Currency substitution

Dollarization is the introduction of the U.S. dollar as a substitute for the national currency of a State, that is a case of currency substitution, in which the dollar is accepted as payment and transaction medium and store of value within the national territory. A distinction should be informal and official dollarization (see below).

Reasons for dollarization

There are mainly three reasons for the conclusion of a dollarization. First, colonization, and secondly, if a country introduces this media independent, and thirdly, as a means to combat the crisis. ( Naranjo 2001: 10)

Dollarization itself is not a new phenomenon. At the turn of the millennium contributed globalization in tariff reductions, free movement of capital and the increase of international trade volume to the development of capital markets and real dollarization. It is also debated in the science of how globalization is forcing small economies, to submit their monetary policy.

The so-called " Impossible Trinity Principle " states that free capital flows, a fixed exchange rate and an independent monetary policy can not occur together. Now this is applicable, for example, Ecuador.

A special feature is played by the access of developing countries to foreign loans, which have to absorb their debt in foreign currencies. According to Tobias, Roy delivers the fact that developing countries or highly indebted countries can not borrow in its own currency, the explanation of dollarization. Even countries with persistent current account deficits are prone to dollarization. He also stated that generally the currencies of developing countries are overvalued due to the high level of debt. (See Roy: 2000, 20) The term " dollarization " in particular in the course of the 1990s, due to the increasing number of countries (particularly the U.S. dollar ) replaced their legal tender by another currency coined. The number of countries whose investment in a foreign currency account for more than 30% of total assets has increased from 7 in 1990 to 46 countries in 2000. ( Yilmaz 2006: 12)

The dollarization term includes different forms of dollarization. In the literature, dollarization is divided into two phenomena. Dollarization is the official currency substitution or "currency substitutability " and as assets or substitution "asset substitutability ". ( Roy 2000: 17), there are different definitions of dollarization. They can be explained as a substitution of assets and substitution of the currency. The asset substitution is taking into account the profitability and risk. This happens when a foreign currency serves as a store of value. The currency substitution also occurs when individuals prefer a different currency as payment for their transactions instead of the local currency. (See Naranjo, 2005: 161 and Roy 2000:32 )

A Dollarization occurs primarily when political instability and hyperinflation prevail. Dollarization is a result of long-lasting monetary mismanagement. In addition, the term " dollarization " of Berg and Borensztein is defined as follows: "as the holding by residents of foreign currency and foreign currency - denominated deposits at domestic banks". This phenomenon can be seen especially in Latin America and other transition economies. ( Berg and Borensztein 2000: 3)

The devaluation as monetary policy can be viewed as a lack of functionality of the decision system. A long-term use of such a policy is not justified, because: "If a government is in possession of a devaluation option, Those who own money issued by the government face the prospect of having Their property rights confiscated in to arbitrary, ad hoc manner via devaluations. . Accordingly, Governments did fail to protect the value of Their money are guilty of not abiding by the rule of law " ( Hanke 2003: 133)

Moreover, it is expected that under such conditions takes place dollarization process. Calvo and Vegh mean by a dollarization process when a foreign hard currency the three main functions of money accepts: cash, store of value and value measurement function. This replaced the country's weak or barely existent domestic " Rule of Law" by a stronger foreign. According to Milton Friedman, Robert Mundell and Friedrich von Hayek dollarization is justified because it stabilizes the expectations of economic agents. (See Hanke 2003: 135)

This image was repeated, especially in developing countries that had difficulties with the determination of the exchange rate and high inflation recorded. Dollarization is an irreversible phenomenon when it derived as a result of the decisions of individuals.

Dollarization can occur in a floating exchange rate, when the risk of devaluation of the currency is very high. The historical developments of depreciation or appreciation contribute to dollarization. One should also consider that a fixed exchange rate, comes a certain risk, namely when the value of a currency is no longer corresponds with its fixed exchange rate to macroeconomic fundamentals. If the currency is need to be adapted, is formed in the individuals need to replace the currency. ( Naranjo, 2005: 161)

The most important elements that facilitate the dollarization are described by Naranjo as follows: "The facts that explain the dollarization especially in Latin America, are the macroeconomic instability, the lack of development of financial markets, loss of credibility of the stabilization program, the globalization of the economy, high. inflation rates in the past, and institutional aspects " ( Naranjo, 2005: 164) dollarization is a long- term process in which the population loses confidence in the state. They question the state's ability to pursue its obligations. Here are states in which an attempt is made to correct the imbalances of the government balance sheets by inflation and money creation.

