Dollarization is a term used to describe the spontaneous use of the U.S. dollar alongside a country’s domestic currency in transactions. Full dollarization of the economy, which means the dollar’s total replacement of the domestic currency, is widely discussed as a way of enabling developing countries to overcome monetary and exchange rate instability. What are the costs and benefits of dollarizing, and which developing countries are most likely to benefit?

A dollarizing country would be relinquishing any possibility of having an autonomous monetary and exchange rate policy

New Answers: The debate about the best exchange rate regime has been with us forever, but new answers keep appearing. The newest answer to the question of what exchange rate regime countries should choose is “none”. That is, countries should forgo using their own currencies entirely and adopt as legal tender a stable foreign currency, most commonly the U.S. dollar. Some prominent economists have begun to argue that essentially all developing countries should dollarize. During the 1980s, much of the debate about exchange rate regimes for developing countries centered on the role of exchange rate pegs in inflation-stabilization programs. Two distinguishing features of the 1990s have changed the terms of the discussion. First, the inflation problem has receded considerably. Second, as the degree of capital mobility and the scale of capital flows have increased sharply, so have the apparent frequency and severity of currency crises.
Because of those crises, the idea of full dollarization has elicited considerable interest. The view has emerged that in a world of high capital mobility, exchange rate pegs are an invitation to speculative attacks and that only extreme choices-a firm peg such as a currency board or a free float-are viable. Advocates of dollarization have attacked both of these alternatives. Free floats, they argue, are not viable for many countries because they result in excessive exchange rate volatility if the authorities resist exchange rate movements. Meanwhile, it has become clear that even currency boards are not immune to costly speculative attacks.
Full dollarization promises a way of avoiding currency and balance of payments crises. Without a domestic currency, there is no possibility of a sharp depreciation, and sudden capital outflows motivated by fears of devaluation are ruled out. Dollarization may also bring closer integration with the global economy as promoted by lower transaction costs and an assured stability of prices in dollar terms. By definitively rejecting the possibility of inflationary finance, dollarization might also strengthen institutions and boost investment.
Yet countries may be reluctant to abandon their own currencies. For one thing, the currency is a national symbol, and proposals to join a monetary union (or directly adopt the U.S. dollar) may draw criticism from some political quarters. From an economic point of view, the right to issue currency provides the government with seigniorage revenues. The central bank can use currency, which does not bear interest, to purchase interest-bearing assets, such as foreign reserves. These seigniorage revenues show up as central bank profits and are transferred to the government. Countries that dollarized their economics would lose these revenues unless the United States decided to share part of the extra seigniorage it would obtain. In addition, a dollarizing country would be relinquishing any possibility of having an autonomous monetary and exchange rate policy, including the use of central bank credit to provide liquidity support to its banking system.
Is dollarization, then, a better exchange rate regime for developing countries? To simplify the discussion, we compare the merits of dollarization to those of its nearest competitor – the currency board. Under a currency board arrangement, the monetary authorities commit to trade foreign exchange for domestic currency on demand at a fixed rate of exchange. This is the only mechanism the central bank can use to increase the base money supply. Thus, the domestic currency is fully backed by a corresponding stock of foreign exchange. Currency board and dollarization arrangements are quite similar, but a comparison is nonetheless revealing. Dollarization implies the loss of seigniorage revenue for the government. But dollarization’s key distinguishing feature is that it would be nearly permanent and irreversible. It would presumably be much more difficult to reverse dollarization than to modify or abandon a currency board arrangement.

Risk Premiums: An expected benefit from the elimination of the risk of devaluation would be a reduction of country risk premiums, and thus lower interest rates, which would result in a lower cost of servicing the public debt and also in increased investment and faster economic growth. With dollarization, the interest premiums owing to devaluation risk would disappear but sovereign risk would not.
Of course, dollarization would not completely eliminate the risk of external crises. Nevertheless, dollarization holds the promise of at least reducing the frequency and scale of crises and incidences of contagion.
In addition to promoting financial integration, dollarization may contribute to trade integration with leading economies that would not be possible otherwise.

Seigniorage: A country adopting a foreign currency as its legal tender would lose the income from seigniorage. First, the country would have to purchase the stock of domestic currency held by the public and banks with dollars from the country’s international reserves or with borrowed funds. Second, the country would give up future seigniorage earnings stemming from the flow of new currency printed every year to satisfy the increase in the demand for money. These increases are likely to become smaller over time, however, as financial development results in a reduced need for currency to effect transactions.

Exit option: Suppose that the real exchange rate in a dollarized country becomes overvalued. This may result from excessive wage increases, a sharp deterioration in its terms of trade, or the dollar itself becoming overvalued relative to the currencies of other important trading partners. Countries with flexible exchange rate regimes can adjust by allowing depreciation to occur in a gradual and nontraumatic way. With dollarization or fixed rates, the real devaluation must be achieved through a fall in nominal wages and prices. Experience has shown that these declines are often achieved only at the cost of economic recessions, because resistance to nominal wage and price reductions can be strong. Countries with currency boards have, of course, already eliminated much of their choice with regard to the exchange rate. But what distinguishes such countries from dollarized economies is that, in extreme cases, the former can devalue more easily.

Despite those experiences, many countries might not profit from an exit option even when the currency is overvalued. Where policymakers have little credibility, or where the dollar is already the unit of account, a nominal devaluation may rapidly lead to enough inflation to undo the positive effects. This implies that devaluation may be a prohibitively costly policy option in some cases and that moving to full dollarization would not entail the loss of an important policy tool.
As lenders of last resort, central banks stand ready to provide liquidity to the banking system in the event of a systemic bank run. The central bank does this essentially by using its ability to create liquidity-something that it would not have in a dollarized system. Currency boards face a similar constraint, because they can create base money only to the extent that they accumulate reserves. Countries with currency board arrangements can, however, retain some flexibility to create money that is not fully backed by reserves, so as to be able to deal with the risk of banking crises.
In a dollarized economy, as in an economy with a currency board, the authorities have the option of obtaining lines of credit from external sources that might be used in the event of a crisis. Experience so far with such lines of credit suggests, however, that they may not be very useful precisely when they are needed, because foreign banks have many ways to reduce their exposures to a country experiencing a serious crisis.
In any case, the importance of a curtailment of the lender-of-last-resort function should not be exaggerated, because the ability of a central bank to deal with a financial crisis solely by printing money is inevitably limited. Dollarization may, moreover, make a bank run less likely. If there are not significant currency mismatches in the banks’positions, depositors may have more confidence in the domestic banking system.