Benefits of Dollarization to Developing Nations

1
Benefits of Dollarization to Developing Nations

• Imtiaz Ahmed

• Laurin Sgroi

2

• Define Dollarization
• Define 3 Levels of Dollarization
• Benefits of Dollarization
• From dollarized country perspective
• From foreign-currency issuing country
• Example of Actual Dollarization Panama
• Conclusion

3

• What is Dollarization?
• Holding using foreign currency as legal tender
  exclusively or in addition to the domestic
  currency
  

• Levels of Dollarization
• Unofficial Dollarization Use of foreign
  currency at same time as domestic currency, not
  considered legal tender
  
• Semiofficial Dollarization Use/holding of
  foreign currency
  
• as legal tender, not used for payment of wages
  or taxes.
  
• Official Dollarization (Full Dollarization)
  Exclusively using
  
• the foreign currency as store of value, instead
  of domestic
  
• currency
• This level of Dollarization is when benefits
  are most
  
• realized

4

• Characteristics of countries that benefit from
  Dollarization
  
• Latin and Carribean
• Small economy
• Little or no economic growth
• Domestic government not exercising financial
  responsibility
  
• Established relationship with country issuing
  foreign
  
• currency

5

• Benefits to the Dollarized country
• Reduction of Transaction Costs.
• Costs of trading with countries with same
  currency eliminated including currency
  conversion, devaluation of domestic currency.
  
• The result of no currency conversion and
  currency devaluation minimized and stabilized
  bid-ask price spreads. This allows greater
  realization of profits from arbitrage.
• Based on the Optimum Currency Area (OCA) Theory
  gains from currency unification beyond and
  above gains of a free trade agreement with no
  commitment to a fixed parity.
• Trade-related gains and savings can be large
  due to increased efficiency of international
  trading.
  

6

• Benefits to the Dollarized country
• Enhanced Credibility towards Domestic Country
• With a passive monetary policy, inflation-bias
  is eliminated.
  
• Inflation Bias the result of domestic
  government worsening inflationary economy through
  monetary expansion.
  
• Eradicate inflationary measures used by domestic
  government to finance existing deficit or
  manipulate the exchange rate of the domestic
  currency.
• Studies show that dollarized economies will have
  a smaller fiscal deficit.

7

• Benefits to the Dollarized country
• Reduction of Country Risks
• Increases the confidence of foreign investors and
  creditors.
  
• Foreign creditors more willing to provide lending
  services due to increased confidence in domestic
  debt being paid
  
• Domestic capital assets become more attractive to
  foreign investors, which means increased inflows
  of foreign investments.
  
• Domestic assets not mobile will increase in
  value.
  
• Example Real Estate
• Increased capital inflows increased capital
  account surplus. Provides financing of existing
  deficits.
  

8

• Benefits to the Dollarized country
• Reduction of Currency Risks/ Stable Monetary
  Policy
  
• Money supply is automatically adjusted resulting
  in a more favorable balance of payments.
  
• Money supply will be aligned with money demand in
  domestic economy.
  
• People of domestic country will have more
  confidence in foreign currency as a means of
  securing the value of property and savings.

9
Money Market Before Dollarization
LM (Ms1)
Ms1
Ms2
Ms3
iInt Rate
iInt Rate
LM (Ms2)
LM (Ms3)
i1
i1
i2
i2
i3
i3
Md (Y1)
Md (Y1)
Qm
Y
Y1

• Demand of domestic currency would decrease if
  country adopts unofficial
  dollarization policy.

Md (Y1)
10
Goods Services Market Before Dollarization
Int Rate
AE
AE1(i3)
i1
i2
AE1(i2)
i3
AE1(i1)
IS1
IS2
IS3
Y
Y1
Y
Y1
Decreasing Interest rates Increasing Prices
(Inflation) Increasing Spending (due to
decrease in real income)
11
Money Market W/ Full Dollarization
LM (Ms1)
Ms1
iInt Rate
iInt Rate
Ms2
LM (Ms2)
i1
i1

i2
i2
Md (Y2)
Md (Y1)
Qm
Y
Y1
Y2
Change in Money Supply (Ms) done by
selling/buying bonds, Not by inflating with new
money supplies
12
Goods Services Market W/ Full Dollarization
Int Rate
AE
i1
i2
AE1(i2)
AE1(i1)
IS2
IS1
Y
Y1
Y
Y1
Y2
Y2
13

• Benefits to the Dollarized country
• Member of a unified currency zone.
• Stabilized interest rates due to less economic
  volatility.
  
