Dollarization Does Not Helps Developing Nations:

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Dollarization Does Not Helps Developing Nations

• By Group 5Ralph Grambusch
• Bo Shen
• Netrika Sorthananusak

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Is Dollarization the cure for developing
countries?
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What is Dollarization?

• Use of any foreign currency by another country.
• Full /Formal /Official vs. Informal
• ---Full dollarization one country officially
  adopting the currency of another for all
  financial transactions, a total replacement of
  local currency.
• ---Informal dollarization most developing
  countries, their residents hold foreign currency
  deposits at domestic banks.

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Countries Officially Dollarized

• Ecuador
• El Salvador
• Panama
• Micronesia
• Palau

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Why Dollarization?

• Economic instability
• High inflation
• Protect assets from devaluation
• Trade integration

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If dollarization is that great, why shouldnt all
developing countries (DC) adopt it?
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Is Dollarization a Savior for DC?

• 1.) Seignorage
• 2.) Exit Options
• 3.) Lender of Last Resort
• 4.) Monetary Policy
• 5.) Debt Deflation
• 6.) Political Issues
• 7.) Prerequisites

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Seignorage

• ---the profit obtained by a government producing
  own currency at a cost lower than face value
  
• ---Inflation Tax

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Seignorage

• Two kinds of losses for DC
• --Stock
• ---immediate
• --Ongoing
• ---year to year
• Quantifiable

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Exit Option

• Virtually non-existent
• Extreme shocks to system
• need devaluation
• Cause macroeconomic instability to leave
• Non-Quantifiable

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Lender of Last Resort

• No FDIC ability
• Poor banking system in place
• higher of bank runs possible
• Non-Quantifiable

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Monetary Policy

• Central banks use it wisely to stabilize and
  promote economy.
  
• Full dollarization implies the complete
  relinquishing of monetary and exchange rate
  policy.
  
• Monetary policy is determined by the U.S. Federal
  Reserve. (assuming US is used)
  
• The only tool would be fiscal policy with limited
  maneuverability.
  

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Monetary Policy contd

• Scenario ONE BOP deficit
• -Country cant change its exchange rate to deal
  with the deficit.
  
• -Income and domestic price level have to fall
  to bring back the balance.
  
• Results It is a downward spiral and it is
  painful. Higher unemployment and social unrest.

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Monetary Policy contd

• Scenario TWO an overvalued dollar
• -It has been experienced for some years.
• -For U.S., not a bad thing after all Capital
  market prospered.
  
• -For DC, makes it more expensive and less
  competitive.
  
• Results DC depends more on trading with U.S. No
  diversification on its foreign trade.
  

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Debt Deflation

• An unanticipated collapse in price that leads to
  bankruptcy, even though the borrowing firms are
  efficient.
  
• It is socially costly and carries a deadweight
  loss.
  
• Why is it a threat to a dollarized DC?

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Debt Deflation contd

• Facts DC depends much more on single product or
  industry than developed countries.
  
• Results Devaluation is no use, since the country
  is dollarized. More likely to trigger debt
  deflation in economy.

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Debt Deflation contd

• Facts DC opens for international trade and terms
  of trade vary widely. Price level is independent
  of US price level.
  
• Results a price collapse in the DC is unlikely
  to trigger an offsetting response by US monetary
  policy.

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Political Considerations

• Giving up ones own currency is often viewed as a
  loss of sovereignty.
  
• Political reasons carry a greater weight than
  economic sense.
  
• Panama in 1988

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Prerequisites for Dollarization

• International currency reserve held in the
  Central Bank must be sufficient to cover stock
  loss
  
• The local currency must be neither over nor
  undervalued.
  
• A strong domestic financial banking system.
• Structural reform including attacking root
  problems of pricing, improving productivity and
  competitiveness.

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Why Dollarize?

• If a country can fulfill the prerequisites, it is
  capable of carrying out sound economic policies
  on its own.
  
• If a country wants to become dollarized because
  of its incapability to establish its own sound
  economic policies, what it seeks is the
  possibility of mishandling its financial and
  fiscal policies under the same bureaucratic
  system in the future.

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Final Words

• Dollarization is not suited for all DC.
• It looks like a easy and quick solution, but very
  dangerous and costly under scrutiny.
  
• Dollarization needs to be studied on a longer
  time basis to be considered a success\failure.
  

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Has Dollarization Been Around Long Enough?

• The old joke states that the exam questions in
  economics remain the same every year- - - - -
  
• Only the answers change

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Questions?