As a symbol of a nation's sovereignty, independent countries usually have their own
currency produced by their Central Banks. In some states, national currencies have reduced in
strength or disappeared in totality due to different reasons losing its usefulness as a medium of
exchange within the borders of the country and in the global market. In such cases, these
countries have the option of adopting a foreign currency to salvage their weakened currency
situations. The foreign currency, usually the US dollar in most cases, can either be used together
with or instead of the country's domestic currency (Brown, De Haas & Sokolov, 2018). This
process is what is known as dollarization, and it usually results in the local currency having
almost the same value and the stability that comes with the US dollar.
Nations can opt for unofficial or official dollarization. In official dollarization, the local
government declares the US dollar to be an official medium of exchange. In some cases, these
countries still allow the use of their domestic currency in parallel, but in other cases, the US
dollar replaces the local money entirely. However, the government discontinues the production
of its local currency by the central bank (Brown et al., 2018). On the other hand, in unofficial
dollarization, the government does not declare the foreign exchange as an official legal tender.
However, the citizens still hold lots of wealth in foreign currency. A nation can also go for
partial dollarization, where it keeps the production of currency through the central bank but still
enforce the US dollar as an official legal tender.
Different nations go for dollarization for various reasons. The significant reason mostly is
for enhanced stability, both economic stability and enhanced monetary system. Another reason
for dollarization is to reduce the rates of inflation in the country presently and future rates as well
(Brown et al., 2018). The potential reduction in the costs of a transaction after dollarization is
DOLLARIZATION 3
also a reason. The reduction is because the nation can comfortably compete in the global markets
against other currencies like the Yen or the Euro.
However, there are few disadvantages to adopting a foreign currency. For example, when
a country gives up the option of printing its own money, the country loses its ability to directly
influence its economy, continually relying on the US economy for decision -making purposes.
The central bank in a fully dollarized economy also loses its role as the lender of last resort for
the other banks in the country (Brown et al., 2018). The use of the US dollar instead of a local
currency damages a nation's sense of pride as it no longer feels like a sovereign state.
Definition and Discussion of Policies that Fall Under Dollarization
Systems guide decision making to achieve rational and reasonable outcomes. Policies
usually show intent and are implemented as a procedure or a way of doing something, often
different from rules or laws. Dollarization also has policies that govern the process to allow more
accessible communication to the countries going through dollarization; to provide a clear
roadmap on the day to day operations of the process (Marcelin & Mathur, 2016). In the
subsequent paragraphs, we discuss the different policies that fall under dollarization.
Financial repression and capital controls policy is an example of policies that fall under
dollarization. Capital controls refer to measures taken to limit the flow of foreign capital in and
out of the country through legislation, taxes, and tariffs (Marcelin & Mathur, 2016). Therefore to
allow dollarization to take place, countries such as Nigeria and Venezuela introduced policies
that imposed capital controls and repressed financial transactions. Imposing controls means that
there was no limit in the flow of foreign currency in and out of the country. As a result, these two
countries adopted the use of the US dollar as a currency in their nation and became dollarized
(Marcelin & Mathur, 2016). Besides, introducing legislative policies that permit the use of
DOLLARIZATION 4
foreign currency as a legal tender allows the country to adopt the currencies in an attempt to stay
afloat.
Through fiscal policy, a government can track its level of spending and revenue rates in
an attempt to monitor the economy of the country. Fiscal policy is based on the theories of
British economist John Keynes, who explained that government changes in tax rates and
spending influence the level of economic activity. When the government spends less but receives
more in taxation, the level of economic activity tends to improve (Marcelin & Mathur, 2016).
However, when the state spends more but taxation levels are lower, the economy levels drop, and
the country faces dollarization in a bid to control its economy.
