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The ABC of Dollarization

Research · September 2015

DOI: 10.13140/RG.2.1.3425.8401

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THE ABC OF DOLLARIZATION
By Carlos Encinas-Ferrer
Full-time Professor
Department of Economic and Administrative Sciences
Universidad Iberoamericana León

INTRODUCTION

Dollarization is a process of monetary integration that has its origin in the gradual,
scaled loss of a currency's functions over time, manifesting traits of the
spontaneous evolution characteristic of the "invisible hand" described by Adam
Smith.

In this process, the logical candidates to act as a substitute for these lost functions
are those currencies most widely used for international transactions, with the
strongest claim being held by that with a hegemonic influence in the economic
zone to which the nation with the weaker currency belongs. It should be noted that
these dominant currencies hold their position due to the fact that they find
themselves relatively unaffected by inflationary processes and enjoy the backing of
extremely solid economies.

This article will deal with the fundamentals of dollarization, outlining its general
characteristics as well as the conditions that give rise to this monetary and
economic phenomenon. It also describes the various forms that it may take and
attempts to determine some of the aspects of dollarization that have yet to receive
sufficient attention with regard to the necessary requirements and the preparatory
steps that should be taken before a country embarks on the official implementation
of a dollarized system.

There are many forms that this monetary phenomenon may take, but all of them
have in common the sequential order in which they penetrate and spread
throughout a country's economy. All have their origin in the existence of a weak
local currency that gradually loses its functions - often without people fully realizing
the fact.

When a country decides to dollarize its economy fully, the only thing it does is to
recognize officially something that in practice already exists –the so-called “de
facto dollarization”-, and limits itself to formalizing the monetary relations by now
taken for granted in the economic sector.
As a monetary occurrence, this is not a recent phenomenon. Throughout history,
there are numerous examples of currencies putting others out of circulation: the
Roman denarius, the Mexican silver peso of the Spanish empire, the pound
sterling in the nineteenth century, etc.

WHAT IS DOLLARIZATION?

Economic theory lacks a general term to describe this phenomenon adequately.

Many of articles and works on the subject include cases of "dollarization" in which
the currency replacing the local coinage is not in fact the dollar, and it is this
approach that will be taken here.

Some economists have already begun to talk of the "euroization" that has been
taking place in Europe since January 1, 2002, but in this they are completely
mistaken. While it is true that the adoption of the euro by countries outside the
European Union but within its sphere of economic influence might justify the use of
the term, the establishment of the euro as the sole currency does not. It should be
remembered that what we are witnessing is the bizarre fact of monetary union
between countries with extremely solid currencies that until now have enjoyed
general acceptance, as is the case with the German mark.

Although the process of dollarization may well result in monetary union, its origin is
very different. Monetary union, as such, is an event that has been sought and
carefully planned for. It is not born of a loss in a currency's functions, a failure that
opens the way to dollarization.

As mentioned at the start of this article, dollarization is a process through which a

currency gradually loses its function as money, functions which are then taken over
by a foreign currency.

For reasons of simplicity, let us call the foreign currency that substitutes for the
local one the ‘anchor currency’.

A market economy necessarily requires that its money is fully operational in terms
of all its functions. In this sense, what is known as dollarization is above all what in
fact should be called the spontaneous remonetarization of an economy, by which
the market ensures that those functions are adequately covered. What is
interesting here is that the process gives rise to a situation in which, at the same
time and unofficially, there are two currencies carrying out these functions, in some
cases for a prolonged period.

MONEY AND ITS FUNCTIONS

Monetary theory tells us that money must, in general terms, fulfill the following
economic functions:
 Store of value
 Unit of account
 Means of payment and exchange

Here, placed in the order in which, in accordance with our investigations 1, their loss
becomes apparent, we examine each in turn.

As a store of value, money must be able to guarantee that it will maintain its
exchange value in the future in such a way that we can be confident of the fact that
we will be able to buy goods tomorrow to the same value of those we bought
today. I believe that it is the loss of this function that constitutes the fundamental
element in triggering dollarization.

