Encouraging Official Dollarization
in Emerging Markets
In many countries that have suffered high inflation and currency devaluations,
the U.S. dollar is in widespread circulation as an unofficial currency.
People trust the dollar because its long-term record has been among the
best in the world. However, few foreign governments have been willing to
officially dollarize, that is, replace their domestic currencies
with the dollar. One reason is that under current arrangements, if they
do so they lose seigniorage--the revenue gained from issuing currency.
This study explores the implications of the United States offering to
share seigniorage with countries that officially dollarize and meet certain
other requirements. It describes what official dollarization is, how it
works, an idea for sharing the seigniorage from the dollar with officially
dollarized countries, and the effects of dollarization both on the United
States and on dollarized countries.
The study concludes that official dollarization has important benefits for the United States and dollarizing countries alike. Dollarization nearly eliminate the risk of devaluation, making domestic and U.S. investment more secure. In most emerging market countries, official dollarization will also reduce interest rates significantly, boosting their economic growth. Higher growth in other countries ultimately means greater demand for American goods and higher growth in the United States as well. People in many emerging market countries have already voted with their wallets for the dollar. By sharing seigniorage with governments that officially dollarize, the United States will promote growth and financial stability both at home and abroad.
In the long term, finding ways of bribing people to dollarize, or at least give back the extra currency that is earned when dollarization takes place, ought to be an international priority. For the world as a whole, the advantage of dollarization seems clear to me... Larry Summers (1992)
1. A MISSING PIECE IN INTERNATIONAL FINANCIAL REFORM
The Asian currency crisis and its repercussions in Russia and Brazil
over the last two years have created fresh interest in reforming the "international
financial architecture" in the hope of making it less prone to trouble.
Proposals for reform range from cautious changes in bank supervision to
sweeping recommendations for establishing a global central bank. A recent
scorecard counts no fewer than 16 proposals (Eichengreen 1999, pp. 124-32).
The proposals have three major drawbacks. First, all require international
agreement, which is worthwhile but may take a long time to achieve and
implement. Improving bank supervision internationally, for example, requires
regulators from various countries to resolve some knotty technical issues
about national differences in accounting and legal standards. After regulators
reach agreement, fully implementing new standards of supervision can take
several years. Reforms that are still more controversial, such as managing
the international monetary system through exchange-rate target zones or
a global central bank, face political obstacles that seem insurmountable
at present, quite apart from their flaws in design.
Second, few of the proposals are well specified, so it is hard to judge
whether they are workable. The complex proposals need to have their complexities
visible before implementation, so that weak spots can be detected and fixed.
To mention one proposal, making an international bankruptcy court effective
will involve developing an extensive code of law to apply to bankruptcy
cases--something that has taken decades at the national level.
Third, most proposals neglect that the Asian crisis has been foremost
a currency crisis; the banking, stock market, and budget crises
that some countries have suffered have resulted from the currency crisis
rather than causing it. Proposals that omit currency reform will not solve
the problem. As Table 1 shows, good currencies are rare; the U.S. dollar
is one of only a handful in the world.
The countries that have suffered most from the Asian crisis have been
developing countries with central banks maintaining pegged exchange rates
to the U.S. dollar. Under a pegged exchange rate, a country promises to
maintain a determinate value for its currency in terms of a foreign currency,
but retains features of monetary policy that give it the freedom to devalue
at any time and make eventual devaluation likely. Pegging and target zones,
a related arrangement, are one of three basic options in exchange rate
policy. Another is a floating exchange rate, like the United States, under
which a country does not maintain the value of its currency constant in
terms of any foreign currency. But though the United States has had relatively
low average inflation under a floating exchange rate, most developing countries
that have tried floating rates have not. Those that have pegged their exchange
rates have done so mainly as a way of restraining the inflation they fear
would happen under floating rates. Ruling out pegging and floating leaves
the third and best option for developing countries: a truly fixed exchange
rate, which unlike a pegged rate has features that prevent devaluation.
What is needed, then, is a policy that can be implemented without time-consuming
multilateral agreement, is well specified, and can prevent future currency
crises by offering developing countries a way of achieving a truly fixed
exchange rate. An option that combines all of these characteristics is
official dollarization, under which countries that wish to do so
replace their domestic currencies with the U.S. dollar. Under official
dollarization, the Argentine peso, for example, will cease to exist, except
perhaps as coins. All peso notes (paper money) and perhaps coins will be
converted into dollar notes; all peso assets, liabilities, and prices will
become dollar assets, liabilities, and prices. Since the current exchange
rate is 1 peso = 1 dollar, a bank deposit of 1000 pesos will become a bank
deposit of 1000 dollars.
Many countries today are already unofficially dollarized. Throughout
Latin America and in most of the former Soviet Union, people have significant
dollar bank deposits domestically or abroad, hold dollar notes, and quote
prices for high-value items in dollars. In some countries, using the dollar
is perfectly legal, in others illegal, but whatever the case, the dollar
is a highly prized currency. In many countries, officially dollarizing
would simply complete the extensive unofficial dollarization that already
A disadvantage for countries thinking about official dollarization (all
of which so far are emerging market economies) is that under current arrangements,
if they dollarize they lose to the United States all their seigniorage--the
revenue they gain from issuing currency. Seigniorage is the difference
between the cost of putting currency into circulation and the value of
the goods the currency will buy. For example, a $1 bill costs about 3 cents
to print, but the government can use it to buy $1 worth of goods. The seigniorage
is 97 cents. For the U.S. government, seigniorage from issuing dollars
is roughly $25 billion a year, which is a large amount in dollar terms,
but less than 1.5 percent of total government revenue and only about 0.3
percent of gross domestic product (GDP).
This study explores the possibility that the United States offer to
share seigniorage with officially dollarized countries, as a way of reducing
or eliminating the loss of seigniorage that they would otherwise experience.
Their participation will be voluntary: they can continue to issue their
own currencies, dollarize and share in the seigniorage that the United
States earns if they meet certain criteria, or even dollarize unilaterally
without sharing seigniorage. Under the arrangement described here, dollarization
will probably cost American taxpayers little or nothing initially, will
probably generate increased seigniorage for the United States in later
years, and will have benefits for trade and for financial markets.
Whether countries share seigniorage with the United States or not, dollarization
is complementary to proposals that the U.S. government has made, both alone
and as part of international groups such as the Group of 22 nations (G-22
1998). It apparently is also complementary to all other proposals for reforming
the international financial architecture. It does not make any other proposed
reforms more technically difficult; in fact, it would make many easier.
Dollarization is in that sense a key missing piece in reforming the international
Countries that avoided any years of 20+ percent inflation: Australia,
Austria, Bahamas, Belgium, Belize, Bhutan, Botswana, Canada, Cyprus, Denmark,
some members of Eastern Caribbean dollar zone (Antigua and Barbuda, St.
Kitts and Nevis, St. Vincent and Grenadines), Finland, France, Germany,
Hong Kong, Japan, Jordan, Kuwait, Luxembourg, Malaysia, Malta, Mauritania,
Mauritius, Morocco, Nepal, Netherlands, Netherlands Antilles, New
Zealand, Norway, Panama, Solomon Islands, South Africa, Sri Lanka,
Switzerland, Thailand, Tunisia, United Kingdom, United
Countries whose currencies lost no more than 25 percent of their
value against the dollar or did better: Austria, Bahamas, Bahrain,
Barbados, Belgium, Bermuda, Bosnia, Brunei, Cayman Islands, Denmark, Estonia,
France, Germany, Hong Kong, Japan, Kuwait, Latvia, Libya,
Luxembourg, Macau, Malaysia, Netherlands, Netherlands Antilles,
Panama, Qatar, Saudi Arabia, Singapore, Slovakia,
Switzerland, Taiwan, United Arab Emirates, United States.
Countries that had no restrictions on buying foreign currency at any time during the period: Bahrain, Germany, Kuwait, Netherlands, Oman, Panama, Qatar, Saudi Arabia, Switzerland, United Arab Emirates, United States.
|Sources: IMF, Exchange Arrangements and Exchange Restrictions,
various issues (series title varies) and International Financial Statistics,
Notes: Bold indicates countries whose currencies satisfy all these criteria, as the U.S. dollar does.
The data start at the beginning of 1971 because that was the first year in which the current system of generalized floating among the major currencies started to emerge. For currencies that did not exist throughout the period, the comparison starts with the first year they existed. The data are for members of the International Monetary Fund, which include almost all independent countries but few dependent territories. Information for some countries is incomplete.
2. BASICS OF DOLLARIZATION
What dollarization is: Dollarization happens when the U.S. dollar
to some extent displaces domestic currency as the preferred currency for
holding savings, making payments, and pricing goods. Often "dollarization"
is used in a generic sense to refer to any foreign currency, not just the
dollar, that displaces domestic currency.
Dollarization can be official or unofficial. Under unofficial dollarization,
typically the domestic currency dominates small transactions but the dollar
is important in large transactions and as a vehicle for savings. Where
people do not trust the domestic banking system, they may also have large
bank deposits abroad in dollars and may hold dollar notes as "mattress
money." These are forms of savings that do not appear in official statistics
of unofficially dollarized countries because the savings are outside the
domestic financial system and in some cases violate national laws against
holding foreign currency.