Monetary policy is an action of the central bank of a country that helps it to control the
money supply within its borders. This policy could incorporate credit, in the form of loans and
bonds, and cash. Monetary policy is put in place to create economic growth and manage the rates
of inflation in the country. Through monitoring interest rates, government bonds, and reserve
requirements, banks in a country can know how much it is capable of lending, and as a result, the
money supply is placed under check (Marcelin & Mathur, 2016). There are different types of
monetary policies used by central banks. Contractionary monetary policy charge higher interest
rates on loans, rendering them expensive to citizens. As a result, few people borrow, thus
slowing economic growth and consequently reducing inflation.
When inflation rates reduce, local currencies regain their strength and usefulness and, as
a result, little or no need for dollarization. Another type of monetary policy is expansionary
policy. In this policy, liquidity increases, giving banks more ability to lend in terms of money.
The interest rates drop, encouraging more people to take loans (Marcelin & Mathur, 2016).
Citizens use the credits to better themselves through investments leading to a rise in the
DOLLARIZATION 5
economy's growth. With a more stable economy, most countries would not go for dollarization
because it makes them stronger when carrying out negotiations of deals that benefit citizens.
Discussion of Examples of Countries that have dollarized
Different countries from different parts of the world have dollarized for various reasons.
Countries mostly from Latin America, parts of Asia, Eastern Europe, and the Sub Saharan Africa
have dollarized. Examples of these countries include Ecuador, El Salvador, Angola, Zimbabwe,
and the Marshall Islands, among others (Marcelin & Mathur, 2016). However, many of these
countries have adopted the US dollar, and they do not have control over the dollar. The Federal
Reserve sets monetary policies on the dollar in Washington, DC which controls the value and
flow of the dollar.
The government of Ecuador formally dollarized in the year 2000 when their currency, the
Sucre, lost its usefulness after being faced by the worst economic crisis of all time. The country
was hit by over fifty percent inflation rates that led to citizens initially acquiring the dollar to
maintain their purchasing power before the government could officially adopt the US dollar as
the legal tender in a bid to achieve economic stability.
The government of El Salvador also began the process of dollarization in the year 2001 to
attain growth and economic stability as a country. However, whereas Ecuador was facing a
financial crisis before dollarization, El Salvador was not doing comparatively bad in terms of the
economy (Marcelin & Mathur, 2016). It dollarized because of low debt levels, and since
dollarization promised reduced interest rates, there would be an increase in investment in the
country.
Panama is also another example of a country that dollarized. It was the first to be fully
dollarized in Latin America in 1904. The dollarization happened after gaining its independence
DOLLARIZATION 6
from Colombia, making the US dollar the legal currency for transactions. Panama's reasons were
different than most of the other dollarized countries. Whereas majority dollarized due to
economic reasons, Panama dollarized due to political and historical purposes (Marcelin &
Mathur, 2016). In Cambodia, dollarization has been very fast and extensive, making it Asia's
most dollarized economy over the past decade. However, the dollarization was surprising
because it occurred during a politically stable period as well as economic stability, unlike the
usual reasons. It is also partially dollarized as the local currency, the riel, is also in circulation
together with the US dollar.
In Africa, an example of a dollarized country is Zimbabwe. Zimbabwe decided to go for
full dollarization when the country faced an economic crisis. The state had allowed too much
money to flow within the economy, yet goods and services appeared to be fewer. This state of
the economy resulted in hyperinflation of all times. Her citizens had lost monetary confidence in
the Zimbabwean dollar and thus held foreign currency in a bid to protect themselves against high
inflation (Marcelin & Mathur, 2016). Moreover, it replaced its most top own domestic currency
and started using the US dollar as an official legal tender in January 2009. Since the formal
adoption of dollarization, amounts of US dollars have been circulating in the country outside of
its banking system, making it mostly a cash-based economy.
The table below shows examples of countries dollarized, the years they adopted the
foreign currency, and their Gross Domestic Product (Marcelin & Mathur, 2016).