Two economic phenomena are responsible for the loss of a currency's purchasing
power, resulting in its obsolescence as a store of value:

 Inflation and its inevitable consequences:

 Depreciation and/or Devaluation

If monetary instability persists for decades, as in the case of Mexico, the process
continues and other functions will gradually become involved.

As a unit of account, a currency must allow us to account for economic

operations in general, such as purchases, production, sales, inventories, balances,
profit/loss status, etc.

Prolonged periods of high inflation destroy this function by not allowing us to have
any degree of certitude as to the real value of our economic processes, nor of the
evolution of our capital.

However, the instability in the local rate of exchange that accompanies the process
is not the sole cause of this loss of function. Economic globalization and the
opening of markets accelerate the process due to what I have termed the
Dominion of International Prices

It should be borne in mind that a significant quantity of goods - both consumer and
intermediate, and especially what we term commodities - nowadays have their
value determined at international prices, and generally in dollars.

Money as a means of payment and exchange is a currency's basic function,

permitting the exchange of merchandise, services and factors of production. It is,
without doubt, the last function that a currency loses, whether tacitly or officially. It
is with this loss that the full dollarization of a country comes about.
To recap, we can say that dollarization is a three-stage process:

Stage One: the local currency ceases to function as a Store of Value. In general,
economic agents seek to conserve the value of their wealth in foreign assets such
as:

 Cash
 Offshore foreign currency deposits
 Domestic foreign currency deposits
 Foreign bonds or other non-monetary assets under domestic control

This first stage corresponds to what we know as Gresham’s Law. It is not correct
that “bad money drives out good money” from circulation, the true is that people
know that with a temporarily fixed exchange rate, “good currency” functions better
in the long run as a Store of Value. We can rephrase it and say “god money drives
out bad money as a store of value”.

Stage Two: the local currency loses its function as a Unit of Account.

Characteristics:

 Companies' financial accounting is carried out in foreign currency while fiscal

and official accounts are registered in the local currency.
 Contracts for goods and services and leasing agreements use the foreign
currency.
 Executive salaries are established with reference to the anchor currency.
 Salary and price indexing are set at the rate of exchange of the anchor
currency.

Stage Three: the currency gradually ceases to function as a Means of Payment.

Characteristics:

 Semi-official dollarization or an official bimonetary system.

 Official dollarization, full or total dollarization.

A clear understanding of these stages allows us to understand the different types

of dollarization that exist, which is something we will take up in the next article.

TYPES OF DOLLARIZATION

The terminology adopted in this section is that established by the economist Kurt
2
Schuler .
1. Unofficial Dollarization.

In its initial form, this corresponds to that defined as Stage One, above, in which
the local currency ceases to fulfill its function as a Store of Value.

As mentioned above, in this phase, economic agents maintain a great deal of their
financial wealth in assets that are considered foreign in their home country
(regardless of whether this may or may not be legal).

In this way, they protect themselves against potential losses in the value of their
wealth as a result of inflationary processes or, indeed, against any attempt to
confiscate it - as was the case in Mexico in 1982, (where the government issued
so-called Mexdollars in order to force the exchange of deposits in dollars for
Mexican pesos at a rate of exchange far inferior to that available on the market) or
more recently in Argentina, with its "corralito financiero" – restrictions on cash
withdrawals.

This unofficial dollarization is gradually bringing about the so-called "currency

substitution" which is accentuated in what we have called Stage Two, in which the
local currency ceases to function as a unit of account.

At the end of this second stage, unofficial dollarization has reached the point at
which the populace thinks in terms of the foreign currency, calculating prices in the
local currency at the rate of exchange with what is now becoming the anchor
currency.

It is at this point that we begin to see proposals to anchor the local currency to an
even greater degree to the foreign currency in order to achieve stability within the
monetary system, but without actually eliminating the national currency. Standing
out among these proposed measures are those seeking to index salaries and
prices with reference to the anchor currency (vide Harry Lane David and Carlos
Encinas Ferrer)3.