Less widespread is official dollarization, in which a country has no
domestically issued notes and perhaps coins, instead using the dollar as
official domestic currency. Many countries have used foreign currencies
at some point in their history: in the United States, foreign coins were
legal tender until 1857. (At the time, Americans predominantly used coins
rather than notes in retail trade.)
Because this study is specifically about officially replacing the domestic
currency with the U.S. dollar rather than any other currency, "dollarization"
will not refer to unofficial dollarization or to currencies other than
the dollar unless specifically mentioned.
Where dollarization exists: Unofficial use of foreign currency
is widespread. A study from the International Monetary Fund reports that
in 1995, foreign-currency deposits exceeded 30 percent of "broad money"
in 18 countries. (Broad money--M2, M3, M4--is currency plus bank deposits,
plus certificates of deposits and other bank liabilities in some cases.)
In another 34 countries, foreign-currency deposits were lower but still
judged significant, averaging 16 percent of broad money (Baliño
and others 1999, pp. 2-3). In most of the cases of the IMF study, the dollar
is the main foreign currency that people hold. A study by the Federal Reserve
System estimates that foreigners hold 55 to 70 percent of dollar notes
in circulation, mainly as $100 bills (Porter and Judson 1996, p. 899),
though other researchers have estimated higher and lower figures (Feige
1997; Rogoff 1996, p. 268). Since dollar notes in circulation are currently
about $480 billion, if the Federal Reserve's estimate is correct, foreigners
hold roughly $300 billion. The highest concentrations occur in Latin America
and the former Soviet Union. In Bolivia, for instance, people are paid
in bolivianos and use them for buying groceries and other small transactions,
but about 80 percent of bank deposits and many bank loans are in dollars,
and expensive goods such as automobiles may be priced in and paid for in
dollars. Russians are estimated to hold as much as $40 billion in dollar
notes, which is more than the value of all ruble notes and deposits (Melloan
The best-known officially dollarized country today is Panama,
which has been dollarized since 1904. Appendix A describes its experience.
Panama issues its own coins and has its own unit of account, the balboa,
but since one balboa equals one U.S. dollar and coins are a small, subsidiary
part of the money supply, that does not interfere with dollarization. Besides
Panama, 11 other economies officially use the U.S. dollar; Table 2 lists
them. Five are U.S. possessions. Another 20 or so small economies officially
use foreign currencies other than the U.S. dollar, such as the Australian
dollar and French franc. Several others issue domestic notes and coins
but also grant the U.S. dollar or another foreign currency status as a
parallel legal tender. Among them is Liberia, which formerly used U.S.
dollar notes exclusively, but now also uses the notes of two rival governments
issued during the civil war of 1989 to 1996. Liberian dollars circulate
alongside the U.S. dollar at depreciated exchange rates (Bogeti and Schuler
Official use of the dollar or other foreign currencies is rare today
except in small economies mainly because of the perceived economic advantages
of an independent monetary policy. An independent monetary policy implies
that a country has a distinct domestic currency, typically issued by a
domestic central bank. According to some economic theories, an independent
monetary policy enables a country to manage the money supply, interest
rates, and exchange rates so as to make economic growth higher or at least
less variable than it would otherwise be. In practice, though, developing
countries with central banks have had worse currencies and lower economic
growth than those without central banks (Ghosh and others 1998; Hanke 1999;
Hausmann and others 1999; Schuler 1996). Despite the poor record of central
banking in developing countries, it persists because many people still
believe that it should work well in theory and because it has the political
advantage of allowing a government to print money when it cannot or does
not wish to cover its budget deficits by other means (generating a type
of seigniorage). Finally, many governments see a domestically issued currency
as a symbol of national identity and political pride, even if their citizens
would prefer to use dollars exclusively.
How dollarization works: In an officially dollarized economy
the money supply works similarly to the way it works within the United
States. Panama, for example, has much the same relation to the continental
United States as Puerto Rico or Pennsylvania. If people want to accumulate
dollars, they spend less; if they want to get rid of dollars, they spend
more. Prices and the money supply are determined by a combination of local
preferences and arbitrage with the rest of the world. As within the United
States, interest rates and price indexes tend to move up and down in relatively
small steps, not in sudden leaps. Inflation rates can differ between Panama
and the United States just as they can between Philadelphia and Los Angeles,
but the use of a common currency, especially if reinforced by free trade,
tends to keep prices of internationally traded goods close to the levels
they have in the United States, putting a ceiling on inflation. Interest
rates tend to be close to U.S. levels, plus a premium for country risk
(political unrest or other factors operating at a national level that reduce
the prospect a loan will be repaid). Because a dollarized system has no
domestically issued currency, except perhaps coins, there is no need for
exchange controls to support the currency and crises in the balance of
payments do not happen (Ingram 1962).
The main difference between a dollarized country such as Panama and
the United States is that Panamanian domestic banks lack access to the
Federal Reserve System as a lender of last resort. The Federal Reserve
acts as a lender of last resort only to U.S. banks, not to banks from other
countries. However, Panamanian banks can borrow in local money markets
that are closely linked to world markets through the presence of U.S. and
other foreign banks. The head offices of those banks can act as sources
of emergency funds for their own branches and for other banks in Panama.
It is also possible for a dollarized country to establish an international
line of credit, such as Argentina has established for its currency board-like
system (BCRA 1998). So, a dollarized system has or can devise substitutes
for a central bank as a lender of last resort.
Seigniorage: Under current arrangements, countries that dollarize
lose to the United States all their seigniorage. Earlier, seigniorage was
defined as the difference between the cost of putting currency into circulation
and the value of the goods the currency will buy--in the case of a $1 bill,
about 97 cents. (Like a $1 bill, a $100 bill costs about 3 cents to print,
so the seigniorage for it is an even larger part of its total value.) More
generally, the concept of seigniorage applies not just to currency, but
to the entire monetary base, which comprises currency in circulation (notes
and coins outside banks) plus bank reserves (note and coins held in bank
vaults, and deposits of banks at the at the central bank or such other
monetary authority as the country has).
An equivalent but more complicated way to think of seigniorage is to
observe that currency pays no interest. Somebody who holds $100 in notes
and coins could instead buy a Treasury bond and earn interest on it. By
holding notes and coins rather than the Treasury bond, it is as if he is
giving the U.S. government an interest-free loan. Under this way of thinking,
seigniorage is the monetary base times some measure of the interest rate.
It is important to distinguish between gross and net segniorage. Gross
seigniorage is the amount earned from issuing currency before taking expenses
into account. Net seigniorage is what is left after paying for printing
notes, minting coins, and employing the staff of the Federal Reserve System.
Net seigniorage is the part of seigniorage available for the rest of the
government to spend. In recent years, the cost of printing notes and minting
coins has been around $400 million a year. The cost of operating the Federal
Reserve System has been roughly $2 billion, of which half has been offset
by fees that banks pay, such as charges for using the Federal Reserve's
check clearing system.
|Northern Mariana Islands*||52,000||0.5||U.S. commonwealth||1944|
issues own coins
|Pitcairn Island||42||0.0||British dependency
also uses New Zealand dollars
|Puerto Rico*||3,800,000||33.0||U.S. commonwealth||1899|
|Samoa, American*||60,000||0.2||U.S. territory||1899|
|Turks and Caicos Islands||14,000||0.1||British colony||1973|
|Virgin Islands, U.K.||18,000||0.1||British dependency||1973|
|Virgin Islands, U.S.*||97.000||1.2||U.S. territory||1934|
|Sources: Statesman's Year-Book 1998-99; CIA
1998; IMF 1998, 1999. Population and GDP (gross domestic product) are for
1997 or latest prior year available.
Notes: * As U.S. possessions, these economies already indirectly receive a share of the seigniorage from being officially dollarized.
About 20 other economies use foreign currencies other than the U.S. dollar, such as the Australian dollar and French franc, as the official currency. Several others issue domestic notes and coins but grant the U.S. dollar or another foreign currency status as a parallel legal tender.
Except for Panama, estimates of GDP are in terms of purchasing power parity, which typically gives higher figures than the alternative method of exchange rate parity.
The net earnings of the Federal Reserve include both interest on its
holdings of Treasury securities, which are like seigniorage, and earnings
from trading activity to support its goals in monetary policy. The Federal
Reserve buys and sells Treasury securities and foreign currencies. When
its trading activity generates a profit, its payments to the Treasury are
higher than the earnings from seigniorage alone would be; when trading
generates a loss, the payments are lower. In 1998, more than 90 percent
of the money that the Federal Reserve paid to the Treasury came from interest
on Federal Reserve holdings of Treasury securities. Table 3 shows payments
to the Treasury and other statistics relevant to seigniorage. Recently
the payments have been about $25 billion a year. The great bulk of seigniorage
derives from notes; seigniorage on coins was only about $600 million in
1998 (United States 1999, p. 261).
3. SHARING SEIGNIORAGE FROM THE DOLLAR
People have occasionally suggested before that the United States share
the seigniorage from dollarization, but nobody has described in detail
how to do so. To show what factors need to be taken into account, this
study offers quite specific ideas, though an implemented version may differ
in some details.
