Total... dollarization
Since the abandonment of the gold standard at the beginning of World War I and the Bretton Woods Conference at the end of World War II, many countries have sought ways to promote global economic stability and, therefore, their own prosperity. For most countries, the best way to achieve monetary stability is to "peg" the national currency to a major convertible currency. Another way is to abandon one's own currency in favor of the U.S. dollar (or another major international currency, such as the euro). This phenomenon is known as total dollarization.
How course binding works
An extreme version of exchange rate pegging is one in which a country "pegs" its national currency to a convertible currency (most often the U.S. dollar). As a result, the local currency has the same value and stability as the foreign currency. Rate pegging usually helps express the value of a national currency relative to the world's convertible currencies and stabilize the exchange rate.
Dollarization as an Alternative
As an alternative to a floating currency, a country may prefer full dollarization. The main reason for such a decision lies in the desire of the state to reduce country risk and thus ensure a safe economic and investment climate. This is usually chosen by developing and transition economies, especially those with high levels of Inflation.
Many economies that have chosen dollarization already unofficially use foreign currency as a monetary reference point in private and official transactions, contracts and bank accounts. Nevertheless, this policy is not a state policy, and the national currency continues to be regarded as the main legal means of payment. Pegging to foreign currency protects individuals and companies from the possible devaluation of the local currency. Full dollarization, meanwhile, is a long-term solution: the economic climate in the country becomes more reliable, and the probability of speculative attacks on the national currency and the securities market is practically reduced to zero.
The reduction of risks attracts local and foreign investors. And the fact that the difference in exchange rates has lost its relevance allows you to lower interest rates on foreign loans.
Disadvantages of dollarization
The introduction of foreign currency has a number of disadvantages. When a country refuses to print its own money, it loses the ability to directly influence its own economy, including the conduct of monetary policy and the formation of exchange rates.
Moreover, the central bank loses income from the issuance of money (the difference between the face value of a monetary unit and the cost of its production). In return, it receives U.S. Federal Reserveand the local government loses a significant amount of funds, which is also reflected in the volume of GDP.
In a fully dollarized economy, the central bank is also losing its role as lender of last resort to other banks. Yet the central bank is still able to provide short-term required reserves to banks in distress. But there is not necessarily enough money to pay out deposit repayments.
Another disadvantage of full dollarization is the fact that national securities must also be redeemed in U.S. dollars. If a country does not have enough foreign exchange reserves, it has to borrow money, which leads to a balance of payments deficit. The second option is to ensure a surplus in the balance of payments.
Finally, since the national currency is the symbol of an independent state, the use of foreign currency can damage the sense of pride of citizens.
Advantages of dollarization
In addition to lowering risks and protecting against inflation, there are a number of equally convincing arguments in favor of abandoning the national currency.
As mentioned earlier, full dollarization helps to create an investment-friendly environment and almost completely eradicates speculation with the national currency and the exchange rate. As a result, the capital market becomes more stable, unexpected outflows of funds stop, and the balance of payments is less and less prone to crises.
An equally important plus is the fact that full dollarization strengthens the global economy because it facilitates the integration of economies.
Many developing countries already use dollarization to varying degrees. Nevertheless, sometimes economies try to avoid this path of development. For many countries, an autonomous economic policy and a sense of independence is too expensive a price they are not willing to pay. After all, the process of full dollarization is basically irreversible.