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As more nations in the Western hemisphere consider adopting the U.S. dollar as their own major currency, this IMP economist separates the fact from the fiction concerning dollarization. How will dollarized nations react to a U.S. monetary policy over which they have no say?
FULL dollarization is attracting increasing attention in both policy-making and academic circles, particularly in the Western Hemisphere. [1] Is this a fad or a future for many small countries wishing to join larger monetary and financial integrations? The advent of the euro, the Argentine dollarization project, and recent currency crises in East Asia, Russia, and Brazil seem to have spurred this renewed interest in full dollarization. But, surprisingly, very little is known about fully dollarized economies and their basic characteristics. Even references on Panama, the best-known dollarized economy, often lack comprehensive analyses of its dollarization experience.
This article attempts to remedy the shortage by discussing some basic facts and questions that are likely to figure prominently in the ongoing and future policy debates on full dollarization, a term used here as shorthand to refer to the use of any foreign currency, not only the U.S. dollar.
Fully Dollarized and Bimonetary Systems
Full dollarization is a complete monetary union with a foreign country from which a country "imports" a currency by making the foreign currency full legal tender and reducing its own currency, if any, to a subsidiary role. (Full legal tender means not only that a currency is legally used in contracts between private parties, but also that the government accepts it, and may use it in payments.) In a few countries, which are also included in this category as borderline cases--perhaps better called bimonetary systems--a foreign currency is used widely in the role of legal tender but it is subsidiary to the domestic currency.
Despite unofficial use of foreign currency in many countries, only a few countries (independent nations and dependencies) have officially adopted a foreign currency as legal tender. The reasons that full dollarization is not more widespread include the political symbolism of a national currency, historical patterns of use of domestic and foreign currency, and economic factors such as the perceived costs of dollarization.
Full dollarization has more than one form. Fully dollarized economies vary with respect to the number of foreign currencies they allow to circulate as full legal tender and with respect to the relationship between domestic currency, if it exists, and foreign currency. Most dollarized countries give only one f oreign currency full legal-tender status, but Andorra gives it to both the French franc and the Spanish peseta (both now subdivisions of the euro). Dollarization need not mean that a single foreign currency is the full and only legal tender. Freedom of choice provides some protection from being stuck using a foreign currency that may become unstable.
About 11 million people live in fully dollarized economies today (see table 1 in Bogetic 1999). All of these economies are small, many are islands, often with only a few thousand inhabitants. Six are members of the International Monetary Fund (IMF): Kiribati, the Marshall Islands, Micronesia, Palau, Panama, and San Marino. Of these, the best-known is Panama, which has 2.7 million people and a gross domestic product (GDP) of more than US$9 billion.
Most fully dollarized economies have convertibility for current-account transactions. Five of the six that are members of the IMF have long accepted Article VIII status. [2] Dollarized economies typically also have few or no restrictions on capital-account transactions (tables 2 and 4 in Bogetic 1999).
A variation of full dollarization is what one might call an officially bimonetary system, in which a foreign currency is legal tender and may dominate bank deposits, but may not dominate payment of wages, taxes, and everyday transactions. In that sense, the foreign legal tender plays a subsidiary role in the domestic monetary system. Based on these criteria, a number of countries and territories could be classified as bimonetary systems (table 2). [3] Again, all are small, though the average size is larger than in the case of fully dollarized economies. Examples are Namibia and Lesotho, which are members of the common monetary area (CMA) with South Africa. They are also the only independent countries that collect seigniorage from either dollarization or a bimonetary system (see section below on seigniorage sharing). The CMA has an agreement for sharing seigniorage and for maintaining common exchange controls with respect to outside countries. The Namibian dollar and the Lesotho loti both circulate at a one-t o-one ratio with the South African rand.
Much like the fully dollarized systems, bimonetary systems typically have highly open economies with liberal current and capital account regulations. They tend to be located in the neighborhood of a dominant economy or groups of economies with which they conduct much of their trade and capital transactions. Hence, the use of the foreign currency in their domestic economies is often necessitated by virtue of their openness and heavy reliance on trade (and factor mobility) with their larger neighbors.
Panama's Experience with Full Dollarization
Panama is the largest fully dollarized economy with almost a hundred years of experience with such a system. While it is, therefore, a natural "laboratory" for understanding how such a system might work in other settings, any inferences must make appropriate allowance for Panama's specific (and, in some respects, not representative) circumstances. The following is a brief overview of some salient characteristics of Panama's experience with full dollarization (for more details, see Moreno-Villalaz 1999).
Monetary System. Since 1904, Panama has used the U.S. dollar notes (paper money) as domestic currency. Panama issues a domestic currency, the balboa (1 balboa = US$1), but it circulates only as coins. Foreign banks have a significant presence in Panama's financial system. There is no central bank and no centralized foreign reserves. The Banco Nacional de Panam[acute{a}] (BNP) is a government-owned commercial bank.
Role of Foreign Banks. In 1970, a banking law liberalized Panama's financial markets and allowed full entry of foreign banks. The capital account is entirely open, and banks are free to invest excess funds in Panama or abroad. Arguably, full financial integration into the world economy and the consequent ability of banks to adjust their portfolios freely between domestic and foreign assets has been an important mechanism of domestic adjustment, preventing the booms and busts in lending, overvalued exchange rates, and falling foreign reserves that have plagued other countries in the region. Foreign banks, mainly U.S. banks, have been de facto lenders of last resort, increasing their exposure to the domestic economy when it has suffered unfavorable shocks because they have perceived opportunities for profitable lending.
Macroeconomic Performance. Inflation averaged 3 percent a year in the 1961-97 period, almost 2 percent lower than in the United States. According to IMF data, in the 1975-98 period, average annual growth in Panama (3.6 percent) exceeded the averages for Central American countries (2.9 percent) and the Western Hemisphere as a whole (3.2 percent). Real interest rates have remained in low to middle single digits. The real exchange rate has shown little variation compared with the real exchange rates of other Latin American countries. There have been no systemic banking crises.
Lender of Last Resort and Banking Supervision. Panama has no domestic lender of last resort. Domestic banks have established lines of credits with foreign banks with branches in Panama and have been able to draw on them during liquidity crunches. The Panamanian government and BNP have not rescued failing banks, but only a few banks have failed in the past thirty years. A privately funded deposit insurance scheme is in the process of being established in accordance with a 1998 law, but as of this writing, the details have not been announced. In 1998, Panama established a new supervisory office of superintendent of banks; before then, a supervisory agency existed but its powers and impact were marginal. Foreign banks are subject to their home country supervision and regulation.
