Distributional effects of dollarisation: the Latin American case

Abstract

Over the past two years Ecuador, El Salvador and Guatemala have adopted the US dollar as a legal currency in their countries. Several other Latin American countries, including Argentina, are currently discussing dollarisation. In this policy paper we look at the existing evidence for answers to two basic questions. First, under what general circumstances might dollarisation make sense? Second, are there clearly differentiated winners and losers from dollarisation and, if so, can we identify them, so that policy can take these political economy factors into consideration? Our review of the evidence demonstrates that there are consistent patterns of distributional effects, both positive and negative, from the choice of exchange rate regime. These effects are presently not considered in exchange rate policy decision making, but should be. While the effects are not as pronounced as those from major trade liberalisation agreements, they are significant. Ways to cushion the effects of exchange rate regime choice should be considered in the future by policy makers. Moreover, we find that dollarisation is embedded in the politics of the region. Dollarisation is often sold as a substitute for the deeper institutional reforms needed to improve economic performance and distribution in Latin America.

Notes

Anil Hira and James Dean are in the Department of Political Science and the Department of Economics, respectively, at Simon Fraser University, Burnaby, BC V5A1S6, Canada. Email: [email protected].

We would like to Benjamin Jerry Cohen, Thomas Willett and Katie Lavelle for their excellent comments in improving this piece. We would like to thank Trinh Phan for research assistance. This article is dedicated by Anil Hira to Regina Brown, for her help in learning about ‘practical’ development finance and her support during a difficult time.

See Wise & Roett (2000); Starr (1999).

See Calvo (1999); Alesina & Barro (2001); Goldfajn & Olivares (2000a).

See Frieden & Stein (2001); Cohen (2002).

See Kessler (2000) for a case study of former Mexican President Salinas' political decision to avoid currency adjustment, leading to a predictable crash.

A traditional argument for the advantage of flexible exchange rates is that, since non‐tradeable wages are sticky, the increase in import prices through a devaluation is an effective way to reduce wages in order to increase competitiveness. See Hefeker (1997: 13–15.

For the purposes of simplicity and brevity, we leave aside a discussion of pegged exchange rates and currency boards. Pegged exchange rates could fall within conventional fixed bands, or could be ‘crawling’, ie adjusted periodically by the central bank. Moreover, the size of bands varies considerably. See Dean (2002) for further explanation.

Argentina's currency basket means some interesting minor departures from currency dollarisation. The upshot is that the currency basket (as opposed to adopting the dollar proper) allows Argentina some very limited ability to influence monetary policy through these financial instruments. See Hanke (2002) for further discussion.

Thanks to Benjamin Cohen for clarifying this.

Frieden & Stein (2001) touch on the electoral cycle aspects as well, ie the desire to move towards fixing currencies before an election, but Starr (1999) points out some flaws in this approach.

Neiman Auerbach & Flores‐Quiroga (2002: 4–5).

Pascó‐Font & Ghezzi (2001) make just this point in their case study on Peru.

See Grosse (2001), esp pp 9–10, 37–41.

See Dean (2001) for measurement of the extent of de facto dollarisation.

NotiCen, 14 December 2000.

Ibid.

Ibid. According to the same report, Alvaro Ramirez, Director of the Union Costariccense de Camaras y Asociaciones de la Empresa Privada (the largest business association), has said that Costa Rica's policy of mini‐devaluations is now in question, and dollarisation could happen in two years. He also predicted that all Central American currencies would be unified within five years to attract foreign investment.

According to Chronicle (ladb), 13 January 1994, Finance Minister Sandoval said ‘Given the huge deposits in dollars already accumulated in the banks, we are moving toward a de facto dollarization of the national financial system’.

Kessler (2000).

James Swenson, ‘Big change for a small nation’, LatinFinance, October 2000, at www.latinfinance.com.

An earlier version of this paper contained a discussion of the details around adoption in each country, and Argentina's abandonment of its dollar peg, but we leave that out for sake of brevity here.

An analysis of both sides for Mexico is found in Neiman Auerbach & Flores‐Quiroga (2002). For endorsements of dollarisation by these groups in Guatemala, see ‘Guatemala allows unlimited use of dollar’, NotiCen, 11 January 2001. For Costa Rica, Ecuador and El Salvador see Nicholas Moss & Richard Lapper, ‘Focus: Latin America’, Financial Times, 29 March 2001; NotiCen, 14 December 2000; and ‘Ecuador completes transition to dollarization’, NotiSur, 15 September 2000. For Nicaragua, see ‘Region: Central American countries debate dollarization of their currencies’, NotiCen, 25 February 1999. For Honduras, see NotiCen, 14 December 2000. In Mexico even some financial groups have voiced reservations, though others have endorsed the idea. See ‘Private‐sector groups informally consider linking Mexican economy to US dollar’, Sourcemex (ladb), 7 October 1998.

For Ecuador, see ‘Ecuador: new austerity measures set off protests’, NotiSur; 19 January 2001; and for El Salvador, see NotiCen, 14 December 2000.

Wise & Roett (2000: 17–18).

‘Ecuador: President Gustavo Noboa begins final year in office with mixed review of dollarization’, NotiSur, 25 January 2001.

