Back Matter
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

References

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Appendix I. Case Study: Ecuador

Background

Ecuador dollarized from one day to another amid a full-fledged financial crisis. As the banking system was falling apart and de facto dollarization had climbed to more than 50 percent of total bank deposits (38 percent a year before) the government announced on January 2000 the adoption of the U.S. dollar as legal tender. The government did not have time to lay out the institutional and operational basis nor to educate the population for the monetary reform. However, simply announcing the country’s official dollarization improved market sentiments and stopped run on bank deposits.

Brief Chronology of Main Events
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Institutional issues

The legislation to implement dollarization was approved on March 13, 2000. The Economic Transformation Law (LTE) established a conversion rate of 25,000 sucres per dollar, the same rate already announced in January 10, 2000. Three key provisions of this law were: (i) the Central Bank of Ecuador (BCE) must not issue domestic currency any more; (ii) the BCE must exchange all sucres for dollars at the given exchange rate; and (iii) all economic agents must convert their accounting to dollars.

The new legislation laid out the BCE’s primary functions. These functions included: (i) promoting macroeconomic stability of the country; (ii) managing the free disposable international reserves; (iii) preserving the functioning of the payments system; and (iv) being a fiscal agent. The LTE did not assign a new mandate to the BCE.

Communication played a critical role in the transition to the new monetary regime. The BCE designed a broad communication campaign entitled “knowing the dollar,” which comprised three phases. Starting on April 2000, a massive educational effort was deployed to get the population acquainted with the new banknotes and coins. For selective audiences, a number of conferences and seminars were organized to explain the functioning of the new monetary regime and its expected benefits. The second stage began on September 2000 and addressed primarily the procedures to replace the old currency with the new legal tender. The major efforts were directed to rural areas. The final stage, implemented in February/March 2001 focused on the procedures required to finalize the currency exchange.

Operational issues

The rate of conversion was established in connection with the need of fully backing money base with central bank international reserves. In the wake of soaring inflation and currency depreciation, the conversion rate boosted exports, but the convergence of domestic to world inflation lasted more than four years.

The BCE changed the presentation of its balance sheet with aim of building credibility and enhancing transparency of the new monetary regime. The new presentation comprised four so-called systems: (i) in the “exchange system” the freely disposable international reserves (FDIR) appeared backing currency in circulation; (ii) in the “financial reserve system” additional FDIR backed bank reserves and central bank securities—in domestic currency; (iii) the “operations system” incorporated public sector and financial sector liabilities, including through other liabilities with international multilateral institutions and treasury operations, which were backed with any remaining FDIR; and (iv) the “system of other operations” included the remaining assets and liabilities plus BCE’s equity and income statement’s balances.

Central bank operations were narrowed down to focus exclusively on short-term liquidity management and to secure the appropriate functioning of the payments system. The BCE was allowed to issue exclusively short-term securities to mop-up liquidity surpluses. Reserve requirements were maintained as an instrument to secure a well-functioning payments system and, hence, the rate was gradually reduced from 11 to 4 percent for all bank deposits. Providing liquidity assistance to banks was legally proscribed.

A major task of dollarization was implementing currency conversion. As a first step, the BCE procured a family of coins with the same denomination than U.S. coins although with own physical characteristics. The local dollar coins began circulating by September 2000, which were exchanged at the BCE branches in the urban areas and at the National Development Bank for the rural areas. Currency conversion lasted one year. Dollarization also required revisiting the country’s statistical data to express them in the new currency.

Appendix II. Case Study: El Salvador

Background

El Salvador adopted the U.S. dollar as legal tender in 2001 in an environment of macroeconomic stability but after years of disappointing economic growth. Year-on-year inflation was on average below 4 percent during 1996– 2000. Since 1993, the colon was pegged to the dollar. Simultaneously, fiscal and external disequilibrium was moderate (on average about 1.5 percent of GDP during 1993–2000) and financial dollarization was low. However, real interest rates were high and economic growth was on average about 3 percent during the second half of the 1990s. With the expectation of reducing real interest rates and fostering economic growth, the Salvadoran authorities officially dollarized at a conversion rate of 8.75 colones per U.S. dollar.

