Dollarization Definition Types Real World Dollarization Examples

Dollarization Definition

The United States dollar is one of the most popular currencies. Thus, currency substitution has become popularly known as ‘Dollarization.’ However, it doesn’t mean that USD is the only currency used.

Story Behind Dollarization

Currently, the world is running on a fiat moneyFiat MoneyFiat money is a currency that is declared by the government to be legal tender and has no physical backing such as gold; rather, the value of fiat money is derived from the market’s demand-supply relationship. India’s and America’s fiat currencies are the India Rupee and the US Dollar, respectively.read more system in which an equivalent amount of gold does not back the paper currency or coins. This has been so since abolishing the Gold standardGold StandardThe gold standard was a monetary term used when gold exchange was used instead of paper currency.read more and its variants.

When gold-backed currencies, increasing the amount of a certain currency would require an equivalent amount of gold to be kept as a reserve. This created a limit on the increase in currency, as gold production has its limitations. However, under the fiat regime, an unlimited amount of money can be printed by countries if need be. This process is also known as Deficit financing.

A drawback is that the currency loses its value in the international market due to oversupply. In exchange for 1 unit of such a currency, lower and lower amounts of foreign currency are available. Ultimately, investors and consumers lose faith in the currency because of purchasing power.

To bring back the faith in the fiscal and economic structures of the country, certain countries at different periods have officially or unofficially adopted a foreign currency as their legal tender. Such foreign currency has international acceptability, and therefore investors and consumers have greater faith in them.

Exchange Rate Regimes

The following image shows the degrees of flexibility of exchange rates:

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Dollarization (wallstreetmojo.com)

There is no separate legal tender under complete dollarization, also known as ‘hard peg’ or currency board system.Under a fixed-rate regime, the domestic currency exchange rate is fixed against a single or a basket of currencies to bring stability.Under soft peg or managed float, the domestic currency can freely float within a certain range, bound by its upper and lower limits.A fully floating exchange rateFloating Exchange RateThe floating exchange rate can be defined as the relative value of the currency of a country. It is determined on the basis of the demand and the supply factors prevailing in the Forex market and no attempt is made by the government for influencing such exchange rate.read more moves freely with the market movements of demand and supply without any political or monetary authority’s intervention.

Types of Dollarization

The following image shows the classification of dollarization based on degree and officiality:

Complete dollarization implies that foreign currency is the only legal tender in the country.Partial dollarization implies that the foreign and local currencies are accepted as legal tender.Official dollarization implies that the country’s government and monetary authorities have accepted a foreign currency as its legal tender.Unofficial dollarization occurs when the people in the country have their savings in foreign currency in the form of investment instruments because they consider that currency as a haven and protection against inflation.

Real-world Instances of Dollarization

#1 – Complete or Official Dollarization

Zimbabwe completely replaced the domestic currency in 2009 with several different foreign currencies after stretched periods of hyperinflationHyperinflationHyperinflation is merely an accelerated level of inflation that tends to quickly destroy the actual value of the local currency since there is a rise in the cost of all products and services, and it causes people to lower their holdings in that particular currency as they opt to participate in foreign currencies that are relatively more stable.read more and extreme economic crisis that led to a complete collapse. As recently as February 2019, Zimbabwe introduced a new currency known as RTGS Dollar, and in June 2019, it became the only legal tender in Zimbabwe.In the case of Panama, at the time of formation of the country, USD was adopted in its constitution as its only legal tender.Many Euro-zone countries except UK and Switzerland accepted Euro as the only legal tender replacing their currencies in 2002.

#2 – Partial or Unofficial Dollarization

Cambodia has dual currencies. The urban economy is governed by USD and the rural economy by their domestic currency Riel. Dollarization is unofficial because the government has never officiated it and is also strongly in favor of de-dollarization; however, it is paradoxically one of the largest dollarized economies in South-East Asia.Nepal & Bhutan use Indian Rupee, and their domestic currencies follow a fixed currency pegCurrency PegA currency peg is a government or central bank’s policy of fixing the nation’s currency exchange rate with respect to a foreign currency or multiple foreign currencies. It aims at reducing the currency risk and encouraging cross border trade.read more.