2. Semi-official dollarization or official bimonetary systems.

In this type of dollarization, the foreign currency is legal tender and may even,
legislation permitting, constitute the majority of bank deposits (as can be seen in,
once again, Argentina). Nevertheless, the local currency remains in use for wages,
taxes and daily expenditures such as food, gasoline and electricity.

Semi-dollarized countries conserve their central bank and the local monetary
authorities still have the power to implement their own monetary policies, albeit
limited in nature. Further on, we will see that this loss of monetary sovereignty is
typical with fixed exchange rates.
3. Full or official dollarization.

Official - also known as total or full - dollarization occurs when the anchor
currency acquires the status of exclusive or principal legal tender, achieving
complete acceptance. This means that, along with government sales contracts,
private agreements may be legally made using the anchor currency as the means
of payment.

Experience has shown us that a local currency may be relegated to use solely as
fractional coinage with negligible value, while the Central Bank of the dollarized
country disappears due to its inability to issue currency or function as a lender of
last resort. Monetary policy ceases to be an instrument of national economic policy.
4
It is interesting to look at the list of countries that, in accordance with Kurt Schuler ,
are to be found at one of these various stages:

Unofficially Dollarized (US Dollars)

 Argentina
 Bolivia
 Mexico
 Peru
 Armenia
 Azerbaijan
 Georgia
 Russia
 Ukraine
 Mongolia
 Mozambique
 Romania
 Turkey
 Vietnam

Unofficially Dollarized (Other Currencies)

 Former French colonies in Africa (Euro)

 The Balkans (Euro)
 Macao (Hong Kong dollar)
 Southern China (Hong Kong dollar)
 Republic of Belarus (Russian Ruble)

Semi-officially Dollarized (US Dollar)

 Bahamas
 Cambodia
 Haiti
 Laos (US dollar and Thai bath)
 Liberia

Semi-officially Dollarized (Other Currencies)

• Bhutan (rupee)
• Bosnia (euro, Croatian kuna, Yugoslav dinar)
• Brunei (Singapore dollar)
• Isle of Man (pound sterling)
• Channel Islands (pound sterling)
• Lesotho (rand)
• Namibia (rand)
• Tajikistan (ruble y other currencies)

Officially Dollarized (US Dollar)

• Ecuador
• El Salvador
• Panama
• Puerto Rico
• Micronesia
• Palau

MONETARY PHENOMENA OF GLOBALIZATION

Within the economic phenomenon of globalization there are forces that lead to
monetary integration. (or as Joan Tugores prefers to call it "Mundialización" –
literally "worldization") Notable among these is the so-called "trilemma of the open
5
economy" (Obstfeld and Taylor, 1998) , according to which a country cannot
simultaneously have a fixed rate of exchange and an open capital market while
maintaining a monetary policy centered on achieving domestic objectives. A
graphic representation of the phenomenon is presented below:

Fixed Exchange Rate

Open Capital Autonomous Monetary

Market Policy
According to the "trilemma" scenario, a country can only aspire to achieving two of
the three conditions depicted in the graphic.

Having a fixed rate of exchange in an open capital market means relinquishing

autonomous monetary policy. Furthermore, given that everything seems to indicate
the impossibility of avoiding opening the doors to international finance while
underdeveloped nations have such high levels of external debt, the rate of
exchange has shown itself to be a fundamental variable within economic policy
since, while national economic society clamors for monetary stability, we also
confront the pressing need to establish a national plan for development. Such a
plan would face serious obstacles if such an effective tool as monetary policy were
not available to us - the terrible price that nations have had to pay for decades of
irresponsible economic policy.

If, as mentioned above, it is now impossible to close national markets to foreign

capital, we find ourselves confronted not by a "trilemma", but a dilemma: a fixed
rate of exchange or autonomous monetary policy. However, it is essential to
bear in mind that it is not enough simply to announce the introduction of a fixed
exchange rate. It is also necessary - especially after the recent experience of
Argentina - to ensure beyond doubt that this will really be the case.