The idea: The U.S. government will make a standing offer to all
qualifying countries. There will no time limit: qualifying countries can
join, or quit, at any time. A later section describes the criteria for
gaining certification from the U.S. government as a qualifying country.
The purpose of the criteria is to be reasonably sure that dollar notes
(paper money), rather than the notes of some other currency, will predominate
in countries that eliminate their domestic currencies. The United States
will accept countries that wish to accept the offer and meet the criteria
for certification, but it will not pressure any country to use the dollar.
To qualify for a share of the seigniorage from dollarization, then,
a country will have to retire from circulation the entire domestic-currency
monetary base, except for coins if it intends to continue issuing them
(like Panama). In most countries the value of coins in circulation is 5
percent or less of the value of notes in circulation, so the amount of
seigniorage from coins is correspondingly small.
Economies that are already dollarized but are not U.S. possessions,
and therefore do not indirectly receive a share of seigniorage through
Federal spending, could qualify for a share by temporarily introducing
their own currencies and then re-dollarizing. To avoid such charades, it
seems fair to share seigniorage with already dollarized economies along
the same lines as with newly dollarizing countries. As Table 2 shows, the
combined population and economic size of already dollarized economies that
are not U.S. possessions is quite small, so sharing seigniorage with them
will be a correspondingly small expense.
To prevent any misunderstanding, the terms of the standing offer will
state that countries accepting it acknowledge that the Federal Reserve
System will not act as a lender of last resort to them, nor will it be
obliged to take any but purely domestic considerations into account in
formulating monetary policy. That does not mean that the Federal Reserve
will ignore conditions in other countries: after all, in its recent policy
making it has considered the possible effect on the U.S. economy of currency
crises in Asia, Russia, and Brazil--places that are not even dollarized.
Furthermore, the Federal Reserve's occasional interventions in the foreign-exchange
market show that it cares about the exchange rate of the dollar with other
currencies, especially the euro and the yen. But countries that become
dollarized need to understand from the start that the standing offer applies
only to sharing seigniorage. The Federal Reserve will not be a multinational
central bank like the European Central Bank.
To strengthen the Federal Reserve System from political pressure arising
from more widespread official use of the dollar, Congress should revise
statute law to give the Federal Reserve a clearer mandate. The Humphrey-Hawkins
Act should be revised and price stability should be made the sole goal
of the Federal Reserve System. A proposal to accomplish just that was Senator
Connie Mack's Economic Growth and Price Stability Act of 1997 (105th
Congress, Senate bill S. 611), which should be reintroduced. A similar
bill in the House of Representatives was H.R. 2360 of 1997, sponsored by
Representative Jim Saxton.
What should be the basis for calculating shares of seigniorage?
The most logical choice as the basis for calculating shares of seigniorage
seems to be the dollar value of currency in circulation. Another possibility
is the monetary base, which, to repeat, is currency in circulation plus
bank reserves. Many countries require banks to hold a minimum ratio of
reserves to deposits; in the United States the ratio is 10 percent. The
part of the monetary base composed of bank reserves is mainly required
reserves, which act as a type of tax on banks because they are typically
higher than banks' economic need for reserves. Currency in circulation,
on the other hand, exists because the public has a genuine demand for it,
not because the public is required to hold a minimum ratio of notes and
coins to total income. Counting the entire monetary base for calculating
shares of seigniorage would in effect reward countries, such as Chile,
that tax their banks more through reserve requirements. This study assumes
for simplicity that only currency in circulation will count for calculating
shares of seigniorage, but the question deserves further thought.
For the purpose of calculating the amount upon which the United States
pays seigniorage, dollarizing countries will be allowed to count the domestic
currency in circulation that the public actually exchanges with them for
dollars, up to a maximum of all domestic currency in circulation.
To become dollarized, a country need only convert domestic currency
in circulation (or at most the domestic-currency monetary base, M0) into
some form of the dollar monetary base; it need not convert broader measures
of the money supply that include bank deposits, such as M1, M2, and M3;
domestic-currency bank deposits will become dollar bank deposits, not dollar
How much seigniorage should the United States share? It is feasible
to divide the seigniorage from dollarization in any proportion: 75 percent
for the dollarizing country, 25 percent for the United States, 50-50, etc.
Dollarization will be more attractive the more seigniorage the United States
gives. This study assumes that the United States will give dollarizing
countries all the net seigniorage from increases in the dollar monetary
base attributable to their becoming dollarized. The United States will
retain all the seigniorage it collects from the approximately $540 billion
of the dollar monetary base already in circulation, except for a
small amount to "grandfather" already dollarized economies.
It bears repeating that sharing the seigniorage from dollarization with
newly dollarized countries--even up to 100 percent of the seigniorage from
converting domestic currency in circulation into dollars--will not reduce
the current level of seigniorage that the United States receives.(1)
To obtain dollar notes, a country will have to give the Federal Reserve
System dollar assets of equivalent value, such as U.S. Treasury securities.
If the country continued to issue its own currency and held the Treasury
securities as foreign reserves, the U.S. government would pay it interest
on the securities. By sharing seigniorage if the country dollarizes, the
U.S. government in effect pays interest on dollar notes that it otherwise
would have paid on Treasury bills. This switch neither adds nor subtracts
from the total interest payments that the U.S. government makes.
Besides sharing seigniorage from the initial amount of dollars, it also
seems fair to share seigniorage from a general increase in the demand for
dollars, according to procedures discussed later. So, if the dollar monetary
base doubles and the interest rate paid remains the same, a dollarized
country will receive approximately double the amount of seigniorage it
received when it first qualified for the standing offer. This seems fair
because presumably dollarized countries will contribute to the general
increase in demand for the dollar monetary base, so they will deserve to
share in the resulting increase in seigniorage. It is like them reinvesting
interest on their holdings of Treasury securities to buy new Treasury securities.
Sharing seigniorage from an increase in demand for dollars also seems fair
because demand for dollars depends partly on inflation, which the United
States controls. As long as inflation remains low, say in single digits
per year, people tend to accumulate more dollar notes when the purchasing
power of the dollar falls, so as to maintain a roughly constant amount
of purchasing power. If the United States did not share the increase in
seigniorage resulting from the reduced purchasing power of the dollar,
it would in effect benefit from higher inflation at the expense of other
countries, ultimately reducing towards zero the real value of the seigniorage
they receive and the incentive for them to remain dollarized. Under the
formula listed later, all qualifying officially dollarized countries will
share proportionally with the United States when the dollar monetary base
expands or shrinks.
Sharing seigniorage is important not so much in itself as for reducing
an obstacle to dollarization. Dollarization has the potential to boost
economic growth in many countries because it nearly eliminates the risk
of devaluation and bring interest rates closer to the levels that exist
in the United States. The gains that higher economic growth would generate
are potentially much larger than the amounts involved in seigniorage.
Issues for a dollarizing country: A country that wants to become
officially dollarized will need to consider a number of issues. Among them
Whether to continue issuing coins, like Panama, or simply use U.S. coins, like Micronesia.
Whether the existing foreign reserves of the central bank are adequate for dollarization.
If reserves are inadequate, how to obtain additional reserves--by selling domestic assets of the central bank or government, borrowing, etc. As is discussed later, the actual foreign reserves of many countries considering dollarization exceed their official foreign reserves because people hold foreign assets not recorded in official statistics, and a credible monetary reform such as dollarization can being some of these unrecorded reserves into official coffers.
If the United States allows the monetary base beyond currency in circulation to be used for calculating shares of seigniorage, whether the government should convert that part of the monetary base into the dollar monetary base, convert some of it into bonds, or simply write it off.
What exchange rate to use for exchanging domestic currency into dollars. (The more units of local currency per dollar, the lower dollar reserves need to be for immediate dollarization.)
How fast dollarization should proceed. (Immediate dollarization, while technically feasible, may not always be viewed as politically most expedient.)
How to handle the legal aspects of changing currencies; for example, whether to revise contracts for high rates of interest, which were made under the assumption that they would be repaid in a domestically issued currency with higher inflation than the dollar.
How to reorganize the components of the central bank, since dollarization
will transfer to the Federal Reserve System the function of making monetary
Such issues can be complicated, but it is not necessary to discuss them
here because they do not directly concern the United States and are to
some extent treated elsewhere (Schuler 1999). Under the standing offer,
each country that wishes to share seigniorage from dollarization will be
free to take the route to dollarization that it thinks best so long as
it ends up meeting the criteria that the U.S. government has established
for sharing seigniorage. The U.S. government will have no role except to
assure itself that after the conversion is complete, domestic-currency
notes (and coins, if the dollarizing country chooses) are no longer circulating.
How a dollarizing country will obtain dollars: To obtain dollar
notes and coins from the Federal Reserve System, a dollarizing country
will give to the Federal Reserve highly liquid dollar assets of equivalent
value from a short list specified by the U.S. government--deposits at the
Federal Reserve, U.S. Treasury securities, or funds at U.S. banks. (The
gold that many countries keep on deposit at the Federal Reserve Bank of
New York could also be part of the list, although this is a question that
requires further thought.) The dollar assets can be given to the Federal
Reserve directly or though the intermediary of a bank that specializes
in handling dollar notes. The Federal Reserve will only give dollars in
exchange for specified dollar assets; it will not simply give dollars away.
