Syllabus
GS Paper 3 – Effects of Liberalization on the Economy, Changes in Industrial Policy and their Effects on Industrial Growth.
Context
Javier Milei, the newly elected president of Argentina, has garnered attention with his proposal to substitute the nation’s currency, the “Peso”, with the US dollar.
Dollarization:
- This refers to the practice where a country opts to use two currencies concurrently – its own local currency and typically a more robust, well-established currency such as the US dollar.
- Dollarization typically takes place in developing nations where the central monetary authority is weak or the economic environment is unstable.
- This usually occurs when a country’s currency becomes unstable or depreciates due to high inflation or other economic issues.
- For instance, Zimbabwe conducted a dollarization experiment to determine if adopting a foreign currency could curb high inflation and stabilize its economy.
4 types of dollarization:
- Complete Dollarization: This refers to the scenario where a foreign currency is the sole legal tender in a country.
- Partial Dollarization: This is a situation where both foreign and local currencies are recognized as legal tender.
- Official Dollarization: This occurs when the government and monetary authorities of a country accept a foreign currency as its legal tender.
- Unofficial Dollarization: This happens when the citizens of a country hold their savings in a foreign currency through investment instruments.
Importance:
- Economic Stability: Dollarization can lead to economic stability by reducing inflation rates and stabilizing prices. This is because the dollar is less susceptible to devaluation and volatility compared to the domestic currency.
- Promotion of Investment: Dollarization can help avoid currency crises, which in turn reduces the sovereign risk premium and lowers interest rates. This can lead to increased investment and growth.
- Boost to Trade: Dollarization can facilitate trade and integration with international markets. The dollar, being stronger and more widely accepted than the domestic currency, can boost trade.
- Attracting Foreign Direct Investment (FDI): Dollarization can encourage foreign direct investment (FDI) as investors do not have to worry about exchange rate risks or currency fluctuations.
- Cost Effectiveness: Dollarization can promote fiscal discipline and a competitive financial system. This is because the government and banks cannot rely on printing money to finance their deficits or bailouts.
Three economies that are fully dollarized – Ecuador, Panama, and El Salvador – have experienced successful economic outcomes following dollarization.
Ecuador Model of Dollarization
Price Stability: Dollarization helped Ecuador reduce its inflation rate from over 100% in 2000 to around 4% in the subsequent years.
Lower Interest Rates: The interest rates declined, making credit more affordable, which encouraged investment and consumption.
Fiscal Discipline: Dollarization limited the government’s ability to finance its spending by printing money. This improved the country’s credit rating and reduced its country risk premium.
Social Spending: The country utilized its oil revenues to increase social spending, which helped reduce poverty and inequality.
Issues Associated with Dollarization
- Loss of Monetary Autonomy
- Dollarization can diminish a country’s monetary autonomy, meaning it cannot adjust its money supply or interest rates based on its economic needs.
- For instance, Greece benefited from using the Euro as a common currency, but lost its policy autonomy.
- Similarly, Ecuador’s dollarization led to the loss of monetary and exchange rate policy autonomy.
- Seigniorage: A country can lose the revenue generated by issuing currency, a concept known as seigniorage.
- Loss of National Identity: The country may face a loss of public support or legitimacy, especially if the decision to dollarize is perceived as imposed by external forces or interests.
- Vulnerability to External Factors: Dollarization can increase a country’s vulnerability to foreign influence and external shocks, as it depends on the US monetary policy and dollar availability.
- Liquidity Risks: Dollarization can impair the lender-of-last-resort’s ability to provide emergency liquidity to the financial system in times of crisis.
Way forward
- Role of Dollarization: While dollarization is not a panacea, it can pave the way to success when used effectively in tandem with domestic policy.
- Implementing Dollarization: The implementation of dollarization in a country should be based on factors such as dollar reserves, fiscal policy, trade policy, and external shocks to fully realize its potential.
Source: The Hindu
Practice Question
What is the importance of dollarization? What are the difficulties associated with it? Suggest measures. (150 words)