Dollarization

While governments were trying to insure the economies from currency crises by accumulating larger reserves of hard currency to back up domestic circulation of local currency, economic agents, particularly in those countries with a history of inflation and currency crises, have been adopting at different speeds the direct use of foreign currency in many daily transactions and using their own money less. In some instances, countries have abandoned their own currencies, such as Panama and, more recently,

Ecuador and El Salvador, without becoming members of a monetary union, as is the case of the European Union system. Leaving aside the issue of monetary unions, here we focus on a trend in monetary, financial, and fiscal conditions particularly since the 1980s that has been called dollarization.65 This term covers different definitions, from countries that, as mentioned, have unilaterally abandoned their own currencies to different degrees of currency substitution, domestic asset and liability dollarization, and external indebtedness in dollars.

In general, in several developing countries, mostly but not only within the "urbanized" group, an important percentage of both deposits and loans in the banking system are denominated in dollars. Although this seemingly takes care of the currency mismatch from the point of view of the banks, that problem is not significantly resolved if debtors have their incomes in domestic currency and would be forced to default in case of a large adjustment in the exchange rate. In turn, banks might not have enough foreign exchange reserves (neither the domestic economic authorities) to finance large withdrawals of foreign currency deposits from economic agents that see the deterioration of the banks' asset side and want out. Also, governments and private sectors that are increasingly indebted abroad and for which their tax receipts and sales, respectively, are denominated in local currency will also be affected by large devaluations. For a government with dollarized public debt, the devaluation would result in a fiscal crisis as well, through different channels: First, the increase in pesos of the payments of the public debt is not matched by tax receipts that remain in pesos; second, the likely banking crisis may require intervention by the public sector with public funds; and third, the recession caused by the banking crisis would reduce tax receipts. In summary, dollarization creates a strong constituency for exchange rate stability.

Although the reasons for dollarization appeared linked originally to high inflation in those countries, the phenomenon has persisted and even intensified, even when inflation declined, leading to the consideration of other causes such as volatility of domestic inflation vis-a-vis volatility of the real exchange rate, possibly linked to lack of a credible monetary policy and imperfections in financial markets and regulations that offered implicit advantages to holdings of dollars (such as the perceived implicit guarantee of government intervention to bail out banks in case of a large devaluation). Whatever the reasons, dollarization under different definitions appeared to increase in several developing countries up to the early 2000s. Reinhart and Roggoff (2003) utilize mul-tivariate criteria to identify various types of dollarization, depending on whether the phenomenon affects assets and liabilities domestically or externally, and whether the private sector participation in the dollarization process is significant. Under three indicators (foreign currency deposits over total deposits, external debt as percentage of GDP, and private sector participation in that debt; see Table 16), dollarization has gone up in all regions, but it is clearly more advanced in LAC, particularly the Southern Cone, and in the Transition Economies. These measures, however, do not include,

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