So, dollarization according to this arrangement requires that a country
have 100 percent backing in dollar assets for whatever it dollarizes. Dollarization
does not require that a government already have all the necessary assets
in dollars before it can even consider starting to dollarize. The government
and the central bank can have assets in other currencies, provided they
can readily trade them for dollar notes or for assets acceptable to the
Federal Reserve. In some countries, domestic-currency assets may have a
sufficiently liquid market that the central bank can obtain a substantial
amount of dollars by selling them. Again, the U.S. government will have
no role in deciding what route a country takes to dollarization; all it
will do is certify that a country qualifies for sharing seigniorage.
The dollarizing country will agree with the United States on a date
for becoming officially dollarized, which will become the date on which
the United States begins crediting to that country a share of seigniorage.
By that day, at least 75 percent of domestic currency in circulation must
have been exchanged for dollars. From that day on, no new domestic-currency
notes and (if applicable) coins will be manufactured or placed into circulation,
and the plates and dies used to make them will be destroyed. A threshold
of 75 percent seems advisable because it is unrealistic to expect that
people will redeem 100 percent of the domestic currency in circulation
for dollars. Some notes will be kept by collectors, or will have been lost
or destroyed. Substantial rather than total replacement of the monetary
base should be the standard for determining that a country is dollarized.
Especially in large dollarizing countries, governments will probably
find it desirable to allow people to continue to exchange domestic currency
in circulation for dollars for some time after the date of official dollarization.
The grace period will give people who live in remote areas time to exchange
their domestic currency for dollars. To reflect this, the United States
could allow dollarizing countries to make a final addition to the initial
dollar amounts of their shares of seigniorage one year after the date of
Implementing dollarization in the dollarizing country: Besides
the monetary base, other assets, liabilities, and prices will also be expressed
in terms of dollars. For bookkeeping purposes, assets, liabilities, and
prices will be converted on the books from domestic currency into dollars
at the exchange rate that the government has set. In dollar terms, they
will presumably have the same value that they had before. The only difference
will be that now they will be expressed in dollars, which are a more stable
unit of account.
By the day a country becomes officially dollarized, laws making the
domestic currency a legal tender will cease to apply, although the government
of the country may continue for some time afterwards to accept domestic
currency in circulation and pay out dollars in exchange. The dollar should
be made a legal tender but, in keeping with the voluntary nature of the
standing offer, the United States should not pressure any dollarizing country
to make it a forced tender. A legal tender is a currency that may legally
be used in transactions between consenting parties, whereas a forced tender
is a currency that people are legally required to accept even if they do
not want it. It is possible for multiple currencies to be legal tender
at the same time, though the notes of one currency will tend to dominate
The rate of return for paying seigniorage: What rate of return (interest rate) should be used to calculate seigniorage? As has been mentioned, one way to think of the dollar monetary base is as being like Treasury securities, but paying zero interest. This suggests using the interest rate on some kind of Treasury security to calculate the gross seigniorage of dollarization. The Federal Reserve System pays out seigniorage to the Treasury weekly. If many countries become dollarized, weekly payments to them could be administratively complicated. Quarterly payments
|Year||Monetary base, end of year
|Average currency in circulation
|Average interest rate, 90-day Treasury bill
|Federal Reserve gross expenses
|Federal Reserve net expenses
|Federal Reserve payments to Treasury
|1997||513.2||425.5||5.07||2.2 est.||1.1 est.||19.6||1601.2|
|1998||528.6||460.1||4.81||2.2 est.||1.1 est.||24.5||1652.6|
|1999||--||--||--||--||--||25.4 est.||1727.1 est.|
|Sources: IMF 1999, line 14 (monetary base--the IMF
calls it "reserve money");
Economic Report of the President 1999,
pp. 408, 412, 419 (currency in circulation, interest rate, Federal budget);
Federal Reserve System, various issues (Federal Reserve gross and net expenses);
Historical Tables 1999, pp. 40-1 (Federal Reserve payments to Treasury).
Notes: Monetary base for 1998 is November. Net expenses (column 5) are those not covered by fees collected for clearing checks and performing other services. Federal Reserve payments to the Treasury are mainly seigniorage, but also include the Federal Reserve System's gains or losses from trading Treasury securities and foreign currency.
seem reasonable. If seigniorage is paid quarterly, a logical choice
is to instruct the Federal Reserve System to calculate the rate of return
on the monetary base using the average rate of the 90-day Treasury bill.
The Federal Reserve will pay interest on the part of currency in circulation
that the dollarizing country has exchanged for dollars, sharing seigniorage
according to a formula in the next section.
The economist Robert Barro (1999) has suggested an alternative way of
calculating and sharing seigniorage, which does not involve using an interest
rate. He uses Argentina as an example since it is now debating dollarization.
Under his plan, if Argentina had peso notes equivalent to $16 billion,
it would give them to the Federal Reserve System in exchange for $16 billion
in dollar notes. Unlike this study, Barro would not require Argentina to
give the Federal Reserve any dollar assets and he would make a lump-sum
payment up front instead of making a series of smaller quarterly payments
for as long as Argentina remains dollarized.
The problem with Barro's idea is that Argentina could take the lump-sum
payment, then turn around and reintroduce its domestic currency, cheating
the U.S. government out of $16 billion. The United States would have $16
billion in peso notes that it could spend, but Argentina could simply print
new notes of a different design and declare the old ones invalid. Similar
problems apply if instead of peso notes the Federal Reserve holds Argentine
government bonds. Argentina seems trustworthy, but not all countries may
4. FORMULAS FOR SHARING SEIGNIORAGE
Having analyzed the principles of sharing seigniorage, let us proceed
to formulas that can be used to calculate how to share seigniorage.
Net seigniorage: Recall that gross seigniorage is the revenue
earned from issuing currency before taking expenses into account, while
net seigniorage is what is left after paying for printing notes, minting
coins, and employing the staff of the Federal Reserve System. It is the
net seigniorage that can be shared with other countries. A simple and logical
formula to calculate the share of net seigniorage that a dollarized country
will receive from the United States is:
Dollarized country's dollar share of net seigniorage
= ([total average dollar monetary base over the period
x average interest rate on 90-day Treasury bills during the period]
- net cost of operating the Federal Reserve)
x dollarized country's share of total dollar monetary base
x proportion of seigniorage revenue that the United States pays
If the United States pays 100 percent of the net seigniorage attributed
to a dollarized country's use of the dollar, the last term of the formula
is 1 (the decimal equivalent of 100 percent) and the term drops out of
the formula. If the United States pays 75 percent rather than 100 percent,
the last term is instead 0.75.
The share of a dollarized country in the total dollar monetary base
will be determined when it becomes dollarized. (If only currency in circulation
counts as the basis for calculating shares in seigniorage, one could use
total dollar currency in circulation instead of the total dollar monetary
base. That would change the percentages for each country but not the dollar
amounts of the shares of seigniorage.) Using Argentina as an example again,
suppose it becomes officially dollarized on January 1, 2000, and that all
the calculations are made on the basis of the calendar year. Suppose further
that the dollar monetary base on December 31, 1999 is $550 billion. To
dollarize, the Argentine government gives to the Federal Reserve System
Treasury securities totalling $16 billion, the amount of Argentine peso
currency in circulation (notes and coins outside banks) that the public
has exchanged. In return, the Argentine government receives $16 billion
of dollar notes. Argentina's dollarization raises the total monetary base
to $566 billion, so
Argentina's share of total average dollar monetary base
= $16 billion ÷ $566 billion
= 0.028, or 2.8 percent
(These numbers, though only examples, are fairly close to the actual
numbers. The numbers in the examples will sometimes be rounded off.)
For many years the dollar monetary base has grown by 5-10 percent a
year, partly from higher demand for dollars in the United States and partly
from higher demand abroad. Argentina will share the increased seigniorage
that comes from an increased circulation of dollars. Its share will be
proportional to the share of the total dollar monetary base it had when
it became dollarized. So, if no new countries become dollarized in 2000,
Argentina will still be credited with 2.8 percent of the total (in decimals,
0.028). Suppose that the average interest rate on 90-day Treasury bills
is 5 percent a year (in decimals, 0.05), which is above the current level
of about 4.25 percent a year but is in line with the average level for
1996 to 1998. Suppose further that the net cost of operating the Federal
Reserve remains $1 billion, and that the average monetary base during 2000
is $580 billion. Plugging these numbers into the formula for net seigniorage
Argentina's dollar share of net seigniorage
= ([$580 billion x 0.05] - $1 billion) x 0.028 x 1
= ($29 billion - $1 billion) x 0.028 x 1
= $784 million
Adding new dollarizing countries: The figure of $580 billion
is assumed to be the
average for the entire year 2000. Suppose that
the amount of the dollar monetary base on December 31, 2000 is $600
billion. Argentina will be credited with 2.8 percent ($16.8 billion). Now
suppose that on January 1, 2001, Brazil dollarizes, and that its action
adds $50 billion to the monetary base, raising the monetary base immediately
to $650 billion. The shares of the total monetary base will be recalculated
to acknowledge Brazil's presence. Instead of being assigned a share of
2.8 percent ($16.8 billion ÷ $600 billion), Argentina will now be
assigned a share of about 2.58 percent ($16.8 billion ÷ $650 billion).
