Questions About Pegs
Can these advantages offset the costs of a country giving up its own currency? The answers are complex, and in the end turn on each country’s specific circumstances. But more and more countries are seriously considering full dollarization as they deal with the changes in the world economy, particularly over the past 20 years.
During the inflation-plagued 1980s, much of the debate over exchange regimes for developing countries centered on the role of exchange rate “pegs”. Countries generally pick from a range of possibilities, including tying their currencies to baskets of other currencies (such as those of their trading partners), indexing their currencies in some way to their own inflation rates, or even banding together in groups, as many French-speaking African nations have through currency unions tied to the French franc.
In the 1990s, global inflation abated and capital mobility and the scale of capital flows increased sharply. While countries welcomed the investment flows, they faced a new threat, as speculative attacks rose in frequency and severity against currencies that capital markets viewed as vulnerable to devaluation.
Generally, the victims of these currency crises were maintaining some sort of pegged exchange rate regime. Consequently, the belief began to emerge that in a world of high capital mobility, exchange rate pegs might themselves attract speculative attacks and that only extreme choices, such as a free float or a currency board were viable. The currency board regime, under which the domestic currency is fully backed by international reserves, is the strongest form of pegged exchange rate option.
Advocates of full dollarization attack both of these choices. Free floats, they argue, are not viable for many developing countries because they risk excessive exchange rate volatility. So far, only the largest developing economies, with relatively advanced financial systems, such as Korea, Brazil, and Mexico, have attempted floating. While experience is limited, these experiments have worked thus far without major disruption.
Meanwhile, currency boards have fallen prey to costly speculative attacks. Argentina and Hong Kong SAR1, using currency boards successfully, nonetheless suffered sharp increases in interest rates and recessions in recent years as speculative attacks spread to them from other countries.
The Appeal of Dollarization
Against this background, then-president Carlos Menem of Argentina suggested in 1999 that Argentina adopt the U.S. dollar as the ultimate solution to its long history of difficulties with monetary and exchange rate policy. In January 2000, Ecuador, in the context of a deep economic and political crisis, adopted the U.S. dollar as its legal tender.
Prominent economists have begun to argue that essentially all developing countries should dollarize, and some industrial countries have even been urged to consider it. Partly prompted by the example of European countries giving up their currencies for the euro, some have suggested that Canada should adopt the U.S. dollar as the North American Free Trade Agreement (NAFTA) evolves.
Weighing the pros and cons of full dollarization is complicated by the virtual absence of historical experiences. Panama is the only sizable country with a history of using a foreign currency—the U. S. dollar—as legal tender, and it is fairly small, and has very close historical, political, and economic links to the United States. Even if there were more country experiences to assess, they would have to be over longer periods than is usual for evaluating monetary and exchange rate options. That is because dollarization is nearly permanent, and some of its benefits can be gained only in the long run.
This analysis of full dollarization compares it to its nearest competitor, the currency board. This comparison captures the main implications of dollarization and how its effects differ from those of simply adopting a very firm peg. Furthermore, if the costs and benefits of a currency board turn out to be at least equivalent to dollarization, a currency board would be a simpler and preferable alternative for a country seeking a firmly pegged exchange regime.
The differences between currency boards and dollarization are few, but important. Dollarization’s key distinguishing feature is that it is permanent, or nearly so. Reversing dollarization is much more difficult than modifying or abandoning a currency board arrangement. In fact, the largest benefits claimed from dollarization derive from the credibility it carries precisely because it is nearly irreversible. And yet for some countries under particular circumstances, the irreversibility could come at a very high cost.
A government adopting full dollarization gives up the revenue from the loss of seigniorage (see Box 2, What Is Seigniorage?), whereas a currency board country does not. But a dollarizing country, by completely eliminating the risk of currency devaluation, gains lower interest rates on foreign borrowing.
The analysis below examines these issues in more detail. Quantifying the potential savings from lower interest rates turns out to be more complex than it first appears, but the cost of seigniorage loss can be roughly estimated. Important effects on economic stability and global financial integration resist quantification. Giving up any possibility of devaluation is costly for some countries, negligible for others. And all must consider the implications of a reduced national role in providing lender of last resort facilities and backing for their banking systems.
Is dollarization, then, a better exchange rate regime, especially for developing countries? The answer for each country depends ultimately on its own unique characteristics, but a closer look at the pros and cons of dollarization offers some general guidance.
Box 2. What Is Seigniorage?
