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What’s it? Dollarization means adopting the U.S. dollar as a currency and unit of account by countries other than the United States. The term also has a broader meaning: the adoption of foreign currency by a country other than its issuing country. Thus, dollarization does not necessarily involve the use of United States dollars.
The U.S. dollar is indeed the preferred choice. Because it is a benchmark in the international market, many countries prefer it over other strong currencies, such as the Euro and Japanese Yen. For this reason, we use the term dollarization.
Furthermore, there is also the term partial dollarization. This occurs when a country gives the U.S. dollar equal status to its own currency or pegs its currency one-to-one against the U.S. dollar.
How dollarization works
Dollarization is a phenomenon where residents of a country use foreign currency extensively in addition to domestic currency. They may not believe in domestic currency, so they prefer to hold foreign currency.
Dollarization can be official or unofficial. Official means the government has a policy of replacing the domestic currency with foreign currency to facilitate economic activity. Unofficial means there is no government policy to do so. People prefer to hold foreign money, perhaps because its value is more stable over time.
The purpose of dollarization
Dollarization, the act of adopting a foreign currency as a legal tender, can be a drastic step for a country’s economy. But why do nations consider such a move? The primary driver is often a desperate attempt to regain control over runaway inflation.
Imagine a country experiencing hyperinflation, where prices skyrocket, and the domestic currency loses value rapidly. People lose faith in their own money, hoarding foreign currencies like the US dollar, which is seen as a safe haven. This can create a vicious cycle: as people lose trust in the local currency, they spend it faster, further accelerating inflation.
Dollarization offers a potential escape hatch from this economic turmoil. By adopting a stable currency like the US dollar, a country can:
- Anchor inflation: The US dollar’s relative stability can help suppress inflation in the adopting country. Prices become more predictable, facilitating economic planning for businesses and consumers.
- Boost confidence: Using a well-established currency like the US dollar can restore public confidence in the financial system. This can encourage people to save and invest, promoting economic growth.
- Reduce borrowing costs: Dollarization can lead to lower interest rates for businesses and governments. This is because investors perceive less risk when lending in a country that uses a stable currency.
Essentially, dollarization becomes a strategy to break free from the grip of hyperinflation and lay the foundation for a more stable and predictable economic environment. However, as with any major economic decision, dollarization comes with its own set of challenges, which we’ll explore in the next section.
Types of dollarization
Dollarization isn’t a one-size-fits-all solution. The extent to which a country adopts a foreign currency can vary, resulting in three main types:
Unofficial dollarization: This is the most informal stage. People have lost faith in their domestic currency and primarily use foreign currency (like the US dollar) to store value. They hold onto US dollars as savings or for larger purchases, fearing the domestic currency will lose value rapidly. While US dollars might be preferred for some transactions, the domestic currency remains the legal tender for everyday purchases and official payments like taxes.
Semiofficial dollarization: Here, the foreign currency gains some official recognition but doesn’t completely replace the domestic currency. It becomes legal tender, but its use is limited. Businesses might use US dollars for specific transactions, like international trade, while domestic transactions, like buying groceries or paying salaries, still rely on the local currency. This creates a dual-currency system, reflecting a period of transition or a lack of full confidence in the domestic currency.
Official dollarization: This is the most complete form of dollarization. The foreign currency becomes the official medium of exchange for all transactions, replacing or existing alongside the domestic currency at a fixed exchange rate. Prices are quoted in US dollars, businesses and consumers use it for everyday transactions, and the government recognizes it for official payments. This complete adoption signifies a strong commitment to the stability offered by the foreign currency.
When adopts dollarization
Adoption of the U.S. dollar usually occurs when a domestic currency loses value as a medium of exchange. The common cause is hyperinflation.
Hyperinflation causes the purchasing power of the domestic currency to fall rapidly. Money becomes worthless in a matter of days. People then prefer to hold it in cash or exchange it for a more stable foreign currency, such as the U.S. dollar.
The adoption of U.S. dollars usually occurs in developing countries. They tend to have relatively weak monetary authority or an unstable economic environment.
Dollarization may be an official monetary policy in which the central bank makes decisions. It is also a process to avoid ongoing hyperinflation by economic actors, even though the central bank doesn’t issue an official policy.
Once the U.S. dollar was recognized as the official medium of exchange, people were able to use it in everyday transactions.
Dollarization process
Dollarization isn’t a one-time switch that flips overnight. It’s typically a gradual process that unfolds in stages:
Stage 1: Seeking refuge (store of value)
Imagine a country grappling with economic instability. People, worried about the declining value of their domestic currency, start holding onto foreign currency, like the US dollar, as a store of value. This means they see the US dollar as a safe haven for their savings, a way to preserve their purchasing power over time. They might use their domestic currency for everyday transactions like buying groceries, but for larger savings or investments, they turn to the US dollar.
