Dollarization Does Not Make Sense Everywhere

The revised version of the paper has benefited from the discussions at the conference, as well as helpful comments from Marcel Fratzscher and highly competent research assistance from Katherine Russ.

© Institute for International Economics

Introduction

My title reflects a conviction that it is profoundly mistaken to debate the merits or otherwise of dollarization in the abstract, assuming that the advantages are the same everywhere, or even everywhere in the Western Hemisphere. Exchange rate flexibility may well make sense in some parts of the region, but in other parts it does not. My paper endeavors to explain the reasons for that conclusion, and the criteria that lead me to judge some places to be much stronger candidates for dollarization than others.

Intellectual Framework

I propose to compare fixed rate systems against flexible rate systems, using a battery of five criteria drawn from the optimal currency area literature for that purpose. The first is size: small size points to fixed rates. The second is openness: an open economy points to fixed rates. The third is trade concentration: trade focused on the dollar bloc points to a fixed rate to the dollar. The fourth is similarity of shocks: similar shocks suggest fixed rates. The fifth is liability dollarization: the more extensive this is, the more difficult and dangerous does it become to devalue (as several papers at this conference argue convincingly, most particularly Augusto de la Torre's account of Ecuador's recent history).¹

There are also at least three different fixed-rate systems under discussion at this conference: currency boards, dollarization, and monetary union. (I might have added a fixed exchange rate maintained by a central bank, which we have learned that Barbados still succeeds in making work, with the aid of capital controls.) These differ in terms of seigniorage, the interest premium a country has to pay, financial depth, access to a lender of last resort, and influence on decision making. A comparison of these five characteristics across the three regimes is offered in table 1. The second and third rows accept the claim of the proponents of dollarization that adoption of the dollar would eliminate currency risk and thereby reduce interest rates, and also that it would offer a short cut to deepening the financial system. The final column also shows normal preferences over those five characteristics. This makes it clear that monetary union would be the preferred regime: if it were on offer, one would expect any country for which the optimum currency area criteria are reasonably favorable to fixity to choose this option.² However, since the chance of the Fed offering a seat on the Open Market Committee to Canada (let alone Argentina or Mexico) would seem to be minimal,³ even a favorable outcome on the optimum currency area criteria has to be weighed against the disadvantages of dollarization vis-à-vis monetary union. (There is also a case for a country to dollarize as a counsel of despair if it has decided it is incapable of governing itself, but I do not regard that as a general problem.)

Regional Disaggregation

Excluding the United States for obvious reasons and Cuba as sui generis, the remainder of the Western Hemisphere may be divided into the following country groupings:

• Canada
• Central America and the Caribbean
• Mexico
• Brazil
• Argentina
• The rest of Mercosur: Bolivia, Chile, Paraguay, and Uruguay
• The Andean group: Colombia, Ecuador, Peru, and Venezuela.

Table 2 shows how these different groupings match up on the five criteria drawn from the optimum currency area (OCA) literature. The entries for the first three criteria are objective and quantitative; those for similarity of shocks are impressionistic and qualitative.

Conclusions

Although Canadians customarily think of Canada as a small economy, it is in fact the ninth largest economy in the world, which makes it large by my standards. The openness and trade concentration criteria suggest that Canada would be quite a good candidate for a fixed dollar exchange rate, but John Murray pointed out that Canada still receives very different shocks to the United States because of the importance of its resource-based exports. In addition, it has no problem of liability dollarization; floating is unproblematic; its interest rates are actually lower than those in the United States; it already has deep financial markets; it would lose a lender of last resort capacity under dollarization; and it would have no seat at the policy table. These factors lead me to regard Canada as an unlikely candidate for dollarization.

The small countries of Central America and the Caribbean have all the characteristics of being part of a dollar OCA. They would lose seigniorage, but for most of them, at least, that is probably outweighed by the saving in interest costs that they could expect. They are too small to exert any influence on US policy whatever the rulebook says. Most of their shocks seem likely to parallel those in the United States, with the exception of natural disasters, to which devaluation seems a poor policy response in any event. The only other disadvantage of dollarization is that they would lack a lender of last resort, but one suspects that use of the central bank to bail out banks in countries as small as these would be a disaster anyway. This implies that dollarization would be virtually all gain and almost no loss, at least in economic terms.

