The Dominican Republic, like much of the extranjero vecino, is economically-married to the United States. Far more so, in fact, that any of the Russian Federation’s near abroad. The U.S. absorbs 72% of the country’s exports and provides 48% of its imports. Americans and Dominicans resident in the United States make up 38% of all tourist arrivals. Finally, and most strikingly, the huge hole in the Dominican Republic’s trade balance left after export sales and tourism receipts is plugged by remittances from Dominican workers living in the United States — an amount equal to 7 percent of the country’s GDP last year.
The relationship goes beyond mere commercial convenience: under CAFTA, Washington effectively sets Santo Domingo’s investor protections, labor standards, and environmental regulations. Eat yer heart out, Vlad.
Still, there is one way in which the United States is conspicuously absent from Dominican life — the main currency is the “gold peso,” not the greenback. That also wasn’t always true: between 1905 and 1946, the Dominican Republic used the dollar as its currency, and if anything, the economic relationship is closer now than it was then. This brings up three obvious questions, of course. Why did the D.R. reintroduce its own currency? What effects did that have? And should it go back to the dollar?
I’ll try to take a stab at all three below the fold.
As many of you may know, several countries in this hemisphere use the U.S. dollar as their currency. Panama has used it continuously since 1903; El Salvador and Ecuador have recently joined Panama. Several West Indian territories, most prominently the Bahamas, also use the greenback, although most also issue their own fully-backed bills at par. Elsewhere, the dollar is legal tender in Liberia, East Timor, and the jurisdictions formerly known as the Trust Territory of the Pacific Islands.
The Dominican Republic has a history of adopting foreign currencies. After a long and dolorous period of paper money, the D.R. adopted the French franc in 1889. This was a bit of a problem, since most Dominicans conducted their business in Mexican silver pesos, and the franc had a higher silver content than the peso at the official exchange rate of FFr5 = M$1.25. So the D.R. switched to the Mexican silver peso in 1891. In 1894 the country switched its monetary standard to gold, introducing the “gold peso” at par with the gold dollar, but the desperate Heureaux government continued to force the national bank to print paper money until Heureaux died in a hail of bullets in 1899. (This makes reading primary-source statistics from the period rather interesting.) In 1900, the government officially abandoned the gold peso and adopted the U.S. dollar, but no one noticed, so they went ahead and did it again in 1905.
Dollarization lasted four decades. The United States killed it, something that should not be surprising to anyone familiar with the tenor of the late 1940s. In 1946, a group of American advisors convinced Trujillo to re-establish a Dominican central bank and reintroduce the gold peso.
The economists who advised Trujillo seem amusingly naïve to a more-informed ear: “The continued existence of dollar contracts and payments would deprive the monetary authorities of much of their power.” True ... but by “monetary authorities” they meant Rafael Trujillo. Would depriving him of power be a bad thing?
Well, the general answer to that question is no, but in terms of control over the currency it’s actually hard to say, since the gold peso remained pegged to the dollar throughout Trujillo’s reign. In 1963, two years after his fall, a black market opened up. By 1985 the difference between the official value of the currency and its black-market value was too great (Venezuela is currently replaying this movie), and in that year the government finally let the currency float. The gold peso immediately lost more than two-thirds of its value.
Dominican growth stagnated in the 1980s, but growth also stagnated in Panama, which used the greenback. (Although, as Carlos has pointed out, Panamanian growth stagnated for rather different reasons.)
Perhaps a better test would be Panamanian and Dominican economic performance before the 1982 international economic crisis, during which Panama used the dollar and the D.R. used a currency pegged to the dollar at 1-to-1. Panamanian labor productivity grew only a little bit faster than Dominican between 1951 and 1982 — 5.8% versus 4.9%. Considering Panama’s other advantages, it’s hard to say that dollarization made the difference.
Similarly, both countries have turned in impressive growth performances over the past decade, despite the phenomenal Dominican banking crash discussed in a previous post. In fact, it wouldn’t be hard to argue from theory that the D.R. would have done rather worse had it adopted the dollar around the same time that Ecuador and El Salvador did, say in 2000 or 2001.
The D.R., unlike Panama, had neither a sophisticated banking system nor a similarly sophisticated system of bank regulation. I have no reason to think, therefore, that dollarization would have prevented the kinds of shenanigans that brought down Baninter in 2003.
A dollarized Dominican Republic been confronted with the same banking crisis, its central bank would not have been able to print money in order to insure depositors. Rather, it would have confronted three rather risky options.
One would have been to let the banking system collapse — that would almost certainly not have ended well.
A second option would have been to have the government go out and borrow dollars in order to pay depositors. God only knows if the D.R. would have been able to obtain money from the markets at an acceptable interest rate — I tend to be skeptical. The IMF would be a more likely option, and the IMF did in fact help out the D.R. during the crisis ... but the scale of needed help would have been far larger, and the IMF has a record of requiring governments to undertake ... ah ... counterproductive actions in the midst of economic crises.
The U.S. government could have lent the money to the D.R., but considering how much political capital the liberal Clinton Administration needed to burn to help very important Mexico in 1995, I’m not sure whether the rather more conservative Bush Administration would have bothered to help not-so-vital Santo Domingo in 2004.
