Ahigh degree of dollarization can yield both costs and benefits. This section examines how dollarization can help or hurt an economy.
Drawbacks of High Dollarization
Loss of Seigniorage
A main cost of high dollarization in Cambodia is the loss of seigniorage revenue for the government. Box 5 presents recent methods used in the literature to measure seigniorage.
In Cambodia, commercial banks’ required reserves at the National Bank of Cambodia are not remunerated, so iR is equal to zero and seigniorage is thus equal to iAA. Interest income series from the National Bank of Cambodia overseas deposits are available since 1995 and were used to compute seigniorage. Estimates of seigniorage are shown in Table 2, in absolute and relative terms.12 Both estimation methods show a relatively low yearly seigniorage in terms of GDP, but yield a higher seigniorage in terms of government revenue, 11¼ percent a year on average—however, that is chiefly a consequence of the very low level of government revenue. Thus, with the exception of 1998, when there was a large expansion in domestic currency to finance the budget deficit, seigniorage associated with dollarization since 1994 has been relatively moderate.
Estimates of Seigniorage
Estimates of Seigniorage
| 1994 | 1995 | 1996 | 1997 | 1998 | 1999 | 2000 | 2001 | ||
|---|---|---|---|---|---|---|---|---|---|
| Reserve-Money Method | |||||||||
| Change in reserve money (billions of riels) | 57.8 | 28.6 | 135.3 | 95.5 | 257.3 | 127.3 | 231.1 | 198.6 | |
| In percent of GDP | 0.9 | 0.4 | 1.6 | 1.0 | 2.4 | 1.1 | 1.9 | 1.5 | |
| In percent of government revenue | 19.9 | 4.8 | 21.0 | 12.7 | 29.2 | 13.5 | 17.3 | 13.0 | |
| Central-Bank-Profit Method | |||||||||
| Interest income (billions of riels) | … | 18.6 | 28.9 | 47.4 | 58.7 | 67.6 | 114.7 | 88.4 | |
| In percent of GDP | … | 0.3 | 0.3 | 0.4 | 0.6 | 0.6 | 0.9 | 0.7 | |
| In percent of government revenue | … | 2.9 | 3.9 | 5.4 | 6.2 | 5.1 | 8.0 | 5.8 | |
Estimates of Seigniorage
| 1994 | 1995 | 1996 | 1997 | 1998 | 1999 | 2000 | 2001 | ||
|---|---|---|---|---|---|---|---|---|---|
| Reserve-Money Method | |||||||||
| Change in reserve money (billions of riels) | 57.8 | 28.6 | 135.3 | 95.5 | 257.3 | 127.3 | 231.1 | 198.6 | |
| In percent of GDP | 0.9 | 0.4 | 1.6 | 1.0 | 2.4 | 1.1 | 1.9 | 1.5 | |
| In percent of government revenue | 19.9 | 4.8 | 21.0 | 12.7 | 29.2 | 13.5 | 17.3 | 13.0 | |
| Central-Bank-Profit Method | |||||||||
| Interest income (billions of riels) | … | 18.6 | 28.9 | 47.4 | 58.7 | 67.6 | 114.7 | 88.4 | |
| In percent of GDP | … | 0.3 | 0.3 | 0.4 | 0.6 | 0.6 | 0.9 | 0.7 | |
| In percent of government revenue | … | 2.9 | 3.9 | 5.4 | 6.2 | 5.1 | 8.0 | 5.8 | |
In case the authorities wanted to move to full dollarization, such a move would involve additional seigniorage losses. It would involve an initial “purchase cost” plus additional future annual seigniorage losses stemming from a larger money supply in dollars. To adopt the dollar as legal tender and withdraw the domestic currency entirely from circulation,13 the monetary authorities would have to purchase the stock of domestic currency held by the public (and banks), effectively returning to the holders seigniorage accumulated over time. Fischer (1982) measures this initial purchase cost of full dollarization by expressing domestic currency in circulation as percent of GDP. In the case of Cambodia, this would correspond to 4 percent of the estimated 2001 GDP, and using the end-2001 exchange rate, the cost would be $139 million, or about one-third of net official reserves. The additional annual seigniorage losses associated with full dollarization could be computed by using one of the two methods explained earlier.
Measuring Seigniorage
Berg and Borensztein (2000b) state that “the ancient concept of seigniorage is a government’s profit from issuing coins for a cost less than face value. This concept is also relevant for paper currencies. Neglecting the minor cost of printing money, seigniorage is simply the increase in the volume of domestic currency.” In other words, seigniorage represents the profit accruing to the monetary authorities from their right to issue the legal tender. While there is a general agreement on the concept of seigniorage, methods of estimating it empirically vary among economists.