The ancient concept of seigniorage as a government’s profit from issuing coinage that costs less to mint than its face value is essentially the same with paper currencies: abstracting from the minor cost of printing paper money, seigniorage is simply the increase in the volume of domestic currency.
Currency can be thought of as non-interest bearing debt, and the ability to issue it as a source of revenue for the monetary authorities. In addition, reserve requirements on banks may also be non-interest bearing (or be remunerated well below market rates levels) and thus contribute to seigniorage. Thus, the annual flow of seigniorage is frequently measured as the increase in base money (the sum of currency plus bank reserves).
As counterpart of the issuance of currency, the central bank acquires assets that do pay interest, such as foreign currency reserves, government securities, and loans to private banks. In a currency board system, for example, the central bank must acquire foreign reserves in an amount equal to the domestic currency issue. As a result of issuing non-interest bearing debt (currency) and holding interest-earning assets (foreign reserves, etc.) the central bank earns a gross profit, which is often also called seigniorage by central banks.
The Risk Premium
An immediate benefit from eliminating the risk of devaluation is reducing the country risk premium on foreign borrowing and obtaining lower interest rates for the government and private investors. Lower interest rates and more stability in international capital movements cut the cost of servicing the public debt, and encourage higher investment and economic growth.
The magnitude of this potential gain is hard to measure. Argentina, now using a currency board under which the peso rate is fixed at a ratio of one-to-one to the U.S. dollar, provides a good example of the difficulties. There, a higher interest rate for borrowing in pesos than for U. S. dollars persists as evidence that lenders see a risk that the exchange rate peg will be abandoned. Yet interest rates on dollar-denominated Argentine government and private securities also exceed those on industrial countries’ debt, reflecting a risk of default by the country, or sovereign risk, on those securities.
With dollarization, the interest premium owing to devaluation risk would disappear, but the premium for sovereign risk would not. Since government and the private sector can choose to borrow in foreign or domestic currency in Argentina’s heavily dollarized economy, they can already eliminate the cost of devaluation risk by borrowing in dollars. The key question, then, is: would full dollarization, by eliminating currency risk, substantially reduce the default risk premium on dollar-denominated debt?
Examining yields on bonds with different features can help disentangle how markets perceive sovereign, or default, risk as distinct from devaluation risk. Sovereign risk can be measured by the spread on dollar-denominated Argentine government bonds over U. S. Treasuries. This spread has tended to come down with time, but has still averaged 3.3 percentage points during 199798. Devaluation risk can be measured by the spread between peso- and dollar-denominated Eurobonds, which averaged 2.5 percent over the same period.
Arguments exist on both sides of the question of how much of the sovereign, or default, risk to attribute to devaluation risk. Although sovereign risk and devaluation risk move closely together, this does not establish a causal link from one to the other. In fact, it is plausible that most of both dollar and peso spreads are explained by common factors. For example, a global “flight to quality” would raise both the measured risk of default and risk of devaluation. In this case, dollarization would not help reduce dollar spreads very much.
In fully dollarized Panama, for instance, the absence of currency risk does not insulate the country from swings in market sentiment toward emerging markets generally. Moreover, since movements in Panama’s spreads cannot reflect devaluation risk, the implication is that at least a part of Argentina’s spread also cannot be explained by currency risk alone.
Devaluation risk might increase sovereign risk for several reasons. For example, governments acting to avoid currency crises may be increasing the risk of default. Mexico did this in 1994 by issuing too many dollar-denominated bonds or dollar-indexed bonds in its defense of the peso. Or a government may impose capital controls, causing other debtors to default on dollar-denominated debt, as Russia did in 1998, blocking private debtors’ access to foreign currency, and preventing them from servicing their foreign debt obligations. Conversely, devaluation may reduce default risk by improving the domestic economy and the fiscal position, as it has in the European Monetary System. Even devaluations that initially slow the economy may improve longer-term prospects and thus reduce the risk of sovereign default.
Only by analyzing historical interest rate data for individual countries is it possible to get a sense of the magnitude of the reduction in the risk premium in the event of dollarization, inferring what markets assess as the probability of default on foreign debt in the absence of currency crisis risk.
Seigniorage
A country adopting a foreign currency as legal tender sacrifices its seigniorage, the profits accruing to the monetary authority from its right to issue currency. The immediate cost of this issuance can be significant, and it continues on an annual basis thereafter.
Dollarization involves two kinds of seigniorage loss. The first is the immediate “stock” cost: as the dollar is introduced and the domestic currency withdrawn from circulation, the monetary authorities must buy back the stock of domestic currency held by the public and banks, effectively returning to them the seigniorage that had accrued over time. Second, the monetary authorities would give up future seigniorage earnings stemming from the flow of new currency printed every year to satisfy the increase in money demand.