Advantages

Stability: The exchange rate riskExchange Rate RiskExchange Rate Risk is the risk of loss the company bears when the transaction is denominated in a currency other than the company operates. It is a risk that occurs due to a change in the relative values of currencies.read more reduces when the foreign currency is accepted as a legal tender. Due to this, the investor community and consumers have greater confidence in the economy as they have faith that the value of their wealth will not face sudden shocks or complete erosion.Faster Development: With greater stability comes greater FDIFDIA foreign direct investment (FDI) is made by an individual or an organization, into a business located in a foreign country. The host nation receives job creation prospects, advanced technology, a higher standard of living, infrastructural development, and overall economic growth.read more and FPI as investors do not face the challenges of speculating the movement of their investments. This leads to faster development of emerging economies as investors feel greater transparency.Lower interest rate premiums: Government and corporate debts can be issued at lower interest rates when denominated in the internationally acceptable currency because of the reduced premium associated with country riskCountry RiskCountry risk denotes the probability of a foreign government (country) defaulting on its financial obligations as a result of economic slowdown or political unrest. Even a little rumour or revelation can make a state less attractive to investors who want to park their hard-earned income in a reliable place.read more, one of the components of the interest rate calculation. This leads to lower lending rates and stimulates capital investmentCapital InvestmentCapital Investment refers to any investments made into the business with the objective of enhancing the operations. It could be long term acquisition by the business such as real estates, machinery, industries, etc.read more.Cost-effectiveness: The cost of printing and maintaining the domestic currency is reduced or eliminated.

Disadvantages

Loss of Seigniorage:First, let’s understand the meaning of SeigniorageSeigniorageSeigniorage in economics is the difference between the costs of production of currency and what the currency is actually worth. It is the revenue earned by the government while printing or minting the money. read more. When a country issues or prints currency, it effectively borrows the same. If not backed by gold, it is backed by the government’s full faith. Therefore, there is no interest charged on this loan.The money thus saved is used by the government to fund its various expenses. When the country dollarizes, it loses its right to print its own money and therefore also loses current and future Seigniorage.To dollarize, the country first reduces the amount of domestic currency by buying it back in the open market. It uses the accumulated Seigniorage to fund this activity, and the country doesn’t accumulate in the future Seigniorage.Default risk: Even though the country issues debt in foreign currency, it all boils down to its capacity to pay back the debt. Suppose it cannot stimulate investment and achieve the required development. Its chances of defaulting increase. Had such debt been issued in the domestic currency, it would print more currency to pay back the debt, but that is not an option after dollarization.In tandem with the foreign economy: When dollarization occurs, the country is no longer immune to the macro-economic upheavals in the foreign country, which causes depreciation of the foreign currencyDepreciation Of The Foreign CurrencyCurrency depreciation is the fall in a country’s currency exchange value compared to other currencies in a floating rate system based on trade imports and exports. For example, an increase in demand for foreign products results in more imports, resulting in foreign currency investing, resulting in domestic currency depreciation.read more.Loss of monetary autonomy: The central bank of the dollarized country loses its freedom to impact the policy rate and, in turn, the lending rate. This leads to a lack of control over the country’s economic environment and money supply

Conclusion

To sum up, dollarization or currency substitution has its merits and demerits, and the trade-off exists. However, as far as practical and real-world observations are concerned, the benefits of dollarization are more on the economic front while disadvantages are more on the political front.

Choosing the appropriate degree of dollarization is important so that when a need arises, there should be ample exit options. Suppose the country can utilize this policy to its benefit. It can easily achieve development, but it may never recover from its ill fate if it becomes complacent and short-sighted.