Implementing Official Dollarization

Contributor Notes

Authors’ E-Mail addresses: ljacome@imf.org, alonnberg@imf.org

This paper identifies key aspects that countries willing to officially dollarize must necessarily address. Based on country experiences, it discusses the critical institutional bases that are necessary to unilaterally introduce a new legal tender, describes the relevant operational issues to smooth the transition toward the use of the new currency, and identifies key structural reforms that are necessary to favor the sustainability over time of this monetary regime. The paper is aimed at providing preliminary guidance to policy makers and practitioners adopting official dollarization. The paper does not take a position on how appropriate this monetary arrangement is. Experiences from adopting dollarization in Ecuador, El Salvador, Kosovo, Montenegro, and Timor-Leste are illustrated briefly.

Abstract

This paper identifies key aspects that countries willing to officially dollarize must necessarily address. Based on country experiences, it discusses the critical institutional bases that are necessary to unilaterally introduce a new legal tender, describes the relevant operational issues to smooth the transition toward the use of the new currency, and identifies key structural reforms that are necessary to favor the sustainability over time of this monetary regime. The paper is aimed at providing preliminary guidance to policy makers and practitioners adopting official dollarization. The paper does not take a position on how appropriate this monetary arrangement is. Experiences from adopting dollarization in Ecuador, El Salvador, Kosovo, Montenegro, and Timor-Leste are illustrated briefly.

I. Introduction

The purpose of this paper is to identify key institutional and operational aspects that countries willing to officially dollarize must necessarily address.2 Based on country experiences, we identify the main decisions that are necessary to unilaterally introduce a new legal tender. The paper is aimed at providing guidance to policy makers and practitioners in this endeavor. Given its operational focus, the paper does not take a position about how appropriate this monetary arrangement is.

Official dollarization has been a topic of interest during the last two decades. Initially, de jure unilateral dollarization had gained popularity between academics and policy makers after Ecuador and El Salvador adopted the U.S. dollar as legal tender.3 However, following the demise of the Argentinean currency board in 2002 and its political and economic aftermath, enthusiasm for super-fixed exchange rate regimes, including dollarization, decreased. Today, in the context of the recent world financial instability, a renewed interest has emerged about the benefits of adopting this monetary regime, even as a unilateral decision. Behind this interest is the perception that by not having a domestic currency, countries could have avoided major depreciations, which, in some countries, eventually damaged their financial systems.4 In general, the most important rationale for dollarization has been the desire to import a tested monetary policy framework that facilitates preserving price stability and contributes to fostering economic growth. Other than this, post-conflict countries as well as many small open economies that are closely linked to a large country issuing a strong international currency—via trade and capital flows—have always maintained formal dollarization on their radar. This is more often the case for developing countries, less so for developed economies with strong monetary policy credibility.

Official dollarization has elicited some interest, but this has mostly focused on the benefits of adopting this monetary arrangement and has not addressed implementation issues. The literature on dollarization has primarily focused on its pros and cons (see Berg and Borensztein (2000), Panizza and others (2003), and Levy-Yeyati and Sturzenegger (2003)). A few other studies have been produced to answer questions such as when or which countries should dollarize (Eichengreen (2002) and Calvo (2002)). Geographically, studies have mostly looked at Latin America given the vast de facto dollarization in this region (Corbo (2001) and Salvatore (2001)), with little emphasis on country experiences, except for Panama (Moreno-Villalaz (1999) and Goldfajn and Olivares (2001)). Only Gruben and others (2003) address operational aspects of dollarization.

The rest of the paper focuses primarily on how to implement unilateral dollarization.5 Section II provides a summary view of official dollarization in the world map; section III identifies the main institutional and operational issues to be addressed when a country dollarizes; section IV singles out key structural reforms that should be approved in order to strengthen credibility and sustainability of dollarization. Experiences from adopting dollarization in Ecuador, El Salvador, Kosovo, Montenegro, and Timor-Leste are illustrated briefly in the appendix to this paper.

