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Dollarisation: Panacea for all exchange regime woes

Atul Prasher

MANY RECENT happenings have renewed interest in dollarisation. The experience of Argentina's currency board-like system since 1991, the currency board's role in Bulgaria's stabilisation programme (1997) and Panama's successful running of official dollari sation since 1904, have stirred debate, especially in Argentina, Ecuador and Mexico. The establishment of the monetary union in Western Europe and the willingness of other economic zones to follow suit has contributed to this debate.

The contagion effects of Tequila crisis (1994), East Asia crisis (1997), Russian default (1998) and Brazilian crisis (1999) have left the wounded world looking for a stable monetary regime. Most recent of these happenings is the adoption of the US dollar as the country's legal tender by Ecuador. The prime reason is that it is seen as a way of starting reforms and restoring investor confidence. It promises immunity far superior than free float, soft peg or even fixed-rate regimes from speculative attacks , thereby avoiding currency and balance of payment crisis, and is the next logical step from the currency board.

There are only 28 countries with full dollarisation and the best known is Panama. But the kind of interest it is generating now may soon change the monetary face of the world. Is it indeed a better exchange rate regime? Dollarisation refers to the total replacement of domestic currency. Quite a radical idea, as it means abandoning a national symbol. With the adoption of foreign currency, inflation will come down at a stroke.

Exchange rate instability will disappear. Most of the dollarised economies have convertibility for current account transactions and few or no restrictions on capital account transactions. Panama, the largest officially dollarised economy, uses the US dol lar notes as domestic currency alongside the balboa (coins only). There is no central bank and no centralised foreign reserves.

The capital account is entirely open, and banks are free to invest excess funds in Panama or abroad. There have been no systemic banking crises. There is no domestic lender of last resort. Foreign banks, mainly the US banks, have been de facto lenders of the last resort. An example is Bhutan, which has unofficial dollarisation, making it bimonetary economy.

The most obvious benefit of dollarisation is that it eliminates or at least greatly reduces domestic currency risk and, with it, the risk of currency crises. The benefit is presumably greatest for countries with a history of currency crises and highly vo latile exchange rates resulting from loose monetary policy.

Countries whose trade is integrated with dollarised zone countries would gain immensely by the elimination of exchange risk. Exchange risk with other currency zones, however, will remain. This would also reduce country risk premiums and lower the interes t rates. Investments would increase and, at the same time, the cost of public debt will go down. But this is not guarantee of reducing sovereign risk.

Dollarisation can foster fiscal discipline as it eliminates the Government's power to print currency and continue with high fiscal deficit. Overall, dollarisation can help reduce risk premiums, but cannot eliminate risk. Nevertheless, it holds the promis e of at least reducing the frequency and scale of crises and incidences of contagion.

Though in the 1990s inflation became a non-issue, nonetheless dollarisation can reduce the volatility of the real exchange rate. For countries with low inflation that basket-peg their currencies, it is possible that the multilateral real exchange rate wi ll become more variable. However, the opportunities for hedging against currency movements will also increase.

Dollarisation eliminates one leg of each hedging transaction against non-dollar currencies and the costs involved. By reducing the exchange risk, it can reduce the need for reserves. It is not that dollarisation is free from problems or costs. Adopting c ountries would lose earnings from seigniorage. The country would have to purchase the stock of domestic currency held by the public (and banks) with dollars from the country's international reserves or with borrowed funds. These costs are significant. Fo r instance, the currency in circulation in Argentina is equivalent to roughly $15 billions (5 per cent of GDP) and the annual increase in demand has averaged around $1 billions (0.3 per cent of GDP).

A dollarising country's loss would be the US' gain. So it has been suggested that it must share this seigniorage with the former based on some formula like the Barro proposal. It used to be common among British colonies but there is none between the US a nd the Panama. The only sharing arrangement that exists is between Lesotho, Namibia and South Africa within their Common Monetary Area (CMA) agreement.

Central banks would lose their role as lender of the last resort. In this capacity, central banks provide liquidity to the banking system in the event of a systemic bank run. Currency boards face a similar constraint because they can create base money on ly to the extent they accumulate reserves. Currency boards, however, allow countries to retain some flexibility to create extra money during the times of crisis. In the 1994 crisis, the Argentinean central bank was able to, accommodate partially the run on domestic deposits by reducing temporarily the reserve coverage of the monetary base.

Hong Kong, in the 1997 Asian crisis, introduced a discount window to provide short-term liquidity to banks. In a dollarised economy, the authorities can obtain lines of credit from external sources that might be used in the event of a crisis. But they ma y not be useful when needed.

Another way is to build up a reserve fund in anticipation of crisis. But this loss of lender of last resort capacity is not that big a thing to worry about as dollarisation may make a bank crisis more unlikely. Also, no central bank in times of crisis ha s been successful in stemming it.

The central banks cannot set their own monetary and exchange policy, but seeing the track record of many developing countries, it is better they lose this freedom. In a dollarised monetary system, the national government cannot devalue the currency or fi nance budget deficits by creating inflation, because it does not issue the currency. Also, the days of independent monetary and exchange policy are over. The monetary and exchange policy of almost all the countries is to some extent affected by the Feder al Reserve policy. Even a country such as India, with less than one per cent of the world trade and attracting only $4 billions of FDI, is not unaffected. Fed rate hikes affect us too.

There is also the risk of catching flu whenever the currency, which is used, sneezes. This happened with Chile in August 1982 when it had to devalue the peso after the tight monetary policy adopted by the Federal Reserve. The monetary authority of the co untry, whose currency is used presumably, directs policy for its own perceived benefit; not necessarily that of dollarised countries.

Overall, the world wide desire to have stable monetary and exchange regime, the high cost of periodic currency crises, and the generally good performance of the Argentine currency board-like system and Panama's experience with full dollarisation, would l ead to more and more countries experimenting with monetary unions and dollarisation. This millennium would see action in not only Latin America but also in Asia, Africa, East Europe and may be in the Indian sub-continent, if business sense dawns on the p oliticians.

(The author is an alumnus of Kirloskar Institute of Advanced Management Studies, Harihar.)