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The Dollarization Debate$

Dominick Salvatore, James W. Dean, and Thomas D. Willett

Print publication date: 2003

Print ISBN-13: 9780195155358

Published to Oxford Scholarship Online: November 2003

DOI: 10.1093/0195155351.001.0001

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Pressures for Currency Consolidation in Insurance and Finance

Pressures for Currency Consolidation in Insurance and Finance

Are the Currencies of Financially Small Countries on the Endangered List?

12 Pressures for Currency Consolidation in Insurance and Finance
The Dollarization Debate

George M. von Furstenberg

Oxford University Press

Abstract and Keywords

E-commerce, regional economic integration, and global liberalization have eroded the monopoly of small currencies in their home markets. These factors now threaten the continued viability of these currencies in the medium-term. Partial currency consolidations are likely to be unsuitable in the new environment leading to regional monetary union.

Keywords:   currency consolidation, e-commerce, exchange rates, monetary union

The currencies of a few geographically small countries, like Switzerland, are financially big, and the currencies of some large countries, like China and Brazil, are financially small. Neither type of currency, one small and internationally fit and the other large and protected, is of interest here because the viability of each is not as yet in question. Instead the focus is on the declining usefulness of the separate currency denominations maintained by that large number of small open economies whose currencies play little or no role in international finance. There is a real question of whether such currencies will survive, even in domestic use, when faced with the ever‐decreasing restriction of competition from the international currency dominant in the region and from those most expert at doing business in it.

As Eichengreen (1994, p. 39) anticipated, “the problem posed by deep integration is that accompanying changes in technology, politics, and market structures may render [the provision of monetary stability] possible only under a very limited set of international monetary arrangements.” This chapter argues, and in small part substantiates, that e‐commerce, regional economic integration, and global liberalization have eroded the monopoly of small currencies in their home markets. These developments now threaten the continued viability of a number of them over the medium run. Even partial currency consolidations, such as those afforded by currency boards, are likely to prove unsustainable in the new environment that is leading to regional monetary unions.

A Glance at History and Prospects

Briefly looking both back and ahead suggests that, in matters of currency competition, we may be returning to conditions once common in many parts of the world. In British North American colonies (Schweitzer, 1997), for instance, several moneys and coinages, foreign and domestic, competed for acceptance side by side. Declaring certain notes and coins legal tender for the settlement of money debts both public and private did little to (p.207) prevent contracts from being made, and settled, in other denominations or standards. Nor did something need to have legal tender status in the colonies to be accepted as payment and hence to be valuable there.

This situation changed only when strong regulatory and legal restrictions were enacted by independent states to shelter their national currency from competition by other denominations on their home turf. As with the Legal Tender Act that was adopted during the U.S. Civil War in 1862, legal tender laws were needed to introduce a national fiat money, but that did not necessarily make it more widely used than established moneys. Gresham's law could come into operation only when a new form of money was declared legal tender at an overvalued legal exchange rate for money and debt contracts denominated in some older form or substantiation of money.

Over time, many countries sought to strengthen the issuing authority's monopoly power in order to afford effective protection for the national currency. Such action led from the production of national money in monopolistic competition with other such moneys to positively reserving the domestic market for its use. To assure such exclusivity, the domestic currency may have been sheltered by capital controls and by banking regulations that strictly limited the booking of foreign currency assets and liabilities for domestic residents and gave the national denomination exclusive rights in many home‐country applications.

These barriers have tended to erode over the past two dozen or more years as worldwide internal and external liberalization have taken hold. As a result, national moneys have been exposed to international competition and have to struggle for survival once again. Barriers to foreign competition have been falling first in developed and then in developing countries as they have integrated into the liberal international trade and investment regime and have extended national treatment to foreign suppliers with fewer or expiring derogations. Freer cross‐border provision of financial services and a changed official attitude to foreign establishment and takeovers have encouraged foreign entry. These developments also have opened the door to more widely denominating and trading domestic claims in international denominations. Providing such foreign‐currency‐denominated loan, debt, and equity financing is a business in which foreign providers, domiciled in the country that issues the relevant international currency, tend to have a funding and marketing advantage.

