January 2002
Dollarization: Making International Trade Seamless
By Betty S. Harper, Phil Harper, and Carlos Coronel
Many small to mid-size businesses are wary of expanding into international markets because of the variation in national business environments. Business transactions require the added step of converting currencies. Both political and economic factors influence currency exchange, resulting in transaction and translation gains or losses. Investors must consider whether the country in which they are investing has a stable currency.
One way for U.S. businesses to curtail such losses is to negotiate all international transactions in U.S. dollars. Responsibility for the translation is then on the foreign partner. One alternative is to use currency hedges. Another option is to engage in business transactions where countries have officially adopted the U.S. dollar as the standard of currency (dollarization). This option reduces the currency risk and makes it easier for businesses to expand outside of their home markets.
Dollarization
People have long engaged in unofficial dollarization by choosing (as a store of value) to use foreign currency rather than their own domestic currency. In some South American countries, deposits in dollars exceed deposits in the domestic currency. Official dollarization occurs when a country adopts the U.S. currency as its legal tender. The International Monetary Stability Act of 2000, introduced in the U.S. Congress by then-Senator Connie Mack III, would allow nations to adopt the U.S. dollar as their own currency. The bill was designed to extend the price stability experienced by the U.S. economy to other national economies and slow runaway inflation.
In January 2001, El Salvador adopted the U. S. dollar as its currency. Panama has used the U.S. dollar as a national currency since 1904, and Ecuador dollarized in 1999 following a banking crisis. Argentina may be the next country to follow suit. Mexican president Vicente Fox met with U.S. President George W. Bush in 2001; Mexico, the United States’ largest trading partner in Latin America, would also like to dollarize.
What fuels dollarization? In one word: trade. Currently, the U.S. two-way trade with 31 million Canadians exceeds that with 500 million Latin American neighbors. Dollarization has stabilized Latin American markets where runaway inflation once reigned. Dollarization best benefits small countries where trade is heavily tied to countries already using the dollar, a condition that describes most Latin American countries.
Dollarization does present economic and political hurdles. A country that eliminates its own currency and adopts the U.S. dollar loses seigniorage—the profit a nation earns from issuing its own currency. The U.S. government earns approximately $25 billion annually in seigniorage, approximately 1.5% of total revenue. Although seigniorage might seem to be quite small in terms of a national gross domestic product, it can be a major component of a developing nation’s budget.
Dollarization’s Results in Ecuador
Despite a change in political power in 1999, Ecuador continued its dollarization policy and the economic climate remains positive. Many currency problems have been overcome by dollarization. For example, companies previously had to develop accounting software with duplicate fields—entries for a transaction in U.S. dollars and in local currency. As an another example, the retail value of a car was stated in U.S. dollars in Ecuador’s open market. Because wages were paid in sucres, many individuals could not meet their car payments. Public transportation was affected when a taxi company that had bought a fleet of new automobiles had to return them because fares (stated in sucres) could not keep up with the debt (stated in dollars).
Companies began to advertise their products in U.S. dollars long before official dollarization because of drastic daily currency fluctuations. Retailers would require a 50% payment in U.S. dollars when an order was placed, with the remaining 50% due (in U.S. dollars) upon delivery. For example, a computer imported from the U.S. when the exchange rate was 6,000 sucres to the dollar would cost 3,960,000 sucres ($660 dollars). It would then be advertised at 4,500,000 sucres. If the computer was not sold within a reasonable period of time (sometimes a matter of hours), the replacement cost of the unit would result in a loss because of the volatile exchange rate.
Between January and December of 2000, inflation in Ecuador plunged from 14.3% per month to 2.5%. Prices stabilized and a measure of confidence returned to the business sector. Paulina Batallas, of Deloitte & Touche in Quito, cited increasing sales and hiring as evidence that business confidence had increased. Local banks reported an increase in deposits, a positive early indicator that the plan is working. The Ecuadorian Business Confidence Index stabilized principally because of applying the dollarization system and the resulting decrease in political conflicts and economic problems (Exhibit 1).
Andrew Rose, an economist at the University of California, Berkley, found that trade between two countries sharing a common currency is triple that of comparable countries with separate currencies. Data developed by the U.S. Department of Commerce depicts the marked change in trade activity between the United States and Ecuador (Exhibit 2).
The value of Ecuadorian exports to the United States rose from $250 million at the beginning of 1999 to approximately $647 million for the fourth quarter of 2000. As a percentage of total U.S imports, the value of Ecuadorian imports rose from 0.17% in the fourth quarter of 1998 to 0.20% in the fourth quarter of 2000. The value of U.S. exports to Ecuador decreased from $1,684 million in 1998 to $1,039 million in 2000. As a percentage of total U.S. exports, the value of exports to Ecuador fell from 0.21% in the fourth quarter of 1998 to 0.14% in the fourth quarter of 2000.
Business imperative. Dollarization will increase trade with the United States and increase investment. This should increase economic growth, stabilize prices, and raise living standards. Dollarized foreign economies provide U.S. businesses with a more dependable trading partner. Businesses’ concerns about conversion risks and the need for currency hedges and the measurement of translation gains or losses will be minimized. Its economic success will likely cause more nations to consider dollarization as a way to increase trade with the United States.
Editor:
Robert H. Colson
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