References

  • Berg, Andrew, and Eduardo Borensztein, 2000, “The Pros and Cons of Full Dollarization,” IMF Working Paper No. 00/50 (Washington: International Monetary Fund.)

    • Search Google Scholar
    • Export Citation
  • Bordo, Michael, 1993, “The Gold Standard, Bretton Woods and Other Monetary Regimes: An Historical Appraisal,” NBER Working Paper No. 4310 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation
  • Calvo, Guillermo, 1999, “On Dollarization” (unpublished; College Park: University of Maryland).

  • Calvo, Guillermo, and Carmen Reinhardt, 2000, “Reflections on Dollarization” (unpublished; College Park: University of Maryland).

  • Caprio, Gerard, Michael Dooley, Danny Leipziger, and Carl Walsh, 1996, “The Lender of Last Resort Function Under a Currency Board: The Case of Argentina,” World Bank Working Paper No. 1648 (Washington).

    • Search Google Scholar
    • Export Citation
  • De Nicolo, Gianni, Patrick Honohan, and Alain Ize, 2003, “Dollarization of the Banking System: Good or Bad?IMF Working Paper No. 03/146 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Dornbusch, Rudiger, 2001, “Fewer Monies, Better Monies,” NBER Working Paper No. 8324 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation
  • Fischer, Stanley, 1999, “The Frequency of Global Crisis Highlights Need to Consider International Lender of Last Resort,” paper delivered at the joint luncheon of the American Economic Association and the American Finance Association, New York, January 3 in www.imf.org/external/np/speeches/1999/010399.htm.

    • Search Google Scholar
    • Export Citation
  • Ghosh, Atish, Anne-Marie Gulde, and Holger Wolf, 2002, Exchange Rate Regimes: Choices and Consequences (Cambridge, Massachusetts: MIT Press).

    • Search Google Scholar
    • Export Citation
  • Gulde, Anne-Marie, David Hoelscher, Alain Ize, David Marston, and Gianni De Nicolo, 2004, Financial Stability in Dollarized Economies, IMF Occasional Paper No. 230 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Ize, Alain, and Eric Parrado, 2002, “Dollarization, Monetary Policy, and the Pass-Through,” IMF Working Paper No. 02/188 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Ize, Alain, and Andrew Powell, 2004, “Prudential Responses to De Facto Dollarization,” IMF Working Paper No. 04/66 (Washington: International Monetary Fund).

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Levy-Yeyati, Eduardo, and Federico Sturzenegger, 2003a, “Dollarization: A Primer,” in Dollarization, ed. by Eduardo Levy Yeyati and Federico Stufzenegger (Cambridge, Massachusetts: MIT Press), pp. 152.

    • Search Google Scholar
    • Export Citation
  • Levy-Yeyati, Eduardo, and Federico Sturzenegger, 2003b, “To Float or to Fix: Evidence on the Impact of Exchange Rate Regimes on Growth,” American Economic Review, Vol. 93, pp. 117393.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Panizza, Ugo, Ernesto Stein, and Ernesto Talvi, 2003, “Measuring Costs and Benefits of Dollarization: An Application to Central American and Caribbean Countries,” in Dollarization, (Cambridge, Massachusetts: MIT Press) pp. 133200.

    • Search Google Scholar
    • Export Citation
  • Rogoff, Kenneth, Aasim Husain, Ashoka Mody, Robin Brooks and Nienke Oomes, 2004, Evolution and Performance of Exchange Rate Regimes, IMF Occasional Paper No. 229 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Schmitt-Grohe, Stephanie and Martin Uribe, 1999, “Dollarization and Seigniorage: How Much Is at Stake?Research Papers (Piscataway, New Jersey: Department of Economics, Rutgers University).

    • Search Google Scholar
    • Export Citation
  • Tornell, Aaron, and Velasco, Andres, 1995, “Fixed Versus Flexible Exchange Rates: Which Provides Mode Fiscal Discipline?NBER Working Paper No. 5108 (Cambridge, Massachusetts: National Bureau of Economic Research).

    • Search Google Scholar
    • Export Citation
  • Verde, François R., and Marcelo Veracierto, 2000, “Dollarization in Argentina,” Economic Perspectives, Federal Reserve Bank of Chicago, Vol. 24 (First Quarter), pp. 2435.

    • Search Google Scholar
    • Export Citation
  • Vuletin, Guillermo J., 2003, “Exchange Rate Regimes and Fiscal Performance: Do Fixed Exchange Rate Regimes Generate More Discipline Than Flexible Ones?” (College Park: University of Maryland).