‘Ecuador: new austerity measures set off protests’, NotiSur, 19 January 2001.

See ‘Salvadorans protest dollarization on May Day’, 1 May 2001, at Investorsuniverse.com; and ‘Ecuador drifts between opportunity and deadlock’, The Economist, 23 December 2000. On conaie, see Jameson (2001:18).

Quote is from ‘So far, adopting US currency has not been answer for Latin American economies’, NotiSur, 17 January 2003.

‘Ecuador completes transition to dollarization’.

‘Ecuador: new austerity measures set off protests; ‘Ecuador: President Gustavo Noboa faces strikes and bank crisis’, NotiCen 27 July 2001; and author interviews in Quito, Ecuador in August 2001.

See Alfredo Calcagno & Sandra Manuelito, Argentine convertibility: is it a relevant precedent for the dollarization process in Ecuador?, serie estudios estadísticos y prospectivos no15, Santiago: cepal, July 2001.

‘Delay for Guatemala dollarization’, bbc, 1 May 2001, at news.bbc.co.uk

‘El Salvador: fmln expels former presidential candidate Facundo Guarado from party’, NotiCen, 11 October 2001.

See Amy Taxin, ‘A downside of dollarization’, Sun‐Sentinel.com, 24 May2001, at www.sun‐sentinel.com, for a description of the recessionary effects of dollarisation on Ecuadorean regions close to the Colombian border.

On the de‐listing trend, see Steve H Hanke, ‘Waiting for a big bang’, Latinfinance, February 2001.

There are widespread reports of resistance to dollarisation in both Ecuador and El Salvador among small businesses and particularly the informal sector. See, for example, Benjamin Ryder Howe, ‘Getting used to the greenback: the peculiar hitches of a growing Third World trend: conversion to the dollar’, Atlantic Monthly, May 2001, at www.theatlantic.com. For El Salvador, see NotiCen, 11 January 2001. My own recent personal experience (Hira) in Argentina is that small‐scale vendors will not accept dollars.

See Narayan (2000) on this interesting disjuncture between the theoretical and expected benefits of liberalisation and the actual perception of abandonment thanks to government cutbacks among the marginalised in the developing world. Perhaps one major exception is the control of inflation.

Ecuador, Guatemala and Argentina, have ongoing recessions and major debt problems, and El Salvador is suffering from the effects of the recent earthquake.

Thus, a recent US government export guide for Ecuador points out that, despite dollarisation, numerous non‐tariff barriers continue to impede trade. See also Andrew Bounds, ‘The Americas: Guatemala urged to curb spending’, Financial Times, 29 May 2001, which points to the weak tax base, and tax evasion of 40%!

On Panama, see Edwards, pp 7, 14.

‘Will the foundations hold?’, LatinFinance, special issue, November 2000.

Plies & Reinhart (1999).

Eichengreen (2001).

See Kaminsky & Reinhart, 1996 & 1999 for an exposition of the links between weak banking systems and currency crises.

See Krueger (2000). See also Hira (2003) for more on regulatory policies in regard to energy.

To date, only Guatemala has been able to pass a tax increase in its value added tax, a measure unsuccessful so far in several other Latin American countries, including El Salvador. See Financial Times, ‘Warning of Ecuador default’, 19 April 2001; ‘Guatemala urged to curb spending’, 29 May 2001; ‘Argentina’s riches to rags tale’, 21 March 2001; ‘Last chance’, 19 March 2001; ‘Cavallo’s plan', 23 March 2001; and Nicholas Moss, ‘Ecuador’s finance chief risks losing momentum: Congressional opposition is holding up financial reforms needed to meet the country's commitment to imf demands', 28 March 2001.

See Quiroz & Opazo (2000).

See Cardoso (2000), esp pp 76–77, for more on this.

See Kessler (2000) for detailed coverage of Mexico, esp pp 64–66; Krueger (2000); and Cardoso (2000)

Swenson (2000). This is the case not only in Latin America, but elsewhere, such as Ghana.

Dollarisation appears an option any time there is a major fiscal crisis as there is no stomach for raising domestic (non‐tradeable) taxes. Menem's suggestion for dollarisation takes place in the throes of the Argentine crisis. Indeed Ecuador's ‘Ley Trolebus’, which set up dollarisation states that ‘radical measures’ are needed ‘to overcome the economic crisis’ and that adoption of the dollar is ‘the only way’ that this can be done. See the preface to this law.

In general, Latin American countries seem to neglect the importance of improving factor productivity, which would negate to some extent the price effects of dollarisation on tradeables. A recent study by Arteta (2001: 6) points out that Ecuador has not had factor productivity improvements in 30 years! In a recent interview, Ecuadorean Economy Minister Gallardo said that the government would have to rely upon tariffs, since there was no way under dollarisation to absorb foreign shocks in consumer goods, capital goods, and raw materials markets. This definitely seems to be a step backwards.

Additional information

Notes on contributors

James W Dean

Anil Hira and James Dean are in the Department of Political Science and the Department of Economics, respectively, at Simon Fraser University, Burnaby, BC V5A1S6, Canada. Email: [email protected].