The end result now clearly in view is that individual and corporate citizens in many small countries will be able to choose to make payments in more than one acceptable currency and to freely incur debts or acquire assets denominated in different currencies. Furthermore, using financial derivatives, they will be able to swap, alter, or hedge their currency exposure increasingly at will. However, they can do so only at considerable cost when their own currency is involved: risk premiums that are reflected in interest rates and hence cause the forward exchange rates for small currencies to (p.208) exceed their expected future spot rates add to the cost of hedging. These risk premiums are almost entirely due to currency risk, in the sense that absent currency risk, very little remains of what was formerly identified as country risk, as southern members of the Euro Area can attest. It is inconceivable, for instance, that Mexico, if it dollarized completely, would face premiums as high as the 300 to 340 basis points that were observed on its sovereign dollar borrowing in 2000. This is the yield spread over comparable U.S. Treasuries that Mexico's central bank (Banco de México 2000, p. 16) has identified, quite conventionally and yet misleadingly, as pure country risk.

The question then is how many currencies will remain in wide use under arrangements that are more open to foreign currencies. Will the local currency be among the survivors? In my view, globalizing and centralizing tendencies tend to weigh against such a prospect if the country is financially small to start with and if it lacks a very large internal market in which strong network externalities from the use of the domestic money can still be obtained. This naturally leads to the search for a quantitative perspective on what is small and how much countries that lie next to an area with a dominant currency still use their own money.

To What Extent Does a “Small” Open Economy, Like Mexico, Use Its Own Money?

The Federal Reserve has put forward (Leahy, 1998) a new method for estimating summary measures of the foreign exchange value of a currency. The method provides for calculating a set of weights to be applied to a country's most important bilateral exchange rates while also taking account of competition between imports and goods produced and sold in the same country, including the home country. The resulting weights are so comprehensive that they can be used for purposes other than deriving effective exchange rates, for which they were originally intended. In particular, the weights sum to unity when including the weight for the one‐to‐one exchange rate of a country's own currency. The latter weight provides a useful inverse measure of its foreign currency dependence or degree of monetary openness.

Application of the method to Mexico when a total of n countries are considered calls for establishing the following.

  1. The market shares of Mexican‐produced goods in each of their n − 1 major foreign markets, X MX,j, as well as in Mexico itself, X MX,MX

  2. The market shares of foreign‐produced goods sold in Mexico, M MX,j, as well as of Mexican goods sold in Mexico, M MX,MX

  3. The market shares of goods imported by each of Mexico's major trading partners in all goods sold in the respective country j, M j,k, (p.209) where jk, as well as the share of home‐produced goods sold in the respective country, M k,k

With these definitions, the weight on the k‐currency real exchange rate with the Mexican peso would be:
W MX , k = Σ j = 1 , n X MX , j M j , k .

By setting k = MX we can calculate the weight of the Mexican peso in Mexico to gauge how important the domestic currency remains in that country relative to other currencies used in its economic transactions. The United States (US), the Euro Area (E), and Japan (J) are Mexico's major trading partners, as they together accounted for 92 percent of its goods exports and 85 percent of its imports in 1999. (These import and export weights are normalized to 100 percent to represent all exports and imports.) With the market share values for 1999 calculated from data provided by the IMF (2000a, 2001), application of the above formula to obtain the weight for the Mexican peso yields:

W MX , MX = X MX , MX M MX , MX + X MX , US M US , MX + X MX , E M E , MX + X MX , J M J , MX = 0 . 717 ( 0 . 710 ) + 0 . 271 ( 0 . 011 ) + 0 . 010 ( 0 . 001 ) + 0 . 002 ( 0 . 000 ) = 0 . 512 .