Throughout history, there have been different attempts to establish fixed parity
between currencies, such as the Gold Standard or the use of pure precious metals
in minting (as was the case with the Mexican silver peso of the seventeenth and
eighteenth centuries). Recently we have witnessed the introduction of a single
currency, the euro, in a dozen European countries with a combined population of
over 300 million inhabitants.

One modern method of firmly anchoring the exchange rate to a stronger currency
is to constitute a "currency board". In this system the mass of money in circulation
is backed one hundred percent by the Central Bank's reserves. Any outflow of
capital therefore causes a corresponding reduction of circulating cash, and this
implies an immediate rise in local interest rates. In the case of an inflow of capital,
there an increase in the amount of money in circulation and a corresponding
reduction in domestic interest rates.

The experience of Argentina –a impure currency board- , however, has severely

undermined confidence in this monetary instrument. The existence of a solid legal
backup, such as the constitutional obligation to apply it, has demonstrated its
insufficiency.

Given the impossibility of a fixed rate of exchange based on precious metals

(which are commodities whose international value may fluctuate wildly) and the
unfeasibility of improvising regional single currencies, as well as the failure of the
currency board approach in Argentina, full dollarization could well become the only
measure -as well as the most popular and attractive for many people- capable of
guaranteeing the fixed parity so desired in our Latin-American economies,
debilitated by years of inflation, bad fiscal management, questionable financial
systems, generalized corruption and, above all, systems of production with serious
structural problems.

We should take into account the fact that our economies have now been traveling
gradually towards dollarization for many decades. In Ecuador, Panama and El
Salvador, the currency in legal circulation is the US dollar. In Honduras, Nicaragua
and Guatemala, there are firm indications of a willingness to do likewise, while
countries such as Mexico, Argentina, Bolivia Peru and Venezuela all show the
signs of being unofficially dollarized economies.

In the next article, I will show how this process of dollarization or remonetarization
has come about in Mexico, a country now far advanced along the route to
dollarization.

WHAT BRINGS ABOUT DOLLARIZATION? THE CASE OF MEXICO

The economic history of Mexico in the last 25 years provides a good example with
which to analyze the process we have been studying in this series of articles.

From 1976 on, the Mexican economy has been in a slow but constant process of
dollarization. After 22 years of monetary stability during which the exchange rate
held firm, that year's currency devaluation was such a surprise to ordinary society
that for days afterwards it was still possible to acquire imported goods at the price
offered prior to the change in parity. Economic agents, lacking previous experience
of such a situation, were unable to react to protect the real value of their
inventories.

In 1982, twenty-four hours after the second great devaluation of that year, it was
still possible to buy travelers checks at the previous exchange rate - clear evidence
that not even the financial establishment had a clear idea of the general
implications that devaluation has for all micro and macroeconomic aspects of
production relations, whether in the field of finance or that of commercial activity.

Towards the close of 1987, after the financial crisis in October of that year that
provoked another swingeing devaluation of the Mexican peso, the stock market
was still selling Pagares de la Federación - government bonds made out and
payable in US dollars - at a controlled rate of exchange.

We should recall that, following the introduction of currency controls in 1982, two
types of exchange rate existed in Mexico: the first, supposedly free and dictated by
the supply and demand of currencies, and the other, largely fixed and controlled by
monetary authorities, through which the latter sought to limit the effects of changes
in parity on the imports of both basic goods to be consumed by the population and
production input factors.
The strong devaluation of the currency meant that this controlled exchange rate
could not be maintained, given the considerable disparity or price differential
between it and the free rate. Some weeks later, the Mexican government would
find itself having to pay 22% more for government bonds issued in dollars. The
people who had acquired these Treasury bonds thus achieved earnings of 25%,
including the interest generated from the investment, in just 15 days.

Eighteen years of bitter experience in terms of devaluation ensured that by

December 1994, Mexico was more than prepared for further changes in parity,
indeed to such an extent that, just moments after the devaluation, practically all
prices had increased. Economic agents were well aware of the implications of
devaluation both in macro as well as microeconomic terms.

Over this period, the particular monetary functions of the Mexican Peso were
somewhat taken over by the American dollar.