According to Berg and Borensztein (2000a), seigniorage can be measured by two alternative methods: the reserve-money method and the central-bank-profit method. These two methods ignore the costs of currency production and are also called the “flow cost” approach.
According to the reserve-money method, the monetary authorities earn seigniorage from the flow of new currency emitted into circulation, corresponding to the demand of money over time to conduct transactions. The reserve-money method measures seigniorage as the increase in reserve money in a given period:
where R is the nominal stock of reserve money, P is the price level, h is the growth rate of reserve money, and m is the real stock of reserve money. This method assumes that there is no interest paid on some components of reserve money, such as commercial banks’ reserves deposited at the central bank.
The central-bank-profit method measures seigniorage as the difference between what the central bank earns on its assets that back reserve money, and the interest that it pays to the holders of reserve money (typically commercial banks, which hold reserve deposits at the central bank). Seigniorage is thus equal to:
where iA is the rate of interest earned by the central bank on its assets, A is the nominal stock of central bank assets, iR is the rate of interest that the central bank pays on reserve money, and R is the nominal stock of reserve money.
Lower Official International Reserves
Another potential drawback associated with high dollarization in Cambodia stems from lower official international reserves. In the presence of an effective national currency, agents who hold foreign currency (e.g., exporters and foreign aid recipients) need to acquire national currency to do business in the country. Part of the foreign currency sold by these agents to purchase national currency is likely to end up in the coffers of the central bank, thereby boosting the country’s international reserves. Conversely, those agents who would like to purchase foreign currency to do business abroad have to buy it from the market. If the central bank refrains from supplying foreign currency to the exchange market, foreign currency outflows from official reserves are reduced. Accordingly, although Cambodia’s net international reserves have steadily increased since the early 1990s (Figure 11) and are now equivalent to about three months of imports of goods and services, they could be still higher—including accrued interest earnings—were the country not so highly dollarized.
Official International Reserves
(In millions of U.S. dollars)
Source: National Bank of Cambodia.We would argue, however, that in a highly dollarized economy, official reserves do not play the same role (i.e., increasing confidence in the national currency and weathering temporary external shocks) as in a country with a sole national currency. In a highly dollarized economy, the external credibility of the national currency is usually already largely compromised. And since the U.S. dollar is an international “reserves money,” economic agents who hold a large amount of dollars have the means to react to a temporary external shock. Thus, the main difference in the status of “reserves” seems to be that these “reserves” are in the hands of agents, rather than in those of the monetary authorities. We would suggest that in an open economy like that of Cambodia this is not necessarily undesirable—as far as minimizing output loss is concerned—because in such an economy the markets are the economic driving force.14 We recognize, however, that if the current high levels of dollar inflows were to abate, and were no longer available to finance the current account deficit, the importance of reserves would grow.
Loss of an Effective Monetary Policy
In a highly dollarized economy, the foreign currency component of broad money cannot be directly influenced by the monetary authorities. Money supply in the economy is not determined by the monetary authorities but by the behavior of agents holding both foreign- and domestic-currency-denominated assets, including cash. As money supply in the economy becomes endogenous, the authorities may not be in a position to fight inflation by tightening domestic money supply in an appropriate manner. Based on empirical evidence, Hoffmaister and Végh (1995) assert that in Uruguay (a highly dollarized economy), dollarization may have severely hindered the effectiveness of monetary policy. High dollarization in Cambodia thus limits the effectiveness of the National Bank’s monetary policy in that its operations in riels have almost no impact on overall monetary developments.15
While in a highly dollarized economy, the monetary authorities cannot influence money supply directly, they can control other related variables, such as base money and the reserve requirement rate of banks. In theory, these monetary policy tools should allow them to control domestic money supply indirectly. In Cambodia, however, as financial intermediation is limited and conducted almost entirely in foreign currency, the National Bank’s ability to control base money is severely limited. The National Bank retains changes in reserve requirements as a potential tool, but this regulatory instrument cannot be used frequently for the sake of financial stability. In fact, since December 1993, the National Bank has changed the reserve requirement only once, in January 1998, raising it from 5 percent to 8 percent.16 As another potential monetary instrument, a refinancing facility was introduced in Cambodia in June 1994. The only assets eligible for this facility are trade bills denominated in riels. The refinancing facility allows the lender to redeem the bills before maturity at a discount of 70 percent of face value. However, no commercial bank has ever used this facility.
