Dollarization in developing countries

It is the fall of 2014 in Argentina, and I need some cash. I have read enough about Argentina’s political situation to hear that going to an ATM machine here is a bad idea. As strange as it sounds, word is that I can get around twice as many pesos per dollar on the street versus a bank. And the strangest thing is it actually turns out to be true. From the hawkers yelling out “Dolares!! Dolares!!!” on Calle Florida to the exchanges hidden behind scary unmarked doors surrounded by burly guards to the random Western Union stores with unadvertised dollar exchange desks, it seems to be an open secret that the official government exchange rate is something that only a fool would follow. Welcome to Argentina. Don’t use the ATM machines.

Blue rate versus exchange rate

Why? What was happening here? The official and unofficial exchange rates existed because Argentina spent years trying to fight to stop the devaluation of its peso by using its currency reserves to buy up billions of pesos in an ultimately futile effort to try to keep their currency’s value higher than the market was saying it should be. This was coupled with currency and capitol controls that blocked money from leaving the country. Unfortunately, the case of Argentina proved that it is not possible to fight the market forever. The country’ biggest problem was that its people lacked confidence in the nation’s currency because Argentina has had so many historical episodes of inflation. It is completely normal and rational that people in countries with historically high levels of inflation would try to protect themselves against the expectation of inflation. How do they do so? One of the most common strategies used is to convert their local money into a foreign currency – typically the dollar. In fact, this is such a common strategy around the world that 80 percent of all U.S. bank notes in existence are actually $100 bills! Why? Those $100s are not being circulated or used, least of all in the United States. Instead, this 80 percent figure indirectly reveals that people all around the world are using U.S. banknotes as a type of savings account to protect themselves from their domestic currency’s volatility. This is what was happening in Argentina.

When I visited in 2014, Argentina had a street price (called the “blue” rate) for the dollar that was totally out of sync with the official exchange rate because demand for dollars due to distrust in the country’s peso was so high that people on the street were willing to sell many more Argentine Pesos for one dollar than Argentina’s government was trying to say their peso should be worth. Situations like this occur when people expect their domestic currency to continuously lose value through inflation. When this happens, people will be so willing or eager to get rid of that native currency in exchange for dollars that they will do so even if it means selling their currency at a rate far below the official exchange rate. This confusing system of official and unofficial exchange rates in Argentina finally collapsed this past January when a new president was sworn in and the effort to artificially maintain an official exchange rate was largely abandoned. It remains to be seen what will happen to the value of the Argentine Peso.

Argentina is not alone in this struggle. In fact, in some countries, the domestic currency situation deteriorates to the point that the dollar becomes a semi official or de facto medium of exchange. This is the situation in Cambodia where about 80 percent of the currency in circulation is dollars and ATM machines will only dispense dollars to people that hold non-Cambodian bank accounts. Ecuador has gone a step further and since 2000, the country joined El Salvador and Panama and no longer has its own currency. Ecuador dollarized. What does this term mean? And what is going on with these countries’ currencies?

Currencies in developing states such as Ecuador are frequently volatile because these countries have weak domestic markets, little manufactured exports, and currencies whose values are highly dependent on international capital markets that are themselves highly volatile. Developing countries like Ecuador often rely on raw material export markets for income to finance government expenditures. In Ecuador for example, 88 percent of exports come from primary products like oil, bananas, or shrimp! When raw material prices fall, government receipts in countries like these can no longer keep pace with expenditures and the only way to stay solvent is to borrow money by selling bonds. Unfortunately, given these countries’ tenuous economic situations, the interest rates on their bonds are usually high and only become higher the economy does not improve and borrowing has to continue (compare this to the US, which thanks to very low interest rates, can get away with routinely funding budget shortfalls by selling bonds). Faced with first budget shortfalls and then large debt payments, developing countries soon resort to printing more money to make up for their shortfall. Unfortunately, this is only a temporary solution because all that excess printed money soon causes rampant inflation. The country spirals down towards collapse and its citizens rush to convert their money into crisp $100 bills at whatever price they can get.

This brings me back to Ecuador. By 2000, the country was on its 42nd president since 1930. That works out to a new president about every year and a half. This is an unbelievable level of political volatility. The country was routinely among the most politically unstable in Latin America. Injected into this endemic political chaos in late 90s were a series of domestic and international crises that repeatedly hit the country’s economy. Rampant inflation hit the economy and by the end of 1999, Ecuador was on the verge of economic collapse. Faced with the prospect of hyperinflation, the country abandoned its currency and made the US dollar legal tender at the beginning of 2000. In a matter of months beginning on March 20, the government set an exchange rate of 25,000 Ecuadorian Sucre to one dollar, imported millions of U.S. coins and bank notes, converted all ATM machines, bank accounts and credit cards to USD, and shredded all of its old Sucre notes as quickly as people brought them in for exchange. Eight months after the announcement of dollarization, and after a 116-year reign as the country’s currency, the Ecuadorian Sucre ceased to exist as a currency on September 9, 2000. The whole exchange cost about $540 million but since it averted a total economic collapse, this price tag was probably a bargain.