Argentina's percentage share of the total dollar monetary base will change,
but the dollar amount of its share will remain $16.8 billion. The addition
of Brazil will not change the dollar amount of Argentina's share, nor will
it change the amount of seigniorage that Argentina receives, if the cost
per dollar of issuing dollars is constant. If, as is likely, there are
some economies of scale in issuing dollars, so that the costs of issue
do not rise quite as fast as the increase in the total dollar monetary
base, then Brazil's decision to dollarize will generate a slight savings
in costs. Argentina, Brazil, and the United States will share the savings
in the form of slightly higher net seigniorage.
If Brazil reintroduces a domestic currency or otherwise becomes ineligible
for seigniorage, the division of seigniorage will be recalculated to give
the United States, Argentina, and other remaining dollarized countries
a proportionally bigger share. So, if adding Brazil as a dollarized country
caused Argentina's share of net seigniorage to fall from 2.8 percent to
2.58 percent, dropping Brazil will raise Argentina's share back to 2.8
percent, assuming that no new countries have dollarized in the meantime.
Note that if a country reintroduces a domestic currency, the total dollar
monetary base does not necessarily fall. The people of the country may
well hold onto dollar notes as "mattress money" if they do not trust the
reintroduced domestic currency. Short of searching everyone's house, the
government may not be able to acquire the dollars it dispersed to the public
when it dollarized.
Already dollarized economies: What about economies that are already
dollarized? Seven--the Marshall Islands, Micronesia, Palau, Panama, Pitcairn
Island (a negligible case), the Turks and Caicos Islands, and the British
Virgin Islands--are not U.S. possessions and so receive no seigniorage
directly or indirectly. Their combined population is fewer than 3 million
and their combined gross domestic product in 1997 was only about $10 billion.
Unlike newly dollarizing countries, they have in effect already given up
dollar assets in exchange for currency in circulation. We cannot know precisely
how large the circulation is, so it is necessary to estimate. Perhaps the
simplest way to do so is to assume that already dollarized countries are
average in terms of their ratio of currency in circulation to gross domestic
product. This would put them in the range of 4 to 6 percent of GDP; let
us use a figure of 5 percent (in decimals, 0.05). The formula for calculating
the dollar amount of estimated currency in circulation for an already dollarized
economy is then:
Estimated currency in circulation of an already dollarized economy
= GDP x world average currency in circulation as a percentage of GDP
For 1999, the total GDP of already dollarized economies that are not
U.S. possessions should be roughly $11 billion. Total estimated currency
in circulation for those economies is:
Estimated currency in circulation for non-U.S. already dollarized economies
= $11 billion x 0.05
= $550 million
Suppose again that the average interest rate on 90-day Treasury bills
is again 5 percent a year (in decimals, 0.05), and that the United States
pays 100 percent of the net seigniorage attributable to a dollarized country's
use of the dollar. The seigniorage that the United States will share with
the already dollarized countries that are not U.S. possessions will then
Dollar share of seigniorage for non-U.S. already dollarized economies
= $550 million x 0.05 x 1
= $27.5 million
Panama will receive almost 90 percent of that amount because its economy
is such a large proportion of the total. The whole amount, though, is minuscule
compared to the roughly $25 billion of total seigniorage from dollarization,
and "grandfathering" already dollarized economies into the arrangement
to share seigniorage will merely reduce slightly the increase of
$900 million in expected Federal Reserve payments to the Treasury this
Why these formulas? The formulas are quite simple. That is their
appeal: because they involve easily verifiable numbers, countries that
are considering dollarization will know what to expect if they dollarize,
and there will be less scope for arguments about how to share seigniorage.
To divide the seigniorage in exact proportion to each dollarized country's
use of dollars, the ideal situation would be to know how many dollar notes
and coins are circulating there. Without a distinct issue of dollars for
each country, one that stays within national boundaries, it is impossible
to know the precise amount. In some countries demand for dollar notes and
coins will grow faster than average, in others slower than average. Because
every country will receive an increase in seigniorage equal to the average
increase (excluding the one-time effects of new countries becoming dollarized),
some countries may receive somewhat more seigniorage and others less than
they would if it were possible to determine with a high degree of accuracy
how many dollar notes and coins are circulating in each country. However,
giving every qualifying country a proportional share of the increase in
seigniorage has a rough-and-ready fairness to it because a high degree
of accuracy is out of reach.
Other formulas for sharing seigniorage are conceivable, but involve
difficulties because they are harder to verify and contain more room for
controversy. Estimates of currency usage from household surveys have been
questioned in the United States, because they give much lower figures than
the total of currency actually in circulation. That is the case even though
in the United States the underground economy is estimated to be smaller
and notes are therefore presumably less widely used for illegal payments
than they are in many other countries. Formulas based on estimates of GDP
are likewise problematic because calculating GDP involves many statistical
assumptions. Such formulas are appropriate only for countries that have
already been dollarized for many years, where one cannot use the simple
method of basing calculations on the dollars exchanged for domestic currency
in circulation during dollarization.
5. CRITERIA FOR QUALIFYING TO SHARE SEIGNIORAGE
Countries wishing to qualify for sharing seigniorage from dollarization
will require certification by the U.S. government. The criteria for certification
will be simple and uniform.
The purpose of certification will be to ensure that a country has retired
its domestic currency from circulation and that dollars are sufficiently
widely used that the country is contributing significantly to total seigniorage.
If people in the country mainly use the notes and coins of some other currency,
such as the German mark, the country would be receiving seigniorage to
which it is not contributing.
To be certified, a country will need to satisfy economic, legal, and
political criteria. Meeting the criteria will not give a country a right
to seigniorage from dollarization: seigniorage will be a gift of the U.S.
government, not an entitlement. But it will be a gift that is dispensed
according to clear rules established by law, not an arbitrary amount that
varies according to whims.
Economic criteria: There must be a high probability that people
in a dollarizing country will use at least the amount of dollars that comprise
a country's initial share of the total dollar monetary base. Later, the
country must continue to belong to the dollar zone rather than to the zone
of another currency.
Some indications that a country is likely to belong to the dollar zone
if dollarized are that it currently considers the exchange rate with the
dollar the most important exchange rate; it buys and sells mainly dollars
when it intervenes officially in the foreign-exchange market; most exports
are priced in dollars; if foreign-currency deposits are allowed, the dollar
is the main foreign currency held; and dollar notes already circulate more
widely in an unofficial or semi-official manner than the notes of any other
To illustrate, compare Argentina and Bulgaria. Argentina meets all the
tests just mentioned. Bulgaria does not: the exchange rate of the Bulgarian
lev is fixed to the German mark rather than the dollar; the Bulgarian National
Bank buys and sells marks rather than dollars in the foreign-exchange market;
most exports are priced in marks or in euros, the new Western European
currency of which the mark is now a subdivision; and Bulgarians seem to
hold more mark notes than dollar notes. Bulgaria is part of the mark/euro
zone rather than the dollar zone. If Bulgaria were to dollarize, the mark
would probably drive the dollar out of circulation quickly. Sharing seigniorage
would give Bulgaria revenue to which it had contributed little because
Bulgarians were not using the dollar.
Argentina or other qualifying countries must have retired at least 75
percent but no more than 100 percent of domestic currency in circulation
and exchanged it for dollars. (In exceptional cases where there is reason
to believe that much domestic currency in circulation has been destroyed,
the U.S. government can reduce the lower limit below 75 percent.) In exchange
for the dollars that have replaced domestic currency in circulation, the
government of the dollarizing country must have given to the Federal Reserve
an equal amount of specified dollar assets, such as U.S. Treasury securities.
The plates used to print domestic notes and, if applicable, the dies used
to make domestic coins must be destroyed, along with the notes and coins
There should be a provision to prevent dollarizing countries that have
large excess foreign reserves from engineering big last-minute increases
in the dollar value of domestic currency in circulation just to gain an
undeservedly share of seigniorage. One way to do this is not to count for
seigniorage sharing a greater dollar value of domestic currency in circulation
than the average value for the previous year plus a growth factor of no
more than perhaps 10 percent. At its sole discretion, the U.S. government
could allow exceptions in unusual circumstances: during a currency stabilization
following a high inflation, for example, the dollar value of domestic currency
in circulation often increases at double digit rates as demand for it revives.
Dollarization will be most effective in making the financial system
strong if it is combined with removing exchange controls (which restrict
the ability to buy foreign currency) and opening the financial system so
that foreign firms can compete on an equal basis with domestic firms. As
desirable as a more open financial system is, though, it seems inadvisable
to make it a condition for sharing seigniorage. From an economic standpoint
it may be desirable to open the financial system to foreign participation
before dollarizing, but for political reasons that may be impractical.
Countries that have dollarization or currency boards, which in many ways
work like dollarization, have found that if their financial systems were
initially closed, necessity eventually forced them to allow foreign firms,
so as to take full advantage of the international pool of investment funds.