Stage 2: Widespread use (unofficial dollarization)
As trust in the domestic currency continues to erode, the use of foreign currency (e.g., the US dollar) starts to creep into everyday transactions. Businesses might start pricing their goods and services in US dollars, and some consumers might prefer to pay with US dollars instead of the local currency. This widespread use, even though not officially sanctioned, indicates a growing unofficial dollarization.
Stage 3: Official recognition (full dollarization)
In the final stage, the government formally recognizes the foreign currency as legal tender. This means the foreign currency becomes an official medium of exchange alongside (or even replacing) the domestic currency. People can use it for all transactions, from paying taxes to buying groceries. This official endorsement signifies the government’s attempt to instill confidence in the financial system and stabilize the economy by leveraging the credibility of a stable foreign currency.
Examples of countries that adopt dollarization
Among the countries that implemented dollarization policies was Zimbabwe. The country has been doing it to stabilize the economy and get out of hyperinflation.
As is known, the annual inflation in Zimbabwe reached 231 million percent in July 2008. As a result, the value of the country’s currency dropped and became worthless.
Many Zimbabweans have begun adopting foreign currency to conduct business transactions or turn to simple bartering to escape the decline in money’s purchasing power.
Then, in 2009, the country’s government announced the U.S. dollar’s adoption as the currency in the economy. Because inflation was still ongoing, the government also suspended the use of the Zimbabwean dollar in 2015.
Benefits of dollarization
Dollarization offers a tempting solution for countries grappling with economic turmoil. Let’s delve into the potential benefits that make it an attractive option:
Taming the inflation: Imagine a country battling hyperinflation, where prices spiral out of control, and the domestic currency loses value rapidly. Dollarization can act as a currency anchor. By replacing the unstable domestic currency with a stable one like the US dollar, prices become more predictable. This predictability allows businesses to plan for the future and invest with more confidence. Consumers also benefit from knowing the value of their money and are less susceptible to erosion.
Reduced risk and lower borrowing costs: Dollarization can act as a shield against currency crises. When a country pegs its currency to a stable one like the US dollar, it reduces the risk of sharp devaluations. This perceived lower risk translates to lower borrowing costs for businesses and governments. Investors are more willing to lend when they perceive less risk of their investment losing value due to currency fluctuations. Lower interest rates can then stimulate investment and economic growth.
Boosting trade: International trade often involves currency exchange, which can add transaction costs and introduce exchange rate volatility. Dollarization with a major trading partner like the US can simplify trade transactions. Businesses no longer need to worry about currency fluctuations when pricing goods or settling payments. This can potentially lead to increased trade volumes and economic integration between the adopting country and the US.
Efficiency gains: Maintaining a central bank and managing a domestic currency can be resource-intensive. By adopting a well-established currency like the US dollar, a country can potentially eliminate the need for a domestic central bank. This frees up resources that can be directed towards other crucial areas like infrastructure development, education, or healthcare.
Drawbacks of dollarization
While dollarization offers a path toward economic stability, it’s not without its drawbacks. Here’s a closer look at the potential downsides a country might face:
Loss of monetary policy independence: One of the biggest sacrifices of dollarization is the relinquishing of control over monetary policy. The domestic central bank loses the power to set interest rates, a key tool for managing inflation and economic growth. Interest rates are now determined by the issuing country’s central bank (e.g., the US Federal Reserve), which might not always align with the adopting country’s specific economic needs.
Limited toolkit: Since the domestic central bank no longer controls the money supply, some traditional economic tools become less effective. For instance, lowering interest rates to stimulate a sluggish economy might not have the desired impact if the US dollar supply remains unchanged. This limited policy toolkit can restrict a country’s ability to respond effectively to different economic challenges.
External dependence: A dollarized economy becomes heavily reliant on the economic health of the issuing country. Interest rate hikes or economic slowdowns in the US, for example, can have a ripple effect on the dollarized country. This external dependence can leave the adopting country vulnerable to events beyond its control.
Farewell seigniorage: Governments generate revenue by printing their own currency, a concept called seigniorage. By adopting a foreign currency, the government forfeits this source of income. While not a direct cost, it’s a missed opportunity to generate revenue that could be used for public spending.
Not a one-size-fits-all solution: Dollarization’s success depends heavily on a country’s unique economic circumstances. A country with a strong track record of fiscal discipline might benefit more from dollarization than one with a history of economic mismanagement. It’s crucial to carefully evaluate the potential benefits and drawbacks before embarking on this path.
