NS3040 Dollarization in Latin America Fall Term, 2018 CFR, The US Trade Deficit: How Much Does it Matter?

Dollarization: Overview Dollarization is the national use of another country’s currency Typically the issuing country is the major trade partner of the adopting country Enables the adopting country to stay competitive regardless of the movement in the issuing country’s currency Enables the adopting country to be just like California with respect to the United States Three countries in Latin America have full dollarization Panama -- 1904 Ecuador -- 2000 El Salvador -- 2001

Dollarization In addition to full dollarization – country removes its own currency and only uses dollars, other forms include Fixed exchange rate with the dollar – keep local currency but requires large amount of dollar reserves De-facto dollarization – dollar circulates and is recognized as legal tender along with national currency Motives for dollarization Loss of confidence in national currency – usually high rates of inflation -- Argentina currency board Reduce investor foreign exchange risk – El Salvador

Ecuador I Ecuador strange case – no hyper inflation, but banking crisis resulted in shift into dollars Impact mixed Growth increased from average of 2.4% before crisis (1980-99) to 4.0% (2000-2015) – probably due to oil boom Inflation dropped from average of 37% per annum to 13% with dollarization Inflation remained above that of trading partners thus making its products very expensive

Ecuador II Ecuador anticipated full dollarization would Problems Lower borrowing costs by eliminating foreign exchange risks -- no local currency to depreciate Force private banks to police their own risk taking since no bail- out from central bank possible Problems Difficult to maintain liquidity due to dollar outflows Higher rate of domestic inflation – appreciation of real exchange rate -- current account deficits Higher interest rates outside Ecuador result in dollar outflows

Ecuador III Ecuador did not implement reforms to make dollar system work System depends on flexible wages and prices Socialist governments did not undertake labor market reforms and prudent regulation Country’s economic freedom fell from “mostly unfree” in 2007 to “repressed” by 2016 Country did not build up reserves during good oil years Lead to 2008 default on external debt Shut country off from international capital markets Country became almost totally dependent on China’s willingness to provide capital

El Salvador I El Salvador – had no pre-dollarization crisis Felt adoption of dollar would speed up FDI inflows – integrate El Salvador into U.S. market. Interest rates did come down However liquidity crisis because increase in FDI never materialized FDI as share of GDP actually fell to one of lowest in region Lesson – stable currency may be necessary for sustained growth, but not sufficient

El Salvador Ii El Salvador did not establish environment to take advantage of dollar Poor rule of law Dramatic increase in violent crime – gangs Country ranks low in World Economic Forum Competitiveness Index in Labor market efficiency -- 122/138 Goods market efficiency -- 102/138 Institutions needed for growth -- 132/138

Assessment Problem – very hard to move from dollar back to a local currency – confidence problem Ecuador trying to shift through a cryptocurrency – probably just increases investor uncertainty Best solution – bite the bullet and introduce market reforms to increase positive effects of the dollar.