This Selected Issues and Statistical Appendix paper examines recent economic developments and medium-term outlook for Liberia. This paper focuses on economic developments during 2003 and 2004 and the medium-term challenges of reconstruction. The paper explores the pros and cons of adopting full (de jure) dollarization in Liberia. It reviews the theoretical arguments for and against adopting dollarization and the associated empirical evidence. The choices of monetary and exchange rate regimes made by other post-conflict countries are presented. The paper also assesses whether Liberia, in its current post-conflict situation, could benefit from dollarization.

Abstract

This Selected Issues and Statistical Appendix paper examines recent economic developments and medium-term outlook for Liberia. This paper focuses on economic developments during 2003 and 2004 and the medium-term challenges of reconstruction. The paper explores the pros and cons of adopting full (de jure) dollarization in Liberia. It reviews the theoretical arguments for and against adopting dollarization and the associated empirical evidence. The choices of monetary and exchange rate regimes made by other post-conflict countries are presented. The paper also assesses whether Liberia, in its current post-conflict situation, could benefit from dollarization.

II. Adopting Full (de jure) Dollarization in Liberia12

A. Introduction

30. This chapter explores the pros and cons of adopting full (de jure) dollarization in Liberia. The first and second sections review the theoretical arguments for and against adopting dollarization and the associated empirical evidence. The third section presents the choices of monetary and exchange rate regimes made by other postconflict countries. The final section assesses whether Liberia, in its current postconflict situation, could benefit from dollarization.

B. Arguments For and Against Full Dollarization

31. Supporters of dollarization state that its adoption reduces policy and exchange rate risks, which, in turn, would create better conditions for sustainable growth.13 They argue that in an environment of high inflation, dollarization could represent a precommitment mechanism to anchor inflation expectations. It would impose fiscal discipline, thereby providing enhanced policy credibility. Exchange rate risk would be eliminated. The reduction of policy and exchange rate risks would, in turn, increase confidence among international lenders and investors, leading to lower interest rates, fiscal expenditures (due to lower interest payments), more foreign direct investment, domestic investment, exports, and higher GDP.

32. There is a price for sustainable growth under dollarization. A dollarized economy would give up its seigniorage revenues. As indicated in Berg and Borensztein (2000), dollarization involves two kinds of seigniorage loss: the immediate cost to buy back the local currency in circulation, and the future seigniorage from the issuance of new currency to accommodate money demand. Therefore, a dollarized economy would need to run a balance of payments surplus, either through capital inflows from external borrowing or FDI, or through a current account surplus.

33. The loss of exchange rate and monetary policies would require adjustments through output and prices. Under a floating exchange rate regime, the exchange rate acts as a shock absorber, allowing the domestic currency to depreciate until external balances are reestablished. By contrast, dollarization would impose a more painful adjustment mechanism, as the reduction of the current account deficit would require either a fall in prices (including wages), a reduction of output, or a combination of both.

34. Full dollarization would also expose banks to new risks. On one hand, banks’ direct exposure to currency risk and to the credit risk of unhedged corporate clients is reduced, if banks operate only in U.S. dollars. On the other hand, new risks emerge because higher output volatility would imply higher potential losses from client default, and the lack of a lender of last resort would require banks to build higher liquidity and equity position. This, in turn, would negatively affect credit expansion and result in higher lending rates.

35. Regarding the argument that dollarization establishes fiscal discipline, some observers argue that forms of funding deficits beyond money creation still exist. Fiscal deficits could still be funded with external or domestic loans, supplier credit, or arrears. In the event that the resulting fiscal stance places excessive pressure on aggregate demand, the eventual pressure on the current account would have to be dealt with as described above.

36. Dollarization may also not remove all exchange rate risks. This risk reduction would depend on the exposure of the economy to currencies other than the U.S. dollar. If trade with main external partners is conducted in other currencies, some exchange rate risks would remain.

C. Empirical Evidence

37. Rogoff et al (2004) finds that fixed exchange rate regimes may create some degree of credibility, if countries implement consistent policies. His overall conclusion was that there are gains from adopting floating exchange rates, as a country develops economically and institutionally, because floating rates permit a more rapid adjustment following shocks. At the same time, a fixed exchange rate regime becomes less relevant to achieve credibility. For developing countries with low exposure to capital movements, however, fixed exchange rate regimes appear to offer some measure of credibility, provided that developing countries implement consistent policies.

