Dollarization Helps Developing Nations

1
INTRODUCTION

• Dollarization Helps Developing Nations
• Group 1 The Pro Team
• Greg Beane
• Tim Coffing
• Erik Gretarsson

2
INTRODUCTION

• Dollarization
• The Adoption of a (Presumably Stronger) Foreign
  Currency as Sole and Legal Tender
• Dollarization is Not Limited to Countries
  Adopting the US Dollar as Their Sole and Legal
  Tender
• De Facto Dollarization
• De Jure Dollarization
• Unilateral Dollarization
• Dollarization Agreements
• Currency Unions (The Euro Monetary Union (EMU))

3
OVERVIEW

• Focus on Developing-Nation Dollarization
• Historical Overview
• Dollarized Countries / Economies
• Reasons Behind Most Dollarizations
• The Bi-Polar View
• The Issues
• Pros Arguments in Support of Dollarization
• Cons Arguments Against Dollarization
• Panama, Ecuador, El Salvador and Argentina
• Summary Conclusion

4
HISTORY

• European-Currency Dollarizations
• 1278 Andorra (French Franc Spanish Peseta)
• 1700s Greenland (Danish Krone)
• 1797 Channel Islands (Pound Sterling)
• 1834 Saint Helena (Pound Sterling)
• 1865 Monaco (French Franc)
• 1897 San Marino (Italian Lira)
• 1921 Liechstenstein (Swiss Franc)
• 1929 Vatican City (Italian Lira)
• 1974 Northern Cyprus (Turkish Lira)

5
HISTORY

• Pacific-Currency Dollarizations
• 1800s Norfolk Island (Australian Dollar)
• 1800s Pitcairn Island (New Zealand Dollar)
• 1892 Tuvalu (Australian Dollar)
• 1901 Niue (New Zealand Dollar)
• 1914 Nauru (Australian Dollar)
• 1926 Tokelau (New Zealand Dollar)
• 1943 Kiribati (Australian Dollar)
• 1955 Cocos Islands (Australian Dollar)

6
HISTORY

• US Dollar Dollarizations
• 1898 Guam (US Dollar)
• 1899 American Samoa (US Dollar)
• 1899 Puerto Rico (US Dollar)
• 1904 Panama (US Dollar 1 Balboa)
• 1917 US Virgin Islands (US Dollar)
• 1944 Marshall Islands (US Dollar)
• 1944 Micronesia (US Dollar)
• 1944 Northern Mariana Islands (US Dollar)
• 1944 Palau (US Dollar)

7
HISTORY

• US Dollar Dollarizations More Current Examples
• 1973 British Virgin Islands (US Dollar)
• 1973 Turks Caicos (US Dollar)
• 2000 Ecuador (US Dollar)
• 2001 El Salvador (US Dollar)
• Ecuador El Salvador
• More Interesting Than Other Cases
• More Recent
• Macroeconomic Reasons

8
HISTORY

• Euro Monetary Union (Version of Dollarization)
• 1999 Austria (Euro)
• 1999 Belgium (Euro)
• 1999 Finland (Euro)
• 1999 France (Euro)
• 1999 Germany (Euro)
• 1999 Ireland (Euro)
• 1999 Italy (Euro)
• 1999 Luxembourg (Euro)
• 1999 Netherlands (Euro)
• 1999 Portugal (Euro)
• 1999 Spain (Euro)

9
HISTORY

• EMU (Euro Monetary Union)
• Happened Quickly in the Aftermath of the European
  Monetary System (EMS) Crisis of 1992
• The (Disguised) Adoption of the Deutche Mark
• The Euro Area Groups Developed Countries Together
• Participating Countries Preserve Their (Limited)
  Influence
• Very Strict Policies Prior to Adoption of the Euro

10
HISTORY

• Bi-Monetary Systems
• 1966 Bahamas (Bahamian Dollar US Dollar)
• 1974 Bhutan (Bhutan Ngultrum Indian Rupee)
• 1998 Bosnia Herzegovina (Bosnian Marka,
• Croatian Kuna Euro)
• 1967 Brunei (Brunei Dollar Singapore Dollar)
• 1980 Cambodia (Cambodian Riel US Dollar)
• 2000 East Timor (US Dollar Indonesian Rupee)
• N/A Haiti (Haitian Gourde US Dollar)

11
HISTORY

• Bi-Monetary Systems
• 1800s Isle of Man (Local Pound Pound
  Sterling)
• 1999 Kosovo (Yugoslav Dinar Euro)
• N/A Lesotho (Lesotho Loti South African
  Rand)
• 1944 Liberia (US Dollar Liberian Dollar)
• 1993 Namibia (Namibian Dollar South African
  Rand)
• 1994 Tajikistan (Tajik Ruble Use of Other
  Currencies
• is Permitted)
• 1967 Brunei (Brunei Dollar Singapore Dollar)

12
HISTORY

• Reasons Behind Most Dollarizations
• Historical
• Political
• Countries Currently Considering Dollarizing
• Latin American Countries
• African Countries
• East European Countries

