A Day Late and a Dollar Short?

Is dollarisation a cure-all for unstable, hyper-inflationary nations? It is very hard to make that judgement, especially since stronger currencies, whether it be the dollar or euro, are also subject to changes in their value which may or may not benefit the dollarised economies in the short-term.

In the year 2000, Andrew Berg and Eduardo Borensztein, economists with the International Monetary Fund (IMF), wrote an article, ‘Full Dollarization: The Pros and Cons’, which addressed a growing global trend amongst countries that had long histories of economic turbulence and challenging exchange rate policies.

The lure was and still is that full dollarisation, the abandonment of a local currency so that all transactions will be done in a more stable currency, generally the US dollar or the euro, would ‘cure’ these problems. This would also include the elimination of all local currency in circulation, a giant endeavour for any country, let alone those where cash still plays a significant role in daily transactions.

In my purview, which is Latin America, three countries have officially dollarised their economies: Panama, which has been dollarised for more than a century; Ecuador, which has just completed 24 years of dollarisation; and El Salvador, which abandoned the colón and replaced it with the dollar in 2001.

Colombia has, in the past 20 or so odd years, toyed with the idea of dollarisation but not very seriously. And although President Menem contemplated dollarisation of Argentina in 1999, more recently, President Milei made a campaign promise to ‘dynamite’ the Central Bank of Argentina, which included dollarisation, to jump-start his country’s flailing economy. Today, however, six months into his government and with improved economic indicators, this is not such a certain scenario.

Recent history among the countries that have dollarised shows some benefits. Ecuador decided to dollarise its economy when it was going through a deep crisis, with hyperinflation of 106% in 2000 and today, despite having the highest inflation in the last five years, at a little over 4%, they boasted several years of relatively stable inflation, with numbers as low as 0.5% per annum.

Panama adopted the dollar as its currency in 1903, eliminating exchange rate risks, but their economy was and is very closely tied to the United States, which makes their results not necessarily repeatable in other countries.

In the case of El Salvador, where more than 40% of its residents are actually living and working either in the US (more than 80%) or elsewhere, economists had to take into consideration that nearly 20% of El Salvador’s GDP was already in dollars paid into the country as remittances made by Salvadorean emigrants, clearly a very good reason to dollarise.

Nevertheless, one should note that in both Ecuador and Panama, dollarisation meant a rise in the cost of living, as well as a progressive de-industrialisation with increased unemployment, and forced the nation to survive largely on exports.

Some countries in the region, although they have not officially dollarised their economies, have what is known as partial dollarisation. This means they keep their currencies and the management of foreign exchange policy by their central banks even though consumers and businesses prefer to effect most transactions in dollars. Clear examples are Venezuela and Perú, where many do not trust the value of their own currency for mid- to longterm transactions.

Unfortunately, the history of dollarisation is still relatively recent except for the case of Panamá which is not comparable to other countries. Moreover, dollarisation will not avoid the risk of external or internal crises, especially since local and foreign investors may decide to flee from a country because of political or financial problems that may raise questions regarding the soundness of the nation’s financial system with or without dollarisation.

For full dollarisation to work well, nations would need to align their monetary policies to become dependent on, in the case of the US dollar, on the Federal Reserve (Fed), and this dependency does not always translate well for local economic realities.

Particularly in the case of recessions, a nation would not be able to counteract drops in exports or boost its economy from the management of interest rates or issue additional currency responsibly when needed to finance public spending.

Finally, it is a well-known fact that productivity is variable amongst all countries and this will not be changed by eliminating its currency. Since the decision to dollarise is usually made when a nation’s currency is highly depreciated in value, the corresponding exchange rate for the dollar would be quite negative for many of the nation’s inhabitants unless they have the means of being paid in dollars from abroad or have a miraculous jump in productivity, a highly unlikely circumstance in most cases.

Dollarisation is defined as the process whereby the US dollar is de facto adopted as the currency of a country, and the central bank and government do not issue their own currency. Partial dollarisation is when the dollar is accepted and circulates alongside the domestic currency.

Dollarised countries procure their banknotes from the Fed but not the coins. So whilst Ecuador, El Salvador and Panama are fully dollarised, they still issue their own coins – the sucre, the colón and the balboa respectively. The coins are all equivalents of their US counterparts.

Similarly, Timor Leste, which has been fully dollarised since 2000, has issued its own centavo coins since 2003, again on a par with US coins.

A similar principle applies to sovereign states that are officially ‘eurorised’, namely Andorra, San Marino, Monaco and Vatican City, all of which have monetary agreements with the EU granting them the right to produce limited quantities of euro coins with their own design on the national side, but not to issue euro banknotes.

Kosovo and Montenegro also use the euro as the de facto domestic currency, albeit without an agreement with the EU. This is keeping with an older practice of using the German mark, which was previously the de facto currency in these countries.