II. Official Dollarization: Where do we Stand?

Adopting a foreign currency as a legal tender entails costs and benefits. Conventional wisdom typically identifies the costs associated with official dollarization as: (i) loss of seigniorage; (ii) limited or no ability to provide lender-of-last-resort (LOLR) assistance to troubled banks; (iii) lack of exchange rate to be used as a shock absorber; and (iv) inability to reduce the value of financial commitments denominated in domestic currency via a large exchange rate depreciation or through fueling inflation. In turn, benefits of officially adopting dollarization are: (i) convergence of domestic inflation towards world inflation; (ii) elimination of currency risk, which reduces domestic interest rates; (iii) better environment for investment as a result of stable inflation and lower interest rates; and (iv) absence of the so-called “original sin,” which help to reduce the country risk as currency mismatches in the country’s balance sheet disappear.6

Against this background, as of end-2008, eleven countries have unilaterally dollarized worldwide (Table 1). Three of these countries are emerging markets, one is a high income country, and the rest are developing nations with very small economies—some of them considered micro states.7 Seven countries substituted their domestic currency for the U.S. dollar and three countries dollarized in the current decade. Yet, only two countries, Ecuador and El Salvador, went through the complex endeavor of replacing their established national currencies with the U.S. dollar as legal tender. Kosovo, Montenegro, and Timor-Leste shifted from one to another foreign currency prior to becoming independent states.

Table 1.

Formally Dollarized Countries (Excluding participants in currency unions; based on the IMF’s classification in the AREAER1/)

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Annual Report on Exchange Arrangements and Exchange Restrictions (2009), except for Kosovo which is not included. Also not included are three non-IMF member states (Andorra, Monaco, and the Vatican), which are using the euro after a special agreement with the EU authorities although they are not members of the EU.

Excludes the issuance of coins for primarily numismatic purposes.

As of 2007.

The year of adoption corresponds to the countries’ independence date.

Prior to 1979, Kiribati issued national coins, some of which are still in circulation.

The Deutsche mark (DM) was introduced as parallel legal tender to the Yugoslav dinar.

Panama maintains the balboa as the national currency, but only balboa coins circulate.

San Marino uses the euro on the basis of a formal arrangement concluded in 2000 with the European Community, through a monetary agreement with Italy (on behalf of the European Community). This arrangement allows the use of the euro as the official currency, and the minting of a specific amount of coins for circulation, collection, and commemorative purposes.

Source: Annual Report on Exchange Arrangements and Exchange Restrictions, International Monetary Fund.

During 2009, Zimbabwe transited to a unique form of unilateral an officially dollarized economy. In an environment of hyperinflation—after years of quasi-fiscal operations and central bank monetization of government deficits—the government officially authorized the use of any traded foreign currency as legal tender without formally abolishing the Zimbabwe dollar as legal tender.8 The most prominent currency used during 2009 was the U.S. dollar while the South African rand was, to a considerable extent, used for small cash transactions. Neighboring countries’ currencies are also used in some regions.

A snapshot of key macroeconomic indicators shows that dollarized economies have, in general, performed well vis-à-vis other groups of countries, classified by exchange rate regimes.9 The most remarkable outcome is that, during 2004-2009, inflation converged to and remained close to world inflation in the dollarized countries—including in Ecuador, where inflation had reached 100 percent year-on-year in 2000. Merging these countries with others featuring hard peg regimes, shows that inflation was on average lower and volatility larger because of the high pass through to domestic inflation originated on the 2007-2008 supply shock (Figure 1).10 In turn, economic growth in hard-peg countries was less dynamic and more volatile than in the rest of the developing and emerging market countries. Among the dollarized countries, aggregate figures hide an uneven performance on a country basis, with Panama ranking at the top (7.6 percent) and El Salvador at the bottom (2.3 percent) during 2004-2009. The other remarkable outcome is that dollarized countries seem to have maintained their fiscal position in check and a stronger fiscal stance than the rest of the developing and emerging market countries.

Figure 1.
Figure 1.

Key Macroeconomic Indicators in Groups of Countries

Citation: IMF Working Papers 2010, 106; 10.5089/9781455200658.001.A001

Source: IMF International Financial Statistics, IMF World Economic Outlook, and IMF Annual Report on Exchange Arrangements and Exchange Restrictions.

Focusing exclusively on the officially dollarized countries, country risks indicators have improved, except in Ecuador. The EMBI spread for El Salvador and Panama was lower or close to the composite EMBI spread, reflecting their strong fiscal position, their capacity to pay back their debts, and the absence of currency risk. Interest rates margins over similar U.S. rates also followed the same trend. Not surprisingly, both indicators rose in the wake of the recent financial crisis in El Salvador and Panama as a result of capital outflows—like in other emerging markets—and fears of possible banking crises, given the large presence of U.S. and European banks in those economies. The maintenance of an elevated country risk and higher interest rates in Ecuador reflect idiosyncratic factors of political economy nature, which that ultimately led to a debt default in 2008.

