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Appendix I. Case Study: Ecuador
Appendix II. Case Study: El Salvador
Appendix III. Case Study: Kosovo
Appendix IV. Case Study: Montenegro
Appendix V. Case Study: Timor-Leste
The authors would like to thank Karl Driessen, Simon Gray, Karl Habermeier, and other colleagues in the Monetary and Capital Markets Department for helpful comments on earlier versions of this paper. We are particularly indebted to Alain Ize for reading, extensively commenting, and discussing the content of the paper. Remaining errors and omissions are the authors’ responsibility.
By official dollarization, we mean a country’s unilateral decision of adopting a foreign currency as a legal tender. The term dollarization, therefore, also encompasses euroization, that is, the adoption of the euro as a legal tender. In that context, it excludes the formal accession to the euro area by European Union (EU) member states.
The term “legal tender” is here defined as the currency used in a country that, by law, may be offered in payment of a debt and that a creditor legally cannot refuse.
In practice, capital outflows hit all countries alike and, in the case of the dollarized economies, financial systems still received the impact via lower external financing.
Issues not covered in this paper also include implementing bilateral dollarization, acceding to the European Union, or how to introduce a monetary union.
The “original sin” refers to a situation in which countries are unable to issue debt in their own currency and, hence, obtain financing by issuing debt denominated in a major international currency. As a result, countries become vulnerable to large exchange rate depreciations as they may increase considerably government expenditures, casting doubts about the countries capacity to pay back the debt.
These nations typically have small and not necessarily wealthy populations, which cannot easily reach economic “critical mass.” In addition, they are closely integrated with a big neighboring country. Since the fixed cost of issuing own currency is high, these countries have rather decided to use an existing currency.
Zimbabwe reached a hyperinflation in February 2007. In mid-November 2008, the monthly inflation rate was estimated at 79,600,000,000 percent—equivalent to a daily rate of 98 percent—unmatched since the hyperinflation in Hungary in 1946. A number of re-denominations of the national currency in 2006–09 failed to restore confidence in the Zimbabwe dollar. As a result, this currency gradually went out of circulation during the second half of 2008, as people started to demand foreign currencies for payments.
We picked 2004 as the first year of the comparative period in order to capture the steady state information in the dollarized economies.
The classification of countries is based on the 2008 IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions. The sample of dollarized countries comprises the four largest dollarized economies, namely Ecuador, El Salvador, Panama, and Montenegro. The hard-peg countries comprise a total of 30 countries: the former group, the currency board countries (Bosnia & Herzegovina, Brunei Darussalam, Bulgaria, Djibouti, Estonia, and Lithuania), plus the countries belonging to the East Caribbean and the two African currency unions. The inflation targeting group includes Brazil, Chile, Colombia, Ghana, Guatemala, Hungary, Indonesia, Mexico, Peru, Philippines, Poland, Romania, Serbia, South Africa, Thailand, and Turkey. In addition, excluding the IMF’s World Economic Outlook list of 32 advanced countries, the soft-peg countries comprise 63 countries, whereas 39 countries are classified as non-inflation targeting emerging and developing countries featuring flexible exchange rate regimes.
For historical reasons, the ministry of finance is, in a number of countries, the formal issuer of coins rather than the central bank. In some such cases, limits may exist on the issuance of coins by the central bank as it may be seen as central bank financing of the state budget.
Nonetheless, the Central Bank of Ecuador influences commercial bank interest rates by defining administratively a cap on lending rates. It also regulates fees and commissions charged by commercial banks.
When planning for the European Economic and Monetary Union (EMU), special criteria were selected to define and to monitor the convergence of the economies towards the EMU. Only European Union member countries whose economies fully met these so-called Maastricht convergence criteria during a certain period were eligible to join the EMU. The idea was that by this design, the EMU would consist only of economies that had proven their ability to conduct prudent policies in the monetary and fiscal areas. Accordingly, the Governing Council of the ECB has stated that: “…it should be made clear that any unilateral adoption of the single currency by means of “euroisation” would run counter to the underlying economic reasoning of EMU in the Treaty, which foresees the eventual adoption of the euro as the endpoint of a structured convergence process within a multilateral framework. Therefore, unilateral “euroisation” would not be a way to circumvent the stages foreseen by the Treaty for the adoption of the euro….”
Any seigniorage sharing should be typically considered a gesture of goodwill from the country issuing the foreign currency and not an entitlement for the dollarizing country.
“Currency rounding” typically affects dollarizing countries with a high inflation background.
Strictly speaking, beyond the transition period, there is no need to provide backing, except for bank reserves at the central bank and for coins when the country issues them locally.
The alternative presentation of the Central Bank of Ecuador balance sheet is a good example to follow for countries dollarizing in a crisis environment (see details in the Appendix).
The desagio has been applied in several previous episodes in which countries introduced a new domestic currency or when a currency board arrangement was established. The Plan Bonex in Argentina at the time of the introduction of the currency board in 1991 is a case in point.
Interest rates were required to be adjusted for only one time, to 16.82 percent and to 9.35 percent for lending and deposit rates.
For instance, the government may set reference rates of 100 percent and 10 percent for domestic currency and dollar denominated interest rates. Thus, applying these rates, a 120 percent local currency interest rate will be converted into a 12 percent rate in dollars.
The initial unremunerated 20 percent reserve requirement was converted into a liquidity requirement of about 23 percent of deposits. These reserve requirements are comprised of three parts: (i) the first 25 percent is deposited and remunerated at the central bank or at a foreign bank, and can be automatically withdrawn; (ii) the second 25 percent is made of deposits at the central bank or a foreign institution, but could also be constituted by purchasing ad hoc government securities. Banks can have automatic access to these funds as well, but the central bank charges an interest rate in proportion to the amount withdrawn; (iii) the remaining 50 percent is constituted only by purchasing ad hoc government securities and banks cannot withdraw these funds without authorization of the Superintendents of Banks, who will impose a regularization plan to the troubled bank. Today, liquidity requirements are about 22 percent in effective terms, with an additional 3 percent that was introduced during the election cycle of 2004.
However, dollarized countries may be less prone to suffer financial crises because the lack of an exchange rate eliminates the possibility that financial institutions have currency mismatches or are exposed to the credit risk associated with dollar loans provided to domestic currency-earning firms or individuals.
Ecuador followed this path. The recently created liquidity fund will accumulate resources up to one time the amount of the system’s regulatory capital.
Argentina purchased this facility to serve the same purpose following the introduction of the currency board arrangement (see Baliño and Enoch, 1997).
This aspect has been developed by Ize et al. (2005), where the focus is on partially dollarized economies. A distinction is there made between self insurance and external insurance, which is relevant for fully dollarized economies.
For instance, El Salvador agreed with the Fund on an US$800 million Fund program that would mainly serve as a liquidity buffer in the case that a liquidity event were to happen.
In El Salvador, this period lasted six months following the approval of the law that officially established dollarization.
Overtime, however, the law has been changed extensively, which eventually has undermined the fiscal discipline initially envisaged.
From a sample of 123 developing and emerging market countries, central banks are empowered to provide short-term credit—at less than one year maturity—in 60 countries, to cope with seasonal fluctuations in governments’ revenues (see Jácome and others, 2010).
This rate has changed over time as a prudential measure.
El Salvador increased the coverage of the existing deposit insurance; Panama and Ecuador do not have any.
Although foreign direct investment is particularly attractive, excessive amounts into the non-tradable sector can have destabilizing effects.