Dollarisation

Dollarisation refers to the use of a foreign currency, particularly the US dollar, alongside or instead of a country’s domestic currency for transactions, savings and other monetary purposes. Dollarisation can happen informally, where businesses and people choose to conduct transactions with USD or foreign currency, and it can also be formally adopted by a country. It commonly develops when high inflation, persistent currency depreciation or economic instability reduces confidence in the domestic currency, encouraging people to shift towards a more stable foreign currency.

Types of Dollarisation

• Partial Dollarisation: A foreign currency is widely used alongside the domestic currency for transactions, savings, deposits or financial contracts, without completely replacing the domestic currency.
• Full Dollarisation: A country officially adopts a foreign currency as its legal tender, replacing its domestic currency.
  • Example: Ecuador adopted the US dollar as legal tender in 2000.
    • Panama has used the U.S. dollar since 1904.

Why Does Dollarisation Occur?

• High Inflation or Hyperinflation: Rapid increases in domestic prices reduce the purchasing power of the domestic currency, encouraging people to hold a more stable foreign currency.
• Persistent Currency Depreciation: When the domestic currency repeatedly loses value, households and businesses shift their savings and transactions towards foreign currency to protect their wealth.
• Macroeconomic Instability: Economic crises and large macroeconomic imbalances weaken confidence in the domestic currency and increase demand for foreign currency.
• Low Confidence in Monetary Policy: A history of high and unstable inflation or large devaluations reduces confidence in the ability of monetary authorities to maintain currency stability.
• Protection of Savings: People hold foreign currency as a store of value to protect their savings against inflation and depreciation of the domestic currency.
• Government Adoption for Monetary Stability: In some cases, governments officially adopt a stable foreign currency to establish a more credible monetary framework after prolonged monetary and exchange-rate instability.

Advantages

• Greater Currency Stability: Adoption of a relatively stable foreign currency eliminates the risk of depreciation of the domestic currency against the adopted currency.
• Lower Inflationary Risk: It restricts the ability of domestic authorities to finance expenditure simply by creating domestic currency.
• Lower Borrowing Costs: Elimination of devaluation risk can reduce the currency-risk premium and lower borrowing costs, although sovereign/default risk remains.
• Greater Confidence: A stable currency can improve confidence in the monetary and financial system.
• Retention of Domestic Savings: Greater confidence in the monetary system encourages residents to keep their financial savings within the country rather than moving them abroad, increasing funds available to domestic borrowers.
• Lower Transaction Costs: Reduced need for currency conversion and hedging against exchange-rate risk lowers transaction costs, particularly for businesses engaged in foreign trade.
• Greater Economic Integration: Use of a common currency strengthens trade and financial integration with other economies using the same currency.
  • For example, Ecuador’s adoption of the US dollar reduced currency-conversion and exchange-rate costs in transactions with the United States and other dollar-based markets.

Disadvantages

• Loss of Independent Monetary Policy: Domestic monetary policy is effectively determined by the central bank issuing the adopted foreign currency.
• The monetary policy suitable for the currency-issuing country may not suit the dollarised country. For example, the issuing country may tighten monetary policy during a boom while the dollarised economy is experiencing a recession.
• Loss of Exchange Rate Adjustment: The country cannot devalue its currency to respond to economic imbalances or restore competitiveness.
• Loss of Monetary Sovereignty: Giving up the national currency has political and sovereignty implications, since issuing a national currency has traditionally been an important attribute of an independent state.
• Loss of Seigniorage: The government loses much of the income it would otherwise earn from issuing its own currency.
• Limited Lender of Last Resort Function: Since the central bank cannot create the adopted foreign currency, its ability to provide emergency liquidity during a systemic banking crisis becomes constrained.