III. Implementing Unilateral Official Dollarization: Key Issues to Address

A first question to answer is whether specific pre-conditions should exist before adopting de jure dollarization. There are two competing views in this regard; one that believes that having pre-conditions in place before introducing a foreign currency as legal tender will yield more benefits, and the other that claims that dollarization actually puts pressure to immediately adopt similar policies (see Eichengreen (2002)). These pre-conditions, at the minimum, refer to having: (i) a robust financial system and strong financial supervision in order to minimize the likelihood of banking crises in an environment of no—or at most limited—lender of last resort (LOLR) facilities; (ii) solid public finances that give sufficient assurances to market participants about the sustainability of fiscal policy; and (iii) flexible labor markets to facilitate macroeconomic adjustment in response to external shocks. While the circumstances in which Ecuador dollarized suggest that it is not entirely critical to have these pre-conditions in place, having them in place or in a well-advanced stage might increase the chances of achieving a smooth transition and, more importantly, reducing downside risks, which may induce an upward bias in country-risk indicators and domestic interest rates.

Adopting official dollarization entails taking decisions on a vast array of institutional and operational aspects and, hence, there is no single list of issues that all dollarizing countries should address. Most countries have specific structural features; more important, dollarization is typically adopted under diverse circumstances. For instance, while Ecuador dollarized in the midst of a systemic financial crisis with high inflation and under a flexible exchange rate regime, El Salvador did it in an environment of macroeconomic stability and fixed exchange rate. As a result, the rate at which the domestic currency was converted to the U.S. dollar was an issue in Ecuador and not in El Salvador. Similarly, while choosing the new legal tender was not an issue in these two countries, it was a major topic of discussion in the case of Zimbabwe in early 2009.

Yet, there are a number of issues which invariably need to be addressed. These involve institutional matters to define the building blocks of the new monetary arrangement and also operational aspects aimed at securing a smooth transition and the proper functioning of the new monetary regime.

A. Institutional Issues

Official dollarization demands strong political support. Countries should carefully weigh the costs and benefits of adopting a foreign currency as a legal tender. Once the decision of officially dollarizing is adopted, enacting a clear legal framework is critical, which ideally should be endorsed by the society at large. While large groups in the country may be unwilling to abandon the national currency—many times because of national pride— such endorsement is easier to garner if the country is going through a period of very high inflation. Ecuador and Zimbabwe are cases in point as inflation discouraged using the domestic currency as store of value and, hence, their economies were already de facto highly dollarized.

Dollarization requires the approval of legislation defining the legal basis of the new monetary arrangement. A new law should be approved by parliament involving changes to the central bank law and to other pieces of legislation, sometimes including the constitution. Other financial sector legislation may also be amended to reflect the changing circumstances, including regulations on accounting or the relevant legislation that allows claims and obligations originally made in the national currency to be converted into the new currency. Also, the regulations governing the operations of national payment systems may need to be evaluated and typically revised.

The new legislation should define an alternative role to the central bank. This implies assigning the central bank a different objective and changing its functions and responsibilities accordingly. While having a central bank is not strictly necessary under formal dollarization, in practice central banks have continued existing in the dollarized countries. Among the largest dollarized countries, Panama has no central bank. Ecuador, El Salvador, and Montenegro have preserved a central bank with no commercial bank responsibilities. Kosovo and Timor-Leste have central banking authorities created after independence, which prominently function as financial sector supervisors. De facto, the new primary objective of central banks in officially dollarized economies typically should be to foster and maintain a stable financial system. Among the various tasks and functions often assigned to the central banks are to conduct financial surveillance and issue prudential and supervisory regulations, handle cash currency (banknotes and coins),11 manage international reserves, provide a centralized clearing function for the payment system, serve as fiscal and financial agent of the state, undertake macroeconomic studies, and advise governments on macroeconomic topics. Other typical central bank responsibilities should be prohibited, most notably, printing new currency notes (but not necessarily minting national coins) as well as conducting interest rate policy, while the ability of serving as LOLR is drastically curtailed.12

The central bank should be reorganized in line with its new mandate and responsibilities assigned. Its governance arrangement should reflect the new role of the central bank. For instance, if the new mandate of the dollarized central bank is primarily to preserve financial system stability and oversight the payments system, board members should be required to have the relevant expertise, and the board structure, functions, and operational arrangements should be designed accordingly. Also, because seigniorage is eliminated, central bank financing is restricted and, hence, an alternative income model—dependent partially or fully on the government budget—should be developed. If the central bank mandate is primarily to preserve financial stability, financial institutions’ contributions should also be an important part of the central bank revenue sources. Provided the central bank does not issue any security or bond, it does not require maintaining a specific level of capital. However, because central banks should remain autonomous to exercise its responsibilities aside from short-run political considerations, legislation should establish that the government underwrites central bank liabilities.

