Dollarization: Meaning, How It Works, Example, Pros, and Cons

What’s it: Dollarization means adopting the U.S. dollar as 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 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 and unofficial. Official means the government takes a policy to replace the domestic currency and use 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 the adoption of dollarization

The dollar’s adoption as a currency has become a means of controlling inflation and interest rate volatility. That is usually one of the options when it occurs during hyperinflation when people no longer believe in the domestic currency.

Adopting countries benefit from the credibility of the U.S. dollar. The U.S. dollar is considered a relatively stable currency. Therefore, if used as a medium of exchange, the U.S. dollar value isn’t affected by ongoing domestic inflation.

When is dollarization usually adopted?

The U.S. dollar adoption usually occurs when a domestic currency loses value as a medium of exchange. The common cause is usually 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 one of the official monetary policies in which the central bank makes decisions for it. Or, it is a process to avoid the 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.

Adoption process

Dollarization is usually done in stages. In the initial phase, adoption occurs when people start to adopt foreign currency as a store of value. They still haven’t used the foreign currency as a transaction payment. They still use the domestic currency for various transaction purposes, such as paying taxes and other bills.

Then, the adoption of currency began to be widely used in the economy by economic actors. They hold most of their financial wealth in foreign currency assets. At this stage, foreign currency is also not a legal means of payment.

The next stage is the official dollarization. The government recognizes the foreign currency as a means of payment and a store of value.

Types of dollarization

Dollarization has three main types:

• Unofficial dollarization. Foreign currency is still the unit of the store of value. People haven’t used it as a means of payment to facilitate transactions.
• Semiofficial dollarization. Foreign currency has become the legal tender but plays a secondary role in domestic transactions. Economic actors only use it for specific transactions. They still use the domestic currency for everyday transactions such as buying products, paying taxes, and paying salaries.
• Official dollarization. Foreign currency is the means of payment and unit of calculation. Economic actors use it entirely in their daily transactions.

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 had 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.

The pros and cons of dollarization

Dollarization advantages 

• The adoption of dollars is one way to get out of hyperinflation. That will slowly lead to more stable prices.
• Full dollarization avoids currency crises. That helps reduce the sovereign risk premium. As the risk premium falls, it leads to lower interest rates and higher investment.
• Dollarization facilitates trade growth. It reduces the costs of trade transactions between the adopting country and other countries that use the same currency.
• The U.S. dollar adoption is useful if it helps take advantage of economies of scale in monetary policy. I mean, the adopting country saves resources because supply is determined by the issuing country, the United States of America.

Weakness of dollarization

First, adopting foreign currency eliminates independence in making monetary policy. These countries effectively outsource their monetary policy to the U.S. Federal Reserve, determining the money supply and the U.S. dollar value.

As a result, U.S. monetary policy will affect the country’s economy. Of course, U.S. monetary policy is in the interests of the U.S. economy and not in the countries’ interests adopting the dollar.

Due to the adoption of foreign currency, the monetary authority is not responsible for money creation.

Second, the interest rate channel is ineffective as a monetary tool. Say, central banks in adopting countries lower interest rates to stimulate the economy. The decline in interest rates has no impact on the economy. Even though interest rates fell, it did not increase the amount of U.S. dollars in circulation. Only the U.S. central bank can do this.

Third, dollarization has no effect on the adopting country’s creditworthiness. Thus, the U.S. dollar interest rate in that country will not be the same as the U.S. dollar interest rate in the United States.

Fourth, the domestic monetary authority no longer generates seigniorage income because it does not issue currency.