Country Year
Adopted
Currency
adopted
Issue of
National
Coins
GDP in
billions of
US dollar
Previous own
currency
Ecuador 2000 US dollar Yes 45.79 Yes
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El Salvador 2001 US dollar No 20.37 Yes
Kiribati 1979 Australian
dollar
No 0.067 No
Kosovo 1999 euro No 4.688 No
Marshall
Island
1986 US dollar No 0.163 No
Micronesia 1986 US dollar No 0.232 No
Montenegro 1999 Euro No 3.49 No
Palau 1994 US dollar No 0.164 No
Panama 1904 US dollar Special case 19.74 Special case
San Marino 1999 Euro Special case 1.7 No
Timor-Leste 2000 US dollar No 0.46 No
Table 1: Countries that have dollarized 1 (Marcelin & Mathur, 2016).
Benefits of Dollarization
Dollarization has been most beneficial to these countries. However, it is not uncommon
to encounter certain cases where the land was disadvantaged after dollarization. After fifteen
years of dollarization, Ecuador received significant benefits from incorporating the US dollar as
an official legal tender in their country. After facing hyperinflation of sixty percent in 2000, the
inflation significantly reduced in the year 2000 as recorded by the Atlas Network (Çufadar &
Özatay, 2017). This consequently led to a change in interest rates and higher risks involved.
When inflation and interest rates reduce, the buying power of the citizens improves significantly.
This is because the majority can access money at their disposal. Thus, monetary confidence
among the citizens comes back, and as such, they can purchase expensive assets without fear of
DOLLARIZATION 8
depreciation. Following the dollarization, the overall economic status of Ecuador improved, and
the country experienced stability that had never been experienced.
The economic stability of Ecuador is evident when it ranks the best in Economist Steve
Hanke's Misery Index List. Steve came up with a Latin America Misery Index list after adding
all positive elements witnessed in the economies of different countries, such as low-interest rates.
He subtracted all the negative aspects of the economy (Çufadar & Özatay, 2017). The resultant
list had Ecuador topping, followed by El Salvador and Panama, both of which had dollarized.
The ranking was a bid to show how beneficial the dollarization process had been to these
nations. The table below shows the Latin America Misery Index Rankings by Steve Hanke.
Rank (Worst to Best) Country Misery Index Major contributing
factor
1 Venezuela 79.4 Inflation
2 Argentina 43.1 Inflation
3 Brazil 37.3 Interest rate
4 Dominican Republic 29.8 Unemployment
5 Nicaragua 27.0 Interest Rate
6 Honduras 26.8 Interest Rate
7 Costa Rica 25.6 Interest Rate
8 Peru 23.9 Interest Rate
9 Uruguay 23.8 Interest Rate
10 Bolivia 19.6 Interest Rate
11 Colombia 19.1 Interest Rate
12 Paraguay 17.9 Interest Rate
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13 Trinidad 14.6 Interest Rate
14 Chile 12.7 Interest Rate
15 Ecuador 12.4 Interest Rate
16 El Salvador 8.2 Unemployment
17 Panama 7.5 Interest Rate
Table 1 : Latin America Misery Index Rankings by Steve Hanke (Çufadar & Özatay, 2017).
Dollarization was also beneficial to these countries in the sense that administrative
expenses reduced. Money minting by the central bank of a country stops after the adoption of the
foreign currency. The stoppage means that the cost that could have produced domestic currency
goes into other administrative functions. Also, better financial services and sector comes with
dollarization (Çufadar & Özatay, 2017). This is because, other than adopting the US dollar, the
country incorporates financial integration with the United States. With foreign financial
institutions coming into the country, the domestic financial institutions are forced to improve the
quality of their services to compete favorably (Çufadar & Özatay, 2017). As a result, citizens end
up with a very viable financial sector thanks to the financial integration due to dollarization.