Although recent experiences show that countries that unilaterally dollarized typically did not encounter legal constraints from the currency issuing country, some adverse reaction may take place, in particular, when it comes to euroization. Since adopting the euro is the final step in a staged process of convergence and policy coordination, the EU authorities—and not least the Ecofin Council and the European Central Bank (ECB)—are far less complacent with unilateral dollarization using the euro given that member countries should follow the road map in place for adopting the euro as legal tender.13 For countries that cannot or will not join the EU, this may not be a major issue. By early-2010, this matter is especially topical for Montenegro, where membership discussions with the EU are underway, and for Kosovo, which plans to apply for membership. So far, there have been no cases of acceding countries in the EU which were unilaterally euroized at their time of accession. It is, therefore, a considerable uncertainty about the way these cases will be dealt with, and that this will likely be determined at the time of accession.

In general, approaching the authorities from the country that issues the new legal tender is warranted to explore areas of cooperation. This cooperation may involve a wide range of issues, from seeking a comprehensive agreement for a formal monetary association at one extreme—with the aim of obtaining a share on the seigniorage generated in the issuing country—to a simple cooperation agreement to facilitate the availability of banknotes (and maybe coins).14 In the latter scenario, countries might explore the conditions to ensure that the transport of new cash currency runs smoothly and the replacement of unfit banknotes is seamlessly accepted—although these arrangements could also be done with commercial banks. In addition, clearing will at times need to go through that country’s banking system, though not necessarily on the central bank’s books.

The government and the central bank should prepare and disseminate a timetable for dollarization. There is no specific duration for the transition period. It can be as short as less than six months, like in Ecuador, where dollarization was adopted in the middle of a full-blown economic crisis. In general, the span for the implementation of official dollarization hinges on a number of factors, including the level of public support, the degree of macroeconomic stability, and institutional features such as the maturity of contracts in which dollar and domestic currency contracts coexist. The transition period should give sufficient time to explain economic agents about the road to dollarization, and how to operate under the new monetary regime. The timetable for dollarization should at least specify dates for: (i) when the rate of conversion will enter into effect and, if relevant, when the new currency will be officially the legal tender; (ii) when the central bank will stop conducting open market operations; (iii) when the central bank will start replacing the domestic currency with the new currency; (iv) the period of time in which both currencies will be allowed to circulate and the date when domestic coins and banknotes will be phased out from circulation; and (v) the dates in which financial system balance sheets will be converted into “dollars” and new accounting rules for the corporate sector will enter into effect.

A comprehensive communication strategy is at the heart of the implementation and success of official dollarization. Governments should respond and explain very basic questions that citizens may have, including why dollarization is adopted, how it will be implemented and, in particular, what is the timetable for its full implementation. Special emphasis should be given to the dissemination of: (i) the rate of conversion to re-denominate in dollars existing domestic currency prices, assets, liabilities, contracts, and financial transactions; (ii) a transitory period in which prices of goods and services will be announced in both currencies and the date in which the local currency will stop serving as mean of transaction; (iii) also important is to deploy a media campaign aimed at limiting “currency rounding,” which tends to delay the achievement of price stability and, hence, elevates the level of prices.15 Specific information about the procedures for this transition should be provided to the financial system and other private enterprises in order to secure a smooth currency conversion in their balance sheets and contracts. The public sector should also receive clear guidelines as to how to migrate to the use of the new legal tender. In general, educating and informing the public is critical for the success of the currency conversion. To achieve this, all types of media (newspapers, radio, television, and internet) should be used, as well as posters and other informative material. Communication needs to reach economic agents and the general public at large.

B. Operational Issues

The conversion rate

As a country dollarizes, the most important operational issue to define is the rate at which the local currency is converted into the new legal tender. This may not be a problem if the country has a fixed exchange rate regime or if the economy is in steady state. However, in an environment of macroeconomic instability defining the exact exchange rate is not obvious. Two considerations are in order to guide this decision. First, choose the closest number to the market rate that makes it quick and easy for economic agents to make conversions between the two currencies. And, second, the conversion rate requires that key central bank liabilities are covered by the existing stock of net international reserves.

