The Dollarization Debate

AuthorAndrew Berg and Eduardo Borensztein
PositionEconomist in the Developing Country Studies Division of the IMF's Research Department/Chief of the Developing Country Studies Division of the IMF's Research Department

    Full dollarization of the economy is widely discussed as a way of enabling developing countries to overcome monetary and exchange rate instability. What are the costs and benefits of dollarizing, and which developing countries are most likely to benefit?

There is an old joke that says that the exam questions in economics remain the same every year-only the answers change. Certainly, the debate about the best exchange rate regime has been with us forever, but new answers keep appearing. The newest answer to the question of what exchange rate regime countries should choose is "none." That is, countries should forgo using their own currencies entirely and adopt as legal tender a stable foreign currency, most commonly the U.S. dollar. Last year, the Argentine government gave serious consideration to dollarization, and some prominent economists have begun to argue that essentially all developing countries should dollarize. Not only developing countries, however, are considering dollarization. Prompted partly by the adoption of the euro this year, some have suggested that Canada should adopt the U.S. dollar. (Dollarization is also used to describe the spontaneous use of the U.S. dollar alongside a country's domestic currency in transactions. As used here, however, the term refers to the dollar's total replacement of the domestic currency-that is, "full" dollarization.)

New answers to the exchange rate question appear because the world continually presents new problems to policymakers. During the 1980s, much of the debate about exchange rate regimes for developing countries centered on the role of exchange rate pegs in inflation-stabilization programs. Two distinguishing features of the 1990s have changed the terms of the discussion. First, the inflation problem has receded considerably. Second, as the degree of capital mobility and the scale of capital flows have increased sharply, so have the apparent frequency and severity of currency crises. And many of the targets of these fierce speculative attacks were maintaining some sort of pegged exchange rate regime.

Because of those crises, the idea of full dollarization has elicited considerable interest. The view has emerged that in a world of high capital mobility, exchange rate pegs are an invitation to speculative attacks and that only extreme choices-a firm peg such as a currency board or a free float-are viable. Advocates of dollarization have attacked both of these alternatives. Free floats, they argue, are not viable for many countries because they result in excessive exchange rate volatility or a de facto "soft peg" if the authorities resist exchange rate movements. Meanwhile, it has become clear that even currency boards are not immune to costly speculative attacks: for example, Argentina and Hong Kong SAR suffered from episodes of financial contagion in recent years that resulted in sharp increases in interest rates and recessions.

Full dollarization promises a way of avoiding currency and balance of payments crises. Without a domestic currency, there is no possibility of a sharp depreciation, and sudden capital outflows motivated by fears of devaluation are ruled out. Dollarization may also bring other benefits: closer integration with both the United States and the global economy would be promoted by lower transaction costs and an assured stability of prices in dollar terms. By definitively rejecting the possibility of inflationary finance, dollarization might also strengthen institutions and boost investment.

Yet countries may be reluctant to abandon their own currencies. For one thing, the currency is a national symbol, and proposals to join a monetary union (or directly adopt the U.S. dollar) may draw criticism from some political quarters. From an economic point of view, the right to issue currency provides the government with seigniorage revenues (resulting essentially from the difference between the cost of producing and distributing paper money and coins and their (greater) purchasing power). The central bank can use currency, which does not bear interest, to purchase interest-bearing...

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