Dollarisation

Why in news?

Javier Milei, the recent winner of Argentina’s presidential election, has drawn attention for his plan to replace the country’s currency “Peso” with the dollar.

What is dollarisation?

• It is the process by which a country decides to use two currencies the local currency and generally a stronger, more established currency like the US dollar.

• Occurrence- It occurs in developing countries with a weak central monetary authority or an unstable economic environment.
• It usually happens when a country’s currency becomes unstable or loses its value due to high inflation or other economic problems.
  • Example- Zimbabwe ran a dollarization test to see if the adoption of foreign currency could reduce high inflation and stabilize its economy.
• Types- There are 4 types of dollarization that countries can adopt.

What is the significance of dollarisation?

• Economic stability- It can lower inflation rates and stabilise prices, as the dollar is less prone to devaluation and volatility than the domestic currency.
• Promote investment- It can avoid currency crises, which reduces the sovereign risk premium and lowers interest rates, leading to higher investment and growth.
• Boost trade- It can facilitate trade and integration with international markets, as the dollar is stronger and more widely accepted than the domestic currency.
• FDI destination- It can encourage foreign direct investment (FDI), as investors do not need to worry about exchange rate risks or currency fluctuations.
• Cost effective- It can promote fiscal discipline and a competitive financial system, as the government and the banks cannot rely on printing money to finance their deficits or bailouts.

3 fully dollarised economies - Ecuador, Panama and El Salvador have had successful economic outcomes following dollarisation.

What are the issues of dollarisation?

• Monetary autonomy- It can reduce the country's monetary autonomy, which means it cannot adjust its money supply or interest rates according to its economic needs.
  • Greece benefited from using the Euro as a common currency, but lost its policy autonomy.
  • Ecuador’s dollarisation led to losing of monetary autonomy and exchange rate policy autonomy.
• Seigniorage- It can lose the revenue generated by issuing currency.

Seigniorage is a term that refers to the profit that a government or a central bank makes by issuing money.

• Country’s identity- The country may face a loss of public support or legitimacy, especially if the decision to dollarise is perceived as imposed by external forces or interests.
• External factors- It can increase the country's vulnerability to foreign influence and external shocks, as it depends on the US monetary policy and dollar availability.
• Liquidity risks- It can impair the lender-of-last-resort’s ability to provide emergency liquidity to the financial system in times of crisis.

What lies ahead?

• Dollarisation is not a silver bullet, but if used well in conjunction with domestic policy, it can offer a route to success.
• Dollarisation should be implemented in a country based on dollar reserves, fiscal policy, trade policy and external shocks to realise its full potential.

References

1. The Hindu- Can dollarisation save an economy
2. Indian Express- Dollarisation in Argentina