    • Search Google Scholar
    • Export Citation

APPENDIX I

Table. Fiscal Discipline in Developing Countries 1998-2003

article image
Note: ** and *** show that the null hypothesis is rejected at significant levels of 5% and 1%, respectively.

Table. Fiscal Discipline in Developing Countries (1998-2003)

article image
Note: ** and *** show that the null hypothesis is rejected at significant levels of 5% and 1%, respectively.

APPENDIX II

Table. Fiscal Discipline in Developing Countries by Subperiods

article image
Note: ** and *** show that the null hypothesis is rejected at significant levels of 5% and 1%, respectively

Table. Fiscal Discipline in Developing Countries by Subperiods

article image
Note: ** and *** show that the null hypothesis is rejected at significant levels of 5% and 1%, respectively.

APPENDIX III

Liberia’s Historical Experience With Dollarization 13

Between World War II and the early 1970s, overall favorable world market conditions for Liberia’s exports and foreign direct investment helped sustain a fully dollarized regime, which Liberia had adopted in 1946. Liberia financed its current account deficits through foreign direct investment and foreign loans. Since the government did not maintain official foreign reserves, external equilibrium was automatically maintained through changes in the volume of U.S. dollars in circulation and in the net foreign assets of commercial banks. Following the discovery of iron ore, the first mining concession was awarded in 1946, followed by a large inflow of foreign direct investment, mainly in the mineral but also in the rubber sector. During 1950-62, Liberia’s real domestic product increased at least two and a half times, while the value of exports doubled (as a result of sales of iron ore and rubber), and government revenues increased more than ten fold.

In the mid-1960s, real GDP growth flattened following a sharp decline in private investment, as the new iron ore facilities neared completion. At the same time, the rapid expansion of public investment, funded by external and domestic banks, started to put pressure on government finances. In 1962, Liberia became a member of the IMF and, one year later, the government called on the IMF to assist in devising a program of financial reforms and debt renegotiations. A comprehensive financial program was put in place to mobilize additional financial resources, curb expenditure, and terminate reliance on short-term debt. In addition, an agreement was reached with Liberia’s major creditors on a rescheduling of debt repayments falling due in the period 1963-68.

Liberia’s economic and fiscal performance, benefiting from a global boom for its main export commodities (iron ore and rubber), improved markedly between 1969 and 1974. The rate of growth of real GDP averaged 6 percent. Exports of forestry products, because of an increase in the exploitation of forestry resources, also contributed to Liberia’s improved performance. The government ran large surpluses in its current operations that it used to finance development expenditures and applied to debt amortization.

Between 1975 and 1979, the oil crisis and global economic downturn led to a significant slowdown in Liberia, and the rate of real GDP growth averaged slightly over 2 percent (negative real per capita growth). The terms of trade deteriorated while the recession in industrial countries affected Liberia’s production of iron ore and rubber, which were exported mainly to European countries. The traditional trade surplus started to decline and became negative in 1976. After years of recording overall surpluses, the central government registered an overall deficit in its operations in 1975-76 as well as in subsequent years, as a result of increases in developmental expenditures and operational losses of public corporations. Overall deficits were financed by foreign resources obtained on concessionary terms and, to a small extent, by commercial loans. In 1977, the government contracted a eurodollar loan, which was used mainly to finance public corporations.

A central bank (The National Bank of Liberia) was put in operation in July 1974, but it did not succeed in moderating the consequences of the shock to the terms of trade. The government remained committed to maintaining the U.S. dollar as the predominant means of payment. Since the central bank did not have sufficient reserves to follow countercyclical policies to any significant extent, it was unable to neutralize the impact of the external shock on the economy. Serious liquidity squeezes started to appear that—in the context of rising international rates—put additional pressure on domestic rates and domestic investment.

After 1980, Liberia’s internal and external balances rapidly worsened further, and dollarization was eventually abandoned (Box). Political instability, together with a decline in exports due to global recession, declining reserves of iron ore, stagnating rubber production, and a significant decline in the terms of trade, contributed to the collapse of confidence, both internal and external in the Liberian economy. Private capital left the country and investment plummeted. Foreign funding of the rising fiscal and external deficits eventually dried up, and a local currency, the Liberian dollar, was introduced in 1988.14

Liberia. Fiscal Deficits During the 1980s

Liberia’s overall fiscal deficit rose to more than 10 percent of GDP during the 1980s. This poor fiscal performance was marked by both a steady decline in revenues and a rise in expenditure. Deficits were financed largely through (i) an accumulation of arrears on external debt-service payments and domestic payments arrears (including wages and salaries arrears), (ii) the emergence of various forms of government liabilities (including duty drawbacks and unpaid vouchers owed to suppliers), and (iii) borrowing from the banking system (mainly through the central bank).