This process of dollarization has increased to such an extent that, today,

throughout the huge area that makes up the Mexico – US border, a span of over
three thousand kilometers, the US dollar is as common and accepted as the
Mexican Peso itself. We can be sure that in this area it is only salaries that fail to
change with the movements of the US currency. This situation demonstrates that a
bimonetary system, albeit unofficial, already exists: a practical and functional
system that is gradually spreading to other cities and communities beyond the
border region, and in which the dollar is coming to be accepted in a wide and
diverse range of transactions.

Similarly, a large amount of companies now quote the prices of all kinds of
merchandise based on the day’s exchange rate, consequently ensuring that these
are changed within hours of any depreciation on exchange markets. Once again, it
is only salaries that are not adjusted accordingly, making the labor factor that which
suffers the greatest consequences of monetary instability. It is for this reason that
the ever-increasingly stated proposals for implementing the process of dollarization
in our economy on a more formal basis prove so attractive to the great majority of
the population.

With regard to salaries, it should be pointed out that more and more labor
contracts, particularly for higher-level executive positions, are fixed in dollars.

Furthermore, the sale and leasing of real estate is commonly established in dollars
based on the exchange rate on the day the transaction takes place.

This trend is not unique to Mexico. In Europe, many quotes are given and leases
set in dollars rather than euros. Nevertheless, the increasing circulation and
strengthening of the common European currency have led to a change in this
practice.
So what exactly has been the force behind this global process of dollarization?
Undeniably, it has been due to the soundness of the US economy, together with
the fact that large proportions of commercial transactions taking place in the world
are carried out in US dollars. Similarly, financial movements in emerging (or, as
Josué Saenz would say, submerging)6 economies are, almost in their entirety,
carried out in this currency. For this to be possible, some $480,000 million dollars
are now in circulation throughout the world, of which US$300,000 million are in
foreign hands7.

However, the recent weakening of the US economy, together with the

strengthening of the euro, has provided an alternative to the dollar in the
“remonetarizing” process under consideration. A strong euro, on the road to
revaluation, represents the greatest risk facing the US economy –think in
Petroeuros instead of Petrodollars-, given that the US$300,000 million in foreign
hands mentioned previously could easily prove to be more attractive in the form of
the single European currency, a change which would lead to a depreciation in the
US currency and its economy becoming swamped with dollars. Faced with this, the
US Federal Reserve would be forced to raise domestic interest rates in order to
avoid a sharp rise in the rate of inflation, though consequently discouraging
investment and delaying the recovery of the country’s economy.

Should this scenario become a reality, Latin America would find itself under even
more pressure from US interests to accelerate the process of full dollarization, so
guaranteeing that dollars held in international reserves would not return to the their
place of issue.

Despite the possible strengthening of the euro, I believe that the economic and
geographic ties that we have with the US would prevent our country from replacing
the dollar in the ‘remonetarizing’ process in which we find ourselves, a process
which the overvaluation of the peso and the renewed monetary instability of our
economy will hasten. Within this scenario, the latter will lead to us sharing a
prolonged depression with the US.

It should be pointed out that there are forces at work within the US aimed at
encouraging the complete dollarization of the Mexican economy (together with that
of Latin America in general). Let us remember that the first call for Mexico to
abandon the peso and adopt the dollar came in the second half of 1995, from the
renowned MIT economist, the recently deceased Rudiger Dornbusch. Since then,
many other influential specialists have made similar calls.

So how would the US benefit from the dollarization of the Mexican economy, apart
from its avoiding the return of dollars to its economy? It is clear that the evolution of
the North American Free Trade Agreement (NAFTA) will lead, sooner or later, to
the need for a common currency amongst its current members, the USA, Canada
and Mexico, as well as any future members. The creation and introduction of a new
currency, as in the case of the euro in Europe, would represent an enormous cost
for the US, for which reason, they would prefer the predominant currency to be
their own.

It is unlikely that Canada would accept such a situation and, in response to the, in
my opinion inevitable, dollarization trend, the renowned University of Vancouver
economist, Herbert Grubel, in 1999, proposed the creation of a single currency for
NAFTA members to be known as the Amero, pursuing the notion that gave rise to
the euro.