Another critical decision is to define a backing rule that allows covering specific central bank liabilities with international reserves. The backing rule is particularly relevant during the transition period, to assure the viability of the new monetary regime. This implies that, at the minimum, coins and banknotes of the local currency should be covered, but covering base money plus interest-bearing securities issued by the central bank is optimal. Failing to secure this backing rule would undermine the credibility and, eventually, the sustainability of the new monetary system.16 If a meaningful surplus of international reserves remains after applying the appropriate backing rule, a productive use of this surplus could be to create an emergency liquidity facility, which could be used beyond the transition period to cope with episodes of financial distress in absence of LOLR facilities. In dollarized countries that are highly dependent on the export of a single commodity, accumulating excess international reserves is warranted as a buffer to confront negative shocks. When it comes to new countries, international reserves are typically not available in meaningful amounts to provide a desirable backing of central bank liabilities. This would not necessarily prevent a successful effort to undertake official dollarization, because typically these countries keep utilizing the same currency that was used before, and, hence, there is no local currency to back. For instance, in Kosovo, no functioning central bank authority existed at the time of the de facto exit from Serbia, but parts of the Yugoslav payments bureau system still remained in Kosovo. In general, national central banks were built up over time, step by step, which had implications for a gradual phasing in of single national legal tender currencies.

To make explicit the viability of the new monetary regime and enhance the transition’s credibility it is desirable to change the central bank’s balance sheet presentation. In the new structure of the balance sheet, market participants should be able to monitor the availability of international reserves to back domestic currency in circulation as well as central bank securities.17 The modified presentation of the central bank balance sheet also gives information about any room for central bank’s systemic liquidity management and, if possible, the likely limited provision of LOLR support. In case the central bank possesses quasi-fiscal liabilities, they should be absorbed by the government.

Interest rates’ conversion

When the country dollarizes under stable macroeconomic conditions, there is no need to change the parameters of contracts maturing after dollarization enters into effect, although negotiations may be allowed. Typically, interest rates decline following the official dollarization of the economy. In an environment of macroeconomic stability, the less disruptive way of converting domestic currency interest rates to dollar-denominated interest rates is to maintain the original terms and conditions of the contract and apply them at the conversion rate. Thus, at the expiration of the contract, all assets and liabilities, as well as interest rates in domestic currency are valued in dollars at the conversion rate. However, the converted into dollars’ interest rates will probably still reflect the previous expected devaluation and country risk premiums. Even if these premiums are not large, the post dollarization converted interest rate will result in higher rates compared to those agreed in contracts during the post-dollarization period. To tackle this distortion, voluntary renegotiations may be allowed during an interim period. El Salvador followed this course of actions as financial institutions were authorized to convert gradually colones interest rates into dollar interest rates during the first three months after the law establishing official dollarization was approved.

When the country dollarizes under high inflation conditions, the government may set rules to convert domestic currency interest rates—agreed before dollarization was announced—into dollar rates. When inflation is running at very high levels, the domestic currency is typically in a free fall, and the country risk and interest rates in local currency are also inevitably high. In these circumstances, simply applying the conversion rate to transform interest rates into dollar-denominated rates will result in rates that are much higher—still reflecting devaluation and country risk premium—than the prevailing interest rates following the adoption of dollarization. Against this backdrop, and considering a possible asymmetry of powers of negotiations between the two parties in the contract, for example between the bank and a customer, a government intervention to “dollarize interest rates” may be warranted. This approach is disputed by Gruben and others (2003), who argue in favor of no government intervention. They claim that contracts always incorporate time-inconsistency contingencies, including dollarization. Moreover, they argue that governments are not well informed to interfere by changing the parameters of pre-dollarization contracts, and that introducing changes ex-post tend to create moral hazard in detriment of market discipline.

Converting domestic currency interest rates into dollar interest rates is difficult to implement in an environment of high inflation or hyperinflation. Typically, countries may approve legislation establishing the new level of interest rates for both domestic and dollar-denominated contracts (the so-called desagio in Spanish).18 For instance, Ecuador implemented a desagio rule by adjusting interest rates in sucres and dollar-denominated contracts to lower levels. The new rates were set and disclosed simultaneously when the adoption of the new legal tender was officially announced.19 There is no standard procedure to convert domestic currency interest rates into dollar interest rates. One alternative is to define reference rates for both the domestic currency and the new legal tender—as proposed in Schuler (2002)—and to convert interest rates from domestic currency to dollars by measuring them in terms of the reference rates.20 Of course, defining the reference rate is critical; for the domestic currency, a central bank interest rate from open market operations is a valid pick; similarly, an equivalent central bank dollar rate can be chosen and, if it does not exist, a Libor or a Fed funds rate, plus an appropriate premium, may be used.