13
HISTORY

• The Bi-Polar View
• Intermediate Exchange Rate Regimes and
  Conventional Pegs are Inherently Vulnerable to
  Sudden Aggregate Shocks
• Growing Consensus that Arrangements Anywhere
  Between Floating Regimes and Hard Pegs are Not
  Sustainable in the Long Run

14
THE ISSUES

• Pros
• Reduced Transaction Costs
• Enhanced Credibility
• Reduced Country Risk
• Cons
• Loss of the Exchange Rate Instrument
• Loss of the Lender of Last Resort
• Loss of Seignorage

15
Pros

• Reduced Transaction Costs
• Costs Associated with Multiple Currencies
• Between 0.25 0.50 of GDP per Year According to
  the European Community (EC) Commission (Prior to
  the Euro)
• Probably Higher in Less-Developed Economies due
  to Higher Bid-Ask Spreads
• Effects of Exchange Rate Volatility on Trade
• Significant and Negative Correlation (Large
  Sample of Developing Countries and Central
  American Countries)
• The Potential Gains from Reduced Transaction
  Costs are Proportional to the Strength of the
  Trade Links within the Common Currency Area

16
Pros - Reduced Transaction Costs
17
Pros - Reduced Transaction Costs
18
Pros

• Enhanced Credibility
• Two Important Dimensions Monetary Fiscal
• Passive Monetary Policy
• Eliminates the Inflation Bias
• Governments No Longer Tempted to Inflate the
  Economy through Unanticipated Money Injections
• Stronger Financial Constraints Imposed on
  Governments
• Inflationary Financing of the Deficit Not an
  Option Anymore
• Governments Forced to Keep Budgets in Check
• Dollarized Regimes Systematically Display Lower
  Inflation
• Studies Support the Claim that Dollarization
  Elicits Fiscal Discipline

19
Inflation in Central America, 1960 1968 (Values
Relative to U.S. Inflation)
20
Pros

• Reduced Country Risk
• High Cost of Capital is One of the Most Important
  Factors Hampering the Development of
  Non-Industrialized Countries
• Dollarization Results in
• Elimination of Devaluation Risk (Default Risk)
• Reduction in Cost of Interest Rate Defenses
  Against Speculative Attacks
• Increased Efficiency in Financial Intermediation
• Enhanced Monetary and Fiscal Policy Credibility
• Perceived Seniority of External over Internal
  Debt
• Country Risk in Financially Dollarized Countries
  Tends to Fall Significantly on News of Potential
  Dollarization

21
Cons

• Loss of the Exchange Rate Instrument
• Fixed Exchange Rate is Unable to Isolate the Real
  Economy from External and Real Shocks
• No Evidence Found Supporting that Flexible
  Regimes are Successful in Isolating Domestic
  Monetary Variables from External Ones
• The Failure of International Capital Markets to
  Insure Developing Economies Against Cyclical
  Fluctuations Detracts from the Usefulness of
  Monetary Policy as a Short-Term Adjustment
  Mechanism, Rendering it Less Valuable
• The Resilience of Domestic Rates in Panama
  Indicates that Full Dollarization may have
  Provided a Better Isolation Device Against
  Temporary Changes in Market Sentiment Toward
  Emerging Economies, a Benefit That Appears to
  More than Offset the Loss of Independent Monetary
  Policy

22
Degree of Asymmetry of Economic Shocks
Cycles
Economic Cycles Are Highly Correlated
23
Cons

• Loss of the Lender of Last Resort (LLR)
• Central Bank Loses Its Ability to Provide
  Additional Liquidity to the Banking Sector During
  Transitory Shortages
• Alternative Mechanisms to Provide Liquidity
  Insurance Exist
• International Financial Community Provide a
  Credit Line (for a Fee)
• The Domestic Agency Collects Contributions
  Directly from the Domestic Banking Sector and
  Insures Them Up to the Certain Amount
• Moral Hazard Crises are Not Independent of
  Government Actions
• Dollarized Countries are Likely to Rely Heavily
  on IMF Assistance
• Actual LLR Cost Specifically Attributable to Full
  Dollarization is Smaller the Higher the Initial
  Financial Dollarization Ratio
• The Cost of Losing the LLR Function is the Cost
  of Holding the Stock of Excess Reserves that
  Substitutes for It

24
Cons
25
Cons

• Loss of Seignorage
• Two Components
• Purchase of the Initial Stock of Foreign Currency
• Purchase of Later Increases in the Stock of
  Foreign Currency
• Share of Seignorage Revenues from Host Economy

26
Panama Dollarized in 1904

• Experiences Have Been Very Positive
• Open Economy With Many Foreign Banks
• Foreign Banks Have Been De Facto Lenders of Last
  Resort
• No Central Bank and No Centralized Foreign
  Reserves
• Solid Macroeconomic Performance (Last 40 Years)
• Inflation Has Averaged 3 Per Year
• Growth Rates Have Averaged Between 2.5 and 8.1
• No Systemic Banking Crises
• Several Major Shocks Resulted in Significant
  Economic Disruption, But All Were Weathered
  Successfully
• Banks Responded in a Stabilizing Fashion

