In the past decades, it has been more common to see struggling emerging markets adopt other countries currency, be it partially or totally. It is usually the currency from a dominant investment and trade partner. Such has been the case of the dollar being introduced in East Timor in southeast Asia, Zimbabwe in Africa, and El Salvador and Ecuador in Latin America (looney, 2017).
What is Dollarization
It consists of legalizing the use of the US dollar in the economic activities of another country. This type of measure could consider the change to any other currency. Still, the economic power and influence of the United States in some regions have been determinant in these decisions. (Velazquez, 2018)
The truth is that no country with a stable economy would consider currency substitution. Still, there is not a single cause for substituting the currency. In most cases, it has to do with economic volatility.
When a country’s economy presents uncontrollable inflation levels, devaluation of its currency, and an unstable exchange rate, there are usually grounds for dollarization. starting by an informal substitution (used on the streets without being legally accepted), and in more extreme cases, followed by formal dollarization of the economy. (Demidenko, 2017)
Consequences of dollarization
It is common knowledge that there is no secret formula for fixing a decaying market. As with any other policy, dollarizing the economy comes with its pros and cons.
The main reason why governments seek full dollarization is to bring economic stability and sometimes even political stability by stabilizing the volatility of exchange rates and inflation. This would attract international investors and facilitate cooperation and trade with the global market, promoting investment and growth.
On the other side, by dollarizing, there is a loss of flexibility in terms of monetary policy. Since another state controls the currency, the country becomes dependent on debt, and international investments, and it is impossible to be competitive in exports in the short run.
Two experiences of dollarization.
At the beginning of the millennium, El Salvador and Ecuador shared a series of characteristics in their economies. Both countries relied on a small number of exports and they were unstable economically. In both countries, the dollar was used on a day to day basis in an informal manner since remittances formed a big part of the population’s income.
In 2001, the country entered total dollarization, leaving behind its old currency, the Colon. This decision brought the reduction of inflation as well as interest rates and eliminated the exchange risk. But at the same time, this decision added to the low productivity of the country, and the loss in competitiveness, forced to lower costs and salaries, mostly affecting the working class.
In the year 2000, Ecuador was in the middle of an economic crisis. With uncontrollable inflation, the country decided to dollarize, stopping this way the growth of inflation. This decision, although it helped solve immediate problems, also affected mostly the working class of the country. While the elite already had their savings in dollars and could benefit from the devalued exchange rate proposed to exchange the old currency, most of the population saw their savings turned to nothing by the devaluation. (Velazquez 2008)
Dollarization occurs in developing countries with an unstable currency, which has lost its value and its usefulness as an exchange medium for local transactions. States that have implemented full dollarization have seen their economic catastrophes stopped and usually have attracted more investors thanks to the new stabilization of the economy. On the other hand, the possible profits taken from the volatility of the old currency can no longer be, due to the use of the anchor currency.
The possible effects of currency substitution, in this case, dollarization, need to be studied in detail before implementing it. Actions are taken to prevent as much as possible the devaluation of old currency and, with it, the personal savings of the population.
Image: Gerd Altmann
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