In the case of Argentina, the first, or stock, cost of dollarization would be the redemption of about $15 billion in domestic currency held outside the central bank, or about 4.0 percent of gross domestic product (GDP). In addition, the loss of seigniorage on account of the increase in currency demand would amount to about another $1.0 billion annually, or about 0.3 percent of GDP.
For countries that do not already have enough foreign reserves to buy up their domestic currency and thereby dollarize, the acquisition of the initial stock could add indirect costs. If the country lacks the credit to borrow the reserves, it would be forced to accumulate them through current account surpluses. The cost of this could be substantial in forgone investment if, as is usual for developing countries, the better policy would otherwise be to run some sustainable level of current account deficit.
The United States would get more seigniorage from dollarization in other countries. There is, therefore, a case for the U.S. authorities to share part or all of these additional seigniorage revenues with countries that adopt the U. S. dollar. A precedent exists in the arrangements between South Africa and three other states that use the rand (Lesotho, Namibia, and Swaziland). While the United States has no sharing arrangement with Panama or any other legally dollarized economy, there have been some initiatives in the U.S. Senate to consider legislation providing for seigniorage reimbursement.
Important as risk spreads and seigniorage are, dollarization may offer gains that, although not immediately observable, may provide larger benefits over time. In addition to raising developing countries’ borrowing costs, currency crises wreak havoc on the domestic economy. In Mexico, GDP fell by 7 percent in 1995, and the Asian countries affected by currency crises witnessed recessions in the range of 715 percent of GDP in 1998. Most of the severely affected countries in recent crises devalued and floated their exchange rate, but even countries with currency boards such as Hong Kong SAR and Argentina suffered fierce speculative attacks that, although weathered successfully, dealt them serious economic setbacks.
Dollarization will not eliminate the risk of external crises, since investors may flee because of problems of weakness in a country’s budget position or the soundness of the financial system. This sort of “debt crisis” can be as damaging as any other, and indeed, Panama has experienced several.
Nevertheless, dollarization holds the promise of a steadier market sentiment as the elimination of exchange rate risk would tend to limit the incidence and magnitude of crisis and contagion episodes. Moreover, large swings in international capital flows cause sharp business cycle fluctuations in emerging economies even when they do not involve balance of payments crises.
Effect on Trade and Financial Links
A powerful but still longer-term argument for full, legal dollarization is that it makes economic integration easier with the rest of the world, and insulation of the domestic financial system correspondingly more difficult. Dollarization may establish a firm basis for a sound financial sector, and thus promote strong and steady economic growth. The argument here is that dollarization is perceived as an irreversible institutional change toward low inflation, fiscal responsibility, and transparency.
Furthermore, dollarization may contribute to greater economic integration than otherwise would be possible with the United States, or any other country whose currency is adopted. A number of studies have found evidence that Canadian provinces tend to be more integrated in trade volume and price level differences among themselves than with U.S. states that are closer geographically, trading in the order of twenty times more among themselves than with nearby U. S. states. The use of a common currency may thus be a vital factor in market integration, given the fairly low transaction costs and restrictions to trade across the U.S.-Canada border.
Dollarization could also bring about a closer integration in financial markets. One of the most profound effects of Panama’s dollarization is the close integration of its banking system with that of the United States and indeed with the rest of the world, particularly since a major liberalization in 1969–70.
Exit Option
With full dollarization, a country completely gives up control of monetary and exchange rate policy. This may seem identical to currency board arrangements, since a country with a currency board cannot devalue. However, there is some scope for exit from the pegged exchange rate with a currency board, if only under extreme circumstances. Indeed, the elimination of this risk of devaluation is the main purpose of full dollarization.
Benefiting from Devaluation. Large shocks, such as a big jump in world oil prices or fall in the price of an important export, may require countries to devalue. Otherwise, they must absorb these shocks through lower nominal wages and adjustments in domestic prices. Substantial recession may then be unavoidable, particularly for economies with rigid labor markets.
Experiences such as departures from the gold standard and the 1994 devaluation of the CFA franc suggest that an exit option may have great value in the presence of extreme, unexpected shocks. During the Great Depression, for example, the industrial countries that fared best were those that exited earliest from the fixed exchange regime of the time—the gold standard. Argentina was one of them, suffering only a relatively minor economic setback by abandoning convertibility early, then actively stimulating the economy through monetary policy to offset the deflationary impact of capital outflows.