Sovereignty Sinks in Latin America as Dollar Rises

Sovereignty Sinks in Latin America as Dollarization Rises

• Globalization has created as many losers as winners in Latin America.

• Of the three fully dollarized Latin American countries, not one has experienced compelling benefits from the adoption of the U.S. currency.

• Panama represents the most successful example of a dollarized country, but still remains underdeveloped and is stuck in a cycle of dependency.

• Partial dollarization allows a country to create its own central bank and establish tighter control over its own economy.

• Partial dollarization involves less risk of insolvency than full dollarization.

• The bottom line is that dollarized societies give up a big chunk of their sovereignty.

Dollarization, which is the official adoption of the U.S. dollar (USD) as the national currency has sometimes delivered a mixed signal to several Latin American nations. Globalization—the increased economic interdependence and integration of countries fuelled by the digital age—has led to intercontinental competition in the production of commodities and services. National currencies are no exception. According to a study done by Benjamin Cohen, market dominance in the field of international currencies uniquely belongs to the developed countries of the northern hemisphere just as is the case in other facets of global trade. Not surprisingly, the most widely used international currency is the USD because of its traditional dominance in the global economy, with a 16 percent market share in commercial service exports and 9.6 percent share in merchandise trade. Globalization, along with increased capital flows (the movement of foreign exchange across borders) and developing nations’ weak financial institutions have sent more countries into the economic periphery of the international financial system than free trade proponents would like to believe.

U.S. dominance of global trade and commerce can be harmful to the national currencies of Latin America’s less developed nations, which as in all other facets of international trade, find it difficult to compete in the global economy. The reluctant economic hegemony by the northern states often leads to currency crises in poor nations. Latin American countries are not immune to the widespread currency instability that has seized many developing nations.

The USD also provides a form of financial measurement for countries prone to erratic economic policies. Dollarization affords them the discipline and financial credibility necessary to attract foreign investment and the stability to effectively be integrated into global markets. Dollarization also reduces the transaction costs associated with currency conversion for poor South American countries—a main factor in the European Union’s decision to adopt the euro as its single currency. Nevertheless, the question remains whether the benefits of dollarization are worth the loss of economic autonomy for Latin American countries.

Weighing the Costs and Benefits
In the short run, dollarization brings up a number of specific benefits. First, central banks are encouraged to ensure the reliability and efficiency of the general financial system, as they are discouraged from lending money to inefficient banks because of their position as a currency distributor. Second, because under this system, the government does not print its own currency under this system, it must diversify its economy by financing its public debt through alternate means.

However, some would argue that dollarization is not sustainable in the long run, particularly since the USD has recently witnessed its devaluation relative to other major world currencies such as the euro and the yen. If the USD were to lose more value, its importance in the international financial system would diminish significantly and the euro would gain in relevance. While this scenario would benefit developing countries whose monetary units are pegged to a group of currencies other than the USD, it would be detrimental to the economies of countries that have dollarized.

Another risk of dollarization lies in the large U.S.’ trade deficits, which could potentially destabilize the world’s financial system. If the U.S. were ever to consider defaulting on its debts, a worldwide currency crisis reminiscent of the Great Depression of the 1930s could result, severely harming dollarized Latin American countries. Another facet to consider is that the benefits of seigniorage— the difference between the cost of producing a currency and the actual purchasing power of the money—will be lost with the adoption the USD, causing the dollarized countries to forfeit this source of revenue and transfer it to the U.S. government. Dollarized countries also effectively shift all monetary decision-making powers to the U.S. Federal Reserve, an entity that is not particularly motivated to take into consideration the effects its policies will have on the dollarized countries.

The Fully Dollarized Countries
In the late 1990s, the growing external debt held by Latin American countries and the cycle of recession and inflation which inevitably accompanied it, exacerbated currency problems and played into Ecuador and El Salvador’s decisions to dollarize in 2001, with Panama had already adopted the USD after it achieved its independence from Colombia in 1904.

Panama’s Dollarization
Since gaining independence, Panama has used the USD for all official transactions and has no central bank to distribute or oversee the currency. The traditional balboa is still in use, but the exchange rate to the dollar is one to one and the old currency is considered a USD, only differing in appearance.