27
Panama Dollarized in 1904

• Experiences Have Been Very Positive
• Sovereign Spreads Consistently Lower Than in
  Other Latin American Countries (Lower Country
  Risk)
• Nominal Interest Rates the Lowest or Nearly the
  Lowest in Latin America
• Real Interest Rates Also Relatively Low and
  Steady
• Only Latin American Country Where 30-Year
  Fixed-Rate Mortgages Are Available in Domestic
  Currency

28
Ecuador Dollarized in 2000

• Dollarization in Response to
• Widespread Political and Financial Crisis
• Following Brazils Devaluation in January 1999,
  the Ecuadorian Sucre Came Under Increased
  Speculative Pressure
• In 1999 Inflation Topped 60
• Sucre Plunged from 7,000 to 30,000 to the US
  Dollar
• In March 1999 Eight Troubled Banks Closed and
  Days Later the Government Froze Deposits in the
  Entire Banking System
• Massive Loss of Credibility in Ecuadors
  Political and Monetary Institutions

29
Ecuador Dollarized in 2000

• Experiences
• Currency Speculation Has Ended
• Sucre Fixed at 25,000 to the US Dollar
• Inflation Dropped to 16 by January 2002
• Highest Growth Rate in Latin America in 2001
• Negative GDP in 1999 2000
• Banking Deposits Up 60 by December 2001
• Country Risk Upgraded
• Popular Acceptance Mixed
• Lack of Government-Provided Information
• Nickels, Dimes Quarters Have No Numbers

30
El Salvador Dollarized in 2001

• Dollarization in Response to
• Long Debate on Benefits and Costs
• Colon Pegged at 2.50 per US Dollar for a
  Half-Century
• Devaluation in the 1980s During Lengthy Civil
  War
• Colon Pegged at 8.75 per US Dollar in 1992
• Colon-US Dollar Parity Stable for Ten Years
• Salvadoran Economy Closely Tied to the US
• Neither Crisis Nor High Inflation Concerns
• Relatively High Growth with Low Inflation
• Decision Based on the Belief that Benefits
  Outweighed Costs

31
El Salvador Dollarized In 2001

• Experiences
• Lower Interest Rates
• Growing Consumer Credit
• Cheaper International Financing
• Reduced Transaction Costs for Firms
• Widely Accepted and Understood by the Population
• Economic and Fiscal Reforms
• Budget Deficits Due to Rebuilding After Two
  Earthquakes
• Ministerial Budgets Cut by an Average of 17 in
  2002
• Higher Productivity and Lower Costs

32
Argentina A Candidate for Dollarization?

• Convertibility Plan of 1991
• Established a Currency Board System
• Peso Was Pegged to the US Dollar at a One-to-One
  Ratio
• Prior to 1991
• Monthly Inflation Rates as High as 200
• Annual Growth Rates Around -1 (1980-1990)
• After 1991
• Annual Inflation lt 10
• Annual Growth Rates Around 4.3 (1991-1998)

33
Argentina A Candidate for Dollarization?

• Full Dollarization Considered in 1999
• Prompted by Lingering Doubts About the
  Credibility of the Currency-Board System
• Tequila Hangover Created Speculative Pressure
  Against the Peso in 1995
• The Argentine Government Threatened to Officially
  Dollarize, which Helped Reduce the Pressure

34
Argentina A Candidate for Dollarization?

• The Crisis of 2001 2002
• Shrinking Economy, Surging Inflation Banking
  System in Ruins
• Largest Default on Public Debt Ever - 155
  Billion
• Some Would Like to Blame the Currency-Board
  System
• Strong Dollar Made Argentinas Economy
  Uncompetitive
• It is Questionable to Blame the Currency-Board
  System
• Governments Failure to Run Big Budget Surpluses
  During the Economys Long Boom Was Probably More
  Important
• Massive Corruption
• Inefficient Tax System High Rate of Tax Evasion

35
Argentina A Candidate for Dollarization?

• Benefits From Dollarization
• Improved Credibility
• Permanent Elimination of Currency Risk
• Lower Spreads Are Believed to Amount to 1 of GDP
• Decline in Interest Premiums
• Tighter Trade and Financial Integration
• Greater Fiscal- and Financial-Sector Discipline
• Low Cost Associated with Seignorage
• Only About 0.22 of GDP
• Lower Transaction Costs

36
Summary

• Historical Overview
• The Issues Pros Cons
• Panama
• Ecuador
• El Salvador
• Argentina

37
Summary

• Benefits From Dollarization are Likely to
  Outweigh Costs In Developing Countries That
• Have High Financial Dollarization
• Seek to Adopt Important Trade Links with Other
  Users of the Foreign Currency
• Have Pervasive Credibility Problems Resulting in
  High Country Risk
• Experience Persistent High Inflation or Frequent
  Currency Collapses When Attempting to Use an
  Exchange Rate Anchor

38
Conclusion

• Therefore
• Dollarization Can Help Developing Nations!

39
Questions?