In the same way the weight of the U.S. dollar for Mexico is calculated as:

W MX , US = X MX , MX M MX , US + X MX , US X US , US + X MX , E M E , US + X MX , J M J , US = 0 . 717 ( 0 . 252 ) + 0 . 271 ( 0 . 870 ) + 0 . 010 ( 0 . 022 ) + 0 . 002 ( 0 . 016 ) = 0 . 417 .

The conclusion derived from the application of this weighting scheme is that the weight of the U.S. dollar in the Mexican economy has risen to within 10 percentage points of that of its home currency. Furthermore, the Mexican peso's share is barely above 50 percent, judged merely by its trade in goods and ignoring services, workers' remittances from the United States, and asset pricing in dollars. The result is conservative also in that it ignores not only U.S. currency circulating in Mexico but also any dollarization that has already occurred inside Mexico's domestic business in order to insulate some of its cash flow from exchange rate fluctuations.

This is an important finding that suggests that small open economies in the vicinity of large countries or groups of countries with an international currency already depend importantly on a money other than their own. They are much more exposed to currency crises and exchange rate instability than the share of bilateral trade in relation to GDP (X MX,US = 27.1 percent), or to domestic absorption (M MX,US = 25.2 percent), would suggest.

(p.210) International Portfolio Diversification Works Best in the Dominant Currency Denomination

Economists have often deduced that, from the point of view of obtaining optimal consumption insurance through portfolio diversification, the investment portfolios of otherwise comparably positioned investors from Canada, France, and Japan should look very much alike. The failure for them to do so, because citizens strongly favor claims on their own country's obligors, has been labeled the home bias puzzle (see Lewis, 1999). Hausmann et al. (2000, pp. 142–44) have argued that for emerging market economies, all of which are financially small, there is even a presumption against investing at home from the point of view of consumption insurance. The reason is that in a currency crisis, just when income and output fall and internal and external sources of credit dry up, domestic asset values collapse. Adding a large negative wealth shock to a negative current income shock would impart a double blow to consumption for investors at home.

Had these investors instead been invested in international foreign currency claims when the sharp real depreciation of the domestic currency occurred, they would have benefited from the real appreciation of the domestic value of their foreign holdings. This would have reduced, rather than amplified, the blow to consumption from a currency and financial crisis. Hence, to obtain optimal consumption insurance, investors in small emerging market countries should invest outside their own country and currency to an extent even greater than what is fitting for the average international investor. When Uruguayans hold 85 percent of their savings in U.S. dollar‐denominated accounts in their own country, they are acting to reduce this double exposure to a degree that depends on whether they deposit in domestically owned banks or in local branches of foreign banks. In Argentina about 50 percent of bank assets are held in foreign‐controlled institutions by a variety of measures (IMF, 2000b, p. 153). Multinational financial institutions are almost always originating in the key‐currency countries that have long been leading the development of the financial services industry and have determined its international coordination and supervision. They bring their privileged key‐currency connection with them wherever they establish around the globe and make that denomination their stock in trade.

Large international currencies convey other advantages to foreign users. To protect their international standing, such currencies and their financial infrastructure tend to be consistently well managed. Emerging market economies, in particular, commonly experience real exchange rates that are both highly variable and prone to drift up between major corrections, not necessarily around a fixed mean. Hence denominating annuities and pensions and lump‐sum or life insurance settlements of any kind in such currencies would provide far less calculable real‐value assurance than denominating in one of the large currencies. The latter are key to international pricing in product and finance markets and reliable stores of value and of future purchasing (p.211) power over a broad range of goods. The added purchasing‐power risk thus detracts from the suitability of small currencies for extended use in intertemporal trades, and this contributes to the case for currency consolidation.

