main currencies rather than continuing with one’s own currency. A precondition is that a country’s external trade should be dominated by the adopted currency. Otherwise, say for a country to adopt the Dollar when most of it’s trade was in Yuan and Euros, that trade would be disrupted by swings in the values of these currencies which would work against it’s interests.

The main reason for a country to have either a peg or a formal currency adoption is due to confidence. It could be that there is insufficient confidence internally or internationally in it’s own institutions such that the value of the currency is unstable and there is a constant risk of inflation.

The disadvantages are the loss of the option to devalue the currency if costs are out of line and the loss of the option of Central Bank funding as an arm of Government policy, something which is very topical during the COVID 19 crisis as Governments seek to avoid borrowing excessively. Central Banks can bail out a country’s commercial banking sector but where they don’t have their own currency they must borrow to do this.

In Latin America three countries formally use the Dollar as their domestic currency; Panama, El Salvador and Ecuador.

Panama - has used the US$ since independence from Colombia 1903 and one could argue that it would never have become Latin America’s only offshore financial center had it not been for the US$ system. Since the turn of the Millennium it has been one of the fastest growing economies in the region.

El Salvador - the disastrous chain of Central American wars ended in 1992 with the signing of the Chapultepec Accords. The economies of the affected countries were badly scarred and had recorded mostly negative growth in the 1980’s. In 1994 El Salvador pegged the Colon to the US$ and formally adopted the Dollar in 2001.

El Salvador runs a negative trade balance which is mostly covered mostly by remittances. Inflation is in low single digits and Government debt and deficits are under control. Economic policy is based around agriculture, zonas francas, and the CACM (Central American Common Market). It has the highest homicide rate in Latin America which is a legacy of the civil wars and the new drugs wars. Growth is unspectacular at 2-3% p.a. but on the other hand there has been no major crisis since 1992.

Ecuador -- adopted the US$ in 2000. This followed a major downturn leading up to turn of Millennium due to the collapse in the oilprice. In addition, the banks had a currency mismatch on their balance sheets from lending in Dollars to debtors who traded in Sucres. Inflation had started to soar.

Ecuador’s growth post dollarization similar to pre at 3-4% a year. Oil is the main export and lack of diversification is a worry.

For the other countries in Latin America inflation is in low single digits. The exceptions are Argentina (double digit inflation) and Venezuela (hyperinflation). Argentina did actually maintain a dollar peg in the 1990’s but was forced to abandon it after it’s main trading partner, Brazil, devalued. Since then Argentina has struggled with a lack of fiscal discipline and continuity in economic policy.

Venezuela is a country that probably should adopt the dollar as their currency as soon as they achieve regime change as that would allow normal economic life to resume given the complete institutional collapse.

One of the arguments against Dollarization is that it hampers regional trade integration; e.g. for an Ecuadorian company trading with Colombia and Peru it will lose competitiveness if either of these countries devalues. The counterargument is that many business contracts are written in Dollars for that same reason.

For countries with their own currencies a route out of excessive domestic indebtedness is quantative easing. This is where the Central Bank buys the Government’s own debt. This is, in effect, money creation and is a tool currently being deployed by the US Federal Reserve and the ECB to fight the COVID 19 crisis. However it is also a policy that can be used unscrupuously and lead to a loss of public confidence and inflation. Countries which don’t have their own currencies have surrendered this policy option.