A Substantial decline in the interest rates is the ultimate benefit accrued from
dollarization for local borrowers. Since the US dollar is usually more reputable, more stable,
established, and has assured security, there is immediate confidence in the currency (Çufadar &
Özatay, 2017). Low rates lead to increased borrowing and investments, which eventually lead to
economic growth. However, dollarization has not been all beneficial to these states. It also has
certain disadvantages to its name. The most significant disadvantage is the loss of seignorage
(Çufadar & Özatay, 2017). Seignorage is the ability to create money. Seignorage is usually part
of revenue accrued by the government outside of taxation.
DOLLARIZATION 10
Another disadvantage is the forfeiting of monetary autonomy. A dollarized country does
not have control over its money supply and exchange rates. As a result, it loses its sense of pride
since all authority on monetary autonomy is left to the Federal Reserve in Washington (Çufadar
& Özatay, 2017). The central bank of a dollarized nation also loses its function as a lender of last
resort since it gave up its ability to discount freely during a financial crisis. Domestic banks are,
therefore, at risk of potential liquidity.
Examples of How Specific Companies have been affected by Dollarization
The US dollar has been incorporated as a medium of exchange by many different
companies across different sectors of the economy. Companies ranging from manufacturing,
banking industry, telecommunications sector, oil and gas industry, the tourism sector, and many
other sectors of the economy. The US dollar provides a more manageable medium of exchange,
which is uniform and readily available to many countries other than the United States. There are
companies affected by the process of dollarization in their countries. Some were affected
positively, while others were affected negatively.
An example of a company affected is the Toyota Motor Corporation. Toyota sells cars
outside of Japan using the available foreign currencies. It uses the US dollar in the United States,
rupees in India, and the euro in France. After transacting using these foreign currencies, it goes
ahead to convert back to the domestic currency of Japan. The money obtained after the
conversion is dependent on the world's exchange rates at that moment, thus affected by
dollarization (Çufadar & Özatay, 2017). For instance, if the dollar exchange rates are high,
Toyota does not get value for their cars, but if the exchange rates are low, the company benefits
highly.
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Airbus is the world's largest manufacturer of airlines registered in the Netherlands but
trades in countries like Germany and Spain. Airbus's play a significant role in the designing and
manufacturing of aircraft and its products. Considering Airbus is not a United States company, it
has listed its prices in US dollars because it deals in a globalized market. The sanctions placed by
the US government on their currency significantly affect the operation of the company (Çufadar
& Özatay, 2017). Airbus and other multinational companies are not sure of when they could be
stopped from using the US dollar or predict when the exchange rates for some currencies to the
dollar are greatly affected.
Russia's largest oil company Rosneft has officially switched the currency of its contracts
from US dollars to Euros. This came about by the need to shield its transactions from the
recently placed US sanctions, CEO Igor Sechin says. Russia has been on the journey of de-
dollarization for a while, and Rosneft's switch is in a bid to reduce the dependence on the dollar.
Mechanics of Dollarization
As discussed earlier, dollarization occurs when citizens of a country use a foreign
currency, usually the US dollar, together with their currency or instead of the existing domestic
currency. It can occur officially or not. However, to look at the mechanics of dollarization, we
are focusing on the official dollarization- a case where the government has officially made the
US dollar an official legal tender for transactions within its borders. The mechanics of
dollarization seek to explain the features of the process, where it exists, how dollarization works,
costs, and benefits of the whole process and issues that arise when the dollarization process
occurs in a country.
In official dollarization, mostly, the local currency is replaced by the foreign one. This
replacement helps to reduce problems that could have arisen from shifting between the foreign
DOLLARIZATION 12
currency and the domestic currency now and then. Most problems faced by developing countries
such as hyperinflation and high-interest rates emanate from their weakened domestic currency.
Therefore, replacing this currency with a better valued foreign currency goes a long way in
curbing the menace of high inflation rates (Brown et al., 2018). Once dollarized, a country
becomes unified with the country whose foreign currency it is using. For instance, when Ecuador
or Panama became officially dollarized, they immediately had the same monetary relationship to
New York, the USA, just like Puerto or Cambodia or Zimbabwe. This means that dollarized
nations form a unified currency zone.