Brief Chronology of Main Events
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Institutional issues

El Salvador made domestic and international consultations before adopting dollarization. Given stable macroeconomic conditions, the government had time to build political support and define procedures handled primarily by the Reserve Central Bank (BCR). The Monetary Integration Law (MIL) was presented as a step to integrate the Salvadoran economy to world markets, a vehicle to accelerate economic growth. Dollarization was endorsed domestically and received support from multilateral institutions. Cooperation from the Federal Reserve was obtained exclusively for specific operational issues, such as the provision of U.S. dollars bills and coins, and training of the BCR staff on security procedures to avoid counterfeiting of the new currency.

The MIL laid out BCR powers and established flexible operational procedures for the transition to dollarization. Key elements of the new legislation included the following: (i) prohibit the BCR to extend credit to financial institutions and to print new currency notes beyond the existing inventory; (ii) retain BCR powers to issue bonds and to purchase, sell, and exchange portfolio and securities with financial institutions; (iii) restructure the LOLR framework, establishing a remunerated liquidity requirement (see below); and (iv) allowing the BCR to conduct repo operations with government resources in the event of a systemic liquidity shortfall. The MIL did not establish a deadline for conversion of colones into dollar coins and banknotes. No changes to the presentation of BCR’s balance sheet were adopted.

The Salvadoran authorities deployed a vast communication strategy. Communication was critical to explain the benefits of dollarization in a country that benefit from a strong currency, quasi price stability, and low de facto dollarization. In addition, a public campaign was developed to facilitate trade and financial transactions in the new currency using a conversion rate that was not easy to handle for the vast majority of the population. Prices of goods and services were allowed to be expressed in both colones and U.S. dollars.

Operational issues

The conversion of colones into U.S. dollars lasted about two years. With no specific deadline to conclude the conversion of colones into dollars, the BCR followed a piecemeal approach distributing the new legal tender through the exchange points—primarily commercial banks. The Federal Reserve has been the main provider of dollars (banknotes and coins) directly to the BCR, and also takes care of the replacement of unfit banknotes.

The MIL established a 90-day period for the adjustment interest rates in pre-existing colones credits. To this end, financial institutions were required to refer to two criteria: (i) reduction in their financial costs; and (ii) prevailing interest rates for new dollar credits.

While the MIL retained BCR’s powers to conduct a number of operations with financial stability purposes, it restricted BCR’s capacity to lend to financial institutions. In particular, the BCR preserved its capacity to issue its own securities, although denominated in U.S. dollars. It was also entitled to purchase and swap these securities in the secondary market. In addition, the BCR could also swap assets with financial institutions in under the guidelines issued by its Directive Counsel, and conduct repo operations to preserve systemic liquidity. The MIL authorized the BCR to lend to the Deposit Guarantee Institute but prohibited lending to public and private financial institutions.

The MIL increased the financial system’s liquidity requirements. It converted previous bank reserves into a remunerated liquidity requirement that banks can access to fund short-term liquidity shortfalls. Key rules for the use of these resources are the following: the first 25 percent is drawn free of interests; the second 25 percent is charged a market interest rate; the use of the remaining 50 percent requires authorization from the Superintendence of Banks and accepting a regularization plan designed together with the BCR.

