Dollarization: A Primer
Eduardo Levy Yeyati
and
Federico Sturzenegger
July 2001
1
Background
currency and financial crises  Conventional
pegs are running out of favor.
 Recent
 Bipolar view: Floats vs. “hard pegs” (CBA, currency
unions, unilateral dollarization).
Casual evidence:
Currency crises in South East Asia and Latin America
Monetary integration in Europe, EMU waiting list, African
ECOWAS
 Dollarization in Ecuador and El Salvador, other Latam
countries (Guatemala, Nicaragua).
2
Background
Speculative attacks on the HK dollar and the Argentine
peso and, in particular, the recent collapse of the
Argentine peso suggest that a currency board may not be
hard enough to avert a currency crisis.
 As a result, the recent discussion has increasingly
focused on the potential benefits of moving forward
towards full dollarization.
3
Where are we coming from?
 All long-standing dollarized economies were due to
historical and political reasons.
 Many are very small open subnational economies
(Panama is a clear outlier).
 Lack of relevant experiments.
4
Dollarized Countries
Country
Andorra
Channel Islands
Cocos Islands
Cyprus, Northern
Greenland
Guam
Kiribati
Liechstenstein
Marshall Islands
Micronesia
Monaco
Nauru
Niue
Norfolk Island
Northern Mariana Islands
Palau
Panama
Pitcairn Island
Puerto Rico
Saint Helena
Samoa, American
San Marino
Tokelau
Turks and Caicos Islands
Tuvalu
Vatican City
Virgin Islands, British
Virgin Islands, U.S.
Ecuador
El Salvador
Population
Political Status
Currency used
63,000
Independent
Frenc franc and Spanish
peseta
140,000
British dependencies
pound
sterling
600 Australian external territory
Australian dollar
180,000
de facto independent
Turkish lira
56,000 Danish self-governing region
Danish krone
150,000
U.S. territory
U.S. dollar
80,000
Independent
Australian dollar
31,000
Independent
Swiss franc
60,000
Independent
U.S. dollar
120,000
Independent
U.S. dollar
30,000
Independent
Euro (French franc since
1865)dollar
8,000
Independent
Australian
2,000 New Zealand self-governing
New Zealand dollar
2,000 AustralianTerritory
external territory
Australian dollar
48,000
U.S. commonwealth
U.S. dollar
18,000
Independent
U.S. dollar
2.5 m.
Independent
1 balboa = US$ 1; dollar
notes
56
British dependency
New Zealand
and US. dollars
3.5 m.
U.S. commonwealth
U.S. dollar
6,000
British colony
pound sterling
60,000
U.S. territory
U.S. dollar
24,000
Independent
Euro (Italian lira since 1897)
1,600
New Zealand territory
New Zealand dollar
14,000
British colony
U.S. dollar
10,000
Independent
Australian dollar
1,000
Independent
Euro (Italian lira since 1929)
17,000
British dependency
U.S. dollar
100,000
U.S. territory
U.S. dollar
12.9 m.
Independent
U.S. dollar
6.1 m.
Independent
U.S. dollar
Since
1278
1797
1955
1974
Before
1800
1898
1943
1921
1944
1944
1999
1914
1901
Before
1900
1944
1944
1904
1800s
1899
1834
1899
1999
1926
1973
1892
1999
1973
1917
2000
2001
5
Fix vs. flex: OCA Theory
Lower transaction costs (McKinnon) vs. loss of the
exchange rate instrument, inversely proportional to the
degree of factor mobility (Mundell), and the correlation
of shocks within the region (Kenen).
How relevant are OCA considerations in practice?
 Alternative motivations (linkage politics, credibility issues)
of existing unions and prospective candidates.
Free trade areas like ECM or NAFTA have shown substantial
trade gains without a common currency.
6
Fix vs. flex: Financial integration
 Impossible trinity: Under capital mobility, monetary
policies cannot be aimed both at maintaining stable
exchange rates and smoothing cyclical output
fluctuations.
 Capital account liberalization makes this restriction
more stringent ==> move to the extremes (Fischer,
2001).
7
The weak currency problem
Financial dollarization (as opposed to currency
substitution):
 Limits the scope of exchange rate fluctuations that monetary
authorities can afford to tolerate ==> fear of floating
 Imposes some of the constraints (e.g., LLR, inflation tax
base) associated with de jure dollarization
 Foreign currency-denominated external debt
introduces an additional currency mismatch.
8
Fix vs. flex: The credibility argument
 Tradeoff between a suboptimal response to external
shocks and the credibility gains of a monetary rule
(mitigation of the inflation bias the plagues a weak
currency):
 Hard peg as a commitment mechanism (credibility)
 Hard pegs as a source of fiscal discipline
 Dollarization as the extreme (irreversible) peg
9
The pros
Reduced transaction costs
Sources:
Exchange rate volatility.
Multiple currencies:
EC Commission estimates for EMU between 1/4
and ½ of GDP per year (presumably higher for less
developed economies with wider bid-ask spreads)
 Combined gains: Mixed evidence (Rose ,2000;
Persson, 2001).