• Financial Integration
• Increases opportunity for foreign financial
  institutions to compete in domestic financial
  environment.
  
• Domestic consumers have increased choices in
  financial planning.
  
• Creates incentive for domestic financial
  institutions to improve quality of services in
  order to be competitive.
  
• Domestic financial institutions reduce costs of
  conducting bank-related transactions
  
• Domestic financial institutions reduce holdings
  of both currencies in reserve, only need to hold
  reserves of foreign currency.
  

14

• Benefits to the country of foreign currency
• Increased price stability due to elimination of
  exchange rate volatility with currency of
  undeveloped countries.
  
• Enhances the economy through stronger trade
  relations with undeveloped countries, creating
  economic growth.
  
• Development of financial/economic synergies.

15

• Panamas Experience with Official Dollarization
  Legacy of a Century
  
• Since 1904, Panama has used U.S. Dollar notes
  (paper money) as domestic currency 1 Balboa
  US 1
  
• No Central Bank, No Centralized Foreign
  Reserves.
  
• Government-owned Commercial Bank Banco Nacional
  de Panama.
  
• Capital Account (KA) is entirely open and banks
  are free to invest excess funds in Panama or
  abroad.
  
• Foreign Banks, mainly US banks have been de facto
  Lender of Last Resort.
  
• Panama experienced solid Macroeconomic
  Performances with 3 average inflation per year
  in 196197.
  
• Growth averaged 8.1 from 1961-71 and from
  1978-81. For other years 2.5 average.
  

16

• Panamas Experience with Official Dollarization
  Legacy of a Century (continued)
  
• Real interest rates have remained in low-to
  mid-single digits and,
  
• Nominal interest rates were also very low
  comparing to other Latin American countries.
  
• Long-term Domestic Credit Panama is the ONLY
  Latin American country where 30-year fixed-rate
  mortgages are available in domestic currency.
  
• Real Exchange rate has shown little variations
  comparing to other Latin American countries.
  
• The Panamanian Government and Banco Nacional de
  Panama have NOT rescued failing banks. But few
  banks have failed over past 30 years.
  

17

• Panamas Experience with Official Dollarization
  Legacy of a Century (continued)
  
• All major shocks to the Panamanian Economy were
  NOT related to the Monetary System
  
• Canal Zone crisis in 1964, 1967-69
• Oil Shock in 1973, 1979
• Latin America Debt Default in 1982
• Crisis immediately preceding and during
  the embargo and the U.S.
  invasion 1988-89.
  
• All caused a withdrawal of Domestic Deposits and
  Economic Dislocations. But Private Banks
  responded rapidly and adjusted their portfolio by
  selling assets abroad and increasing domestic
  credit despite the outflow of domestic deposit

18

• Conclusio n
• Dollarization does have benefits
• Stable prices and interest rates
• Increased confidence in domestic economy
• Increased international trade due to reductions
  of transactions costs.
  
• Favorable effect on Balance of Payments
• Increased foreign investments.
• Economies where Dollarization is beneficial
• Latin (South American), Caribbean
• Insignificant economic growth
• Government with no financial restraint.

19

• Sources
• Dollarization A Primer, Eduardo Levy Yeyati
  Federico Sturzennegger, Business School,
  Universidad Torcuato, Di Tella, July, 2001.
  
• Basics of Dollarization, January, 2000 edition,
  Connie Mack (Chairman of the Joint Economic
  Committee)
  
• Testimony Dollarization in Emerging-Market
  Economies and Its Policy Implications, Joint
  Hearing of the Subcommittee on Economic Policy,
  Subcommittee on International Trade Finance,
  Committee on Bank, Housing Urban Affairs, US
  Senate, April 22, 1999.
• Dollarization Will the Quick Fix Pay Off in the
  Long Run, Myriam Quispe-Agnoli.
  
• Lessons from the Monetary Experience of Panama
  A Dollar Economy with Financial Integration,
  Moreno-Villalaz, J.L., Cato Journal, Vol. 18,
  No.3, P-421-440, 1999, Cato Institute.
• Official Dollarization Current Experiences and
  issues, Zeljko Bogetic, Cato Journal, Vol. 20,
  No.2, P-179-213, Fall 2000, Cato Institute.