Of the three dollarized Latin American countries, the Panamanian case is the closest the strategy has come to being successful. Panama exhibits optimistic economic indicators and a stable inflation rate, which has stayed at 1.7 percent for some 30 years—lower than that of the U.S. The country also enjoys an open banking system and a large volume of international trade. However, Panama’s relative success cannot be attributed entirely to its dollarization. For example, a 1970 banking law effectively integrated Panama’s monetary system with world financial markets, bringing an influx of foreign banks into the country.

After more than a century of dollarization, the country remains more or less as underdeveloped as the rest of Latin America. The principal disadvantage of the long-standing dollarization policy is Panama’s continued dependence on both the International Monetary Fund (IMF) and the U.S. Treasury Department. Panamanian officials are unable to either print the country’s own currency or control its public finances. Without a central bank, the government has no lender of last resort and is thus unable to rapidly and decisively respond to any potential domestic financial crises. Over a period of 19 years, the IMF has maintained an uninterrupted series of financial programs in Panama, imposing a significant long-term dependency on the country. In other words, dollarization has left Panama with no national currency, no central bank and a significantly decreased domestic control of the financial sector, all of which has largely eroded its national economic sovereignty. Additionally, due to its constraining effect on the government’s ability to be flexible in dealing with both external and internal shocks, dollarization has increased the vulnerability of Panama’s financial system as well as its overall economy. In all, it can not be emphasized enough that imposing the dollarization strategy on Panama, or any other country for that matter, creates a significant threat to a nation’s fiscal and monetary sovereignty.

Ecuador’s Dollarization
In Ecuador, the dollarization process was set in motion after a severe economic collapse in 1999. Dollarization helped Ecuador solve its short-term rampant hyperinflation when the sucre went from an exchange rate of 7,000 to one with the USD in 1999, before soaring to 25,000 to one USD in 2001. The Economic Transformation Act was approved on January 9, 2000, and implemented in 2001. It required that the government stop printing the sucre and declared the USD the country’s official currency. In the first year after the Ecuadorian government completed dollarization, economic recovery was rapid and encouraging.

However, the strategy did not bring significant benefits to Ecuador in the years following its implementation. Rather, the immediate consequence of dollarization was a political crisis that eventually led to the downfall of then-President Jamil Mahuad. When Quito police refused to quell protests against his dollarization decree in the capital on January 21, 2000, demonstrators occupied the National Assembly building and within 24 hours Mahuad was forced to flee the presidential palace. Despite the fact that dollarization was meant to boost Ecuador’s economy, the country is still dominated by poverty and a high disparity in income. As in Panama, the financial system has become more vulnerable to both internal and external crises because of the limits which dollarization places on the flexibility of response. In addition, popular protests continue to flare up and dollar counterfeiting is a widespread problem. While the immediate economic effects of dollarization in Ecuador were beneficial, an assessment of the long term effects is less optimistic and, as in Panama, must take into account the continuing erosion of the country’s sovereignty.

El Salvador’s Dollarization
El Salvador’s dollarization proposal was passed in December 2000 under the presidency of Francisco Flores and took effect on January 1, 2001, with the exchange rate set at 8.75 colones to one USD. In contrast with Ecuador, El Salvador was already an intimate servitor of Washington and had enjoyed economic stability and relatively low inflation previous to dollarization. The strategy was implemented in an attempt to reduce interest rates, instill confidence in potential investors, and promote economic growth, rather than as a last resort solution to financial crisis.

El Salvador’s adoption of dollarization was marked by chaos and delay. The shift was complicated by the infusion of counterfeit bills into the marketplace, in part because there was no campaign to educate the public on the exchange rate and value of the new currency. The quick implementation of the new strategy (proposed in December and put into effect just one month later) contributed to the rough transition and allowed little time for adjustment.

In 2001, the consequences of the dollarization strategy did not look particularly promising as Salvadorans struggled to adjust to the new currency and to a tight monetary policy which negatively affected economic growth. The increase in GNP was recorded at only 1.8 percent as compared with 2.2 percent in 2000 and 3.4 percent in 1999. Nevertheless, the financial transition cannot be entirely blamed for this stagnation, given the simultaneous decline in oil, sugar and coffee prices, which negatively affected El Salvador’s export revenues. Overall, significant benefits from the currency switch have not yet become evidence in El Salvador.