Is there any room for conducting monetary operations and providing LOLR support?

In a dollarized economy, the central bank loses its ability to conduct monetary operations. Given that the central bank is no longer in a position to issue its own national money, it should refrain from conducting monetary operations. Exceptionally, the central bank may redistribute liquidity among financial institutions—although it will necessarily be in limited amounts—during times of financial distress, provided it has international reserves to back these operations.

Bank reserves should be used primarily to support the operation of the payments system, but could also serve as an instrument for liquidity cushion. In Ecuador, bank reserves are used for payment systems purposes, whereas in El Salvador reserve requirements are an integral component of the financial safety net. In particular, in the latter country, bank reserves count in the calculations of liquidity requirements, but they are also part of a prudential liquidity measure determined by the Superintendency of Banks in absence of a central bank LOLR facility.21 To avoid taxing financial intermediaries, ideally, bank reserves should be remunerated. The interest rate paid on bank reserves should be consistent with the return the central bank obtains from investing these funds—which are effectively part of the international reserves.

Dollarizing countries should compensate—at least partially—the lack of an LOLR. Without the privilege of printing money, central banks in de jure dollarized countries are unable to fully exercise their function of LOLR. Yet, these countries may be hit by financial crises, which make the case for assisting problem banks with liquidity assistance.22 In practice, central banks in officially dollarized countries may only provide liquidity support if they hold a surplus of international reserves—which may not be large in a dollarized economy—like in countries with a currency board arrangement. An additional or complementary alternative is to build a contingent liquidity fund—constituted, for example, with foreign loans—to substitute central bank’s role as LOLR.23 A similar arrangement consists in purchasing a private insurance policy with—foreign—private financial institutions, which is activated as needed or, in general, in case of crises.24 However, this arrangement may be very expensive and, hence, would entail large fiscal costs. Moreover, it would hardly work to tackle a systemic financial crisis, as observed in 2002 in Argentina.

With limited ability for central banks to act as LOLR, the focus is moved to the Ministries of Finance and to international multilateral institutions. The ability to deal with solvency problems in banks in the context of a financial crisis, the strength of the fiscal authority, and its willingness to allocate fiscal resources to a rescue effort, will be the key factors in determining the banks’ chances of survival.25 Other than this, the recent financial crisis in the industrial world and its impact on the dollarized countries—which also have a large presence of international banking institutions dominating the financial system—showed that multilateral and regional financial institutions can play a crucial role in mitigating potential liquidity crunches.26

Currency issues

Procurement of the new currency. The central bank should have sufficient convertible currency available to procure the new currency. Banknotes (and coins) from the issuing country need to be purchased in sufficient quantities and in appropriate denominations (and subdenominations). Once dollarization is established and running, a valid question is who should be responsible of feeding the economy with dollar banknotes. While it is conceivable that the private sector could hold this responsibility, it is typically assigned to the central bank, on behalf of the government, given the strategic nature of importing and distributing banknotes to the economy on a timely basis.

“Dollarized” coins or new national coins. Some countries prefer to use national coins after adopting dollarization for various reasons: (i) to preserve a national symbol once the domestic currency has been eliminated and banknotes phased out from circulation; (ii) in case the U.S. dollar is the new legal tender, U.S. coins may be difficult to understand by people without knowledge in English because of the lack of numerals; (iii) also with respect to use of the U.S. dollar, the commonly used four U.S. coin denominations may be too few to fully meet the needs of low denominations; in particular, the lack of a 50 cent coin can be problematic; and (iv) transporting coins over long distances is very expensive measured by value. Ecuador and Timor-Leste are each using national coin series, which are fully convertible to U.S. dollars in their respective countries.

Period of dual currency circulation. Having to deal with two official currencies, leads to extra costs in the market place and other economic inefficiencies. Retail traders have to handle two sets of banknotes and coins and prices should be announced for some time in the two currencies according to the official conversion rate. Also, ATMs and automatic vendor machines need to be reprogrammed. To reduce the economic inefficiencies, the conversion period is normally set as short as possible taking into account the situation in the field to ensure an orderly exchange. 27

Managerial and organizational systems for currency conversion. A currency conversion is a multi-pronged task that demands skill in a multitude of disciplines and at different levels to be successful. Depending on the institutional capacities, the central bank may or may not be in charge of managing the currency conversion. In Ecuador and El Salvador, the central bank led the currency conversion plan. However, in case the central bank lacks the appropriate skills, the best way of organizing and managing a currency conversion is as an off-line project, which avoids running it within the normal bureaucratic central bank organization.