However, once officially dollarized, countries have to drop their monetary policies and
adopt the monetary policy of the United States as elaborated by the Federal Reserve in
Washington. The advantage of the formed unified currency zone is that prices of similar items
are kept within the same range (Brown et al., 2018). For example, if electronic equipment like
television costs 200 US dollars in the United States, the same item will most likely cost around
the same figure, including the shipping costs in Panama. This advantage is only available to
nations within the same currency zone. Since Mexico uses a different currency from the US
dollar, the value of the same television might incur extra costs that did not exist between the US
and Panama. When prices of products are kept within the same range, inflation rates also tend to
be the same. Interest rates of countries in the same unified currency zone also tend to be the
same. Eventually, this is what creates a more economically stable nation than the one before
dollarization took place.
Official dollarization can also incorporate financial integration in a country in the hope of
reaping maximum benefits. The dollarized nations draft laws that allow foreign financial
institutions to operate freely and compete with their domestic financial institutions without
DOLLARIZATION 13
imposing any sanctions on them. This makes the country part of even a bigger international pool
of funds, increasing potential benefits that could be accrued (Brown et al., 2018). Other than an
attempt at stabilizing the economy, financial integration incorporated into dollarization allow
citizens to access financial institutions that have been proved worthy everywhere in the world.
As a result, domestic financial institutions have no option but to improve in their service delivery
to compete favorably
Issues to be Considered when Implementing Dollarization
Under the mechanics of dollarization, several issues need to be looked at by a country
that wants to align its currency with that of a dollar or use the dollar as a legal tender. Are there,
preconditions? Which foreign currency will the country go for, and why? Dollarize formally with
an agreement or not? What are the pros and cons of each? An attempt to answer all these
questions depict important issues during dollarization.
Steps in Official Dollarization
To understand the mechanics of dollarization, one has to know how the process works
from the beginning until a nation is fully dollarized. A country that wishes to be dollarized has to
go through the following procedure through its central banks. For this research, the foreign
currency is the US dollar, and the domestic currency is the sucre. The central bank determines
the portion of its liabilities dollarized. This could be the sucre notes already in circulation or the
entire sucre base.
First, the country’s financial position is assessed. For instance, if the central bank has
sufficient reserves, it could sell for the US dollars and sell to its citizens under fixed exchange
rates. If there are inadequate reserves, the central bank borrows dollars to cover the deficit and
dollarize immediately. Afterward, a declaration of a fixed exchange rate between the dollar and
DOLLARIZATION 14
the sucre is made. These rates begin to operate effectively, provided the declaration has been
made, and consequently, the dollar is announced as the legal tender. A transition period is
declared of not more than ninety days to allow the exchange of quotations of wages and prices in
the sucre to dollars. When the transition period is over, no bank loan or deposit is quoted in sucre
anymore.
Besides, a freeze of the total liabilities and dollarize the ones determined in step one. The
decision on the available coins is ultimately made. These coins can either be valued or devalued.
When valued, the sucre coins are used alongside the dollars. When devalued, the coins are
rendered obsolete. Finally, reorganize the country’s central bank as deemed necessary,
depending on the type of dollarization the country ventured.
Discussion of De-dollarization in Peru.
The US dollar has been prevalent in almost all corners of the world. However, some
countries still prefer to promote and use their local currencies produced by their central banks as
a mode of exchange. Such countries include Peru, which has been trying to reduce their
dependency on the US dollar and even attempt to bypass the dollar’s strength accumulated over
the years. The attempts have seen Peru go through dollarization. It attempted to de-dollarize,
which failed, and it went back to dollarization again due to cases of inflation (Catão & Terrones,
2016). In all this, Peru remained determined and therefore attempted de-dollarization again,
albeit gradual since the early 2000s. To successfully de-dollarize, a nation has to come up with a
policy that makes the domestic currency more attractive to its citizens than the foreign US dollar.
