Dollarization: A Primer Eduardo Levy Yeyati and Federico Sturzenegger July 2001

1. Dollarization: A Primer Eduardo Levy Yeyati and Federico Sturzenegger July 2001 1

2. Background • Recent currency and financial crises  Conventional pegs are running out of favor. • Bipolar view: Floats vs. “hard pegs” (CBA, currency unions, unilateral dollarization). • Casual evidence: • Currency crises in South East Asia and Latin America • Monetary integration in Europe, EMU waiting list, African ECOWAS • Dollarization in Ecuador and El Salvador, other Latam countries (Guatemala, Nicaragua). 2

3. Background • Speculative attacks on the HK dollar and the Argentine peso and, in particular, the recent collapse of the Argentine peso suggest that a currency board may not be hard enough to avert a currency crisis. • As a result, the recent discussion has increasingly focused on the potential benefits of moving forward towards full dollarization. 3

4. Where are we coming from? • All long-standing dollarized economies were due to historical and political reasons. • Many are very small open subnational economies (Panama is a clear outlier). • Lack of relevant experiments. 4

5. Dollarized Countries 5

6. Fix vs. flex: OCA Theory • Lower transaction costs (McKinnon) vs. loss of the exchange rate instrument, inversely proportional to the degree of factor mobility (Mundell), and the correlation of shocks within the region (Kenen). • How relevant are OCA considerations in practice? • Alternative motivations (linkage politics, credibility issues) of existing unions and prospective candidates. • Free trade areas like ECM or NAFTA have shown substantial trade gains without a common currency. 6

7. Fix vs. flex: Financial integration • Impossible trinity: Under capital mobility, monetary policies cannot be aimed both at maintaining stable exchange rates and smoothing cyclical output fluctuations. • Capital account liberalization makes this restriction more stringent ==> move to the extremes (Fischer, 2001). 7

8. The weak currency problem • Financial dollarization (as opposed to currency substitution): • Limits the scope of exchange rate fluctuations that monetary authorities can afford to tolerate ==> fear of floating • Imposes some of the constraints (e.g., LLR, inflation tax base) associated with de jure dollarization • Foreign currency-denominated external debt introduces an additional currency mismatch. 8

9. Fix vs. flex: The credibility argument • Tradeoff between a suboptimal response to external shocks and the credibility gains of a monetary rule (mitigation of the inflation bias the plagues a weak currency): • Hard peg as a commitment mechanism (credibility) • Hard pegs as a source of fiscal discipline • Dollarization as the extreme (irreversible) peg 9

10. The pros • Reduced transaction costs • Sources: • Exchange rate volatility. • Multiple currencies: • EC Commission estimates for EMU between 1/4 and ½ of GDP per year (presumably higher for less developed economies with wider bid-ask spreads) • Combined gains: Mixed evidence (Rose ,2000; Persson, 2001). 10

11. The pros • Enhanced credibility • Inflation convergence: • Significant inflation gains (Ghosh et al., 1999; Levy Yeyati and Sturzenegger, 2001) while the hard peg lasts. • Fiscal discipline: • Smaller government size and narrower fiscal deficits for CU, but not for unilaterally dollarized economies (Fatas and Rose, 2001). Lack of relevant experiments. 11

12. The pros: Enhanced credibility Fiscal Discipline (IMF reporting countries) 12

13. The pros Fiscal discipline 13

14. The pros • Reduced borrowing costs • Powell-Sturzenegger (2001): Balance sheet dominates seignorage only in financially dollarized economies. 14

15. The cons • Monetary policy • Mixed evidence (Stein et al., 2001): • Domestic rates in Latam seem to be more sensitive to external financing costs (country risk) and to worldwide shocks (EMBI+ index) under more flexible regimes. • No systematic countercyclicality under flexible regimes in developing countries. • Failure of international capital markets to “insure” developing economies detracts from the usefulness of monetary policy. 15

16. The cons • Exchange rate flexibility • Differential response to TOT shocks (Broda, 2001; Edwards-Levy Yeyati, 2002). • Greater output volatility (Ghosh et al., 1987) and slower growth (Levy Yeyati-Sturzenegger, 2001, 2002). • Financially dollarized countries cannot afford much flexibility. 16

17. The cons • LLR • Potential substitutes: • Outsourcing (e.g., Argentine Contingent Repo), both centralized (CB) or decentralized (individual banks, parent-subsidiary implicit contract). • Difficult to generalize (who insures the insurer?) • Procyclical hedging • Liquidity buffer (similar to a DIS) • Costly in good times • Procyclical in bad times (De la Torre et al., 2002) • International LLR • Financially dollarized economies face similar constraints 17

18. The cons • Seignorage • Depends on current and future demand for the local currency. • Example: Constant real output growth g, inflation  and currency-to-GDP ratio . • Seignorage: Perpetuity that pays interest i on a stock m=GDP0 that grows at  = (1+)(1+g) -1. • S = (i GDP0) / (i - ) • Assumptions:  = 4%; r = (1 + i)/(1 + p) -1 = 4%, g = 3%,  = 2% ==> S/GDP = 24% 18

19. The importance of initial conditions • Identikit of a prospective dollarizer: • Widespread financial dollarization (weak currency), important trade links with other users of the foreign currency to be adopted, and pervasive credibility problems that result in high country risk and persistent high inflation, or frequent currency collapses whenever they attempt to use an exchange rate anchor. • But… • Dollarization does not impose discipline nor is it an irreversible contract. • The pervasiveness of nominal rigidities and the lack of insurance mechanisms may have been understated in the debate. 19

20. Monetary union vs. Dollarization • Advantages of a MU: • Seignorage sharing. • Shared LLR (at least implicitly) • Shared monetary policy, which may be active vis à vis the rest of the world (EMU). • As a result, it requires members to be in comparably good stance ==> much longer transition period, but... • Institutional credibility borrowing: key for emerging economies with weak currencies and institutions. 20