The Pros and Cons
Andrew Berg, Eduardo Borensztein
©2000 International Monetary Fund
[Preface] [The Pros and Cons of Full Dollarization]
[Questions About Pegs] [The Appeal of Dollarization]
[The Risk Premium] [Seigniorage] [Stability]
[Effect on Trade and Financial Links] [Exit Option]
[Lender of Last Resort Function and Financial System Stability] [Conclusions] [Author Information]
The Economic Issues Series aims to make available to a broad readership of nonspecialists some of the economic research being produced on topical issues by the International Monetary Fund. The series draws mainly from IMF Working Papers, technical papers produced by IMF staff members and visiting scholars, as well as from policy-related research papers. The following paper draws on material originally contained in IMF Working Papers 00/50 and 00/29, respectively, "The Pros and Cons of Full Dollarization" and "The Choice of Exchange Rate Regime and Monetary Target in Highly Dollarized Economies," both by Andrew Berg and Eduardo Borensztein. Readers may purchase these papers for $10 each from IMF Publication Services. Charles S. Gardner prepared this version.
The Pros and Cons of Full Dollarization
Since the end of the Bretton Woods system of fixed exchange rates nearly thirty years ago, the old dilemma facing countries of finding workable currency exchange arrangements has become more challenging, and the choices have become more varied. The decision about which exchange rate system to adopt has become more difficult as world trade and capital markets have become more integrated. New problems have emerged, and with them, new answers to the question of the best exchange regime to promote each country's development objectives. The newest of these solutions is full dollarization, under which a country officially abandons its own currency and adopts a more stable currency of another country—most commonly the U.S. dollar—as its legal tender. From the perspective of any hard currency country, full dollarization may appear more radical than it is: use of the U. S. dollar or another major currency is pervasive to one degree or another in most developing countries, particularly in financial contracts (see Box 1, "What Is Dollarization?"). Full dollarization means taking the next step, from informal, limited dollarization to full, official use of the foreign currency in all transactions. The main attraction of full dollarization is the elimination of the risk of a sudden, sharp devaluation of the country's exchange rate. This may allow the country to reduce the risk premium attached to its international borrowing. Dollarized economies could enjoy a higher level of confidence among international investors, lower interest rate spreads on their international borrowing, reduced fiscal costs, and more investment and growth.
|Box 1. What Is Dollarization? | |This pamphlet focuses on full dollarization, or one country officially adopting the currency of another for all | |financial transactions, except perhaps the need for coins. In considering this choice of exchange regime, two points | |are important to keep in mind: | |The term dollarization is shorthand for the use of any foreign currency by another country. The issues it raises are | |identical for the other countries in the region using the South African rand, for example, and they would be for any | |country of, say, Eastern Europe, considering eventually adopting the euro. | |Most developing countries—as well as transitional economies just adopting market mechanisms—already have a limited, | |unofficial form of dollarization. To a greater or lesser degree, their residents already hold foreign currency and...