38. An additional test found no correlation between exchange rate regimes and fiscal discipline. The test is based on a cross-country regression analysis and a data set of 123 emerging market and developing countries, during 1997–99 and 2001–03.14 Using a binary choice variable, which takes the value one if a country has a primary fiscal surplus or zero otherwise, the model is specified as follows:

Pr(C=1)=α+β1X1+β2X2+β3X3

where X1 is a vector of dummy variables representing exchange rate regimes, X2 is a vector of macroeconomic variables (GDP growth, government effectiveness indicator, a dummy variable for Fund program); and X3 is a vector of control variables including past current account deficit.15 The results show that the likeliness of avoiding fiscal deficit is largely associated with the macroeconomic environment and government’s implementation capacity.

Summary of Probit Model Result

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39. Rogoff et al (2004) also find no significant relationship between growth and the exchange rate regime but observe that fixed exchange rate regimes have larger output volatility. Another study comparing Panama’s and Belize’s economic performance vis-à-vis six other Central American countries finds that the standard deviation of output has been higher in Panama and Belize than in the mentioned country group.16

40. Financial sector data confirm that banks in dollarized economies tend to have high equity and high liquid assets. Banks in Panama, Ecuador and El Salvador exceed the 8 percent capital and 4 percent equity ratios, as recommended by the Basel Committee.

Bank Capitalization and Liquidity in Three Dollarized Economies: Ecuador, El Salvador, and Panama

(in percent)

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Sources: Ecuador, Superintendencia Nacional de Bancos y Seguros; El Salvador, Superintendencia del Sistema Financiero; Panama, Superintendencia de Bancos; and IMF staff estimates.

September, except capital ratio as of February 2004.

Liquid assets are net of public bonds.

D. Choices of Currency Regimes by Postconflict Countries

41. With the exception of East Timor and Kosovo, all postconflict countries have favored an own currency. The main reason against dollarization appears to be high costs associated with the adoption of a foreign currency. For example, Afghanistan once considered full dollarization until a new currency was introduced in 2003, but this option was not explored further, given the considerable cost of replacing the existing local currency.17 In general, such a drastic regime change seemed to have been avoided unless considerable inefficiencies were associated with the regime (Timor Leste), or where the use of local currency was inviable due to an existing loss of confidence (Kosovo).

Foreign Exchange Regime Before and After Conflict

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42. Timor Leste adopted full dollarization. During Indonesian rule, the rupee was the sole legal tender and virtually the only currency in circulation in East Timor. Following the collapse of the financial system in 1999, however, several currencies began to be used, including the Australian, New Zealand, and U.S. dollars. To eliminate the distortions and inefficiencies associated with the simultaneous circulation of multiple currencies, the U.S. dollar was declared the legal tender of East Timor in January 2000. This choice was attributable to the desirable characteristics held by the currency (stable value, wide international use, and convertibility). It was reinforced by the argument that most of Timor Leste’s international trade is denominated in U.S. dollars. The introduction of a national currency was deemed difficult in the absence of a well-developed institutional framework and financial resources to support the value of a new currency.

43. Kosovo is an example of de facto adoption of another country’s currency—the Deutsche Mark (and euro later on). However, the new Yugoslav dinar continues formally as legal tender. Since the Deutsche mark (DM) was already widely used in Kosovo before the conflict, it soon became the dominant currency, and the use of DM was further encouraged by the measurers taken by the UN Interim Administration Mission in Kosovo (UNMIK). The confiscation/freezing of foreign exchange deposits in the early 1990s, the episode of hyperinflation in 1993–94 (2 percent per hour at its peak), and the intensification of ethnic strife eroded confidence in the banking system, leading to a virtual cessation of all noncash transactions. In response to the massive flight to foreign exchange cash holdings and the disappearance of the Yugoslav dinar as a means of transactions, UNMIK legitimized the use of the DM.

E. Liberia’s Experience with Dollarization

44. Between World War II and the early 1970s, overall favorable world market conditions for Liberia’s exports and foreign direct investment helped sustain dollarization, as adopted in 1946. Iron ore, rubber, and timber activities were flourishing, based on high export prices and large inflows of foreign capital.

45. During the 1970s, the oil crises and global economic downturn led to a significant deterioration of economic performance. The trade surplus started to decline and became negative in 1976, and fiscal deficits emerged, owing to a decline in revenue and excessive spending, including to cover public enterprise deficits. The deficits were externally financed.