Legal criteria: The domestic currency must cease to be legal
tender, although the government may continue during a grace period afterwards
to pay dollars for domestic currency in circulation at the exchange rate
it has set. The dollar must have legal tender status, though again, the
United States should not pressure any dollarizing country to make the dollar
a forced tender. The euro and the yen can be legal tender along with the
dollar, for instance, even though the dollar is the dominant currency in
Should a dollarized country experience a civil war or an invasion there
will be rival parties claiming payment of the country's share of seigniorage.
Procedures for handling such a possibility should be developed, as the
U.S. government has developed them for the general question of diplomatic
recognition of governments during civil war or invasion.
Political criteria: The U.S. government must be convinced that
a dollarizing country is acting in good faith, and is not trying to abuse
the sharing of seigniorage somehow. It seems desirable for the United States
to avoid linking the sharing of seigniorage to unrelated political issues.
Dollarization has benefits for the United States even if the Administration
or the Congress disagree with the policies of a country that is considering
dollarization. Only under carefully specified circumstances, war against
the United States being the most obvious example, should a country that
has been certified be decertified for failure to meet political criteria.
Maintaining certification: To continue to be certified to share
seigniorage from dollarization, a country must continue to meet the criteria,
as determined by a periodic review from the U.S. government. The purpose
of the review is not to use recertification as a political weapon, but
merely to determine whether a country continues to deserve seigniorage
because dollars continue to circulate there. As a way of discouraging the
Administration from using the threat of decertification as a political
weapon, decertified countries can be given the option of appealing decertification
to the Congress. However, some actions will be automatic grounds for immediate
decertification without appeal: reintroduction of a government-issued domestic
currency, discrimination against the dollar in legal tender laws, or war
against the United States. A country that is automatically decertified
will forfeit any seigniorage accumulated since the previous quarter but
not yet paid by the United States.
A country decertified on other than automatic grounds will have the
option of negotiating a special bilateral arrangement with the United States
to regain some seigniorage. Take Ukraine as a hypothetical example, since
the dollar is widely used unofficially but Ukraine is close to Western
Europe, which uses the euro. If Ukraine were to dollarize, but simultaneously
grant the euro equal status with the dollar as legal tender, over time
the euro might replace the dollar as the dominant currency in circulation
as Ukraine's economy became highly integrated with the economies of Western
Europe. The dollar monetary base being used in Ukraine might shrink to
perhaps half of the amount credited to Ukraine, so the country would not
really be generating anywhere near its proportional share of dollar seigniorage.
In such circumstances, as long as a Ukraine or another dollarized country
continues to use what the U.S. government estimates to be a significant
amount of the dollar monetary base, the U.S. government can offer to share
seigniorage based on some individually negotiated formula less generous
than the standard offer. Also, to give time for bilateral negotiations
to devise a different formula, seigniorage can continue to be paid according
to the standard formula for one year following decertification on other
than automatic grounds. Offering to continue sharing seigniorage for up
to one year after decertification will be a sign that the United States
will not without warning cut foreign governments off from a source of revenue
that may be important to them.
If a country is recertified within three years of decertification, the
U.S. government could, with Congressional approval, award some of the "back
seigniorage" that the country would have earned from being certified continuously.
This provision will allow the United States to reward a government that
reverses course, such as a country that carries out the first stages of
reintroducing a domestic currency, then reverts to official dollarization.
After three years a country will lose the chance to gain back seigniorage.
Back seigniorage will be purely a gift, awarded solely at the discretion
of the United States.
Who would probably qualify: Under the criteria that have been
described, most countries would qualify to share seigniorage if they decided
to dollarize. The main exceptions are a number of countries in Europe and
Africa that are part of the euro zone. Almost all European countries west
of Ukraine either belong to the European Central Bank or give the euro
more weight than the dollar in their exchange rate policy. Where foreign
notes are heavily used, notably in the Balkans, the German mark rather
than the dollar predominates. Africa's CFA franc, which more than a dozen
countries use, is pegged to the French franc, and there are some other
African countries such as Morocco whose circumstances make it likely that
the euro rather than the dollar would predominate if there were no domestically
issued currency. (The euro now exists as a financial unit, but euro notes
and coins will not replace the German mark, French franc, and other currencies
until 2002.) But in principle, dollarization could extend to every country
in the Americas, Asia, and the Pacific, plus almost all the former Soviet
Union and half or more of Africa.
How many of those countries would actually dollarize is a different
question. Dollarization probably will have little appeal in countries that
already have good currencies. Singapore, for example, has had low inflation
and low interest rates for many years. It is unlikely to dollarize unless
most of the countries around it do so. But most emerging market countries
have currencies that performed much worse than the Singapore dollar, so
for them dollarization is correspondingly more attractive.
Table 4 shows data on some countries where government officials or the local press have recently shown interest in dollarization.
|Curren-cy in circula-tion
|Net foreign reserves
|Source: IMF 1999, lines ae and rf (exchange rates),
11 and 16c (foreign assets and liabilities of monetary authority), 14 (monetary
base--the IMF calls it "reserve money"), 14a (currency in circulation),
60b (interest rate for most countries) or 60l (interest rate for Ecuador,
Panama, and Venezuela), 64 (inflation--consumer price index), 82 (budget
of national government), 99b (GDP), and 99z (population).
Notes: *Countries that have suffered currency crises within the last year.
n.a. = not available.
Population, GDP (gross domestic product), and budget are 1997; monetary base and foreign reserves are end-1998; inflation and interest rates are the average annual rates for 1998; monetary base, currency in circulation, and net foreign reserves are for the end of 1998. Where the data specified are unavailable, the table uses the most recent prior data.
These cases are illustrative, chosen because there has already been some local discussion of the possibility of dollarizing. Panama and the United States are included for comparison.
6. OPTIONS BEYOND THE STANDING OFFER
The standing offer will be open to all qualifying countries. If it seems
prudent, the U.S. government can supplement the standing offer with options
available to selected countries solely at U.S. discretion. The purpose
of the options would be to help countries that might otherwise have difficulty
becoming and remaining dollarized.
Assisting dollarization when reserves are less than 100 percent:
The foreign reserves of many countries are greater than official statistics
indicate, because people already hold considerable amounts of dollar notes
and offshore deposits that escape official detection. It has been the experience
of a number of countries in recent years, including Argentina and Estonia,
that a credible monetary reform can bring dollar notes and offshore deposits
into the domestic banking system. The foreign reserves of the banking system,
including the reserves of the central bank or other monetary authority,
increase. Since dollarization is a highly credible reform, it may well
have a similar effect in many countries.
Even so, there may be cases where a dollarizing country lacks the dollar
assets to convert all domestic currency in circulation into dollars at
the going exchange rate. In such cases, the United States could lend it
the shortfall and keep part or all of the seigniorage in later years to
repay the loan. For example, if a country has domestic currency in circulation
equal to $10 billion at the going exchange rate with the dollar, but only
has $5 billion of dollar assets, the United States could extend a loan
for the remaining $5 billion. Then the country would be able to convert
all domestic currency in circulation into dollars. Instead of paying to
the country the seigniorage from the $10 billion, the Federal Reserve would
keep part or all of it until the $5 billion loan had been repaid with interest.
Such loans have potential problems, which is why they need careful scrutiny
and should require Congressional approval. The United States needs to be
confident that a borrowing country will remain dollarized long enough that
the seigniorage it shares will repay the loan. To help ensure that the
loan will be repaid, the United States should lend no more than 50 percent
of the dollars that a dollarizing country exchanges for its currency in
circulation. To reflect that some element of risk is involved, the loan
should carry an interest rate higher than the rate used to calculate the
payment of seigniorage. The rate should vary according to the likely period
of the loan, and should be the rate for U.S. Treasury securities of the
same maturity plus a premium that may vary from country to country. Countries
that default, by ending dollarization before they have repaid the loan,
will be liable for the same sanctions they would face for defaulting on
other U.S. government loans.
If a country reintroduces a domestic currency before its loan is repaid,
its government is unlikely to receive any direct benefit from the presence
of dollars in circulation within the country. In dollarizing, it will have
dispersed dollar notes and coins to the public, and it will have no easy
way to retrieve them. Dollarization in effect disperses foreign reserves
that under other monetary systems are centralized in a central bank or
other monetary authority; recentralizing the reserves can be difficult.
If people do not trust the new domestic currency, they may continue to
hold dollar notes as "mattress money." If so, the United States will receive
seigniorage from the dollars even though the government of the formerly
dollarized country has broken its promise.
Allowing seigniorage to be pledged as collateral: Dollarizing
countries whose initial dollar reserves are less than 100 percent of domestic
currency in circulation will have another option for obtaining additional
reserves that does not depend on the U.S. government. Because the revenue
from dollarization is a fairly steady source of income, it can be pledged
as collateral, such as for lines of credit with foreign banks to support
domestic banks during financial distress. The terms on which collateral
is pledged is a matter for dollarized countries and their lenders. The
U.S. government need not be involved except to the extent that it obeys
instructions from the dollarized country to deposit seigniorage with one
party rather than another. Again, the Federal Reserve System should accept
no obligation to be a lender of last resort to dollarized countries, though
under existing procedures the Treasury could lend to a country through
the Exchange Stabilization Fund and demand that the seigniorage to be pledged
as collateral. Congress could even require that countries with which the
United States shares seigniorage be required to pledge the seigniorage
as collateral if they borrow from the Exchange Stabilization Fund.
