Explanation of Dollarization

Explanation of Dollarization

Some countries have been frantically seeking ways to enhance global economic stability and thereby their own wealth since the abandoning of the gold standard at the outset of WWI and the Bretton Woods Conference following WWII. The majority of these countries have found that pegging their native currency to a major convertible currency is the best approach to achieve currency stability.

Another option is to forgo the local currency in favor of using the US dollar exclusively (or another major international currency, such as the euro). Full dollarization is the term for this.

Pegging and Its Effects

A currency board is the most severe kind of pegging, in which countries “anchor” their native currencies to a convertible currency (often the U.S. dollar). (See What Is A Currency Board for more information.) & Fixed And Floating Exchange Rates.) The local money thus has the same value and stability as the foreign currency. Pegging has traditionally been used to establish and stable the value of a local currency against the world’s convertible currencies.

Alternatives to Dollarization

A government may elect to implement full dollarization as an alternative to keeping a floating currency or a peg. The primary motivation for a country to do so is to lower its country risk, resulting in a stable and secure economic and investment environment. Developing or transitional economies, particularly those with significant inflation, are more likely to seek full dollarization.

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Many of the countries that have chosen dollarization already use foreign money in private and public transactions, contracts, and bank accounts; however, this is not yet official policy, and the local currency remains the principal legal tender. Individuals and institutions who choose to use foreign currency safeguard themselves from a probable depreciation of the local currency.

Full dollarization, on the other hand, is a near-permanent solution: the country’s economic climate improves as the risk of speculative attacks on the local currency and capital market diminishes.

The lower risk attracts both domestic and international investors to participate in the country and its capital market. Furthermore, the absence of an exchange rate disparity aids in the reduction of interest rates on international borrowing.

Dollarization’s Negative Effects

Adopting a foreign currency has a number of significant disadvantages. When a country gives up the ability to print its own money, it loses direct control over its economy, including the ability to manage monetary policy and any type of exchange rate regime.

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The central bank’s power to collect’seigniorage,’ the profit earned by issuing coins, is lost (the minting of monies costs less than the actual value of the coinage). Instead, the seigniorage is collected by the Federal Reserve of the United States, resulting in a loss of revenue for the local government and the economy as a whole.

The central bank loses its function as lender of last resort for the banking system in a fully dollarized economy. While it may still be able to supply banks in crisis with short-term emergency money from stored reserves, it may not be able to offer enough funds to cover withdrawals in the event of a run on deposits.

Another consequence of full dollarization is that a country’s securities must be repurchased in US dollars. If the country’s reserves are insufficient, it will have to borrow the money by running a current account deficit or find a way to build up a current account surplus.

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Finally, because a local currency is a symbol of a sovereign state, using foreign currency instead of local currency may harm a nation’s prestige.

Dollarization’s Benefits

There are certain strong reasons for a country to opt to give up so much control over its economy, aside from risk reduction and protection against inflation and devaluation.

As previously stated, full dollarization boosts investor confidence and effectively eliminates speculative attacks on the local currency and exchange rate. As a result, there is a more stable capital market, fewer unexpected capital outflows, and a less vulnerable balance of payments.

Last but not least, full dollarization can benefit the global economy by making it easier for economies to integrate into the global market.

Conclusion

Many emerging economies have already adopted dollarization to some degree. Many have shied away from it, owing to the fact that economies that might consider full dollarization are still emerging. For many countries, having an independent economic policy and the sense of individual statehood that comes with it is too valuable to sacrifice in favor of full dollarization, an extreme choice that is largely irreversible.

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