II. DOLLARIZATION: A SURVEY
4. What to Expect with Dollarization
4.2. Dollarization Effects in the Long Run
4.2.1. Devaluation Risk and Country Risk
In 2002 it became 9.4%, already lower than in any of the previous 20 years, and in 2004 it was just 2%. With the fall of inflation, lending interest rates also fell, and credit rebounded significantly. With respect to real GDP, during 1998 and 1999 Ecuador experienced negative growth due to the crisis that led to dollarization, but after the adoption of dollarization it grew at an annual rate of 2.8% in 2000, 5.1% in 2001 and 3.4% in 2002.25 Although not the same as full dollarization, the experience of Argentina with its currency board shows certain similarities with the Ecuadorian experience in the short term. The currency board system moved Argentina from a situation of hyperinflation and economic instability to a situation of low inflation and stability.
However, the collapse of this system in January 2002 certainly has implications to the Ecuadorian experience. According to Beckerman and Cortés-Douglas (2002), Argentina’s clear lesson for Ecuador is that the disciplined management of public finances is crucial for the continued viability of the dollarized system. Sound policies would in fact be more indispensable for a dollarized country because the system does not have an exit option as the convertibility system does.
impossible to find pure free-floating exchange rate regimes among emerging market economies because of the reluctance of their governments to allow large exchange rate fluctuations. They rather use some sort of soft or non-credible pegs. These are intermediate exchange rate regimes, which in a world of high capital mobility can easily become the target of speculative attacks, something that can make international creditors very nervous. According to Eichengreen (2001), history has shown that intermediate exchange regimes collapse sooner or later. Currency boards, although very close to dollarization, still have an “exit” option and can be abandoned at any moment. This was the case of Argentina in January 2002. On the other hand, as Chang (2000) points out, dollarization is much more difficult to reverse. It would be costly, entailing reintroducing a new domestic currency and convincing citizens to turn in their holdings of dollars. The main implication of the irreversible nature of a dollarized system is that the policy arrangement is credible, and in the long run, credibility is supposed to bring many benefits.
Because dollarization is irreversible, devaluation risk is eliminated, at least against the dollar, the anchor currency. As a consequence, inflation tends to decrease because expectations are for the dollar to keep its value. This may be very beneficial for countries with chronic inflation problems. According to De Gregorio (1993) and Fischer (1993), there is a negative relationship between inflation and economic growth, although according to Bruno and Easterly (1998) the direction of causality is uncertain. Bruno and Easterly indeed find that a discrete high inflation crisis is associated with low growth, while the end of such a crisis is associated with high growth, but they regard that more as a short than a long-term effect. Levine and Carkovic (2001) find that inflation does affect
economic growth, but only indirectly. According to Levine and Carkovic, high inflation has a negative effect on growth because it tends to thwart financial development. Under dollarization, low and stable inflation will imply lower and stable nominal interest rates, particularly if there is also further integration of the country’s financial system to the international markets. This environment should stimulate investment and economic growth.
The low inflation and the absence of devaluation risk in a dollarized country will definitely produce a reduction in the nominal cost of domestic credit. However, even with domestic loans denominated in dollars, this cost can still be higher than the cost of credit in the anchor country or the world markets. The difference in the cost of credit across countries would be due to what is called a country risk premium, which reflects the probability of a country to default on its international debt. This probability depends not only on the risk of devaluation, which under dollarization does not exist, but also on other country characteristics such as political stability, degree of indebtedness, legal and social conditions, economic vulnerability, and even geographic factors including size, which could be affecting the solvency of the country. As Chang (2000) indicates, the hope of the dollarization advocates is that the elimination of devaluation risk will promote the reduction of country risk, causing the cost of credit to move even lower. According to Berg and Borensztein (2003), lower interest rates and greater stability in the flow of foreign capital would result in not only increased investment, but also a lower fiscal cost of servicing the public debt. This situation would imply a positive feedback that would lower the risk perception of the country.
Other authors, however, believe that the link between dollarization and country risk is not that straightforward. The restrictions imposed by dollarization may increase the fragility of a country and create situations that would amplify country risk. Powell and Sturzenegger (2003)26 indicate that dollarization not only eliminates the exchange rate as a shock absorber, but also weakens a government’s budget by eliminating seigniorage and the inflation tax as revenue sources. This situation may increase the probability of default in the presence of negative shocks to the economy. If, under fiscal distress, the government chooses borrowing as the financing option, then too much debt will add to the risk perception of the country. In fact, this may be why Goldfajn and Olivares (2001) find that, although dollarized Panama has a relatively good country risk rating, this rating is not better than that of some other non-dollarized Latin American countries. In addition, Panama’s economy seems not to have been completely insulated against the effects of the financial crises of East Asia, Russia and Brazil during the late 1990s. Furthermore, Panama’s economy seems to be equally vulnerable to real shocks as the economy of any other non-dollarized country. This suggests to Goldfajn and Olivares that the absence of devaluation risk alone is not enough to produce further reductions in country risk or to guarantee the cheapest access to international markets. It is clear that the size of the country, its lack of natural resources, and its high level of indebtedness are working against Panama. Goldfajn and Olivares indicate that although Panama has become financially integrated to the U.S., it has lacked fiscal discipline. Under these conditions, it is possible that dollarization has helped Panama keep its relatively good risk rating.
Dollarization may indeed create economic conditions that would lower country risk.
Powell and Sturzenegger (2003) indicate that dollarization eliminates the risk of
speculative attacks on the domestic currency. Berg and Borensztein (2003) argue that the government of a dollarized country would not have to take measures that are necessary to prevent currency crises under other types of regimes – measures that also worsen the risk perception of the country. An example of these measures is the issue of too many dollar- denominated or dollar-indexed bonds, as in Mexico 1994, or the imposition of capital controls, as in Russia 1998. In addition, bank supervision costs are reduced because the currency mismatch between assets and liabilities of banks and firms is eliminated by default under a dollarized system. This mismatch problem is an important source of risk for those countries that are highly dollarized informally. Consequently, under dollarization a country could re-allocate resources more efficiently to pursue needed changes in other crucial aspects. A country may pursue international financial integration or the implementation of more disciplined fiscal policy.