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Why Dollarization is More Straitjacket than
Salvation
By Jeffrey Sachs and Felipe Larrain*
The recent wave of financial crises has prompted some observers to argue that developing countries should abandon their own currencies and instead adopt the U.S. dollar. This conclusion is unwarranted, even reckless. Dollarization is an extreme solution to market instability that has severe costs and would fail developing countries, including those hardest hit the by recent crises.
There are two main arguments in favor of flexible exchange rates and two main arguments in favor of fixed ones. The first argument for flexibility is that an exchange rate depreciation (or appreciation) can act like a shock absorber for an economy. The second argument for flexible exchange rates is that what is good for the United States is not necessarily good for other countries. The main argument for a pegged rate system, by contrast, is that it enforces discipline. The second argument is that there is little cost and no risk in changing currencies if the exchange rate remains stable.
Recent practical experience suggests that most emerging markets are better off with a flexible exchange rate. First, many countries in the last several years have been unable to resist the pressure that builds when markets come to expect that their exchange rates will depreciate. Second, a failed defense can be very costly: A country will find itself in serious trouble if its central bank runs out of reserves trying to defend the national currency. Third, U.S. monetary policy is seldom appropriate for countries whose currencies are pegged to the dollar. Fourth, many emerging markets have experienced sharp declines in world prices for their commodity exports, which demanded either a currency depreciation or a politically treacherous drop in wage levels. Finally, contrary to the conventional wisdom, countries with significant degrees of exchange rate flexibility have behaved with real responsibility, keeping money growth low and inflation under control, even without the straitjacket of a pegged rate or dollarization.
If a country abandons its national currency in favor of the U.S. dollar, the result is very much like a pegged exchange rate. There are, however, some important differences, both plus and minus.
One sharp minus to dollarization is its cost. In opting to dollarize, a country would be forgoing the income it receives when the value of its currency exceeds the cost of producing the currency. Instead of making a profit from its national currency, the dollarizing country would be faced with the expense of buying dollars to swap for its national currency, paying for these dollars either with its foreign reserves or a large dollar-denominated loan.
Another sharp minus is the absence of a lender of last resort to the banking sector. Once a country has dollarized, there is no longer a national central bank that can make dollars available in the event of a sudden withdrawal of bank deposits or string of bank failures.
A final sharp difference (one that is a plus, but also a significant minus) between dollarization and a pegged exchange rate is that dollarization is nearly irreversible. This factor is good in that it allays any fears of a possible collapse of a pegged rate or even of a currency board. However, it can be equally bad if a country gets hit by a rare but extreme shock and desperately needs a currency depreciation.
There may be a golden mean for some countries between the gains from a common currency and the gains from flexibility: the regionalization, rather than dollarization, of national currencies. Suppose countries that are close neighbors have approximately the same economic structure, face the same international shocks, and do a lot of business with one another. They might want to adopt a common currency within the neighborhood, but one that remains flexible vis-à-vis other major currencies such as the U.S. dollar. Many members of the European Union have made precisely that choice. Several additional candidate regions around the world come immediately to mind, and two in Latin America especially: mercosur countries in South America and the Central American countries other than Panama (which is already dollarized).
The world financial system has become treacherous in recent years, especially since many players have not yet learned the ins and outs of globalization. Countries need to learn how to manage financial risks, and a good exchange rate system is part of good risk management.
Flexible exchange rates (either at a national or regional level) are a useful absorber for external shocks. Countries should attempt to limit inflows of hot money, especially very short-term loans from international banks. And countries should strengthen the operating capacity of their central banks and give such banks sufficient independence, so that they can resist political pressures for excessive monetary expansion. Advocates of dollarization are wrong to think that developing countries are congenitally incapable of managing a noninflationary currency. They are correct, however, to warn of the risks and to emphasize the importance of institutional design to ensure the central bank has the professionalism and protection from daily politics that it needs to do a responsible job.
References
John Maynard Keynes’ “The Economic Consequences of Mr. Churchill,” from Keynes’ Essays in Persuasion (New York: W.W. Norton & Company, 1991)
Felipe Larrain’s “Going Green” (World Link, May/June 1999)
Larrain and Velasco’s “Exchange Rate Policy for Emerging Markets: One Size Does Not Fit All,” a working paper (Cambridge: Harvard University, August 1999)
Larrain, ed., Capital Flows, Capital Controls and Currency Crises: Latin America in the 1990s (Ann Arbor: University of Michigan Press, forthcoming)
Jeffrey Sachs and Larrain’s Macroeconomics in the Global Economy (Englewood Cliffs: Prentice Hall and Harvester Wheatsheaf, 1993)
Sachs’ “Exchange Rate Regimes in Transition Economies” (American Economic Review Papers and Proceedings, May 1997)
Sachs’ “Creditor Panics: Causes and Remedies” (Cato Journal, Winter 1999)
Sachs, Aaron Tornell, and Andres Velasco’s “Financial Crises in Emerging Markets: The Lessons from 1995” (Brookings Papers on Economic Activity, 1996)
Sachs and Steve Radelet’s “The East Asian Financial Crisis: Diagnosis, Remedies, Prospects” (Brookings Papers on Economic Activity, 1998)
Endnotes
*: Jeffrey Sachs is Gallen L. Stone professor of international trade and director of the Center for International Development at Harvard University. Felipe Larrain is Robert F. Kennedy visiting professor of Latin American studies at the John F. Kennedy School of Government and the Harvard Institute for International Development. Back.