Fiscal Balance in the 1980s

(In millions of Liberian dollars)

article image
Sources: Liberian authorities; and IMF staff estimates.

National Bank of Liberia, a former central bank.

Table. Liberia: Main Economic Indicators, 1966–2004

article image
Source: IMF Staff Reports.
1

We thank our colleagues Arnim Schwidrowski, Anne-Marie Gulde, Wayne Mitchell, Michael Tharkur, Peter Stella, Arend Kouwenaar, and Arto Kovanen for useful discussions and comments, and are also grateful for editorial support by Elisa Diehl and Elizabeth Larouer.

2

The IMF staff report on Liberia’s 2005 Article IV consultation (http://www.imf.org/external/pubs/ft/scr/2005/cr05166.pdf), published in May 2005, reported the discussions with the Liberian authorities on the adequacy of full dollarization. Some Liberian officials argued that full dollarization could help reestablish fiscal discipline and attract foreign investors. Others favored dollarization as an effective way to ensure stable prices and wages. The Central Bank of Liberia staff were concerned that full dollarization would preclude more active monetary policies.

3

For example, see Calvo (1999) and Dornbusch (2001). For complete discussions of the pros and cons of dollarization, see Berg and Borensztein (2000) and Levy Yeyati and Sturzenegger (2003a). For a discussion of de facto and partial dollarization, see Ize and Parrado (2002), De Nicolo and others (2003), Gulde and others (2004), and Ize and Powell (2004).

4

A dummy for an IMF program has a value of one if the country received financial resources from the IMF during the period, and zero otherwise.

5

Most of the cons of full dollarization discussed in this section also apply to partially (de facto) dollarized economies. Specifically, partial dollarization constrains monetary policy, exposes banks to systemic liquidity risk and involves a loss of seigniorage, to the extent of the effective currency substitution. In addition, banks in partially dollarized economies are more likely to be exposed to higher currency risk than in fully dollarized economies if they (or their clients) have difficulties in matching the currency of denomination of their assets and liabilities.

6

For an alternative way to estimate seigniorage in dollarized economies see Schmitt-Grohe and Uribe (1999).

7

South Africa has agreements with Lesotho and Namibia, where the rand is legal tender, to share seigniorage revenues. The United States has no sharing agreements with countries that use the U.S. dollar as legal tender.

8

Under a floating rate regime, fiscal mismanagement would trigger immediate signals of imbalances and (desirable or undesirable) corrections. For example, large fiscal deficits would quickly be corrected by an exchange rate depreciation. Depending on the monetary policy response, the final result would be a combination of a reduction in real GDP and a reduction in inflation. Persistent fiscal deficits under a loose monetary policy would cause people to abandon the local currency (in favor of goods or foreign-currency denominated financial assets).

9

It is even more difficult in a dollarized economy to provide lending of last resort than under the gold standard. As Fischer (1999) notes, when “the Bank of England was bound by gold standard (or currency board) rules, the Bank of course did not have the ability to create gold. …Nonetheless, … the Bank of England was given permission to break the gold standard rule, and since Bank of England credit was in the event accepted as being as good as gold, it managed to stop the panics…”.

10

An alternative to a lender of last resort is a strategy to strengthen domestic banks, for example, through higher capital. See Caprio and others (1996).

11

See “Islamic State of Afghanistan: Report on Recent Economic Developments and Prospects, and the Role of the Fund in the Reconstruction Process,” IMF Country Report No. 02/219 (Washington: IMF) ().

12

The annual flow of seigniorage revenue is typically measured as the change in the monetary base; and thus, the present discounted value of future seigniorage can also be estimated (Verde and Veracierto, 2000) with a set of underlying assumptions. To better reflect the expected dynamics of the postconflict economy, however, the paper bases seigniorage estimates on the medium-term projections in the IMF staff report on Liberia’s 2005 Article IV consultation (http://www.imf.org/external/pubs/ft/scr/2005/cr05166.pdf).

13

This section is based on IMF staff reports issued between 1969 and 2003.

14

Substantial amounts of Liberian dollars were issued to finance the fiscal deficit. Currency reforms took place in 1988, 1992, and 1999. From 1988 to 1992, the “J.J. Roberts” Liberian dollar was issued. Upon the currency reform in 1992, the “Liberty” Liberian dollar was introduced. Both dollars circulated until the current Liberian dollar gradually replaced them during 1998-2000.

Adopting Full Dollarization in Postconflict Economies: Would the Gains Compensate for the Losses in Liberia?
Author: Miss Liliana B Schumacher and Mr. Jiro Honda