The same year, Robert Mundell, a few weeks before receiving the Nobel Prize for
Economics for his contribution to the Theory of Optimum Currency Areas, indicated
at the Monetary Congress held in San Miguel de Allende in the Mexican state of
Guanajuato, that the future currency of North America would simple go under the
name of the “Dollar”.

In addition, it has been pointed out that the US would save itself the payment of the
interests that Mexico’s central bank receives for investing Mexico’s international
reserves in US treasury bonds. An approximation of this annual saving can be
estimated by multiplying the Bank of Mexico’s net reserves (around US$50,000
million) by an average annual rate of 4.5%, giving us a figure of US$2,250 million,
an amount that Mexico’s central bank would cease to receive. The latter is
equivalent to providing the US with an interest-free loan with the interests that our
country would no longer receive, and which would end up in the US treasury, as
indicated by the then US Treasury Secretary, Lawrence Summers in the first half of
19998.

Moreover, the US would earn interest by being the lender of last resort, a function
reserved for the issuing bank of the currency in circulation, which in this case
would be the US Federal Reserve. The American economist Harry Lane David has
estimated these interests at approximately US$1,000 million annually. Interestingly,
in early 1999 the US Congress authorized its central bank to become the lender of
last resort to foreign banks9, something which it had not until then permitted.

It is clear that all the functions outlined previously would give the US Federal
Reserve and the US Treasury Secretary an enormous influence over our economic
policy and that we would be, in any case, at the entire mercy of US monetary
policy, a situation that would make us even more dependent upon the economic
cycles of the USA.

I believe, however, that the US monetary system would eventually come to share
the seigniorage with Mexico. Indeed, documents produced by the US Congress
(such as that cited by Kurt Schuler) as well as the opinions increasingly shared by
noted economists seem to indicate this.

Furthermore, for some time, a large part of the savings of Mexicans living in
Mexico have been held in dollars in US banks (over US$37,000 million, according
to US Federal Reserve figures for the first trimester of 1999).
In 1999, I forecast that the following developments would take place 10: the
acceleration of the ‘foreignization’ of our banking system; the opening of savings
accounts in dollars and the issuing, within our banking system, of checks and
investments in dollars. Three years on, we can say that these predictions have
been fulfilled almost in their entirety: currently, only one of the major banks in
Mexico is not controlled by foreign banks, Banorte. In addition, the financial system
already offers companies current and investment accounts in dollars, and will
inevitably go on to provide the same for individuals, although following the events
in Argentina, and remembering what occurred in 1982 with Mexdollars, it is difficult
to see private investors being attracted to the idea.

It is worth mentioning that today, many companies and individuals already take out
loans in dollars abroad, as well as foreign exchange coverage – an unknown entity
for our entrepreneurs just six years ago – in order to protect themselves against
devaluation or depreciation of our currency. I should point out that the
aforementioned medium-sized enterprises are becoming increasingly familiar with
these mechanisms, mechanisms that may remove their fear of sudden devaluation
and depreciation in the exchange rate, the only fear that keeps them from taking
out credit in other currencies. The market in foreign exchange coverage will
facilitate the dollarization of credit, as its use amongst medium-sized companies
becomes more widespread.

In this way, our monetary sovereignty will slowly fall into the hands of the US
Federal Reserve and of the US Treasury Secretary, which will place US interests
above those of Mexico.

THE ADVANTAGES AND DISADVANTAGES OF DOLLARIZATION

We have seen that everything now seems to indicate that the monetary dilemma
will come to be limited to having a fixed exchange rate or maintaining the possibility
of an autonomous monetary policy. It is important to emphasize that monetary
autonomy is lost when any type of fixed exchange rate is established and that
simply having our currency in circulation does not guarantee us having sovereignty
over it.

Furthermore, our societies have not only shown themselves to be skeptical as

regards the ability of our economic authorities to carry out sound monetary and
fiscal policy that will end years of instability, but are actually convinced that they
are frankly incapable of doing so. Consequently, the popular theory is that
dollarization is certainly not an undesirable phenomenon.