Appendix III. Case Study: Kosovo

Background

The official currency of Kosovo used to be the dinar, the currency of Socialist Federal Republic of Yugoslavia. However, for years DM were also widely use as money. As a result of a Regulation passed by the local UN administration in late 1999, the DM became de facto also legal tender in Kosovo with a preferred status compared to the new dinar. In the Mitrovica area situated in the northern part of Kosovo, which largely remained under Serbian control, the currency used in Serbia remained the primary legal tender. For the rest of Kosovo, the introduction of the DM represented a recognition of the reality in the field, as the new dinar was discredited financially (the experience of hyperinflation) and politically (the expulsion of Kosovar Albanians and the subsequent war). The choice of the DM was seen as a natural choice, although it was recognized that the physical DM in 1999 was formally merely one representation of the euro. Since the population was familiar with the DM, there was never any discussion on the need for introducing special national coins. During late 1999 and in 2000, dinar coins were used if no pfenning coins were available.

Brief Chronology of Main Events
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Institutional issues

In September 1999, the local UN administration passed a Regulation stating that all compulsory payment to the budget (taxes, customs duties, utility fees, and charges) where to be paid in DM. While the dinar remained formal legal tender, the UN Regulation stated that compulsory payments in that currency were subject to a surcharge of 10 percent in view of the manifest weakness and volatility of the new dinar.

The timing of the official euroization came early, only a few months after the local UN administration had received its mandate. The key reasons for this particular timing were the needs for a consistent UN budget for Kosovo for the financial year 2000. This created a number of institutional challenges such as reaching agreements with Bundesbank and the EU on the formal use of the DM and to have sufficient amounts of the right denominations of the currency transported into the capital. In this work, a resident IMF staff and later IMF advisory missions and technical assistance reports made critical contributions.

Operational issues

The introduction of the DM was successful. The Kosovar population welcomed the change to DM, a currency that represented stability. Since many had hoarded German cash currency for years, they were prepared to use the DM once the political certainty was reestablished and the shift was smooth. In addition to the substantial amounts of money that became available that way, significant amounts of DM banknotes were imported into Kosovo by air by UNMIK. Initially, sufficient vault space was not available, leading to temporary improvisations such keeping cash currency in tents guarded by international military. The balance sheet of the newly established BPK—the nascent central banking authority—grew quickly.

In early 2002, the physical euro was successfully introduced, replacing the physical DM. The management of the dollarization process was from the beginning in the hands of the BPK supported by considerable technical assistance from the IMF and USAID. At the request of the local UN administration, the IMF and USAID provided a number of international staff to support the BPK. Some resident expatriate staff from the IMF and USAID took on key management positions in the BPK; other short-term experts were part of advisory missions or provided peripatetic advice in specialized areas. The ECB supported the euro conversion in Kosovo by cooperating fully with the BPK and made available planning material and sharing ideas on a massive outreach to the population. This was needed as the population were not only unfamiliar with the new banknotes and coins, but often expressed a preference for continue using the established and well-liked DM.

The legal and accounting side of the dollarization was handled by UN legal experts based in Kosovo, combined with assistance from the IMF. The dollarization program was also supported by a communications program using the media—television, radio, and newspapers. It was also supported by printed material prepared by the local UN administration and the BPK. As the population already was well-informed about the physical design and value of the DM, the challenges for the communication program were minimal.

Both the introductions of the DM and the euro took fundamentally place in an effective manner. The competence of local staff and the enthusiasm among the Kosovar population for the use of the new banknotes and coins were key factors that facilitated the conversions.

Among problems encountered, the key issues were staffing and logistics. Almost all bank offices had been destroyed or severely ransacked. So was the case of the branch office of the Yugoslav National Bank in Pristina, where also the vault for storing banknotes could not be used. Moreover, the contributions by local banks were nil as none of the old banks survived and few key staff were any longer available. With no banks and little functioning formal monetization, this meant that more of the work had to be done by outsiders—international experts and NATO troops—to practically implement the dollarization.

Appendix IV. Case Study: Montenegro

Background

At the end of World War I, the independent Kingdom of Montenegro joined what was later known as Yugoslavia. As a consequence, in November 1918, the national currency—the perper (plural perpera)— was substituted for the (Yugoslav) dinar.