International financial derivatives since their inception have functioned almost exclusively in U.S. dollars and in only a few other major currencies. The reason is that the underlying debt and equity claims suitable for listing, securitization, and exchange trading in international financial markets are themselves almost exclusively denominated in dollars, and to a lesser extent in euros and yen. Countries can use only very few other currencies to borrow in international financial markets. Generally, large risk premiums and illiquidity, reflected in wide bid‐ask spreads, discourage denominating in peripheral currencies. Since calculability of risk exposure and a high degree of liquidity of positions taken by major participants, including hedge funds, are essential to the functioning of the market in derivatives, standardization on a common currency is convenient in many, though not all, applications.

The dollar may “intrude” even into exchange contracts between other currencies. International Monetary Fund (1999, p. 49) explains, for instance, that nondeliverable foreign exchange forwards (NDFs) in emerging markets tend to be settled in U.S. dollars for the difference between the implied exchange rate on the contract and the prevailing spot rate on the maturity date of the contract. The IMF notes further that net settlement in domestic currency existed in many industrial countries in the 1970s and 1980s prior to the removal of exchange controls. The big currencies thus tend to get bigger when capital controls are removed.

Common Currency in E‐Trade and E‐Commerce

Many regional and global electronic spot markets and electronic trading platforms price in U.S. dollars or, prospectively, in euros. It may be instructive to consider a simple example. Certain electronic auctions conducted in Canada are bid in U.S. dollars to encourage cross‐border participation. One could, of course, reflect on the screen, second by second, what the auction price amounts to in Canadian dollars. However, little would be gained by this instant currency conversion. For instance, if the U.S. dollar price achieved at auction is final and binding, paying with a debit or credit card on a Canadian dollar account could cost an extra 2 percent commission for the exchange conversion. Uncertainty would be added for the Canadian buyer at auction because the exchange rate would be the interbank sell rate prevailing when the charge is processed by the bank.

Instead of putting up with this cost and uncertainty, the Canadian could, of course, have a U.S. dollar account with his or her Canadian bank or in the United States. But if the balance in that account must be maintained (p.212) by drawing on income earned in Canadian dollars, the problem of uncertain settlement costs does not really go away. With digital signatures now having legal effect, validity, and enforceability in the United States (see Tech Law Journal, 2000) and in a growing list of other countries or country groups, ordering, shopping, and settling in international money anywhere in the region, indeed in the world, has become increasingly attractive. This however creates pressures not just to convert to such money but either to be paid in it or to have payments indexed to it.

In business applications, there are even stronger pressures for currency consolidation. Transnational bidding on business that should lead to standing orders is handicapped if persistent exchange rate movements keep interfering with what subcontractors or component suppliers must ask. To avoid the disruption of continuing relationships by exchange rate movements whose eventual results for competitiveness cannot be hedged, those who seek to be integrated into the regionwide supply chain try to control their costs, from parts to labor, in the same currency in which they must bid.

Should Small Countries Keep Nominal Exchange Rate Flexibility?

Flexible exchange rates are often advertised as a low‐cost and fast‐acting compensatory mechanism for countries with nominal rigidities that are subject to either real or nominal shocks. The unspoken assumption, frequently falsified (see, for instance, Buiter, 1997; Hausmann et al., 2000) is that exchange rates can be counted on to move reliably so as to facilitate efficient adjustment rather than having a disturbing way of their own. Buiter (1999, 50) gives a sardonic example of the heroic deeds to be accomplished by monetary policy enabled by flexible rates against a supposedly unitary shock:

There is assumed to be only one kind of shock, a national aggregate supply shock. The national monetary authority is assumed to observe the national supply shock immediately and perfectly. It then sets national monetary policy instantaneously and optimally to cope with this shock. The national authority knows the true structure of the economy and this structure of the economy makes certainty‐equivalent strategies optimal.

