What is Dollarization? Types of Dollarization

Dollarization is the use of a foreign currency (usually the US dollar) instead of a country’s local currency. This situation may occur for reasons such as the depreciation of the local currency, loss of confidence or high inflation. Dollarization can be divided into two: full and partial. In full dollarization, the foreign currency completely replaces the local currency, while in partial dollarization, the foreign currency is widely used alongside the local currency.

This process usually occurs outside the control of the government or central bank, and individuals and businesses prefer a foreign currency in order to protect themselves from the depreciation of the local currency. Dollarization is especially common in countries with low economic stability, high inflation and high devaluation risks.

Types of Dollarization

Dollarization can be examined in different types according to the areas and level of use:

Full Dollarization (Official Dollarization):

Full dollarization is the adoption of a foreign currency (usually the US dollar) as the official currency of a country. In this case, the local currency is completely deactivated and all economic transactions are carried out in foreign currency. For example, Ecuador and Panama use the US dollar as their official currency.

Partial Dollarization (Unofficial Dollarization):

Partial dollarization is the use of a foreign currency together with a local currency. This type of dollarization can occur in both financial transactions and daily economic activities. Foreign currency is especially preferred during periods of high inflation and depreciation of the local currency. Partial dollarization can also be seen in the banking system as an increase in deposits and loans in foreign currency.

Financial Dollarization:

Financial dollarization is the use of a foreign currency in the banking sector and financial transactions. In this case, people and companies hold deposits in foreign currency and take out loans in foreign currency. Financial dollarization occurs due to the expectation of depreciation in the local currency and the risk of inflation.

Real Dollarization:

Real dollarization is the use of a foreign currency in exchange for goods and services. This type of dollarization occurs when a foreign currency is preferred in trade and daily economic activities. For example, lease agreements, major purchases, and import-export transactions can be made in foreign currency.

Reasons for Dollarization

Dollarization can have many causes, and these causes are usually related to economic instability:

High Inflation:

High inflation causes the local currency to lose value rapidly. In this case, individuals and businesses turn to a more stable and stable currency to protect their savings. The US dollar is often preferred as a stable currency.

Expectation of Devaluation:

The expectation that the local currency will be devalued can lead to dollarization. Devaluation means that the local currency will lose value against foreign currencies. Since this situation will reduce the value of assets held in local currency, people and businesses prefer to hold assets in foreign currency.

Economic and Political Instability:

Economic and political instability reduces confidence in the local currency. Uncertainties in government policies, political turmoil, and economic crises can cause individuals and businesses to turn to foreign currencies.

Ease of Access to Foreign Currency:

Easy access to foreign currency can encourage dollarization. Foreign currency can be more widely used, especially in regions where cross-border trade is intense. In addition, diaspora communities and immigrants sending foreign currency can also contribute to dollarization.

Underdeveloped Financial Markets:

Underdeveloped financial markets limit the ability to save and invest in the local currency for the long term. In this case, people and businesses prefer to hold assets in the more stable and liquid foreign currency.

Economic Effects of Dollarization

Dollarization has both positive and negative economic effects:

Positive Effects:

Price Stability: Dollarization can provide price stability during periods of high inflation. Foreign currency compensates for the depreciation of the local currency, making prices more predictable.

Financial Stability: Financial dollarization can increase confidence in the banking system. Deposits and loans in foreign currency provide protection against depreciation of the local currency.

Trade and Investment: Dollarization can create a safe environment for international trade and investment. Foreign currency facilitates trade and investment transactions by eliminating exchange rate risk.

Negative Effects:

Loss of Monetary Policy Independence: Dollarization prevents the central bank from using monetary policy effectively It makes it harder to manage. When control of the local currency is lost, the central bank loses its ability to manage interest rates and the money supply.

Vulnerability to External Shocks: Dollarization can make a country more vulnerable to external shocks. Sudden changes in the value of a foreign currency, such as the U.S. dollar, can negatively affect the local economy.

Fiscal Pressures: Dollarization can cause fiscal pressures when the government has to repay its debts in a foreign currency. If the local currency depreciates, debt repayments in a foreign currency become more costly.

Income Inequality: Dollarization can increase income inequality. Those with access to foreign currency are protected from inflation and devaluation, while those with income in the local currency may be vulnerable to such risks.

Exit Strategies for Exiting Dollarization

Exiting dollarization is a complex and long-term process. Here are some strategies that can be implemented during this process:

Achieving Macroeconomic Stability:

The first step in exiting dollarization is achieving macroeconomic stability. Controlling inflation, ensuring fiscal discipline and encouraging economic growth increase confidence in the local currency.

Strong Monetary Policy and Central Bank Reputation:

Increasing the independence and reputation of the central bank increases the effectiveness of monetary policy. Transparent and predictable monetary policies reinforce confidence in the local currency.

Developing Financial Markets:

Developing local financial markets is important in the process of exiting dollarization. Increasing long-term savings and investment opportunities in the local currency reduces the tendency of individuals and businesses to turn to foreign currencies.

Encouraging Local Currency:

The government should encourage the use of the local currency. Policies such as tax incentives, discounts for transactions in the local currency and increasing credit and deposit opportunities in the local currency can be implemented.

Exchange Rate Policy:

Exchange rate policy plays an important role in the process of exiting dollarization. Preventing overvaluation of the local currency and a competitive exchange rate policy increase the attractiveness of the local currency.

The process of exiting dollarization requires ensuring economic and political stability, implementing a strong monetary policy, and developing financial markets. These strategies increase confidence in the local currency, reinforce economic stability, and reduce the negative effects of dollarization.