Chronology of Main Events
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Institutional issues

Montenegro had economic and political reasons for leaving the dinar and adopting the euro. The remarkable weakness of the Yugoslav currency and the hyperinflation generated in 1992–93 were key factors in undermining the confidence in the traditional legal tender. As a result, convertible currencies were de facto widely used for all the traditional functions of money. This was in part the result of significant remittances from Montenegrins living and working abroad. Moreover, over time, Montenegro was excluded from sharing seigniorage income with the National Bank of Yugoslavia, which ultimately stopped delivering banknotes to Montenegro.

The Montenegrin euroization was clearly a unilateral action, which initially was liberally tolerated by the key EU institutions due to the special political circumstances under which it took place. However, from the beginning, Bundesbank neither supported nor promoted the introduction of DMs in Montenegro. Bundesbank noted that there were no legal restrictions as to the use of DM in foreign countries. At the same time, Bundesbank stressed that it had no legal obligation to support countries that decide to use the DM as legal tender.

With the introduction of the physical euro and over time, EU’s attitude hardened, emphasizing that only states that can fulfill the stability criteria for membership of the single currency set out in EU treaties are authorized to use the euro. EU and ECB spokesmen increasingly emphasized that unilateral euroization is not compatible with the treaties, which foresees adoption of the euro as the endpoint of a structured convergence process within a multilateral framework.

Operational issues

Like in Kosovo, DM banknotes and coins were already widely used as money prior to the euroization. The successful introduction of the DM in neighboring Kosovo also gave credibility to the move. The choice of the DM was not debated on economic grounds; no other currency was discussed as a potential alternative to the DM. However, the decision was highly divisive on political grounds.

In addition, the choice of timing for the dollarization was determined by political, rather than economic, considerations. It may be noted that the formal introduction of the DM as sole legal tender in Montenegro was taken in late 2000, five and a half years before eventual formal independence from Serbia was a reality.

With respect to the subdenomination of the new currency, there were no serious suggestions to introduce special national coins for normal use. Instead, originally the German pfenning was used and replaced in the course of 2002 by the euro’s cent.

After dollarization, interest harmonization did not become very prominent in the banking sector. In Montenegro, the interest rates offered by commercial banks on loans and deposits have tended to vary considerably, reportedly as a consequence of different risk profiles for the financial institutions and their different customers. Also with respect to the yield of treasury bills, the interest rate dynamics in Montenegro has, by and large, not been in line with the general trends in the euro area. In part, this may reflect differences in inflation rates between Montenegro and key euro economies.

Appendix V. Case Study: Timor-Leste

Institutional issues

Based on a UNTAET Regulation (= law) issued in January 2000, the U.S. dollar was made official currency and legal tender for all public and private transactions. At an early stage, the Federal Reserve had been contacted about the idea to which it had no objections. As in the case of Kosovo, the concept of freedom of contract gave parties to any voluntary transaction (or discharge of any debt) the right to denominate a payment obligation in any currency they wished to agree upon. However, for all compulsory payments to any public authority in the country (for example, taxes, customs duties, utility charges, and public fees), had to be made in the legal tender. On a transitory basis, UNTAET allowed that compulsory payments to the Timorese budget could be made also in rupiah, subject to an additional transaction fee of 20 percent.

Brief Chronology of Main Events
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The choice of these particular arrangements was the result of complex decisions. In early 2000, there was a general agreement that the time was not right for the introduction of a separate national currency. The economic and social conditions were difficult and the capacity to administer a new national currency simply did not exist. After intense discussions, the Timorese leadership agreed to the use of the U.S. dollar as national currency. The U.S. dollar’s relative strength and stability were seen as an advantage to bring down inflation, which had been considerable with the rupiah regime. Additional advantages with adopting the U.S. dollar were that the major export product, coffee, was traded in that currency. Moreover, income from future sales of oil and natural gas, which were being explored, would also be traded in U.S. dollar. Like in Kosovo, a Banking and Payments Authority (BPA) was set up by the UN with IMF support to be in charge of cash currency matters, banking supervision, and otherwise to act in the absence of a central bank. An excellent institutional working relationship between the Fed and the BPA became an important factor in the practical handling of cash currency.