While some Canadian (see Laidler, 1999) and Mexican (see Schwartz and Torres, 2001) economists continue to try to prove that flexible exchange rates work just fine for their countries, they have yet to include complete U.S. dollarization or other forms of monetary union among the alternatives seriously considered. In Mexico at least, such a union would preclude the very currency crises from which advocates of flexible rates get their economic “supply shock” observations. As Calvo and Reinhart (2000) have explained, in many countries there is deep and cogent doubt that floating exchange (p.213) rates in fact have tended to move to facilitate adjustment in the goods and factor markets. Small open economies in emerging market countries rarely find that when things start to go badly—usually first because there is an international‐portfolio or private‐capital‐account shock—exchange rate movements quickly reverse the tide and let conditions improve again. Instead, currency crises commonly make things much worse before they start getting better, and, contrary to once‐popular belief, flexible exchange rates do not preclude such crises.

Even when real exchange rates move in textbook fashion to accommodate the needs of trade balance and production adjustment, some of the other tacit assumptions that make such movement unequivocally beneficial are less and less likely to be satisfied. One of these is that countries are homogeneous internally but heterogeneous internationally in their production structure and shock exposure. Likewise, factor mobility, particularly that of labor, often is assumed to be high internally and low internationally. Mexico's adjustment to the 1999–2000 increase in the price of crude oil shows what can be wrong with these assumptions. The oil price increase and the effect on Mexico's federal budget and current account may have encouraged increased private capital inflows that contributed to an appreciation of the Mexican peso in both nominal and real terms. But only small additional amounts of capital and labor have been attracted to oil and gas exploration and development while the real appreciation has slowed the development of the nonoil sector in the country at large.

If small countries were indeed internally homogenous and externally heterogeneous so that they had a specialized, nationally integrated production structure for final goods, shocks to both domestic supply conditions and to (mostly) foreign demand for the small country's specialized output in theory could be cushioned, and adjustment could be speeded by movement in nominal exchange rates. But for many small open economies, this picture of the production structure bears little relation to the reality they confront in a regionalizing, and to a lesser extent globalizing, economic system. Becoming a component part of international supply chains means that anything that disrupts this chain anywhere will be felt everywhere else in the region.

By the same token, if many countries in the region share in the production of final goods, such as automobiles or electronic appliances, through the production or assembly of parts, any shock to aggregate demand for the final good will affect all who contribute to its supply as well. Under these conditions, exchange rate movements among the partners in the region cannot be part of efficient adjustment. Hence in an economically interlocking world, little remains of the classical case for flexible exchange rates. Once countries are firmly committed to low inflation and do not cherish the freedom to engage in inflationary experiments, they will benefit further by irrevocably relinquishing the option to change their exchange rate with their hard‐currency neighbors. Indeed, currency union would enhance the (p.214) regional integration process by markedly raising trade and GDP within the union (Frankel and Rose, 2000).

Is a Currency Board Arrangement Sufficient for Currency Consolidation?

A number of business and banking groups seeking some form of monetary union with the United States, for instance in Mexico, recently have come out in favor of a currency board arrangement (CBA) because they view such an arrangement as politically more acceptable than complete dollarization. This section argues quite generally that currency boards may, or may not, advance the objective of monetary union. It all depends on how appropriate the choice of the peg is to their trade and finance and what better alternatives are available in their economic neighborhood.

Currency boards in theory have a fixed reserve ratio against high‐powered money and a fixed exchange rate with something “hard” in common with the gold standard. Yet while there were rules of the classical gold standard that were sufficiently widely observed to make the standard credible and speculation generally stabilizing (Eichengreen 1994, p. 43), CBAs now make their own rules. For instance, Argentina's and Hong Kong's CBAs have very little in common in the way they operate, in the extent to which they are backed by reserves and constrained by their particular status, and in the fluctuations they have experienced in their credibility. As described in Dodsworth and Mihaljek (1997) for instance, there is little that is classical or ruled out in the operation of Hong Kong's currency board since it was established in 1983. Indeed, some of its defenses against speculative attack, such as using more than 10 percent of its foreign exchange reserves in August 1998 to discourage short selling by buying shares in the local stock market, have been unprecedented.

