Reflections on Dollarization

Guillermo A. Calvo
University of Maryland and NBER

Carmen M. Reinhart
University of Maryland and NBER

June 16, 2000

During the past few years, many emerging market countries have suffered severe currency

and banking crises. A popular view blames fixed exchange rates--specifically, soft pegs--for these

financial meltdowns. Indeed, fixed exchange rates have been so demonized by some adherents to

that view that the only alternative for emerging markets seems to be to allow their currencies to

float.

Other analysts draw a very different lesson from these events. After all, a country cannot

have a currency crisis if it does not have a domestic currency in the first place; firms, banks, and

households are immune to currency mismatches if all assets and liabilities are denominated in the

same currency. The obvious policy recommendation that follows is that full dollarization may, in

some cases, be desirable. Some observers forecast that intermediate exchange rate regimes will

vanish, as countries move toward corner solutions--with freely-floating exchange rate regimes at

one end, hard pegs, such as currency boards or dollarization, at the other. Thus, the current

circumstances provide the ingredients for a rich policy debate.

Fear of floating

On the surface, at least, a polarization in exchange rate arrangements appears to be taking

place. Eleven countries in Europe chose to give up their national currencies, while Ecuador was

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the first of what may be several countries in Latin America to adopt the United States dollar as its

official national tender. At the other end of the spectrum, Korea, Thailand, Brazil, Russia, Chile,

Colombia, and, more recently, Poland have announced their intentions to allow their currencies to

float. On the basis of “labels,” at least, it appears that the new millennium will be very different,

as far as currency arrangements are concerned.

Yet, a careful reading of the evidence on exchange rate policy presents a strikingly

different picture. Announcements of “intentions” to float are not new. The Philippines

announced it would float in 1988--less than ten years later, its exchange rate policy would be

classified, together with the rest of the Asian crisis countries, under the commonly-used (but ill-

defined) label of a soft peg. Bolivia announced it would float on September 1985 owing to its

hyperinflation--yet its exchange rate so closely tracked the United States dollar that the regime

was reclassified as a “managed” float on January 1998. Korea and Thailand, despite their floating

status, are amassing foreign exchange reserves at the time of this writing. If they are floating,

they are doing so with a life jacket. After all, a floating exchange rate arrangement should obviate

the need for countries to maintain a war chest of reserves. Indeed, once financial markets settled

and capital flowed back to Asia, their currencies are fluctuating much the way they did prior to

the crisis--that is to say, not at all.

Is the middle disappearing? We don’t think so. Empirical evidence suggests that fear of

floating is pervasive, particularly among emerging markets. In a recent study, we find that the

currencies of emerging market economies are less likely to fluctuate than those of the major

industrial countries. The supposedly disappearing middle accounts for the lion’s share of country

practices. Indeed, one of the hardest challenges for policymakers trying to draw lessons from the

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experiences of countries that are at the corners is that there are hardly any countries there to

study. The experiences of some of the floaters like the United States and Japan are not relevant

for emerging markets. Similarly, the number of countries which have eschewed having their own

currency are so few, that it is difficult to draw generalized conclusions.

The reality is that any exchange rate that moves at all is now being labeled as a floating

exchange rate. In truth, these “floating” exchange rate regimes are far removed from what is

classically defined as a floating exchange rate. One change that does appear to be taking place is

that interest rate policy is replacing foreign exchange intervention as the preferred means of

smoothing exchange rates. This is evident in the high variability of interest rates in emerging

markets and in the practices of countries like Mexico and Peru. Does this change make countries

less vulnerable to currency crises? It is possible, but not probable. Interest rate policy will have

its limits (just as international reserves have their limit), as interest rate hikes to defend the

currency take their toll on the economy and the financial sector. All that we can say is that, when

it comes to exchange rate policy, discretion rules the day!

Where does this leave us? Because the experience with dollarization or floating is so

limited that a definitive assessment at this stage is foolhardy, in what follows we will focus on

how to think about these issues.