Exchange points. To meet the time plan for the currency conversion, a suitable number of exchange points need to be identified. Existing banks and money changers should naturally be used, but also post offices; a number of temporary stationary exchange points should also be set up. Mobile units should be organized for the more distant parts of the country that lack much financial infrastructure. All exchange points need to be equipped with trained staff and security personnel, and with counting machines, security detectors, invalidation tools, accounting systems, and reporting systems, using normal telephones and faxes and/or mobile/satellite phones.

Distribution and storage of cash. The government and the central bank should prepare a logistics plan with a time table for key actions to be taken. During the conversion, the distribution and storage of new and old cash currency constitute a major challenge from a logistical point of view. The demands will vastly exceed the needs of a normal year as the exchange will encompass the whole outstanding stock of cash currency and not just the replacement of unfit banknotes together with the annual growth of cash currency. The transportation of currency will require extra resources. In addition, the storage needed for two types of cash currency will require additional temporary storage in containers, secured vaults, strong boxes, and safes. Many of these should be leased rather than purchased outright.

Invalidation and eventual destruction of national banknotes. To avoid fraud, national banknotes need to be invalidated at the time when they are exchanged for the new dollarized currency. Various invalidation techniques should be considered including mechanical shredding, use of ink and dye, and the use of manual and hydraulic punchers. The technique of invalidation used would vary with the conditions at the respective exchange points and should take place in a decentralized manner. All national banknotes should also eventually be destroyed after having been invalidated and counted. Techniques normally used include mechanical shredding and incinerating of banknotes. This is best done centrally rather than in a decentralized manner and should be integrated with the currency reporting system.

IV. Key Complementary Structural Reforms

A package of policy and structural reforms should be prepared, discussed, and approved to strengthen credibility and sustainability of dollarization. The shift to full dollarization raises important challenges and put a premium in intensifying structural reforms. A relevant question is whether these reforms should precede the adoption of official dollarization. While ideally they should be approved before official dollarization is enacted, it may not be possible should the country dollarize in the middle of an economic crisis and, in particular, if the country is going through hyperinflation. In this scenario, structural reforms should be approved in the short run and include, at least, reforms in the fiscal, financial, trade, and labor areas of the economy, as laid out below. Approving other reforms with the aim of boosting productivity and economic growth are also warranted—but their analysis is beyond the scope of this paper.

A. Fiscal Reform

With a central bank unable to provide credit to the government, a set of fiscal rules is desirable with the aim of preserving sound public finances in the long run. This policy entails building a tax base that provides a stable flow of revenues and expenses, consistent with a sustainable fiscal deficit. If government revenues depend critically on the export of one or two commodities, building stabilization funds is appropriate, thereby laying the groundwork for implementing a counter-cyclical fiscal policy. As an example, Ecuador, an oil-exporting economy, approved a fiscal responsibility law in 2002, which was aimed, primarily, at maintaining fiscal deficits in check, reducing the burden of the public debt, and using extra revenues from oil exports to establish a stabilization fund.28

Another key requirement relates to the importance of adequate and timely monitoring of expenditure commitments. Without this, many cash-based budgets in hard-peg countries have run up substantial arrears that have subsequently served to block the entire payment system. In this context, there may be a need for a better bankruptcy and debt resolution framework for dollarized economies.

Reducing or maintaining the public debt at sustainable levels should be an integral component of a prudent fiscal management as a way of preserving the country’s access to capital markets. In addition, governments in official dollarized countries should develop a public debt capacity with the aim of facilitating treasury management. This is also very important because, as observed in many developing countries, governments may need financing to compensate shortages stemming from seasonal fluctuations in tax revenue, which no longer can be provided by central banks.29

Failing to preserve fiscal discipline and/or holding the burden of the debt at moderate levels would maintain country-risk indicators at high levels. Moreover, it would create uncertainty about the sustainability of public finances and, eventually, of dollarization. In this scenario, markets may fear that the government would at some point need to issue a local currency—or some imperfect substitute like the so-called “patacones” in Argentina before the currency board was abandoned in 2002—to cope with a shortage of fiscal revenues and its inability to raise financing in debt markets to pay wages and, in general, government expenditures.