7. LEGISLATION AND ADMINISTRATION
Legislation: To make the standing offer durable and to specify
options beyond it, should any seem advisable, the arrangements described
here, or something like them, should be written into law. The law should
be specific, leaving certain administrative details flexible but specifying
clearly the intent and main points of the arrangement. The more predictable
the rules of the offer are, the more of an encouragement there will be
for countries considering dollarization.
Administration: Who should administer the arrangement that this
study proposes? It seems most appropriate for the Federal Reserve System
to administer certification, decertification, and payment of seigniorage,
though for any international negotiations, such as whether to extend to
a dollarizing country any assistance beyond the standing offer, the Treasury
Department and perhaps the Department of State should be involved. The
precise delineation of responsibilities is a matter for further reflection.
The Federal Reserve is, by design, more independent from the Administration
and the Congress than the Treasury Department. Assigning the Federal Reserve
the responsibility of administering the standing offer will reinforce the
impartial nature of the offer.
Paying shares of seigniorage: To pay a share of seigniorage to
a dollarized country, the Federal Reserve System will credit its government
each quarter with the amount calculated by using the formulas listed earlier.
The government can then leave the funds on deposit at the Federal Reserve,
though presumably they will not earn interest; transfer them to a commercial
bank; or convert them into dollar notes and coins, as it prefers.
8. COSTS AND BENEFITS FOR THE UNITED STATES
The arrangement that this study has suggested has important benefits
for the United States. It is a way for the United States to help itself
and other countries at the same time.
Economic costs: As has been mentioned, "grandfathering" into
the arrangement for sharing seigniorage the seven already dollarized economies
that are not U.S. possessions will cost less than $30 million a year under
realistic assumptions about interest rates and the size of their economies.
That will hardly be noticeable beside the increase of about $900 million
expected this year for the Federal Reserve System's payments to the Treasury
(which include seigniorage plus profits and losses from trading). Dollarization
in countries that currently issue their own currencies is highly unlikely
to reduce the current level of seigniorage that the United States receives,
or even reduce the rate of growth of seigniorage. Recall that giving newly
dollarized countries the share of seigniorage attributable to their using
dollars does not reduce the amount of seigniorage that the United States
currently earns. It is merely like switching the government liabilities
that interest is paid on, from Treasury securities to the monetary base.
Since there are economies of scale in issuing currency, the more countries
are dollarized, the broader the base over which to spread the costs, increasing
slightly the seigniorage that the United States and dollarized countries
Encouraging dollarization in other countries is unlikely to be costly
in the sense of making it harder for the Federal Reserve to conduct monetary
policy. More than half of all dollar notes in circulation are probably
held abroad already, with the greatest growth in foreign holdings apparently
occurring in recent years (Judson and Porter 1996, p. 896). But it has
been precisely in recent years that the Federal Reserve has successfully
reduced inflation first to 3 percent and now to less than 2 percent a year.
Political risks: Does dollarization involve political risks for
the United States? One such risk is the possibility that when the Federal
Reserve System increases interest rates, dollarized countries will try
to exert political pressure on the U.S. government, hoping that it in turn
will pressure the Federal Reserve to keep interest rates inappropriately
low. The pressure is likely to be especially strong if it comes from an
important country such as Mexico.
The claim that this could be a serious risk ignores that the Federal
Reserve already receives criticism, because its actions already affect
even countries that have separate domestic currencies and floating exchange
rates. Furthermore, the quarter- and half-percentage point increases in
interest rates that the Federal Reserve makes are puny compared to the
10- and 20-percentage point increases that central banks have made in such
countries as Brazil, Ecuador, Indonesia, and Russia in the last two years.
As has been mentioned, the most effective way of insulating the Federal
Reserve from political pressure, whether foreign or domestic, is to revise
statute law to give the Federal Reserve a clearer mandate, making price
stability its sole goal.
Another risk is the possibility that a large dollarized country, or
a group of smaller countries, will suddenly reintroduce domestic currencies
and precipitate mass dumping of dollars, forcing the Federal Reserve to
increase interest rates if it wants to keep inflation low. As long as the
dollar continues to be trustworthy, though, people are unlikely to dump
dollars all at once. The best way to prevent mass dumping of dollars is
for the dollar to continue the good performance it has sustained, especially
since the early 1980s.
Benefits: If even one medium-size country such as Argentina or
a number of small countries such as El Salvador dollarize, the United States
is likely to gain more in new seigniorage than it loses from sharing seigniorage
with already dollarized economies. Holdings of the dollar monetary base
seem to be growing faster abroad than in the United States, whereas the
formula for sharing seigniorage assumes that holdings grow equally fast
in all dollarized countries. Accordingly, the United States will gain more
in seigniorage than it otherwise would if the offer to share seigniorage
encourages dollarization in countries that otherwise would have continued
to issue their own currencies. In the future, should electronic money in
the form of credit and debit cards replace most notes and coins in circulation,
in effect capturing seigniorage for issuers and users of electronic money,
the United States will probably be in the forefront of the change because
it is rich and technologically advanced. Again, the formula for sharing
seigniorage will probably give somewhat more to the United States than
its actual share of the dollar monetary base.
Dollarization will nearly eliminate currency risk and will eliminate
currency conversion fees that tourists and businesses alike pay. The gains
will be small in proportion to the U.S. economy, and will depend on how
many countries dollarize. The larger gains will come from higher economic
growth in dollarized countries, which will increase their demand for American
goods. Roughly one-third of U.S. trade in goods is with Japan and Western
Europe, which are unlikely ever to dollarize because they already have
relatively good currencies. But Mexico, which is gaining on Japan to become
the second leading trading partner of the United States, might dollarize,
and even Canada, the leading trading partner, might consider it.
By increasing the number of countries that use the dollar, dollarization
will help the dollar remain the premier international currency, a status
that the euro is now challenging. Dollarization by one or more large Latin
American countries would significantly expand the number of people officially
using the dollar, moving the population of the dollar zone well ahead of
the population of the euro zone.
Dollarization should reduce complaints by American producers about foreign
dumping of goods by ending the possibility that dollarized countries can
devalue against the dollar. Much controversy about dumping arises because
large unexpected devaluations suddenly make the goods much cheaper than
they were before, not because of any technological advantage, but because
of capricious exchange rate policies. It is notable that recent controversy
over imports of steel concerned Russia and Brazil, whose currencies have
It is difficult to measure the precise extent to which faster economic
growth in dollarized countries would benefit the U.S. economy, but it is
clear that there would be a benefit. The faster other economies grow, the
faster their demand for U.S. products tends to grow. Since annual seigniorage
from the dollar is only about 0.3 percent the size of U.S. gross domestic
product, and the annual increase in seigniorage is only about 0.01 percent
of GDP, the potential exists for the growth effects of sharing seigniorage
to be much larger for the United States than the gains to be had from not
sharing seigniorage and not encouraging countries to dollarize.
9. COSTS AND BENEFITS FOR DOLLARIZING COUNTRIES
For many countries, the benefits of dollarization appear to outweigh
the costs by far. However, the purpose of examining the costs and benefits
for them is not to tell any particular country it should dollarize, but
to explain why some countries may wish to dollarize.
Costs: The main readily identifiable cost of dollarization for
dollarizing countries is that of acquiring additional dollar assets, if
existing foreign reserves are insufficient to convert all domestic currency
in circulation into dollars. Note again that to become dollarized, a country
only need convert currency in circulation (or at most the domestic-currency
monetary base, M0) into some form of the dollar monetary base. It need
not convert broader measures of the money supply that include bank deposits,
such as M1, M2, and M3; domestic-currency bank deposits will become dollar
bank deposits, not dollar notes. (However, just as depositors can convert
domestic-currency bank deposits into domestic-currency notes if they choose,
they will be able to convert dollar deposits into dollar notes if they
choose.) For a number of reasons, the costs of dollarization are lower
than have generally been claimed in previous writings by economists (Bogeti
and Schuler 1999, Moreno 1998).
Since the standing offer will give dollarizing countries a share in
seigniorage equal to the dollar value of their domestic currency in circulation
plus a proportionate share in the average growth of the dollar monetary
base, it will eliminate the loss of seigniorage that they would experience
from dollarizing unilaterally (which they are still free to do if they
wish, and which they can accomplish without permission from the United
The loss of flexibility for the domestic government to determine monetary
policy (especially the rate of inflation) and the lack of a domestic central
bank as a lender of last resort are often considered to be costs of dollarization.
However, as has been mentioned, historical experience indicates that developing
countries with central banks have generally had worse currencies and lower
economic growth than developing countries without central banks (Ghosh
and others 1998, Hanke 1999, Hausmann and others 1999, Schuler 1996). The
worst banking crises and costliest bank rescues of recent years have occurred
in developing countries with central banks, suggesting that in developing
countries the existence of a central bank hurts more than helps financial
stability (see Caprio and Klingebiel 1996; Lindgren and others 1996, pp.