10
The pros
Enhanced credibility
 Inflation convergence:
Significant inflation gains (Ghosh et al., 1999; Levy Yeyati
and Sturzenegger, 2001) while the hard peg lasts.
 Fiscal discipline:
Smaller government size and narrower fiscal deficits for CU,
but not for unilaterally dollarized economies (Fatas and Rose,
2001). Lack of relevant experiments.
11
The pros: Enhanced credibility
Fiscal Discipline (IMF reporting countries)
Currency Unions
Total Expenditure
Current Revenue
Overall Budget Surplus
Tax Revenue
Gov Consumption
Obs.
168
171
166
171
406
Mean Median Obs.
26.2
26.9
1639
21.9
23.1
1642
-2.5
-1.6
1630
18.0
20.3
1650
16.4
15.6
2023
Panama
Total Expenditure
Current Revenue
Overall Budget Surplus
Tax Revenue
Gov Consumption
1
Obs.
25
25
25
25
19
Non-CU
Mean Median
28.6
28.9
25.1
25.4
-3.5
-4.0
18.6
18.4
17.9
17.6
Mean
28.1
23.5
-4.2
19.4
15.6
Fix de facto (w/o CU)
Median Obs.
25.7
460
21.6
462
-3.3
449
17.3
463
14.3
608
Panama = CU
P-value
1
Mean
Medians
0.22
0.25
0.09
0.27
0.24
0.08
0.98
0.36
0.45
0.04
Mean
31.7
26.8
-4.5
21.6
17.7
Median
30.7
26.3
-3.4
18.3
16.3
Test (CU=NCU)
P-value
1
Means Medians
0.08
0.37
0.06
0.30
0.00
0.00
0.07
0.65
0.05
0.00
Test (CU=Fix)
P-value
1
Means Medians
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.00
0.03
Panama = Fix
P-value
1
Mean Medians
0.37
0.61
0.64
0.95
0.55
0.95
0.23
0.84
0.84
0.22
Wilcoxon / Mann-Whitney test
12
The pros
Fiscal discipline
Source of finance (in % of GDP)
9.0%
25,000
LECOP
Domestic market voluntary debt
International market voluntaree debt
International organisms
Privatizations and other capital income
Total financial needs (M of dollars)
8.0%
7.0%
20,000
6.0%
15,000
5.0%
4.0%
10,000
3.0%
2.0%
5,000
1.0%
0.0%
0
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
13
The pros
Reduced borrowing costs
 Powell-Sturzenegger (2001): Balance sheet dominates
seignorage only in financially dollarized economies.
14
The cons
Monetary policy
 Mixed evidence (Stein et al., 2001):
 Domestic rates in Latam seem to be more sensitive to external
financing costs (country risk) and to worldwide shocks (EMBI+
index) under more flexible regimes.
 No systematic countercyclicality under flexible regimes in
developing countries.
 Failure of international capital markets to “insure” developing
economies detracts from the usefulness of monetary policy.
15
The cons
Exchange rate flexibility
 Differential response to TOT shocks (Broda, 2001;
Edwards-Levy Yeyati, 2002).
 Greater output volatility (Ghosh et al., 1987) and
slower growth (Levy Yeyati-Sturzenegger, 2001, 2002).
 Financially dollarized countries cannot afford much
flexibility.
16
The cons
LLR
 Potential substitutes:
Outsourcing (e.g., Argentine Contingent Repo), both
centralized (CB) or decentralized (individual banks, parentsubsidiary implicit contract).
Difficult to generalize (who insures the insurer?)
Procyclical hedging
Liquidity buffer (similar to a DIS)
Costly in good times
Procyclical in bad times (De la Torre et al., 2002)
International LLR
 Financially dollarized economies face similar constraints
17
The cons
Seignorage
Depends on current and future demand for the local
currency.
Example: Constant real output growth g, inflation 
and currency-to-GDP ratio .
Seignorage: Perpetuity that pays interest i on a stock
m=GDP0 that grows at  = (1+)(1+g) -1.
S = (i  GDP0) / (i - )
Assumptions:  = 4%; r = (1 + i)/(1 + p) -1 = 4%, g = 3%, 
= 2% ==> S/GDP = 24%
18
The importance of initial conditions
 Identikit of a prospective dollarizer:
 Widespread financial dollarization (weak currency),
important trade links with other users of the foreign currency
to be adopted, and pervasive credibility problems that result in
high country risk and persistent high inflation, or frequent
currency collapses whenever they attempt to use an exchange
rate anchor.
 But…
 Dollarization does not impose discipline nor is it an
irreversible contract.
The pervasiveness of nominal rigidities and the lack of
insurance mechanisms may have been understated in the
debate.
19
Monetary union vs. Dollarization
Advantages of a MU:
 Seignorage sharing.
 Shared LLR (at least implicitly)
 Shared monetary policy, which may be active vis à vis
the rest of the world (EMU).
 As a result, it requires members to be in comparably
good stance ==> much longer transition period, but...
Institutional credibility borrowing: key for emerging
economies with weak currencies and institutions.
20