Finally, a dollarized Dominican Republic could have imposed de facto partial capital controls. For example, the government could have guaranteed depositors while simultaneously preventing them from converting those deposits into dollars at the banks for a period of time. Depositors would still be able to make domestic payments by writing checks.
That, however, would have created all sorts of strange distortions — would you have taken a “guaranteed” check from your customers? If so, by how much would you discount it? I’m not saying that it would have necessarily been impossible to handle the crisis without a lender of last resort — bank holidays and “suspensions” have a very long pedigree in the United States. I am saying that it’s not clear why using the dollar in the context of a severe banking crisis would have been any better than having your own currency ... and there are several reasons to think that it might have been worse.
That’s theory. Any practice? Actually, yes: Ecuador, in fact, dollarized in 2000 in the midst of a collapsing economy, a debt default, and a serious banking crisis. It carried out a combination of options (2) and (3). The government froze all bank deposits. They were only slowly unfrozen. The government took over 16 banks, and eventually shut 14 of them after paying depositors. Despite the fact that the central bank could no longer print money if needed to lend to troubled banks, depositors did not panic when the government finally unfroze their money. The mere fact that the country had adopted the dollar as its currency created confidence in the stability of the banks.
In addition, dollarization helped the government pull off the miracle of reducing inflation and interest rates simultaneously, although inflation fell by more than nominal interest rates (1900 versus 400 basis points in the first year), which created some drag on the economy.
That said, Ecuador’s boom over the last few years has clearly been due to high oil prices and booming production, not dollarization. El Salvador provides an additional test. El Salvador dollarized during a period of economic calm, if slow growth. So what happened? Not a whole lot. Inflation was already low, and it stayed low. Interest rates fell, but investors and entrepreneurs haven’t seen vasty new business opportunities as a result: investment remains relatively low and growth remains relatively slow. If you squint hard, dollarization might have increased the amount of remittances that the country receives, because it reduced the cost of sending money from the U.S. ... but you have to squint real hard.
So what about the Dominican Republic? Should it dollarize? Well, it could. The central bank holds more than enough dollars to replace the entire stock of gold pesos in circulation. It holds almost enough, in fact, to replace the entire stock of gold pesos and all demand deposits at the banks: as of the third quarter of 2007, the central bank held $2.6 billion, while M1 totaled $3.2 billion. So dollarization probably wouldn’t result in a bank run — in fact, the Ecuadorian experience indicates the reverse.
In addition, inflation and interest rates would probably drop a lot, albeit maybe not as quickly as one might hope. Inflation ran over 8% in 2007, and lending rates averaged around 16%. Dollarization would bring both down.
The biggest cost would be in foregone interest on the Dominican central bank’s dollar reserves. (Aka “seigniorage.”) After all, the central bank doesn’t literally hold them in a vault; it invests them in Treasury bills and American banks. If it needed to liquidate some part of those investments in order to replace gold pesos with greenbacks, then it would lose the interest that those investments earned.
It’s also unclear what benefits dollarization would bring. Would Americans be more likely to invest or travel there if the country used the greenback? I have my doubts. Would local entrepreneurial energy be unleashed with lower interest rates? I have my doubts about that too, borne out by El Salvador’s experience. What about economic stability? Don’t fluctuations in the exchange rate play havoc with the prices faced by ordinary people for imported goods? Again maybe ... imports come to only 31% of Dominican GDP, and it isn’t clear that additional exchange rate volatility makes wholesale importers’ lives much more difficult than regular old price volatility.
Finally, would dollarization make the country be less vulnerable to foreign shocks? Well, maybe. One might that foreign investors would be less likely to dump assets in fully dollarized economies. In a world of separate currencies, you might think that your investment in Dominican hotels or commercial paper or whatever was a good investment, but decide to sell it anyway out of fear that the value of the currency might fall. In a dollarized world, the fear of a currency fall goes away. The thing is that the fear of falling (currencies) isn’t the only thing prompting investors in one asset class to sell when something bad happens to another part of the economy.
In addition, a dollarized Dominican Republic would lose the “shock absorber” provided by a flexible exchange rate. A sudden drop in the desire of European wastrels to bum around Santo Domingo right now shows up in a drop in the value of the gold peso, in effect discounting Dominican vacations without forcing Dominican workers and businesses to accept nominal drops in their income. No exchange rate, no shock absorber. That might not be a terrible thing in the long-run, but one can still imagine things getting rather ugly in the short one.
If Dominican dollarization meant getting the full package (access to the Fed window in exchange for Fed regulation of the banks and compensation for the loss of seigniorage revenue), then I’d say it’s a no-brainer. But it doesn’t, and so I’d have to say that the ultimate decision would have to be political. Do Dominicans feel better living in a country that uses the ... uh ... rock-solid currency of its vecino extranjero? Then they should dollarize. Do they prefer the emotional frisson that comes from having their own money? Then they shouldn’t.
Of course, I’m just an (economic) historian working at a business school. And I can’t shake a gut feeling that dollarization should be beneficial for a country in the D.R.’s position. But I also can’t come up with a good justification for that gut feeling either.
As so often, I end with a call for comments and advice from those with more or different knowledge than myself. Is dollarization (or unilateral euroization) a wise policy for small states trapped in the near abroad of a larger neighbor?