Liability dollarization

As noted, many analysts concluded that the soft pegs were responsible for the crises. At

some level, the statement is right because if the exchange rate was allowed to float freely, by

definition some of the international reserve loss would have been prevented. However, such a

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characterization is incomplete. It misses a key point, namely, that in these episodes, either the

government or the private sector, or both, had large foreign-exchange denominated short-term

debt obligations that exceeded the stock of international reserves. Therefore, it is probable that

the currency crises would have taken place even under more flexible exchange rate arrangements.

This brings us to the issue of liability dollarization.

A common misconception in the ongoing debate about dollarization is that it is often

viewed as a drastic measure, requiring, among other things, the surrender of the central bank’s

ability to function as lender of last resort. But dollarization may not be the sharp departure from

existing practices that its critics assume. Partial dollarization is well underway in emerging

markets, particularly those that have a history of high inflation. Analysis of this issue typically

focuses on deposit (asset) dollarization, but debt (liability) dollarization is equally important and

far more widespread--even in countries with an admirable inflation track record. Individual

borrowers with foreign exchange denominated debts not matched by foreign exchange assets can

be forced into bankruptcy by an unexpected depreciation of the exchange rate. The presence of

such currency mismatches may argue for full dollarization.

It is possible that liability dollarization is partly a result of pegging, magnified by the

overconfidence and moral hazard problems that pegging may bring about. As the argument

usually goes, if the exchange rate was allowed to float, domestic investors would shy away from

foreign-exchange denominated debts because they will face a larger currency risk than under fix.

This sounds convincing, but it misses two important points: (1) most emerging markets start from

a situation of partial dollarization (at the very least, liability dollarization), and (2) it is very hard

to find examples of an emerging market ignoring exchange rate volatility. These points reinforce

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each other. Partial dollarization increases the cost of exchange rate volatility which, in turn,

induces the central bank to intervene in the foreign exchange markets to prevent fluctuations in

the nominal exchange rate. In fact, as the cases of Egypt, El Salvador, the Philippines, and

Venezuela attest, this fear of floating may be so severe that the exchange rate spends long

stretches of time at a fixed level, making it observationally equivalent to a soft peg. In turn, fear

of floating induces more liability dollarization, creating a vicious circle from which it is difficult to

exit. Fear of floating also arises from domestic firms’ use of imported raw materials and may also

drive authorities to adopt additional measures, like controls on capital mobility. Even when fear of

floating does not lead to capital controls and countries adopt “market-friendly” ways of stabilizing

the exchange rate through domestic open market operations, such policies have costs both in

terms of the interest rate volatility associated with them as well as their procyclical nature. Thus,

contrary to the view that floating provides authorities with an extra degree of freedom to

guarantee a market-friendly environment, the opposite may happen.

Ineffective Lender of Last Resort.

Another popular view is that the adoption of a currency board or dollarization significantly

detracts from the central bank’s ability to operate as lender of last resort. This view is based on

the conjecture that, since the sums involved in bank bailouts are usually huge, an effective lender

of last resort should be able to issue its own money.

True, a bank’s liabilities are more liquid than its assets, which is why it is susceptible to

runs. A possible way to prevent self-fulfilling bank-runs is for the central bank to step in and bail

out the banking system if a run takes place. If expected by the public, the bailout may never have

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to be activated, thus making lender of last resort capabilities costless to the central bank and

beneficial to the private sector.

However, this explanation of bank runs was formulated in terms of a non-monetary

economy. If the government’s promise is to be credible the government has to be able to finance

the bail-out. At its heart, this is a fiscal issue, because given the sums involved, this normally

requires issuing government debt, that will eventually be serviced by higher taxes. Yet, this may

not be possible for an emerging market that has lost access to international capital markets.

Furthermore, it does not answer the issue of whether relinquishing the issuance of one’s

own money could impair the effectiveness of the lender of last resort. Suppose that deposits are

denominated in domestic currency, and that the central bank guarantees that depositors will be

able to withdraw all of their deposits, if they so wish. Would this insurance be effective in

preventing self-fulfilling bank runs? Not at all--not if this measure does not ensure depositors that

their deposits’ purchasing power will remain intact.

Consider the case in which bank-deposit interest rates are subject to a statutory ceiling. If

depositors expect the currency to weaken substantially, there will be a bank run which the

government cannot stop by issuing money--indeed, issuing money will worsen the currency crisis.