Mexico's position is fairly similar to that of Canada. It is somewhat smaller and slightly less open, but more important are the facts that it has an interest premium, more liability dollarization, and less developed capital markets. Its shocks also differ from US shocks: even today oil and interest rates are significant factors in the Mexican economy, with impacts very different to those on the United States.

Brazil is clearly a much less compelling candidate than Canada for dollarization. Its economy is larger, much less open, and has a far more diversified trade pattern. Its exports still contain an important component of primary commodities (much of it partly processed and therefore statistically counted among manufactures), leading to a presumption that its shocks are unlikely to match those in the United States. It is large enough to develop its own financial markets now that it has stabilized inflation. It has made use of the lender of last resort facility in recent years. It does not have much of a problem of liability dollarization. It increasingly expects to have a place at the table. Perhaps the major disadvantage of not dollarizing is that interest rates could not be expected to fall close to those in the United States. Thus there is not much of an economic case for dollarization, while politically there is no constituency for it. I judge it inconceivable that Brazil will dollarize.

If, contrary to that prognostication, Brazil were to dollarize, then that might be a reasonable policy for Argentina as well. Since Brazil will not dollarize, however, it looks like a terrible policy choice. Argentina has a pretty large economy; it is almost as closed as Brazil; its trade is highly diversified, with trade with Brazil alone almost double that with the United States (and growing more rapidly); and its shocks are more likely to be similar to those faced by Brazil than to US shocks. The only real argument for dollarization is the extent of liability dollarization already. Despite that, I would have thought that a monetary union with Brazil would be a more interesting long-run possibility for Argentina, especially if one believes that the architects of the European Union were right in arguing that a common market would be unable to strengthen and thrive in an environment of exchange-rate instability. It is true that interest rates would not converge to a level as low as dollar interest rates in a Mercosur monetary union, and it would take longer to build deep financial markets. Nevertheless, rather than contemplate dollarization, Argentina would seem better advised to research the possibilities of a Mercosur monetary union (which would certainly face formidable transitional problems, in terms both of de-dollarizing the Argentinean private sector and aligning exchange rates).

The other countries of Mercosur are stronger candidates for monetary union than Argentina on grounds of size and openness. Their direction of trade and probably their pattern of shocks would suggest that they might have more to gain from a Mercosur monetary union than from dollarization. On the other hand, interest rates would not fall as much, financial development would not be as rapid, and some of them already suffer from a high level of liability dollarization. One could probably make an economic case for whichever course seemed politically more attractive.

The Andean countries (Colombia, Ecuador, Peru, and Venezuela) are in an intermediate situation: smaller economies, fairly open, a substantial concentration of trade on North America, though all with important commodity exports that makes it unlikely that they will experience a benign coincidence of shocks with the United States. They probably all have a significant level of liability dollarization. Perhaps the rest would be best advised to wait and see how dollarization works in Ecuador before they make a move.

Concluding Remarks

Dollarization is not something that should be debated in the abstract, as though the issues are the same for Antigua and Argentina, for Barbados and Brazil, for Canada and Costa Rica. Circumstances differ, and policy should therefore differ accordingly. In particular, I see a stronger case for Mercosur to start thinking of creating its own monetary union rather than for some of its members to adopt the currency of a faraway country that shows not the slightest willingness to share its monetary sovereignty.

Table 1: Criteria for choosing among fixed-rate regimes

Notes:


1 Unless Connie Mack's bill passes


2 Except to the extent that a bail-out authority commands resources, which can provide a lender of next to last resort

Source: John Williamson

Table 2: The Optimum Currency Area Criteria for Different Country Groupings

n.a.=not available

Sources: GNP figures are taken from the 1999/2000 World Bank World Development Report. Trade Concentration for each area is computed using the IMF Direction of Trade Statistics, December 1999. All figures indicate 1998 levels.

Notes

1. I neglect the issue of labor mobility, because I have concluded that Robert Mundell is right in thinking this issue is less central than his original analysis suggested.

2. I acknowledge that the Danish electorate defied this expectation.

3. As John McCallum argued in his speech to the conference.