Ecuadorian Sucres to Dollars

What happened next? One of the first problems encountered was with coins. Weirdly, United States coins do not actually have any numerical value printed on them (like a giant “25” stamped on one side of the quarter, for example). This caused immediate confusion because Ecuadorians had both little experience recognizing American coinage and limited English literacy to be able to read the value written on the coins. In addition, because prices in Ecuador are much lower than those in the United States, Ecuador had a much higher need for lower denomination notes and coins than the United States. For this reason, Ecuador imported about 20 million U.S. coins including millions of U.S. dollar coins (12 percent of all dollar coins minted by the US in 2011 went to Ecuador and El Salvador). The country needed so many dollar coins because these would last much longer in circulation than one-dollar bank notes and the country’s government knew that the $1 denomination would be in very high use and demand. For the same reason, Ecuador now mints its own 50-cent coin to supplement US minted coins. A two-dollar note or coin would probably also be very useful here. In my experience, no one ever has change for typical U.S. notes in common circulation because trying to use a $20 bill here at a convenience store is the equivalent to trying to do the same with a $50 bill in the US.

As far as monetary policy goes, Ecuador is subject to the United States Federal Reserve’s policies in almost the same that a U.S. state might be. The country’s monetary authorities have little to no control over interest rates or ability to increase or decrease the money supply. One positive consequence of this is that government-created inflation was essentially eliminated after dollarization: inflation rates collapsed almost immediately from 108 percent in 2000 to less than 2.5 percent today. This has made investing in Ecuador and buying Ecuadorian bonds much more stable and safer. In addition, since all bank accounts are in US dollars, bank deposits have grown since Ecuadorians no longer have to worry about Sucre denominated bank account deposits losing value from inflation. As opposed to hiding $100 dollar bills under the mattress, depositing money into banks injects capital into the economy that can then be invested to sustain and promote growth. Finally, poverty has decreased since dollarization since inflation no longer cuts into wages and economic confidence (and thus investment and stability) has increased. Studies show that after controlling for the changing price of raw materials, dollarization lowered inflation, increased GDP growth, and lowered economic uncertainty in Ecuador.

Unfortunately, dollarization does have its downsides. The U.S. Federal Reserve sets interest rates according to the business cycles within the United States, not Ecuador, and Ecuador has no ability to manipulate the value of its currency in order to boost exports, encourage lending, or otherwise stimulate its economy. Among other consequences, this impacts the ability of Ecuador to compete with neighboring countries with similar exports. It should be noted however, that this is a double-edged sword, since the volatility stemming from the country’s ability to manipulate the value of its currency was one of the causes of Ecuador’s rampant inflation in the first place.

Another consequence of dollarization is that Ecuador’s central bank is not able to function as a lender of last resort. This term means that should a bank in Ecuador be on the verge of failure and desperately need capital, Ecuador can only provide capital insofar as the country’s central bank has deposits of cash itself. This is because Ecuador no longer has the ability to print money at will. The country’s only real option in the event of a huge bank failure would be to ask an international lender such as the IMF for help. This contrasts with the ability of countries such as the United States that can essentially bail out banks by “printing money” to an almost unlimited degree should they choose to do so. Finally, the lack of a domestic currency means that Ecuador has to trade in old US bank notes or purchase new US banknotes to bring new currency into the country versus having the ability to print and sell (at a profit) its own notes. The income the countries make from being able to print money is called seigniorage.

And how does the United States feel about Ecuador or any other country adopting its currency? On the positive side, the U.S. gains some seignorage income from being able to print more money at a profit. In addition, U.S. companies profit from being able to more easily do business with dollarized economies because there are no currency conversion costs or unpredictability. In addition, the U.S. can be expected to benefit from the economic stability that dollarization seems to bring. Economic crashes and rampant inflation benefit neither the citizens of the economy that is imploding nor U.S. investors or political figures. Finally, dollarization can probably be seen as helping U.S. “soft power” by boosting the dollar as an international reserve currency and by increasing American prestige and influence abroad. Risks do exist, but they are relatively small because the countries that are dollarizing have such small economies relative to the United States. Basically, the U.S. faces some inflation risk from unexpectedly large inflows or outflows of physical currency from dollarized countries. In addition, the U.S. faces the theoretical risk that dollarized countries will exert political pressure on the Federal Reserve’s policy decisions since U.S. policies will impact dollarized foreign countries just as much as they do U.S. states.

I think the bottom line for me is that it is clear that using the U.S. dollar has brought stability in many different ways to Ecuador and that it has without a doubt increased the confidence of international investors in the country while also introducing an economic stability that the country had seldom before seen. Indeed, dollarization has coincided with one of their most stable governments in history! However, dollarization has also (and maybe irrevocably) removed all kinds of monetary power from the Ecuadorian government that is traditionally associated with sovereign states. On an emotional level as well, it must be a very odd experience for Ecuadorians to use bank notes printed in English and with U.S. Presidents and U.S. symbols on them. In addition to the cost of importing coins, this loss of national symbols is probably one of the reasons that countries that have dollarized like Ecuador and Panama continue to mint their own coins. Doing so provides at least some symbol of national unity. I think that the lesson for me after reading so much about dollarization is the realization of how much deeper the policy goes beyond what pieces of paper or pieces of metal people are choosing to use in the streets. The phenomenon reveals how tenuous many developing states currencies are as well as the unique and enviable position of the U.S. dollar as a stable unit of exchange in today’s global economy.

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