Apart from each CBA being increasingly sui generis and thus requiring detailed individual assessment, there is also the question of the choice of currency peg that is appropriate for each. It is not true that any and all of the major hard currencies will do. For instance, Hong Kong, Argentina, and Lithuania, all with a U.S. dollar‐based currency board, are surrounded (or will be surrounded when the renminbi starts to float against the U.S. dollar) by countries whose real exchange rates may develop very differently. Because these countries are unduly exposed to foreign‐induced misalignment of their trade‐weighted exchange rate, the rationale for sticking with their CBAs can become doubtful. When such a misalignment becomes acute, as between Argentina and Brazil in the aftermath of Brazil's currency crisis of January 1999, risk premiums surge. They may feed on themselves by placing the benefits of maintaining the CBA further in doubt.

Currency board arrangements that peg unnaturally to a currency from outside their major trading region are prone to stress. Singapore's switch (p.215) from a sterling‐based currency board in 1967 to the U.S. dollar, though precipitated by the desire to disassociate from the pound's devaluation from $2.8 to $2.4, was appropriate to its trade and finance as well. Singapore broadened its exchange rate reference further a few years later when it made the transition to managed floating. By contrast, Lithuania's perverse insistence on maintaining a dollar‐based currency board in what is rapidly becoming a sea of euros has been costly. Real GDP fell over 4 percent in 1999, and little or no growth has been reported for 2000, as the strength of the dollar against the euro persisted during the year.

Thus while CBAs incorporate a strong policy commitment to fixed exchange rates that is backed up by a high level of international reserve, this commitment may still not be sustainable politically when it is perceived to be harmful to the economy and to its secure integration in the region. Only currency boards within economically and financially heavily integrated and interdependent regions are likely to provide adequate insurance against disruptive changes in real exchange rates with their main trading partner or partners. U.S. dollar‐based CBAs with Mexico and Central American and Caribbean countries, and euro‐based CBAs in eastern European countries, thus could qualify as useful precursors to more complete and less reversible forms of currency consolidation. Currency boards established in distant outposts far away from the “peg” country and its currency area, however, represent false starts from the point of view of currency consolidation: they are likely to lead either to floating or to new forms of monetary union in their region down the road.

Even currency boards with the dominant currency next door may not survive for long when the respective financial systems are placed in direct competition with each other. The strength of trade and finance relations, say of countries in the vicinity of the United States or of Euroland, makes the almost complete financial integration and interest rate convergence that is available upon formally adopting the U.S. dollar or euro more attractive than staying in the halfway house of a currency board. Hence if currency consolidation is to be allowed, some form of monetary union is the way to achieve it. Whether that union should take the form of unilateral dollarization or of multilateral and comanaged monetary union as in Euroland is another important matter meriting detailed analysis. I have begun to explore some of these alternative ways of achieving currency consolidation elsewhere (von Furstenberg, 2001, 2002).


As was the case centuries ago, small open economies now make much more use of foreign money, especially the dominant currency of their region, than international trade analysis and past measures of effective exchange rates have tended to recognize. The currencies of financially small countries, in (p.216) particular emerging market countries, are at a distinct disadvantage in both spot transactions in the electronic marketplace and in intertemporal trade and insurance. Even direct consumption insurance counsels residents of emerging market countries exposed to currency crises to keep away from investing in their own currency at home lest shocks to their income be compounded by shocks to their wealth. Foreign financial institutions from the key‐currency countries often bring financial services that are denominated in those very same currencies that the market demands.

Idiosyncratic exchange rate behavior and country risk premiums that are due, in good part, to currency risk are the downside to keeping small countries in small countries. Doing so is more likely to discourage and disrupt their membership in international supply chains than to promote adjustment to supply shocks. Even CBAs are unlikely to prove a highly durable substitute for the more complete forms of currency consolidation provided by regional monetary union. However, they may lead the way to such union if they are established with a peg to the currency that is most suitable for intense commercial and financial relations with neighboring countries in the respective region.


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