With regard to interest rate policy, commercial banks are free to set their deposit and lending rates. Since the National Bank does not refinance banks, it does not influence interest rates and therefore cannot use interest rate policy as an effective monetary instrument. The structure of deposit and lending rates is shown in Table 3. High interest rate spreads are characteristic of lesser developed economies, but the presence of dollarization usually enhances the credibility of the exchange rate and reduces inflation, and thus real interest rates tend to contract. In Cambodia, inflation has been very low and sometimes even negative since 1999, yet the real interest rate on dollar-denominated loans remains at 14 percent a year.17 The sizable spread reflects the high country risk; the high costs of banking (legal uncertainty, litigation costs, and default rates); and the lack of aggressive financial intermediation, owing to few secure lending opportunities. In Cambodia, dollarization does not suffice to offset developmental constraints.
Interest Rates on Deposits and Loans, February 2002:
(In percent per year)
12-month deposits.
Lending rate to private enterprises, including small businesses.
The real interest rate is computed as the difference between the nominal interest rate and the inflation rate—the latter is computed as the average of the CPI during the three-month period ending in February 2002 over the same period a year earlier.
Interest Rates on Deposits and Loans, February 2002:
(In percent per year)
| Riels | U.S. Dollars |
Other Foreign Currencies |
||
|---|---|---|---|---|
| Interest rate on deposits | ||||
| Demand deposits | 3.2 | 2.1 | 1.3 | |
| Time deposits1 | 8.6 | 4.9 | 1.5 | |
| Nominal interest rate | ||||
| on loans2 | 18.4 | 16.7 | 18.0 | |
| Real interest rate on loans3 | 15.7 | 14.0 | 15.3 | |
12-month deposits.
Lending rate to private enterprises, including small businesses.
The real interest rate is computed as the difference between the nominal interest rate and the inflation rate—the latter is computed as the average of the CPI during the three-month period ending in February 2002 over the same period a year earlier.
Interest Rates on Deposits and Loans, February 2002:
(In percent per year)
| Riels | U.S. Dollars |
Other Foreign Currencies |
||
|---|---|---|---|---|
| Interest rate on deposits | ||||
| Demand deposits | 3.2 | 2.1 | 1.3 | |
| Time deposits1 | 8.6 | 4.9 | 1.5 | |
| Nominal interest rate | ||||
| on loans2 | 18.4 | 16.7 | 18.0 | |
| Real interest rate on loans3 | 15.7 | 14.0 | 15.3 | |
12-month deposits.
Lending rate to private enterprises, including small businesses.
The real interest rate is computed as the difference between the nominal interest rate and the inflation rate—the latter is computed as the average of the CPI during the three-month period ending in February 2002 over the same period a year earlier.
Loss of an Effective Exchange Rate Policy
High dollarization implies losing flexibility in the exchange rate policy, as it obviates exchange rate adjustments in response to external shocks. With “rigid” exchange rate arrangements, the monetary authorities cannot manipulate the exchange rate in order to spur the real sector, because changes in the exchange rate of the domestic currency are largely irrelevant in the face of the predominant role of foreign-currency-denominated assets in the economy. The same holds true for market-induced exchange rate depreciation in the case of “flexible” exchange rate arrangements. In the presence of an external shock, highly dollarized economies tend to adjust through the goods and factors market, with the help of the financial markets, if they are sufficiently developed. However, as discussed earlier, some country experiences show that the lack of flexibility in the exchange rate policy may be beneficial rather than detrimental.
Between 1994 and 1999, the National Bank of Cambodia pursued a flexible exchange rate policy, keeping the spread between the official and the market rates below 1 percent, except in a few exceptional periods (Figure 12). Most of the time since late 1999, the National Bank has further kept the spread at only ½ of 1 percent, and it intends to eliminate the spread entirely.
Spread Between Official and Market Exchange Rates
(In percent)
Source: National Bank of Cambodia.Since the National Bank of Cambodia cannot employ most monetary and exchange rate instruments, it lacks the tools to conduct monetary and exchange rate policies effectively. Thus, in Cambodia, the brunt of macroeconomic adjustment falls on fiscal policy.
Benefits of High Dollarization
Isolation from the Effects of Exchange Rate Fluctuations
High dollarization provides some protection against exchange rate risks, as a change in the exchange rate bears only on a small part of money supply (i.e., the domestic component thereof) and financial assets (denominated in domestic currency). Typically, in a highly dollarized economy the bulk of trade-related and of large financial transactions are settled in dollars, whereas the national currency is mainly used for dealing with small-scale nontradables. As a result, in the case of an exchange rate devaluation/depreciation, the pass-though effect of higher import prices on inflation is limited and prices of nontradables settled in local currency are not directly affected. The Asian crisis illustrated dramatically this isolation effect. From July 1997 to January 1998, the Thai baht depreciated by 71 percent against the dollar. During the same period, the riel depreciated by 23 percent (Figure 13). The inflation performance of the two countries shows a similar disparity in favor of Cambodia, and this in spite of the July 1997 political crisis in Cambodia, which certainly did contribute to the riel’s depreciation and to the rise in inflation.18
Riels per U.S. Dollar
(End of period)
Source: IMF, International Financial Statistics.Since 1999, the exchange rate of the riel against the dollar has been relatively stable, and both of them strengthened against the Thai baht and the Vietnamese dong (Figure 14). The largest market for Cambodian exports is the United States and the main sources of Cambodian imports—excluding imports for reexport—are Thailand and Vietnam. The recent appreciation of the riel has allowed Cambodia to benefit from an improvement in its terms of trade. These evolutions could also explain the low level of inflation in Cambodia since the end of 1999.
