Dollarization

Dollarization Definition

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 standardGold StandardThe gold standard was a monetary term used when gold exchange was used instead of paper currency.read more 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:

Dollarization (Exchange Rate Regime)

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Source: Dollarization (wallstreetmojo.com)

Types of Dollarization

Following image shows the classification of Dollarization based on degree and officiality:

Dollarization

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Source: Dollarization (wallstreetmojo.com)

  • 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

#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 currency peg

Advantages

Disadvantages

Conclusion

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 –