Dollarization in the Developing World

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Dollarization in the Developing World

• Team Six
• Kevin Wesley
• Jason Collier
• Jay Alva
• Steve Drucker

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Presentation Outline

• Introduction to Dollarization
• Two Types
• Advantages to Official (Full) Dollarization
• Advantages to Financial Integration
• Case Studies
• Dollarization in Ecuador
• Dollarization in Panama
• Possible Dollarization in Argentina

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What is Dollarization?

• A shift away from a countrys domestic currency
  to some foreign currency in order to fulfill the
  main functions of money
  
• Dollarization refers to the use of any foreign
  currency not just the U.S. dollar
  
• Two forms of dollarization
• Unofficial Dollarization Residents of a country
  hold a large share of their wealth in foreign
  currency Foreign currency, however, unlike the
  domestic currency, cannot be used as legal
  tender
• Official (Full) Dollarization Foreign currency
  has full or predominant status as legal tender.
  Domestic currency either does not exist or plays
  a minor role

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Unofficial Dollarization

• Three stages of unofficial dollarization
• Stage One (Asset Substitution) People hold
  foreign bonds and deposits as stores of value to
  protect against losing wealth through inflation
  of the domestic currency
• Stage Two (Currency Substitution) People hold
  foreign currency in the domestic banking system
  as stores of value and means of payment
  
• Stage Three People think in terms of foreign
  currency
  
• High Dollarization (foreign currency 30) 18
  countries in 1995
  
• Moderate Dollarization (foreign currency approx..
  16) 34 countries
  
• U.S. currency circulating outside the country is
  around 50 to 70 percent of the total

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Deposits in Foreign Currency as of Money Supply
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Official Dollarization

• Foreign currency is legal for use between private
  parties
  
• Foreign currency is used for payments by the
  domestic government
  
• Domestic currency may or may not exist and if it
  does it is reduced to a secondary role (as with
  the Panama Balboa) Usually domestic currency is
  in the form of coins only
• Some officially dollarized economies allow more
  than one foreign currency to be use legally
  
• As of 2000, 29 countries are officially
  dollarized
  
• 15 are not independent (e.g. Guam, Puerto Rico,
  Virgin Islands)
  
• 14 are independent

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Dollarized Countries
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Dollarized Countries
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Advantages of Official Dollarization

• Eliminates or reduces domestic currency risk
• Risk of devaluation of domestic currency
  eliminated and thus so is the risk of a currency
  crisis
  
• Reduces country risk
• By eliminating devaluation risk, the countrys
  risk of high interest rates, high default rates,
  and poor economic performance is reduced
  
• Reduces volatility of real exchange rate
• Reduces the financial systems need for reserves
• This reduces the banks cost of doing business

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Advantages of Official Dollarization

• Lowers inflation and lowers risk of future
  inflation
  
• Officially dollarized countries assure themselves
  of an inflation rate close to that of the issuing
  country
  
• Lower and less variable inflation rates increases
  the security of property rights in money
  
• Lowers transaction costs
• Hedging for currency risk with countries within
  the unified currency zone is unnecessary and thus
  trade and investment with these countries is
  increased.
• Eliminates balance of payment crises

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Financial Integration

• Officially dollarized country has a unified
  currency but not necessarily a integrated
  financial system
  
• Financial integration can help an officially
  dollarized country achieve the full benefits of
  dollarization
  
• Ability to switch funds without exchange risk
  between U.S. and dollarized country reduces boom
  and bust of foreign capital
  
• Improves the quality of the financial system by
  allowing consumers access to internationally
  competent financial institutions

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Dollarization in Ecuador

• Economic Crisis beginning in 1999
• El Nino and sinking Oil prices
• Banking system collapse
• Extreme inflation, currency devaluation, capital
  flight and demonstrations by indigenous
  population
  
• Coup détat by military leaders

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Dollarization in Ecuador

• Gustavo Noboa elected to presidency
• March 1, 2000, Ecuadors Congress approved the
  Ley Fundamental para la Transformación del
  Ecuador
  

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Dollarization in Ecuador
Late January, 2000 - The Central Bank and private
banks start exchanging the sucres in peoples
possession for s dollars at the fixed 25,000
sucres/dollar March 13, 2000 - President Noboa si
gns the dollarization law March - May, 2000 - All
checking and savings accounts, as well as credit
cards operations are expressed in dollars
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Oil Export Prices in Ecuador
(December 1991-August 1999)
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(US/Barrel)
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Financial Stabilization and Economic Rebound

• Rapid regeneration of financial intermediation
• Dollar as unquestioned store of value
• Debts liquated through negative real interest
  rates
  
• Decompression of spending and recovery
• Helped by high oil export prices
• Country risk reversion towards Latin mean
• After external debt restructuring agreement
• In spite of nontrivial risks, constraints, and
  adversities
  
• Political instability
• Deposit unfreeze
• Resolution of remaining troubled banks
• Painful loss allocation from crisis

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Regeneration of Financial Intermediation
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Reversion of Country Risk Towards Latin Mean
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Measures of Economic Recovery
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Measures of Economic Recovery
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Spending Decompression and Economic Recovery
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Other Examples - Panama

• Panama
• Officially Dollarized since 1904
• Largest Dollarized country by population (2.7
  Mil) and economic size (GDP8.7 Billion/yr)
  
• Average rate of inflation of 3 was lower than
  the U.S. average of 5 from 1961 to 1997
  
• No major bank failures
• Ability to obtain 30 year fixed rate mortgages
• Nominal interest rates are lowest in Latin
  America after Dollarization
  

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Other Examples Argentina

• Argentina a country in trouble
• Since the early 1970s Argentinas unemployment
  has risen from 3 to 20
  
• Argentina had traumatic hyperinflation in 1989
  where prices grew by more than 1000
  
• National debt at 132 Billion with GDP at 271
  Billion (48.7 of GDP) in 2000
  
• In December 2001, Argentinas Govt. declared
  default on debt owed to foreigners
  

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Other Examples Argentina

• Argentina a country in trouble
• In December 2001, when IMF announces that it will
  not disburse 1.3 billion in aid to Argentina,
  the countrys risk premium exceeds 40 percentage
  points
• Import Tax increases in 2000 and 2001
• In January 2002, Argentinas Govt. set limits on
  the amount a person could withdraw from the bank
  to repay debts of 750 Million in 2001, and 2
  Billion in 2002
• General fear that the Govt. will devalue the Peso
  to solve its financial problems
  

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Other Examples Argentina cont.

• Potential benefits of Official Dollarization
• Lower interest rates, particularly longer-term
  rates
  
• Exchange controls and restrictions on bank
  deposits could quickly be removed
  
• Rising bank liabilities (deposits, bank notes,
  etc..)
  
• An end to deflation, both in its monetary and
  tax-induced aspects
  
• Higher economic growth, though sustaining growth
  will require continuing work on taxes and
  regulation
  
• Possible seigniorage sharing arrangements between
  the US and Argentina
  
• The central bank has sufficient reserves for
  dollarization at 1 Peso 1 Dollar
  
• Argentina is already Unofficially Dollarized
  possible smooth transition