Riels per Thai Baht and 100 Vietnamese Dong
(End of period)
Source: IMF, International Financial Statistics.The real effective exchange rate has increased regularly—except for the turbulence in 1998—by some 15 percent since early 1995, but this increase seems not to have hurt Cambodia’s exports, presumably owing to the particular nature of the garment industry’s external market (Figure 15).
Effective Exchange Rates
(Average of 1995 = 100)
Source: IMF staff estimates.Financial Re-Intermediation
Another benefit of dollarization in Cambodia has been a gradual financial deepening of the banking system. In economies that have experienced periods of high inflation and an unstable macroeconomic situation, residents tend to become reluctant to hold deposits in the domestic banking system. Dollarization, through foreign currency deposits held in domestic banks, encourages agents to use bank services rather than to hold idle cash balances. When macroeconomic stability is restored in a dollarized environment, agents may have more confidence in the banking system and may be more willing to return to domestic intermediaries if they can hold dollar-denominated assets. More specifically, in Cambodia the dollar deposit growth rate was very low in 1998, at about 1 percent, but rose on average by 25 percent during 1999–2001, while the average riel deposit growth rate was about 32 percent during the latter period.
Economic and Financial Integration
Dollarization may contribute to greater economic and financial integration with the rest of the world. The use of a foreign currency, especially the dollar, which is the most widely used currency in international trade, reduces the transactions costs of purchasing international currency. The more a country’s trade and financial flows are integrated with countries using the dollar, the greater will be the gains from reducing exchange risks. Nonetheless, exchange risks with other currency zones remain. Mundell (1961) analyzes optimal currency areas and provides a good analysis of trade benefits associated with dollarization. Countries highly integrated in terms of trade and factor mobility can benefit from using the same currency. More recently, Rose (2000) and Rose and Frankel (2000) note that a country’s trade can increase significantly if it belongs to a monetary union, or similarly, if its economy is dollarized. Edwards (2001) suggests that benefits from added trade integration can more than offset the costs of dollarization, including the loss of seigniorage. Cambodia, with its high level of dollarization, is likely to have benefited from enhanced trade. Between 1995 and 2001, the share of garment exports in Cambodia’s total exports surged from nil to 83 percent, and since 1998 the United States has become the largest market for Cambodian garment exports (71 percent of total garment exports). While other factors, such as an export license system for the United States, have certainly played an essential role in that expansion, dollarization has also contributed to it, and is likely to be critical in diversifying exports further in the future. However, dollarization hinders price/wage flexibility and therefore requires sufficient productivity gains in the export sector to keep abreast of competitors.
Dollarization holds the promise of macroeconomic stability for foreign investors and the elimination of the domestic exchange rate risk, especially with regard to the repatriation of profits. Dollarization also tends to limit the country’s exposure to currency crises and to contagion episodes, as illustrated by the case of Cambodia during 1997–98. In the medium term, dollarization can also promote the development of domestic financial markets, as the use of dollars facilitates the integration of the domestic market into the rest of the world, owing to lower costs of international financial transactions.
Fiscal Discipline
Another benefit of dollarization is fiscal discipline, as dollarization greatly reduces the government’s ability to fuel inflation through monetized fiscal deficits. Most independent central banks will refrain from unsustainable financing of budget deficits through money creation, since such financing is inflationary and likely to lead to even larger deficits. When monetization of the deficit is hampered, as in a highly dollarized economy where the monetary authorities cannot emit dollars, lest they deplete their reserves, fiscal discipline will likely result (Sargent, 1986). Moreover, dollarization, by removing the seigniorage as a source of easy revenue, leads also to tighter fiscal policy.
In the early 1990s, Cambodia experienced high inflation resulting from monetized budget deficits. Since then, high dollarization has limited the scope for inflationary financing of fiscal deficits and assisted in building financial discipline.19 In addition, Article 24 of the Law on the Organization and Conduct of the National Bank of Cambodia (1996) forbids the National Bank to lend money to the government. Since then the National Bank has done so only once in 1998, at a time of shortfalls in revenue collection linked to political upheaval. Henceforth, the government is committed to eschew central bank financing of the budget. This policy stance has allowed Cambodia to minimize pressures on prices and on the exchange rate.