46. After 1980, Liberia’s internal and external balances rapidly worsened further, and dollarization was eventually abandoned (Box 5). Political instability, together with depressed world demand and declining reserves of iron ore, stagnating rubber production, and a of trade contributed to the significant decline in the terms collapse of internal and external confidence. Private capital left the country, and investment plummeted. Foreign funding of the rising fiscal and external deficits eventually dried up, and a local currency was introduced in 1988.

uA02fig01

International Prices of Liberia’s Exporting Commodities

(Annual changes of average prices, in percent)

Citation: IMF Staff Country Reports 2005, 167; 10.5089/9781451822878.002.A002

Source: IMF Research Department

Liberia. Financing of Fiscal Deficits During the 1980s

The overall fiscal deficit rose sharply to more than 10 percent of GDP during the 1980s. The poor fiscal performance was marked by both a steady decline in revenues and a rise in expenditure. The deficits during the period were mostly financed by (i) an accumulation of arrears on external debt service payments and domestic payments arrears (including on wages), (ii) the emergence of various forms of government liabilities (including unpaid vouchers owed to suppliers), as well as (iii) borrowing from the domestic banking system (mainly from the central bank).

Fiscal Balance in 1980s

(In millions of Liberian dollars)

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Sources: Liberian authorities; and IMF staff estimates.

National Bank of Liberia

Liberia. Main Economic Indicators (1966-2002)

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Sources: Liberian authorities; and IMF staff estimates.

F. Will Dollarization Help Liberia?

47. The August 2003 peace agreement put an end to civil strife, and reconstruction has begun. Overcoming poverty, reversing the dramatic deterioration of living standards, fighting corruption, and restoring good governance practices are the main challenges of the reconstruction work that lies ahead. Against this background, some observers ask whether the reintroduction of full, de jure dollarization would help Liberia grow, and build accountable and transparent economic institutions.

48. The following arguments suggest that dollarization “per se” would not contribute to solving the challenges during Liberia’s reconstruction phase:

  • Liberia’s exports will continue to be commodity-based for some time, exposing the country to potentially serious external shocks. All export commodities show large swings in world market prices, and another commodity with highly volatile prices—petroleum products—represents a high proportion of imports. Under full dollarization, Liberia would have to respond to such shocks through changes in prices, wages, and output, which could put additional strain on the as-yet fragile economic and social situation.

  • The cost of introducing and maintaining dollarization is high. The initial cost of replacing the Liberian dollars in circulation would be, at present, around US$36 million, equivalent to 8 percent of GDP. Over the medium term, to accommodate the increase of money demand arising, for example, from a modest annual rate of growth of 3-4 percent, an annual current account surplus of around US$7 million would be required.

  • Dollarization would also have an impact on growth through the commercial banks. After the losses suffered during the war, Liberian banks are now being restructured and recapitalized. Dollarization would impose an additional burden on banks in terms of more stringent solvency conditions and possibly result in higher lending rates.

  • Dollarization does not necessarily have a positive impact on fiscal discipline. As proved by Liberia’s own history, dollarization can coexist for some time with fiscal deficits, while building imbalances. Furthermore, the objectives of fiscal transparency and accountability are not per se supported by the choice of a currency.

  • Even if dollarization is adopted, Liberia would still be subject to the volatility of the nominal exchange rate between the U.S. dollar and the euro. Liberian exports have traditionally gone to Europe, while most Liberian imports, in particular petroleum products, are paid in U.S. dollars.

Liberia. Estimates of Seigniorage

(In millions of Liberian dollars, unless otherwise indicated)

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Sources: CBL; and IMF staff estimates.

Liberia. Exports by Destination

(Annual average during 1980-2000)

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Source: Liberian authorities; and IMF staff estimates

References

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  • Bordo, M., 2003, “Exchange Rate Regime Choice in Historical Perspective,IMF Working Paper No. 03/160 (Washington: International Monetary Fund).

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  • Honda, J., and L. Schumacher, 2005, “Adopting Full (de jure) Dollarization in a Post-Conflict Country: Do Gains Outweigh the Losses? The Case of Liberia,Working Paper (forthcoming) (Washington: International Monetary Fund).

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  • Levy Yeyati, E., and Sturzenegger, F., 2003, “Dollarization: A Primerin “Dollarization,” MIT.

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12

This chapter was prepared by Jiro Honda and Liliana Schumacher.

13

For a review of the literature on exchange rate regimes and dollarization, see Bordo (2003), and Levy Yeyati et al (2003).

15

A dummy for a Fund program takes the value one if the country received financial resources from the Fund at least for two years during the period, or zero otherwise.

17

See “Islamic State of Afghanistan: Report on Recent Economic Developments and Prospects, and the Role of the Fund in the Reconstruction Process,” Country Report No. 02/219 (10/7/02).

Liberia: Selected Issues and Statistical Appendix
Author: International Monetary Fund