In addition, creating a dual currency system. This means that two different currencies take over the functions of money within a country. Banks offer two different interest rates; a rate in local currency and the other in foreign currency. Due to the risk of inflation and the consequent depreciation of the local currency, the interest rate of the devalued currency that value loss must secure. That is, it consists of the interest rate of the foreign currency plus the expected inflation rate ( Naranjo, 2005: 165). Due to the dollarization waived a country on its monetary independence and is therefore forced to the foreign monetary policy - in this case the U.S. - to accept.

Informal dollarization and its consequences

As mentioned above, the dollarization needs a consolidation phase before they can be identified as such at all. In addition, distinctions between official and unofficial dollarization. The latter is also known as semi - or informal dollarization. The general rule is that dollarization is concluded when a population has lost confidence in their own currency.

Schuler defining the informal dollarization when: " ... residents of a country extensively use the U.S. dollar or another foreign currency alongside or instead of the domestic currency. Unofficial dollarization the occurs When individuals hold foreign -currency deposits or bank- notes (paper money) to protect against high inflation in the domestic currency. . Official dollarization the occurs When a government Adopts foreign currency as the predominant or exclusive legal tender " ( Schuler 2000: 15)

Fischer writes that the informal dollarization " ... is result of a period of economic instability in the past, gene rally a period of high inflation. In seeking Circumstances, economic agents will want to hold safer assets, and the economic and political system wants to produce them. That can be done by Allowing the banking system to offer foreign currency, or exchange - rate -linked, accounts; and the banking system in turn will want to lend in a similar DOCUMENT " (Fischer 2006: 3 )

The process of informal dollarization has also various development phases: First, the assets are substituted, and the foreign currency takes over the store of value function. Select the economic Representatives foreign bonds or move their savings abroad. This is also known as capital flight. In a second phase, the foreign currency takes over the payment and exchange function. That is, it is mostly traded with the foreign currency. The third phase occurs when the prices of different goods or services, such as a house, a car or a TV or the rental of offices is reported in U.S. dollars. These three phases need not necessarily be together, they can also occur together.

According to Naranjo, there are two main disadvantages of informal dollarization. First, the loss of control of the money, and second, the increasing pressure on the exchange rate. ( Naranjo, 2005: 167 ) The informal dollarization of the demand for money is unstable and difficult to control within the economic circle. Thus, the U.S. dollar is a part of the money in circulation, you can not regulate precisely. The money supply is difficult to determine. In countries of the Andean Community, the informal dollarization reaches approximately 80 % to 90 %. ( Aramburú in Comunidad Andina 2001: 59)

By increasing the demand for the U.S. dollar, its value increases in principle. Consequently, the national currency is devalued. In addition, the income or wages are also reduced in the local currency, because purchasing power is falling.

In effect, the weaker social classes are most affected, because their low incomes do not provide protection against inflation and devaluation. Other groups in society also suffer losses, but the consequences are not as severe for them because they have more resources. Due to high inflation, investment and production deals are slowed. That is, projects are delayed or not carried out. Therefore, even greater unemployment. ( Naranjo, 2005: 169) should also be mentioned that shrinks by the semi- dollarization, who scored from the state income by minting or " seignorage ", because the demand for money in local currency decreases as well.

To avoid an unexpected devaluation of a currency, central banks, for example, raise interest rates. Thus, the downward pressure is largely prevented. However, this instrument can not always be used, because credibility plays an important role. Example, it may lead to a vicious cycle: inflation leads to devaluation, and this also promotes inflation. In such scenarios, speculation increases, and the dollarization will be strengthened. The exchange rate destabilizes. The high fluctuations in the exchange rate increase the cost of loans in foreign currency and increase the real cost of national loans. The distortions lead to economic chaos.