B. Financial reform

Banking crises can put at risk a dollarized regime and, hence, adopting a financial reform is critical to secure soundness and stability of the financial system. As a general rule, with limited or no LOLR facilities, there should be more stringent solvency and liquidity requirements. El Salvador has followed this approach as the authorities have increased the required risk-weighted capital-asset ratio to 12 percent—well above the 8 percent required in Basel I—and introduced in 2003 a special liquidity buffer equivalent to 9 percent of deposits.30 In addition, financial surveillance should be upgraded based upon a risk-based approach of bank supervision. Strengthening other elements of a financial safety net is also critical, including prompt corrective actions, a deposit insurance mechanism and, in particular, effective and efficient bank resolution instruments coupled with clear exit rules.31 Ecuador recently approved a comprehensive reform along these lines. However, to get the most from this reform, having well-trained financial regulators is critical and, hence, capacity building should be part of the financial reform agenda.

The presence of foreign owned institutions in the financial system, as branches or subsidiaries, has been also part of the recipe to strengthen official dollarization. Conventional wisdom claims that foreign banks benefit financial systems in developing countries by reducing their vulnerabilities to financial crises, a potential threat to the subsistence of an officially dollarized regime. Foreign banks typically enjoy higher standards of corporate governance, which tend to be emulated by local banks. More important, they are perceived as better prepared to withstand episodes of financial stress and, hence, are less prone to bank runs and benefit from flight-to-quality, either because they have more alternatives to diversify risks because of their international links, or because they have more access to financing in case of a systemic liquidity crunch. In practice, except for Ecuador, other officially dollarized countries have a large penetration of foreign–owned banks. In particular, Panama is already an international financial center and in El Salvador foreign financial institutions recently became dominant players in the market place. Against this backdrop, the internationalization of financial markets has also been criticized in the wake of the recent world financial crisis because, precisely, international banks were the most adversely hit, thereby generating uncertainty about the stability of domestic financial systems.

Even when foreign owned institutions are largely present, there is still a need for robust prudential framework and regulation to address financial stability issues. The support of parent banks cannot be taken for granted, in particular, during periods of financial contagion. Moreover, close cooperation with home supervisors is always needed in order to keep under review the financial health of parent groups and their ability to support their local subsidiaries.

C. Trade Reform

Dollarizing countries should aim at reducing existing trade tariffs and distortions in order to expand the export base and, in general, to favor the sustainability in the new monetary regime. By definition, the appropriate functioning of an officially dollarized regime hinges on the availability of the foreign currency adopted as legal tender, which inevitably is the result of the inflows associated with exports of goods and services and capital inflows. In this connection, dollarized countries should embark on approving far-reaching trade reforms and should put in place a regulatory framework conducive to foster capital mobility inflows, as well as to encourage foreign direct investment.32 In the short run, lowering tariffs also benefit the convergence of domestic to world inflation.

In the long run, dollarized countries should also engage on trade negotiations with various countries in different regions of the world. A more open and integrated economy to world markets fosters exports activities and boosts economic growth. In addition, dollarization benefits from a stable flow of dollars to facilitate domestic transactions, which requires relying on a broad base of exports rather than relying excessively on a single or few commodities that are commonly subject to world price volatility. Also, multiple trade agreements might allow dollarized countries to untie its business cycle from that of the country issuing the foreign currency. Dollarized countries may also benefit from a diversified base of trade partners, because the effective real exchange rate becomes less dependent on the evolution of the foreign currency adopted as legal tender vis-à-vis other currencies.

D. Labor Reform

Since dollarized countries have no direct buffer to cope with the impact of adverse external shocks, they need to minimize nominal rigidities, in particular in the labor market. The competitiveness of tradable activities in officially dollarized countries is, to a great extent, linked to the performance of the foreign currency adopted as legal tender vis-à-vis other currencies. In addition, these countries are exposed to exogenous real shocks without any chance of using the exchange rate as a buffer like other countries. In these circumstances, officially dollarized countries have no other alternative but promoting and maintaining flexibility in the labor market to allow the economy to adjust to the new adverse environment. Thus, dollarized countries should make efforts to gain increased flexibility in the functioning of the labor market. Administrative wage increases should be handled with caution as they affect directly the competitiveness of tradable activities. Incentives for the creation of jobs and for enhancing labor mobility are also relevant.

In the short run, indexation clauses should be phased out to facilitate a rapid decline of inflation. While difficult in dollarizing countries running high and hyper inflation, the elimination of possible indexation clauses in wage contracts is crucial. De-indexation should be included in the legislation that establishes official dollarization and, if possible, should be introduced before dollarization is adopted to eliminate an element of inertial inflation, which might postpone convergence to world inflation.