Operational issues

For most of the period from 2000 until mid-2001, the Indonesian rupiah continued to be used as cash currency by most Timorese, while expatriate staff preferred to use the Australian dollar. During this time, the rupiah totally dominated the national cash payment system, while the U.S. dollar and other convertible currencies were favored as store of value.

In July 2001, after an agreement had been reached with the Indonesian central bank on the repatriation of the rupiah, UNTAET decided to make the U.S. dollar the official currency and sole de jure legal tender for all public and private transactions. In support of the single currency regime, a series of measures were introduced to strengthen the actual use of the U.S. dollar by the Timorese general public.

The promotion of the U.S. dollar comprised actions in a special dollarization program prepared by Fund experts and implemented from mid-2001 until March 2002. It focused mainly on three areas by: (i) insisting on the use of the legal tender for all public and private transactions; (ii) demanding that prices on all goods and service, as well as payment for all goods and service be denominated in the legal tender; and (iii) ensuring that all budgets, financial records, and accounts of all persons be maintained in the legal tender.

The promotion campaign was directed on educating the population on the features and use of the U.S. dollar. The program included seminars, press conferences, presentations, posters, and the use of electronic and printed media. The education campaign was extended to include market vendors, teachers, schools, civil servants, churches, transport operators, and business persons informing them of the provisions of the Regulation, providing coins in the districts, and assisting small businesses to convert prices to U.S. dollars.

Despite strong political support by the Timorese leadership, the initial dollarization effort largely failed. The public preferred to deal with the rupiah, a currency they knew and other concerns did not alter that preference. Also other currencies were frequently used, and the pricing of goods and services led to various nonmarket-oriented exchange rates. This was particularly confusing to the local population and became another reason for eventually supporting the full-dollarization campaign.

The use of coins became an important issue. When the use of dollar was widespread, another problem came to the forefront. An early finding was that the U.S. coins were not readily accepted by the general public, thereby complicating low-denomination payment transactions. To address this, a decision was made in 2003 to replace those coins with newly minted national coins in the five denominations. The new coins had clear numerals and motives connected to Timorese culture or well-known products. The coins quickly became a success and greatly facilitated the eventual actual phasing out of the rupiah.

1

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.

2

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.

3

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.

4

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.

5

Issues not covered in this paper also include implementing bilateral dollarization, acceding to the European Union, or how to introduce a monetary union.

6

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.

7

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.

8

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.

9

We picked 2004 as the first year of the comparative period in order to capture the steady state information in the dollarized economies.

10

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.

11

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.

12

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.

13

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….”

14

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.

15

“Currency rounding” typically affects dollarizing countries with a high inflation background.

16

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.

17

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).

18

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.

19

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.

20

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.

21

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.

22

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.

23

Ecuador followed this path. The recently created liquidity fund will accumulate resources up to one time the amount of the system’s regulatory capital.

24

Argentina purchased this facility to serve the same purpose following the introduction of the currency board arrangement (see Baliño and Enoch, 1997).

25

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.

26

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.

27

In El Salvador, this period lasted six months following the approval of the law that officially established dollarization.

28

Overtime, however, the law has been changed extensively, which eventually has undermined the fiscal discipline initially envisaged.

29

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).

30

This rate has changed over time as a prudential measure.

31

El Salvador increased the coverage of the existing deposit insurance; Panama and Ecuador do not have any.

32

Although foreign direct investment is particularly attractive, excessive amounts into the non-tradable sector can have destabilizing effects.

Implementing Official Dollarization
Author: Åke Lönnberg and Mr. Luis Ignacio Jácome