Dollarization may become an economic shock tactic that would allow inflation and
local interest rates to be drastically reduced – whilst reducing the risk premium of
the country that adopted it. The latter may favor the creation of a flow of investment
from abroad. By becoming dollarized, a country provides economic agents with
exchange stability in that it eradicates the possibility of domestic monetary
authorities devaluating the currency, a measure that forces governments into
austere monetary conditions. The introduction of populist policies would thus be
largely impeded, though their complete disappearance would not be guaranteed,
given that our governments would still be able to incur debt abroad – once again,
we need look no further than the case of Argentina.

In contrast, the disadvantages of dollarization would include the irreparable loss of

seigniorage by our central bank and the loss of monetary sovereignty and
consequently the impossibility of applying monetary policies that would, for
example, allow the impact of economic crises to be reduced. The only instrument
available to those implementing national economic policy would therefore be fiscal
policy, although even in this area the room for maneuver available to fiscal
authorities would be strictly limited.

In terms of Mexico, with its practically complete economic and financial opening
with the USA, dollarization would mean that any economic adjustment whatsoever
would be reflected in economic activity and consequently on employment.

Furthermore, the existence of extended periods of overvaluation, such as those

experienced by the US dollar for some years and which significantly influenced the
crisis in Argentina by making its dollarized economy more expensive in
comparison, is another negative aspect of dollarization.

Due to these factors, an economy such as the Mexican would experience even
greater difficulties in diversifying its foreign trade, trade that is already enormously
dependent upon the US economy. Currently, some 80% of our country’s imports
and exports are derived from trade with the US and Canada11.

PREREQUISITES FOR DOLLARIZATION

There has been very little written on this topic and, in the wake of events in
Argentina, it is essential that the fundamental conditions required to enable a
country to become fully dollarized be clearly established.

 International currency reserves held in the Central Bank must be of sufficient

quantities to enable the local currency to be exchanged for the anchor currency,
as well as to prop up the convertibility of any internal debt mechanisms issued
by the government. If this were not the case, it would be necessary to acquire
them by through external credits, whilst a dollarized country could only obtain
access to them by maintaining a surplus in public finances.

 The local currency must be neither over nor undervalued. This is vital for the
dollarization process. When, in 1995, Rudiger Dornbusch recommended that
Mexico become fully dollarized, he stressed that it was the right time to do it
because the Mexican Peso was then undervalued, which would give it
comparative advantages that would remain over time – since the inflation rates
 in both countries were and would continue to be at a similar level. In my
opinion, these comparative advantages would, with time, prove to be clear
disadvantages in terms of the purchasing power of Mexicans. I do not believe
maintaining salaries permanently depressed to be a rational economic policy
measure in the long-term. Moreover, it would be a serious error to dollarize
whilst the currency is overvalued, since this would make the domestic
productive apparatus permanently uncompetitive with regard to the rest of the
world.

 The balanced management of Public Finances is a crucial prerequisite, since

by not having a monetary policy that generates internal debt, the government
would only be able to sustain a fiscal deficit through the direct acquisition of
debt through financial entities, whether these be domestic or foreign. We should
bear in mind that with full dollarization, the surplus would remain in private
hands rather than in the reserves of the Central Bank.

 Strengthening of the Domestic Financial System and its official supervisory

mechanisms. Financial globalization has revealed the weaknesses of national
banking systems, hence, completely opening the systems, as full dollarization
would imply, would be even more radical.

Full dollarization represents a straightjacket on a country’s economy, a

straightjacket that could only be loosened by applying of a series of structural
reforms that would attack the root problems of prices, productivity and the
distribution of National Income amongst the factors of production. It is essential
that these changes be aimed at raising the country’s competitiveness and
improving the relative prices of its goods and services, whilst at the same time
generating a significantly large internal market.