The loss of national sovereignty in El Salvador must also be taken into account. Increasing dependence on and accountability to the U.S. may well be why El Salvador is the only Latin American country maintaining troops in Iraq. The Salvadoran regiment first went there as part of a Central American battalion in August 2003, but is now the sole unit of the original group still supporting the U.S. cause.

Lessons Learned
As Panama, Ecuador and El Salvador have demonstrated by their lack of significant sustainable development in the years following dollarization, this strategy is must be accompanied by fundamental transformations in financial and banking institutions. Since economic progress has been relatively slow in these three countries, thus defeating part of the purpose of dollarization, some critics believe that other macroeconomic strategies need to be explored for their potential to spur economic growth.

The options open to a country attempting to reduce hyperinflation are numerous and the effects of each model depend on the degree of implementation and on the country’s specific situation. For example, the fiscal policy option involves increasing taxes and decreasing subsidies and government spending; this might tame hyperinflation by decreasing the amount of money in circulation.

Partial Dollarization: A Better Option?
A government wishing to reduce its inflation rate while gaining the economic benefits of co-opting another country’s currency can pursue partial rather than full dollarization. There are three types of partial dollarization: dollarization of payments (residents of the country use foreign currency to make all purchases), financial dollarization (resident’s assets and liabilities are locally held in another country’s legal tender), and real dollarization (foreign currency is used to index domestic prices). A number of Latin American countries have taken advantage of partial dollarization, including Argentina during the decade of rule by President Carlos Menem. By the end of 2001, the percentage of foreign currency being used throughout the region was 84.8 percent in Bolivia, 82.2 percent in Uruguay, 62.8 in Argentina and 43.6 percent in Costa Rica.

Unlike full dollarization, partial dollarization allows countries to use discretionary monetary policies in maintaining control over their economies. A partially dollarized economic plan can set up a central bank with the capacity to manipulate interest rates, sell securities and increase bank reserve requirements in order to better manage the money supply and control inflation.
Though partial dollarization increases a government’s capacity to control its economy, buried within it are important solvency risks. If foreign currency liabilities outweigh assets, then a currency mismatch is created in the bank’s balance sheets and local currency tends to depreciate. This situation occurs when a bank accepts deposits in foreign currency and makes loans in domestic currency. The negative effects of mismatches are detrimental because fluctuations in domestic currency depreciation cause some borrowers to default on their loans.

Lowering solvency risks can be achieved by adopting complementary policies. Banks deposit large amounts of liquid assets in foreign currency abroad or in cash to act as a buffer in case of a possible bank run. In some countries, banks are required by law to maintain safeguards; in other nations, banks voluntarily create them. The size of a buffer is often determined by the amount of international reserves in the central bank. These complementary policies imposed on banks, or assumed by them, are aimed at internalizing the risks of dollarization.

Those who oppose partial dollarization believe a central bank interferes with a country’s economic system and is detrimental to the resident banks. Although the stance that government intervention in the economy curbs macroeconomic growth often has a strong basis, central banks are too important for a country’s economic well-being to be eliminated. They allow for the government to make certain that private banks are stable. Through reserve requirements, the central bank ensures that a country’s banking system will not loan out so much money that banks are not able to guarantee withdrawals to account holders. Furthermore, without a central bank, a country does not have the option of using monetary policy to stabilize the economy.

It is true that there is no perfect economic system. Countries can adopt economic policies that decrease the risk of hyperinflation or recession, but there is no way to entirely avoid economic shocks. Latin American countries can benefit from partial dollarization if they are also able to maintain a strict monetary policy. This strategy has the advantage of using another nations’ currency while allowing each country to establish a central bank. Importantly, if the foreign legal tender in use depreciates, the country’s economy is not injured as severely as it would be in the case of full dollarization. While partial dollarization seems to avoid full dollarization’s pitfalls, its long-term effects remain uncertain. In the short run, though, it is a fact that a number of Latin American countries have effectively employed partial dollarization to stabilize their economies and stimulate growth.

This commentary was prepared by COHA Research Associates Caitlin Hicks, Cate Johnston and Shelliann Powell.

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