It is questionable whether a country's economy can sustain such a process in the long term. The financial system may collapse. Banks must take more risk in order to reduce the loss in value of assets in local currency. At the end, when the economic system is in a critical condition, the state must take over the financial apparatus to prevent the spread of chaos. ( Naranjo, 2005: 172) This happens, for example, by the intervention of the central bank as a lender of last resort. According to state intervention an alternative must be found. As a rule, a currency reform takes place.

Official dollarization

• United States of America
• Other countries with U.S. dollar as legal tender
• Currencies with fixed exchange rate peg to the U.S. dollar
• Currencies with a narrow -band exchange rate to the U.S. dollar
• Members of the European Monetary Union with EUR
• Other countries with euro as legal tender
• Currencies with fixed exchange rate peg to the euro
• Currencies with a narrow -band exchange rate for euros

Dollarization is only official if the government officially recognizes the foreign currency as legal tender. That is, if the foreign currency takes over the role of money wholly owned. The difference to the informal dollarization are the conditions and tools, over which the State has. Today, Panama, Ecuador and El Salvador are among the only Latin American countries that have adopted the U.S. dollar as a currency substitute.

An economy which introduces a foreign currency as legal tender, works much like the gold standard before the First World War in 1913, with the so-called "price - specie flow mechanism". This system requires to David Hume, a combination of policies and a flexibility of prices and wages. Where Keynes said, lowering of wages was a very unpopular policy in the modern economy. Wage reduction is not intended solution for the correction of the exchange rate. Fiscal deficits should not be brought by a national currency devaluation into balance. The policy of the central bank should not be characterized by more money making. This is not a long term solution. For this reason, the economy must be solvent. ( Solimano, 2002: 11) An official dollarization is also easier to analyze than the informal. (See Roy 2000: 207)

The official dollarization is based on four pillars: the currency is completely exchanged by the U.S. dollar; the money supply is printed in U.S. dollars. ( For this, the state must have sufficient foreign exchange reserves ). It's such a capital movement freedom. Funds can flow into the country or leave it again without great state intervention. The central bank loses its role as " lender of last resort" ( Naranjo, 2005: 174). Compared to the informal official dollarization offers certain advantages:

First, the exchange rate risk disappears. External shocks will be a burden for the sector concerned and not as far for the whole economy. Moreover, the entire economics transparent. Investors can be long- term investment plan without having to give special consideration to a loss of value of money. Second, the inflation rates are equal to those of North America. That is, the inflation must remain digit. This goal was achieved in Ecuador. (See Appendix 8.7) Third, be achieved by the reduction in inflation interest rates international levels.

Another advantage of dollarization is the integration of the world economy on the financial markets by, for example, less transaction costs and transparency:

" Financial integration plus official Dollarization give banks a worldwide field in Which to make loans in dollars. Consequently, the location of loans is not Closely linked to the location of deposits. The ability to switch dollar funds without currency risk in between the domestic economy and the rest of the world Tends to minimize the booms and busts did Often do arise in countries having independent monetary policies and financial systems not well integrated into the world System. " ( Bogetic 2000: 189)

For the State of dollarization means financial discipline. Fiscal deficits can not be financed through inflation or currency devaluation, but only through specific taxes or government bonds. (See Naranjo, 2005: 175-185 )

In a dollarized economy, the money supply is determined not by the government or the central bank, but only of the demand for money. In addition, political instability the exchange rate does not affect directly. A disadvantage of the "de jure dollarization " waived the country on its own monetary policy. The economy adapts to external shocks through the product markets with the help of the financial system rather than an adjustment of the exchange rate. (See Bogetic 2000: 189)

Minda summarizes the key benefits of official dollarization: monetary credibility and falling interest rates, economic stability and inflation reduction, World and trade integration, integration of the internal financial system, fiscal and budgetary discipline, stability of the political regime. The disadvantages are: renunciation of an independent monetary policy, waiver of a Abwährungsstrategie, loss of seigniorage and loss of the lender of last resort. (See Minda 2005)