As a first step, a thorough analysis of the current situation would be a priority, as

well as an analysis of the future evolution of comparative prices, starting with the
exchange rate, an element that, in the process of globalization through which we
are living, becomes the fundamental price of a domestic economy. We must never
forget that the thing, which, over time, makes the difference between development
and underdevelopment, are those very relative prices.

In this analysis prior to dollarization, the Relative PPP (Purchasing Power Parity),
above all with its studies of long-term evolution, provides us with an appropriate
reference framework which must be used to develop a program of structural
changes that can be carried out, and which will help to raise the level of domestic
productivity. In Mexico’s case, for example, clearing up public finances and raising
the productivity levels of PEMEX and the CFE, the National Electricity
Commission, to international standards would have a major knock-on effect on the
country’s economy in general.

In my opinion however, if a country were capable of planning and carrying out the
aforementioned measures, it would have no need to sacrifice its monetary
 sovereignty or to dollarize. It would strengthen its own currency and recover the
confidence of both national and international economic agents and, most
importantly, of its own people. Is it possible?

Any country which decides to become fully dollarized does so precisely because of
its inability to establish the aforementioned policies and what it seeks is the
possibility of an economic jolt, a real straightjacket to overcome bad financial,
monetary and fiscal management.

OUTCOME

The process of dollarization is already underway and becoming evermore

widespread with no apparent means of turning back the clock. By continuing with
public policy that encourages monetary instability and undermines the functions of
money, time will come when the currency in circulation in our Latin American
countries, as in many other countries throughout the world, will be the US dollar or
the European Union’s euro. The question therefore is not so much “To dollarize or
not to dollarize?” but rather “When do we allow full dollarization?”

1
Vide, Encinas-Ferrer, Carlos, El Largo Camino de la Dolarización. (article) Contexturas, Año 1, Nº
1, November 1999. Universidad Iberoamericana León.
Encinas Ferrer, Carlos, Propuestas de Dolarización: América Latina y el Mundo.
(conference) Congress on Industrial Relations, Universidad Iberoamericana León. March 2001.
2
Schuler, Kurt, Basics of Dollarizatión, July 1999. Report of Joint Economic Comitee of the US
Congress. Office of the Committee Chairperson, Senator Connie Mack.
http://users.erols.com/kurrency/basicssp.htm
3
David, Harry Lane, Carlos Encinas-Ferrer, ¿Debería México Indexar Salarios y Precios al Dólar?,
(Should Mexico Index Wages and Prices to the Dollar?) Bilingual edition. Universidad
Iberoamericana Golfo Centro, Universidad Iberoamericana León. México. 2000.
4
Schuler, Kurt. Ibid.
5
Obstfeld, M., Alan M. Taylor, The Great Depression as a Watershed: International Capital Mobility
over the Long Run. In Bordo, M. D., Claudia D. Goldin, and Eugen N. White, eds., The Defining
Moment: The Great Depression and the American Economy in the Twentieth Century. Chicago:
University of Chicago Press, 1998, 353-402.
6
Sáenz, Josué. ¿La Dolarización del Peso?. Revista LETRAS LIBRES. Junio 1999, Año 1, Número
6, Pág. 112. México.
7
Schuler, Kurt. Ibid.
8
Maribel González et al.: Apoya EU Dolarizar. REFORMA Newspaper /April 23, 1999.
9
Chip Cummins (AP-Dow Jones). En el marco del TLC la dolarización económica sería clave.
Periódico EXCÉLSIOR del 20 de mayo de 1999, Sección Financiera.
10
Encinas Ferrer, Carlos, “El Largo Camino de la Dolarización”. Revista Contexturas, Año 1, Nº 1.
Noviembre 1999. Universidad Iberoamericana León.
11
Encinas Ferrer, Carlos, La Sobrevaluación del Peso Mexicano Medida a Través de su Comercio
Exterior.(“The Overvaluation of the Mexican Peso Through Its Foreign Trade”) “Mercadotecnia
Global” (“Global Marketing”) E-magazine available at:
http://www.iteso.mx/publica/mktglobal/mayo02/mayo03.html
Instituto de Estudios Superiores de Occidente (ITESO), May 2002 .

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