Eventually, de-dollarization incorporates a mix of macro and microeconomic policies, which
enhance the local currency, and consequently, citizens de-dollarize voluntarily.
DOLLARIZATION 15
Peru has managed to pursue de-dollarization during the last decade after introducing the
inflation targeting regime. Since 2013, Peru’s central bank has promoted the use of its local
currency (soles) in its purchasing and financial system at large (Catão & Terrones, 2016). The
de-dollarization process has continued to thrive due to three primary reasons; Macroeconomic
stability, development of capital markets insoles, and introduction of policies that reflect better
currency risk.
Macroeconomic Stability
Walter J. Wessel describes macroeconomic stability as ‘a situation where the national
economy has minimized vulnerability to external shocks, which in turn increases its prospects for
sustained growth. Both the IMF and the EU emphasize on microeconomic stability since it
protects against currency and interest fluctuations within the global market (Catão & Terrones,
2016). According to the Maastricht criteria, stability is measured using five determinants;
i) Low inflation rates which portray there is a real demand in the market.
ii) Lower and long term interest rates reflect stability even in future inflation rates.
Also, if current inflation is small, but if the nation has higher long term interest rates, the
implication is that eventually inflation will rise and create havoc to the economy. Therefore,
keeping interest rates lower consistently ensures a more stable economy; thus, no need for
continued dollarization.
iii) Currency stability- Peru has been trying to keep its domestic currency as stable as
it can, without frequent fluctuations. This has greatly reduced the threat posed by borrowing in
foreign coin and, as such, keeping the de-dollarization process in check ultimately.
Markets across the world have finally acknowledged Peru’s outstanding performance in
managing economic stability.
DOLLARIZATION 16
Prudential Policy Measures
Peru introduced specific measures that have since helped her in the journey to de-
dollarization by ensuring that a great margin lowers the bank's ability to borrow and lend in
foreign currency. Some of the measures put in place include:
i) Liquidity measurements- Peru came up with a policy that forces its local banks to
always have money in both domestic currency and the US dollar.
ii) Bank reserve requirements. Peru has ensured the banks within its borders have
reserves in the domestic currency.
Development of Capital Market in Soles
Local capital markets have been on the development in Peru over the last decade in its
bid to de-dollarize. Efficient capital markets developed ensures there is easy access to long-term
local currencies. This leads to a booming private sector leading to the creation of jobs and,
consequently, growth in the economy.
Through the above line of action, dollarization ratios of credit and deposit have
significantly reduced. From such results, the ongoing de-dollarization in Peru can continue to
follow the above-discussed fronts. This is to mean that macroeconomic stability can induce de-
dollarization; additional prudential policies could discourage lending and borrowing in the US
dollar. In conclusion, the capital market in local currency in Peru is still small, and developing it
more could help financial de-dollarization.
Conclusion
The dollarization process starts with the evaluation of the state of the economy so that the
decision made to substitute the local currency (partially or fully) avoids an economic crisis and
strengthens the economy. Many countries around the world have dollarized, while some have
DOLLARIZATION 17
maintained the use and strengthening of their local currencies. The dollar plays a significant role
in world trade. Its fluctuation affects many countries because most of them have aligned the
currencies with the US dollar. Dollarization has many advantages, as discussed above. However,
it has some disadvantages which must be assessed before a decision is made to dollarize.
DOLLARIZATION 18
References
Brown, M., De Haas, R., & Sokolov, V. (2018). Regional Inflation, Banking Integration, and
Dollarization. Review of Finance, 22(6), 2073-2108.
Catão, M. L., & Terrones, M. M. (2016). Financial de-dollarization: A global perspective and
the Peruvian experience. International Monetary Fund.
Çufadar, A., & Özatay, F. (2017). Sovereign risk, public debt, dollarization, and the output
effects of fiscal austerity. Journal of International Money and Finance, 72, 75-92.
Marcelin, I., & Mathur, I. (2016). Financial sector development and dollarization in emerging
economies. International review of financial analysis, 46, 20-32.