Dollarization

Updated on May 3, 2024
Article byShraddha Sureka
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Dollarization?

Dollarization is the colloquial term for currency substitution. A country, either officially or unofficially, fully or partially accepts a foreign currency as its legal tender to enhance currency stability, reduce the costs of maintaining its currency, and boost investor and consumer confidence in its economy.

Dollarization

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The United States dollar is one of the most popular currencies. Thus, currency substitution has become popularly known as ‘Dollarization.’ However, it doesn’t mean that USD is the only currency used. This process might be adopted voluntarily or involuntarily and is used for controlling currency volatility, boosting international trade, etc.

Key Takeaways

  • Dollarization is the process by which a country adopts the United States dollar (USD) or another foreign currency as its official currency or as a substitute for its domestic currency.
  • Dollarization” and “currency replacement” are interchangeable.
  • A country may accept all or part of a foreign currency as legal tender to enhance currency stability, reduce the expense of maintaining its currency, and boost investor and consumer confidence in its economy.
  • There are four different kinds of dollarization. The results are cost-effectiveness, accelerated development, stability, and decreased interest rate premiums.

Dollarization Explained

Currently, the world is running on a fiat moneyFiat MoneyFiat money is a currency that is declared by the government to be legal tender and has no physical backing such as gold; rather, the value of fiat money is derived from the market's demand-supply relationship. India's and America's fiat currencies are the India Rupee and the US Dollar, respectively.read more system in which an equivalent amount of gold does not back the paper currency or coins. This has been so since abolishing 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 gold-backed currencies, 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 currency, as gold production 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 is that the currency loses its value in the international market due to oversupply. 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 purchasing power.

To bring back the faith in the fiscal and economic structures of the dollarization countries, certain countries at different periods have officially or unofficially adopted a foreign currency as their legal tender. Such foreign currency has international acceptability, and therefore investors and consumers have greater faith in them.

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Exchange Rate Regimes

The following image shows the degrees of flexibility of exchange rates:

Dollarization (Exchange Rate Regime)

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Types

The following image shows the classification of dollarization policy based on degree and officiality:

Dollarization Types

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  • Complete dollarization implies that foreign currency is the only legal tender in the country.
  • Partial dollarization implies that the foreign and local currencies are accepted as legal tender.
  • Official dollarization implies that the country’s government and monetary authorities have accepted a foreign currency as its legal tender.
  • 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 haven and protection against inflation which is one of the important reasons for dollarization.

The above are the various ways in which dollarization countries can adopt the method to bring back the economic stability and control economic unrest.

Examples

Now let us look at a few examples to understand the concept.

Example#1

Example#2

Effects

Dollarization or currency substitution has its merits and demerits, and the trade-off exists. However, as far as practical and real-world observations are concerned, the benefits of dollarization are more on the economic front while disadvantages are more on the political front. Let us look at its effects:

  • Control on currency volatility – Th edomestic currency experiences lesser fluctuation since it is usually pegged with US dollars, which is highly stable.
  • Boost to international trade – Since the US Dollars are accepted globally fro international trade, it becomes easy for the economy pegged to dollars to conduct trade with various countries worldwide.
  • Investors gain confidence – Dollarization helps in boosting the confidence level of investors in case of those currencies that have a history of fluctuations or extremely high inflation rates.
  • Lack of control on monetary policy – The country adopting this method has to give up its hold on the country’s monetary policies. This may sometimes lead to economic unrest because the dometic economy cannot use any kind of monetary policy tool to boost its economy.
  • Vulnerable to fluctuations on the US – Since now the home currency is tied to US dollars, any fluctuation in US dollar will affect this currency, which may have a significant impact.

Choosing the appropriate degree of dollarization is important so that when a need arises, there should be ample exit options. Suppose the country can utilize this policy to its benefit. It can easily achieve development, but it may never recover from its ill fate if it becomes complacent and short-sighted.

Advantages

There are a few dollarization benefits that a country gets if it adopts the dollarization process to bring stability in its economic conditions.

Thus, the above are some of the reasons for dollarization that are beneficial for an economy.

Disadvantages

Along with the dollarization benefits, it is also necessary to understand the disadvantages. Only then will an economy be able to take an informed decision about the process. Let us go through the following points in detail.

Dollarization Vs Currency Board

Both the above methods are two different ways to manage the currency of a country to avoid currency fluctuations and promote growth. However, let us lok at the basic differences between them.

  • The former is just the method of adopting dollar as the official or unofficial currency of the economy whereas the latter means the country’s official currency is pegged to another foreign currency, which may be dollar, euro or any others.
  • Adopting the former means the home country has to give up its control over the monetary policy of their own country since it is flowing the movement of dollar, but adopting the latter means some control on the monetary policy can be retained with regard to interest rate adjustment etc.
  • The dollarization process gives less flexibility than currency board due to lack of power over the monetary policy of the economy. This is not the case with currency board.
  • The former may make the currency of the country that has adopted dollar vulnerable to fluctuations because it is tied to the currency of the economy whose official currency they has taken.

However, both the methods helps in maintaining the stability in exchange rates inspite of lack of official control on the economy. The country will adopt it or not depends on the political and economic conditions.

Frequently Asked Questions (FAQs)

Which countries are currently dollarised?

Liberia and Panama are the two countries that still solely use the dollar. From the standpoint of the United States, it is amazing that around two-thirds of all dollar, cash is retained outside.

Why do countries adopt dollarization?

A government may decide to dollarize for several reasons, including improved price stability and the cessation of abrupt, fast national currency devaluations.

What is the difference between currency board and dollarization?

The three elements of a currency board are a fixed exchange rate to an “anchor currency,” automatic convertibility (the ability to swap local currency at this fixed rate anytime wanted), and a long-term commitment to the system, which is typically officially expressed in the central bank statute.

This has been a guide to what is Dollarization. We explain the advantages, disadvantages, example, differences with currency board & types. You can learn more from the following economics articles –