Dollarization is the colloquial term for currency substitution, in which a country, either officially or unofficially, either fully or partially accepts a foreign currency as its legal tender for the purpose of enhancing currency stability, reducing the costs of maintaining its own currency and boosting investor and consumer confidence in its economy.
USD being one of the most popular such currency is the reason why currency substitution has come to be popularly known as ‘Dollarization’, but it doesn’t mean that USD is the only currency that is so used.
Story Behind Dollarization
Currently, the world is running on a fiat money system in which the paper currency or coins are not backed by an equivalent amount of gold. This has been so since the abolishment of the Gold standard and its variants.
When the currencies were backed by Gold, increasing the amount of a certain currency would require an equivalent amount of gold to be kept as a reserve. This created a limit on the increase in the amount of currency, as the production of gold has its limitations. However, under the fiat regime, an unlimited amount of money can be printed by countries if need be. This process is also known as Deficit financing.
A drawback to this is that the currency loses its value in the international market, due to over-supply. In exchange for 1 unit of such a currency, lower and lower amounts of foreign currency are available. Ultimately investors and consumers lose faith in the currency because of the actual lack of purchasing power.
To bring back the faith in the fiscal and economic structures of the country, certain countries at different periods of time have officially or unofficially adopted a foreign currency as a legal tender. Such foreign currency has international acceptability and therefore investors and consumers have greater faith in them.
Exchange Rate Regimes
Following image shows the degrees of flexibility of exchange rates:
- Under Complete Dollarization also known as ‘hard peg’ or currency board system, there is no separate legal tender
- Under the fixed-rate regime, the domestic currency exchange rate is fixed against a single or a basket of currencies to bring stability.
- Under soft peg or managed float, the domestic currency is allowed to freely float within a certain range and it is bound by the upper and lower limits of this range.
- A fully floating exchange rate moves freely with the market movements of demand and supply without any political or monetary authority intervention.
Types of Dollarization
Following image shows the classification of Dollarization based on degree and officiality:
- Complete Dollarization implies that foreign currency is the only legal tender in the country.
- Partial Dollarization implies that the foreign currency and the local currency are accepted as legal tender in the country.
- Official Dollarization implies that the country’s government and monetary authorities have accepted a foreign currency as its legal
- Unofficial Dollarization occurs when the people in the country have their savings in foreign currency in the form of investment instruments because they consider that currency as a safe haven and protection against inflation.
Real-world Instances of Dollarization
#1 – Complete or Official Dollarization
- Zimbabwe completely replaced the domestic currency in 2009 with several different foreign currencies, after stretched periods of hyperinflation and extreme economic crisis that led to a complete collapse. As recent as in February 2019, a new currency known as RTGS Dollar has been introduced and in June 2019 it became the only legal tender in Zimbabwe
- In the case of Panama, at the time of formation of the country, USD was adopted in its constitution as its only legal tender
- Many Eurozone countries except UK and Switzerland accepted Euro as the only legal tender replacing their own currencies in 2002.
#2 – Partial or Unofficial Dollarization
- Cambodia has dual currencies, the urban economy is governed by USD and the rural economy by their domestic currency Riel. Dollarization is unofficial because the government has never officiated it and is also strongly in favor of de-dollarization, however, it is paradoxically one of the largest dollarized economies in south-east Asia.
- Nepal & Bhutan use Indian Rupee along with their domestic currencies and follow a fixed peg
- Stability: When the foreign currency is accepted as a legal tender, the exchange rate risk reduces. Due to this the investor community and consumers have greater confidence in the economy as they have faith that the value of their wealth will not face sudden shocks or complete erosion.
- Faster Development: With greater stability come to greater FDI and FPI as investors do not face the challenges of speculating the movement of their investment. This leads to faster development of emerging economies as investors feel greater transparency.
- Lower interest rate premiums: Government and corporate debts can be issued at lower interest rates when denominated in the internationally acceptable currency because of the reduced premium associated with country risk, one of the components that go into the interest rate calculation. This leads to lower lending rates and stimulates capital investment
- Cost-effectiveness: Cost of printing and maintain the domestic currency is reduced or eliminated
- Loss of Seigniorage:
- First point is to understand the meaning of Seigniorage, when a country issues or prints currency, it is effectively borrowing the same. If not backed by gold, it is backed by the full faith of the government. Therefore there is no interest charged on this loan.
- The money thus saved is used by the government to fund its various expenses. When the country dollarizes, it loses its right to print its own money and therefore also loses current and future Seigniorage.
- To dollarize, the country first reduces the amount of domestic currency buy buying it back in the open market, and to fund this activity, it uses the accumulated Seigniorage, and the country, in future, doesn’t accumulate Seigniorage
- Default risk: Even though the country issues debt in foreign currency, it all boils down to its own capacity being able to pay back the debt. If it is not able to stimulate investment and achieve the required development, its chances of defaulting increases. Had such debt been issued in the domestic currency, it would be able to print more currency to pay back the debt but that is not an option after dollarization
- In Tandem with the foreign economy: When dollarization occurs, the country is no longer immune to the macro-economic upheavals in the foreign country which causes depreciation of the foreign currency.
- Loss of Monetary Autonomy: The Central bank of the dollarized country loses its freedom to impact the policy rate and in turn the lending rate. This leads to lack of control on the monetary environment and money supply of the country
To sum up, dollarization or currency substitution has its merits and demerits and the trade-off exists. However, as far as practical real-world observation is concerned, the benefits of dollarization are more on the economic front while disadvantages are more on the political front.
Choosing the appropriate degree of dollarization is important so that when need to be there are ample exit options. If the country is able to utilize this policy to its benefit, then it can easily achieve development but if it becomes complacent and short-sighted, it may never be able to recover from its ill fate.
This has been a guide to what is dollarization and its definition. Here we discuss the story of dollarization countries along with its types and real-world examples. You can learn more from the following economics articles –