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

2. 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
Ecuador
El Salvador

3. 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

4. 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 ( ) to 4.0% ( ) – 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

5. 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

6. 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

7. 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

8. 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 /138
Goods market efficiency /138
Institutions needed for growth /138

9. 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.