Is Dollarization the Solution?

In recent times there has been increasing talk about using dollarization as the strategy to effectively deal with the instability being experienced within the local foreign currency market.

But what do we know about dollarization? We know for certain that it is the epitome of fixed exchange rate regimes. The less rigid versions are for instance:

1. Foreign Currency Peg (Weak Form) shows a government trying to match every dollar of the local currency to that of the anchor currency on its credibility that can change based on perception and currency earnings.

2. Currency Board (Stronger Form) will see a government ensuring that for every dollar of the local currency for instance, there is within its coffers, a dollar of the anchor currency (e.g. USD). This means that when the Currency Board buys anchor dollars, it is pumping back the same amount of local dollars in the system and vice versa. Thus the ratio remains fixed. Theoretically this would work on the ground that there is no extra or increase in domestic liquidity to fuel an excessive growth in the demand for the foreign (anchor) currency.

But we all know that these models have not worked in the past due to specific limitations. These include the vulnerability to external shocks and sentiments that might lead to speculative activities within the local foreign exchange market. If there is a loss of confidence the above two regimes will ultimately collapse. This has been the experience in the many currency crises that we have as examples. The key problem of these models therefore is lack of, or a decline in confidence of those who establish and seek to maintain the system.

But then there is Dollarization which seems to solve the problem of confidence in that it disassociates the Authorities from any intervention or control of the peg that is being administered. Essentially, dollarization is just a substitution of the local currency for the anchor or foreign currency (whether they both continue to be used or the local currency is collected and thrown away leaving just the anchor currency). So picture Jamaicans legal tender becoming US dollars. That is what is considered dollarization. This will definitely solve the confidence problem that causes instability in the foreign exchange rate.

However, one must not think that confidence is the only problem. Dollarization does have its disadvantages as much as it has its advantages. The advantages are that:

1. The government has no control over currency value. So if the US dollar remains strong then Jamaicans will be using a strong dollar to buy goods and services.

2. The government can no longer trade local currency within the market to satisfy its financial obligations. Whatever money the government earn would be through taxes or profits from public sector operations, or borrowing directly from the market as anyone else would (at market rates). As such the fiscal discipline that is being desired is automatically implemented.

3. If the US has low interest rates, then Jamaica will inherit low interest rates. If the US has low inflation, we can expect Jamaica to have low inflation by way of low interest rates as well.

With those benefits however, the disadvantages are made much clearer.

If the government should permit a transition to a dollarized economy, what it is essentially doing is relinquishing the right to be the lender of last resort. There would be no need for a Central bank. This means giving up any form of intervention in the capital market. Handcuffing the government in this way would render them useless should a difficult economic situation arise where there is the need for government to step in and assist.

Our current situation can serve as a very good example. If the US economy should plunge into a financial crisis (which it has) and there is a currency shortage (which there is) in the US , Global economy, and hence the Jamaican economy; under dollarization, the GOJ can do nothing but sit and watch it all happen. If there is a major hurricane and the entire infrastructure becomes ruined, there will be no monetary policy that the government could implement to improve the situation.

The government would be foregoing all interventionist tools that could come in quite handy in difficult times. Is this a good thing? Is it a good thing to leave all our economic policies to the mercy of the US economy? The US will intervene when it deems it fit do so for the sake of its own economy. But the policies that will aid the US in times of difficulty might very well make situations worse for us; a small country that is practically invisible to the US. These are issues that are in need of attention and I do not hear them being debated.

Additionally, a switch from a flexible to a fixed exchange rate will require the cancellation of the wealth a government attains from printed money (Seniorage). The local currency that is held as wealth by the government will have to be discarded. Who will pay for that? That will have to be handed over in ideological terms to the US. The government will be powerless to act in our economic and financial defense.

Can the situation get worse? I believe with Dollarization, the problem of local currency fluctuation will be solved. But then we inherit USD currency fluctuation should they occur. If we adopt Dollarization, we can get the government out of the local capital market and prevent it from completing with local borrowers for loans. This will drive down interest rates. We will have rates significantly lower but not necessarily the same as the US because of country risk and other factors.

What I am saying is that there is some good but it all depends on whether the US is infallible and whether we are exposed to the same factors that the US faces. I don't believe that the US is infallible as the recent past shows and I do not believe that Jamaica has the same experience as the US which means that the economic policies implemented by the US will quite likely negatively affect us; and also, might not be timely to deal with issues that we need to deal with at any specific point in time.

Dollarization therefore might not be such a good idea. I would love to hear your views.

The views expressed above are those of the Author and should not be interpreted as the views of the PSOJ.

James Robinson is a Research Economist at the PSOJ.