This example may not be relevant in economies where a large share of deposits earn interest. In

this case, banks could stop the run by offering higher interest rates on their deposits or by

indexing deposits to prices or the exchange rate. The latter, i.e., “dollarization” of deposits, is a

popular practice in emerging markets.

If higher interest rates are successful in stopping runs, a lender of last resort would not be

needed, because this operation could be undertaken by the banks without the help of the central

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bank. However, we cannot be hopeful about the high-interest strategy because rates may have to

rise to the point run that banks will go bankrupt (and we should not forget the adverse selection

problem). In a market economy where information is limited, depositors might interpret an

individual bank’s increase in its deposit rate as evidence of higher risk. Banks would fail either

because interest rates on their liabilities rise substantially more than on their assets or because

their loans become nonperforming.

Indexation provides a mechanism to implicitly raise deposit interest rates when

expectations of a run arise. However, indexation increases the burden on the lender of last resort

because deposits are now denominated in real terms. Indeed, if all deposits are indexed to the

exchange rate, there would not be a major difference between this case and full dollarization.

Why do advanced countries manage to have an effective lender of last resort? The answer

suggested above is simple: advanced countries never lose access to capital markets. Was it

critical for those countries to be able to print their own currencies? We doubt it. Thus, contrary

to popular belief, full dollarization may not entail a substantial loss of lender of last resort

capabilities in countries that are credit-constrained.

The “sudden stop” problem

Any discussion of exchange rate options needs to give full weight to the environment in

which that policy will be implemented--which requires discussing the characteristics of

international capital markets. As the debt crisis of the 1980s was resolved, official capital flows to

emerging markets shrank and private capital flows assumed an increasingly important role. But,

time and again, such flows have proved to be moody and fickle throughout the 1990s. Indeed,

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emerging markets routinely face what we call the sudden stop problem, or the immediate drying

up of access to world financial markets. When a sudden stop occurs, the effects on the economy

can be devastating.

Some analysts have suggested that the very increase in capital mobility in the past decade

and the limited resources that central banks can muster, relative to the private sector, are a call for

governments to allow their currencies to float. But this recommendation misses a key point--

when capital leaves an emerging market abruptly, it entails a massive swing in a key relative price

in a small open economy, the real exchange rate, with usually devastating consequences for the

domestic economy and financial sector. Thus, few (if any) central banks in emerging markets

would turn a blind eye to such sharp swings in the nominal (and real) exchange rate. The

widespread incidence of fear of floating attests to that fact.

Yet, it is certainly true that capital markets have become increasingly integrated and that

central banks command limited resources. In our view, these observations suggest that central

banks in most emerging markets are powerless to successfully fend-off a speculative attack, act as

an effective lender of last resort, or conduct independent monetary policy, as the latter will be

subjugated to accomodating the whims of the international capital markets. This, of course,

implies monetary policy will tighten when a sudden stop problem threatens (which is usually when

the domestic economy is facing a slump or an adverse shock and would most benefit from low

interest rates). In this environment, it is not clear what benefits an emerging market derives from

having its own central bank and its own currency.

Capital in emerging markets has been moving with an intensity not seen since the late

nineteenth and early twentieth century. This suggests that a system of fixed exchange rates (i.e.,

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hard pegs)-- like the gold standard system of that era--may again be appropriate for emerging

markets.

To fix or not to fix...

In summary, much of the glitter of flexible exchange rates disappears upon closer

examination. The extra degrees of freedom provided by exchange rate flexibility are fallacious or

can be substituted by fiscal policy. A point to remember in the debate over whether dollarization

is appropriate for emerging markets is that these economies are still “emerging.” They are

setting policy in a world in which their own financial markets remain underdeveloped, their trade

is invoiced predominantly in dollars, their corporate and financial institutions have a limited ability

to hedge exchange rate risk, and their governments, more often than not, lack credibility.

Exchange rate movements are costly in this environment. If policymakers take a hard look at the

options for exchange rate regimes in emerging economies, they may find that floating regimes may

be more of an illusion and that fixed rates--particularly, full dollarization--might emerge as a

sensible choice for some countries, especially in Latin America or in the transition economies in

the periphery of Euroland.