Dollarization refers to the process through which a country adopts another nation’s currency, in this case, the US dollar, as a substitution for their own. In the Latin American (LATAM) region, there are three countries that have gone through this process: Panama, Ecuador, and El Salvador. The dollarization processes of Panama and Ecuador took place in different historical periods and responded to very different national needs and contexts. Despite their different starting points, both countries have maintained the U.S. dollar as their national currency to this date.
In the world of economics, the idea of dollarization does not have unanimous support. On the contrary, many economists warn against considering this option as an across-the-border solution. Nonetheless, there is no doubt that for these two countries, the strategy has been effective in providing economic stability while also having an important social cost, especially in the Ecuadorian case.
Dollarization as an option
The factors considered when thinking about dollarization are many, as adopting a foreign currency force in the dollarized economy, will give up control of a state’s liquidity and exchange rates. On the other hand, this economic strategy seems attractive as it serves as a control for high inflation rates and encourages foreign investment by reducing transaction costs, while also reducing borrowing costs. It is important to note that these commonly mentioned advantages assume the lending nation to be exclusively indebted to the foreign investor, in this case the United States. In today’s world, however, that might not be the reality as countries, such as China, continue to offer attractive loans to developing countries including, but not limited to, the LATAM region.
Dollarization does not only mean introducing a new currency, but it also requires a certain degree of economic sovereignty to be sacrificed. Indeed, the U.S. dollar takes the control of currency production and monetary policy away from the individuals in government. For countries that have experienced corruption and institutional instability, this might be its most appealing characteristic. According to the International Monetary Fund, “the main attraction of full dollarization is the elimination of the risk of a sudden, sharp devaluation of the country’s exchange rate.” Nonetheless, the IMF explains that as the dollarized country loses its power to manipulate its currency’s value and depreciation, its competitiveness in the international market might also be affected as its products become more expensive and the local market becoming distorted.
Panama and Ecuador reached the decision to adopt the U.S. dollar as their national currency as they were experiencing very distinct moments in their history. In the case of Panama, the dollar became the official currency in 1904, right after the country had gained independence from Colombia, and when the United States was in control of the Panama Canal. However, the country did not eliminate its national currency, the balboa, which still circulates in the form of coins and in a restricted manner. In fact, balboa bills circulated for seven days in 1941, after the governing president ordered their production before being removed from office. Consequently, the bills were also taken out of circulation.
In the Panamanian case, the decision to dollarize responded to a political strategy to facilitate and encourage the country’s bilateral relationship with the United States. Ecuador, on the other hand, made the controversial decision to adopt the U.S. dollar in the midst of an acute economic crisis, which had led to hyperinflation. According to Ecuador’s president, Jamil Mahuad, dollarization was the only viable solution. In January 2000, the U.S. dollar was introduced to the country with an exchange rate of 4,000 Sucres (Ecuador’s national currency at the time) per dollar. By December 2000, the exchange rate had skyrocketed to 28,000 Sucres per dollar. Different from Panama, the Ecuadorian Sucre stopped circulating that same year and was fully replaced by the U.S. dollar.
Ecuador’s history with dollarization shows much more social discontent than that of Panama. In effect, Jamil Mahuad was removed from the presidential office by social unrest and protests against the decision. The gap between those in favor and against the economic measure widened the already existing social and political crisis the country was facing and marked the beginning of the country’s biggest emigration wave to the United States and Europe. One might argue that the difference between the Panamanian and Ecuadorian social responses is based on the stage of national development. While Panama had just become independent and was in the nation’s forming stages, Ecuador had already been independent for almost two centuries, giving the country time to develop a stronger national identity and a history of bilateral relations and economic conditions.
Despite the controversy around dollarization and the consequences of its application, it is evident that in these two cases, it has been successful so far. Both Ecuador and Panama have maintained surprisingly low levels of inflation for the LATAM region, bringing stability to their economic systems and country as a whole. One must never forget, however, that as with many other economic policies, dollarization, and its process are far from a perfect fit, nor free of disadvantages, and should be used with caution.
- Could dollarization be a viable solution for hyper-inflated economies such as Argentina and Venezuela?
- What would a “dollarization” process look like with other currencies, such as the euro?
- What advantages and disadvantages does the U.S. face by exporting its currency?
- Berg, Andrew Berg & Borensztein, Eduardo. “Full Dollarization: The Pros and Cons”, IMF, 2000.
- GGTN America. “Dollarization in Ecuador turns 20 years old“, 2020.
- Looney, Robert. “Dollarization in Latin America”, Milken Institute Review, 2017.