A related cost that is similarly hypothetical is the possibility that
the United States and, say, Argentina are not what economists term an optimum
currency area. The problem with the standard theory of optimum currency
areas is that it looks at currencies from the viewpoint of how to centrally
plan currency management instead of asking what currencies consumers prefer
(White 1989). In many countries consumers obviously prefer the dollar to
the domestic currency, which indicates that they consider that their countries
are in fact part of an optimum currency area with the United States.
They continue to use domestic currency to some extent mainly because laws
prop it up with special privileges not granted to the dollar or other foreign
currencies. There is a way for governments to test whether the domestic
currency is as well liked as they think: offer government workers a choice
of being paid their fixed wages either in domestic currency, or in dollars
at today's exchange rate. In Mexico, for example, a government worker earning
a fixed wage of 950 pesos a week over the next year would have the choice
of receiving 950 pesos every payday or $100, since the current exchange
rate of the peso is about 9.5 pesos per dollar. If most government workers
prefer to be paid in dollars it is a sign that they consider dollarization
A final possible cost is that because dollarization brings interest
rates in a dollarized country into close correspondence with interest rates
in the United States, it tends to synchronize business cycles more closely
than might happen if a country retains a central bank. There may be times
when a country can grow faster if it has its own central bank that can
lower interest rates. That is true even within the United States. Oil is
a major product of Texas, so high oil prices have benefited economic growth
in Texas while hurting growth in most other U.S. states, while low oil
prices have hurt growth in Texas while benefiting growth in most other
states. Rather than having a separate currency and manipulating it in response
to fluctuations in the price of oil, though, Texans use the dollar. The
Federal Reserve orients monetary policy to the needs of the United States
as a whole, not to the specific needs of Texas or any other state. Over
the long term, it is clear that Texans have benefited from using the dollar
rather than having a separate currency like Mexico or Venezuela, two other
large oil producers. Rather than looking at isolated short-term instances
where a country can grow faster if it has its own central bank, one must
think of the long term. The United States has had better long-term economic
growth than most other countries in part because monetary policy has been
better than in most other countries.
Benefits: Dollarization nearly eliminates devaluation risk with
other dollarized countries and with the United States. No monetary system
can completely eliminate devaluation risk, because a country can always
reintroduce a domestic currency, but dollarization is harder to reverse
than other monetary reforms. Dollarization eliminates a distinct domestic
currency and disperses formerly centralized foreign reserves. Reintroducing
a domestic currency and then devaluing it is harder than devaluing an existing
By nearly eliminating devaluation risk, dollarization promotes investment
and reduces interest rates. In Latin American countries that allow banks
to lend within the country both in dollars and in domestic currency, interest
rates in dollars are lower. Interest rates contain a premium for expected
inflation, and where expected inflation is high, interest rates are high,
even if the inflation does not materialize. Lower interest rates benefit
consumers, businesses, and the government alike by reducing their cost
of borrowing. For most Latin American countries, dollarization should make
interest rates fall to U.S. levels plus no more than about 4 percentage
points of risk premium, as is the case in Panama (see Table 4 above and
the IMF 1999).
Dollarization eliminates balance of payments crises. Under dollarization,
Panama does not worry about its balance of payments any more than Puerto
Rico or Pennsylvania does. Because no separate domestic currency exists,
there is no need to defend it by imposing exchange controls. If, as in
Panama, dollarization is combined with a banking system that is "internationalized"
(highly open to foreign participation, including unrestricted branch banking),
flows of capital are little more noticeable than they are within the United
States. They are not confined within national boundaries, as happens when
a separate domestic currency creates devaluation risk. Hence they tend
not to create the type of booms and busts based on capital flows that East
Asia has experienced in recent years. In an internationalized banking system,
banks looks globally at opportunities for lending and borrowing dollars,
smoothing flows of capital among all the countries and regions that officially
use the dollar. Dollarization in fact encourages internationalization of
the financial system.
Since the United States has lower inflation than most developing countries,
dollarization will reduce inflation for them. In the last 30 years, more
than five-sixths of developing countries with central banks have suffered
at least one year of inflation exceeding 20 percent, and more than one-third
have suffered at least one year of inflation exceeding 100 percent (Schuler
1996, p. 28). Dollarization will prevent them from repeating their experience.
All these benefits of dollarization foster economic growth. The Argentine
government has estimated that dollarization would increase economic growth
there by 2 percentage points a year (Warn 1999). That is almost ten times
the value of seigniorage that Argentina collects from having a domestic
currency--$750 million a year, approximately 0.22 percent of GDP.
Dollarization does not by itself guarantee growth--other economic policies
must also be favorable to it--but by eliminating bad domestic currencies,
dollarization eliminates one of the biggest obstacles to growth in many
This study has investigated a particular arrangement for sharing dollarization,
an arrangement that is simple and easy to implement. An implemented version
may need to differ in some details. In particular, further thought needs
to be devoted to whether to use currency in circulation or the monetary
base as the basis for calculating shares of seigniorage; whether the Federal
Reserve System should accept gold that dollarizing countries have on deposit
at the Federal Reserve Bank of New York in exchange for dollars; whether
dollarizing countries should fulfill any other criteria other than those
described to qualify to share seigniorage; and what should be the division
of labor between the Federal Reserve and the Treasury Department to administer
the sharing of seigniorage.
Few currencies have a long-term record as good as the dollar. Because the dollar has performed relatively well, people in many countries prefer dollars to domestic currency. Unofficial dollarization is already widespread, particularly in Latin America and the former Soviet Union. People in those countries have voted with their wallets for the dollar. Official dollarization would simply give people what they want. The United States should not pressure any country to become officially dollarized. However, by offering to share seigniorage, the United States can remove an important obstacle to official dollarization, and benefit both itself and other countries by doing so.
APPENDIX: PANAMA'S EXPERIENCE WITH DOLLARIZATION
Panama broke away from Colombia to become independent in 1903. Because
of the Panama Canal, Panama has long had important trade and financial
links with the United States. Since 1904, Panama has officially used U.S.
dollar notes as domestic currency. (Before that, dollars had been
circulating unofficially.) Panama has a domestic currency, the balboa (1
balboa = 1 dollar), but it circulates only as coins. The balboa is also
used as the unit of account for paying wages and so forth, but that does
not affect at all the amounts that are paid. Panama has no central bank
and no centralized foreign reserves. The government-owned Banco Nacional
de Panamá operates as a commercial bank that does all the banking
business of the government and has some business with the private sector.
It also acts as a clearinghouse, though banks sometimes clear payments
directly between themselves. If Citibank Panama lends Chase Manhattan Bank
Panama $10 million, they may make the payment through their New York head
A 1970 law liberalized Panama's financial markets and allowed full entry
by foreign banks. Foreign banks have the majority of assets in the banking
system, though much of their assets are foreign deposits placed in Panama
because of its role as an international financial center. Panama has no
exchange controls. Dollarization plus an internationalized financial system
mean that Panama is well integrated into world financial markets. Despite
having experienced large inflows and outflows of capital, Panama has avoided
the booms and busts that have resulted from such flows in other Latin American
Panama's economic performance has been better than average for Latin
America. Inflation averaged 3.5 percent a year from 1971 to 1997, which
was lower than in any other Latin American country and the United States.
Economic growth per person averaged 1.7 percent a year in the same period.
The rather low rate of growth results mainly from laws that make wages
unnecessarily rigid and from tariff barriers--an example of how dollarization
eliminates some but not all obstacles to rapid economic growth. There have
been no system-wide banking crises, and the banking system even survived
intact the problems of 1989 (Moreno 1999).
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1. It is possible to imagine circumstances in which the demand for dollar notes falls in a dollarizing country. Suppose that Russia dollarizes. Russians hold dollar notes of as much as $40 billion because they distrust both the ruble and Russian banks. Dollarization plus allowing foreign banks to establish branches anywhere in Russia makes bank deposits much more trustworthy, and Russians may respond by depositing much of their "mattress money" into banks, reducing their holdings of dollar notes by some billions. However, the same thing can happen without dollarization, for instance if Russia replaces its central bank with a currency board. Russians are evidently the largest holders of dollar notes after Americans, yet their estimated holdings are less than 8 percent of the total dollar monetary base. Since the dollar monetary base has been growing by $25 billion or more a year in recent years, even a large fall in demand for dollar notes in Russia will appear as a temporary slowdown in the rate of growth of the dollar monetary base, not as an actual decline. Only if a similar phenomenon happens in many countries at once will there be a decline in the dollar monetary base and the seigniorage it generates. Even so, the decline will probably be brief. Holdings of dollar notes are very likely to increase as the economies of dollarized countries grow, just as holdings of notes around the world have increased as wealth has increased.
A somewhat related point is that it is possible to imagine that giving any seigniorage at all to dollarizing countries will reduce seigniorage for the United States below what it could have been. Perhaps dollarizing counties would have become officially dollarized even without receiving any seigniorage. If that is correct, though, there should be more dollarized countries already.