When Greenbacks are King

One defines dollarization as the holding of a significant proportion of a country’s assets in a foreign currency, usually in U.S. Dollars. This phenomenon is pervasive and highly diverse in its manifestations. Therefore, it is necessary to distinguish between official and unofficial dollarization. Official dollarization implies the legal status of the “foreign currency” as the country’s means of payment. Unofficial dollarization usually describes the parallel use of a foreign currency and the national currency. The parallel use of a foreign currency can be manifested as a means of payment or as a savings instrument. Both currency and asset substitution usually stem from economic instability and high inflation rates. Of particular interest is that even when the economy has stabilized and inflation is under control, dollarization usually persists (Menon 2008, 2 – 4). This very fact shows the importance of trust for the functioning of the monetary system.

Who dollarizes? 

More than two dozen countries and territories outside the United States use the U.S. dollar. Ecuador and Zimbabwe are the only big countries to use it officially, with the other states that fall into this category being very small or island states. Ecuador introduced the U.S. dollar after a severe financial crisis in 2000. In Zimbabwe, however, the U.S. dollar is only one of eight official currencies, but it has been the most widely used since the hyperinflation of the 2000s (Abadi 2018).

In the Bahamas, Barbados, St. Kitts and Nevis, Belize, Costa Rica, Nicaragua, Panama, Myanmar, Cambodia, Liberia, and several Caribbean territories, the U.S. dollar is unofficially used alongside the local currency. These countries can therefore be categorized as unofficially dollarized (Abadi 2018). However, in some of these economies, the parallel use of the U.S. dollar has a long tradition. For example, Panama has used the U.S. dollar since its independence in 1903, linked to the construction of the Panama Canal. Additionally, Cambodia has seen widespread use of the U.S. dollar since the end of the Khmer Rouge (Kenyon 2014).

Why dollarization? 

Unofficial dollarization occurs when residents lose confidence in their own currency due to strong economic fluctuations or high inflation, for example. As a result, they may turn to another currency to fulfil the currency or monetary functions. On the other hand, official dollarization can be traced to the end of the Bretton Woods system when many developing and emerging countries faced the challenge of managing exchange rates. Full dollarization can help to reduce currency risk and thus general country risk (Berg 2000). In addition, this makes the respective economies more attractive for foreign investment. Thus, official, and complete dollarization can be beneficial to the development process.

There is no such thing as a free lunch

However, dollarization also brings many disadvantages.  With strong dollarization, monetary policy instruments fail to influence the monetary aggregates and control inflation expectations. Instead, impacts from U.S. federal reserve’s monetary policy becomes dominant, and as this is not adapted to local needs, it can lead to economic problems. For example, it is not possible to expand the money supply independently in an economic crisis (Duma 2011, 10).

Furthermore, dollarization can lead to a loss of seigniorage revenue. Seigniorage revenues are the revenues generated by the difference between the value of money and the production costs of money. As a result of dollarization, the real value of money can be lower than the cost of producing it (Duma 2011, 7). Furthermore, dollarization can create liquidity risks. If investors and depositors suddenly change their investment or deposit strategy. This can overwhelm the capacity of local banks and lead to a bank run. In the case of advanced dollarization, the central bank cannot intervene because the deposits are in U.S. dollars (Duma 2011, 9). Given the disadvantages described above, affected countries must ask themselves whether the state of dollarization is still tenable.

The Case of Cambodia

After the Khmer Rouge took power in Cambodia in 1975, they banned private trade, private property, barter, and anything used to store value. All savings and private property suddenly lost their value. From 1975 to 1980, Cambodia was a country without a monetary system (Duma 2011, 5). As a result, Cambodia has been affected by almost all the problems described above. The National Bank of Cambodia was largely unable to conduct long-term monetary policy, seigniorage revenues were negative, and the country’s financial institutions were exposed to permanent liquidity risk (Duma 2011, 7 – 9). However, Cambodia has experienced successful economic development since the 1980s. 

Especially since the millennium, the small tiger economy of Southeast Asia has shown solid economic growth rates. In the meantime, the country is trying to develop out of dollarization. In a coordinated action, small U.S. dollar notes ($1, $2 and $5) were withdrawn from circulation to promote the use of the local riel. This mainly concerns the 1000- and 10,000-riel banknotes (Hunt 2020). In order not to jeopardize the positive economic development of the last two decades by a potential financial crisis, a de-dollarization is necessary. Today, 80% of bank deposits in Cambodia are still denominated in U.S. dollars. This reduces the autonomy of the Cambodian central bank to such an extent that its monetary policy instruments would have only minimal effect in the event of a financial crisis. However, the process of de-dollarization is a delicate balancing act. A rapid shift away from the U.S. dollar could endanger Cambodia’s macroeconomic stability. (Bank of Korea 2020, 1).

Furthermore, de-dollarization also has a geopolitical dimension. The U.S. has certain influences in Cambodia due to the use of the U.S. dollar in the country. Given the close political and economic ties between Cambodia and China, de-dollarization might seem worthwhile for the Cambodian government. As the case of Cambodia illustrates, dollarization usually stems from historical circumstances, but it can certainly help stabilize a country. With increasing stabilization, however, the problems of dollarization come to the fore – a painful and challenging process of de-dollarization must be initiated. The case of Cambodia also highlights the geopolitical relevance of dollarization, as the dollar notes in circulation can be seen as an everyday manifestation of U.S. power.  

Sources 

Abadi, Mark (2018): More than two dozen countries and territories use the U.S. dollar as currency. Business Insider. Available at: https://www.businessinsider.com/usd-countries-use-dollars-as-currency-2018-5. Retrieved on: 09.04.2021.

Bank of Korea (2020): Monetary Operations and F.X. Policy. 2020 BOK Knowledge Partnership Program with Cambodia. 

Berg, Andrew/ Borensztein, Eduardo (2000): Full Dollarization: The Pros and Cons. Economic Issues No. 24, International Monetary Fund. Available at: https://www.imf.org/external/pubs/ft/issues/issues24/. Retrieved on: 09.04.2021.

Duma, Nombulelo (2011): Dollarization in Cambodia: Causes and Policy Implications. IMF Working Paper 11/49.

Hunt, Luke (2020): Cambodia Reduces its Dependency on the U.S. Dollar. The Diplomat. Available at: https://thediplomat.com/2020/12/cambodia-reduces-its-dependency-on-the-us-dollar/. Retrieved on: 30.05.2021.

Kenyon, Jacqui (2014): Why So Many Countries Accept The U.S. Dollar. Business Insider. Available at: https://www.businessinsider.com/why-other-countries-accept-the-us-dollar-2014-4. Retrieved on: 09.04.2021.

Menon, Jayant (2008): Cambodia’s Persistent Dollarization. Working Paper Series on Regional Economic Integration No. 19, Asian Development Bank.