Dolarización y pesificación en el extranjero vecino

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? 

Comments

[Carlos]

Imports are about a third of Canada's GDP as well. I'm not seeing an internal push for Canada to become US-dollarized. Even during the Bretton Woods years, Canada spent more time on the float than in the band. And although the Dominican Republic's economy is much smaller than Canada's, in terms of population, it's as large as Canada west of Ontario -- the areas which benefit most from the float, I suspect.

So the mechanism in favor of dollarization can't be the inherent goodness of a common currency itself.

You mention Panama's success with dollarization. But Panama also shows the risks of dollarization and American interference in local politics -- with the proviso that while Panamanian financial institutions were quite strong, its monetary institutions were exceedingly weak. If strong-armed with the dollar by the United States, the Dominican Republic would simply dust off the printing presses. So why dollarize in the first place?

And I'd think the Bayesian prior for some sort of malign intervention by the United States from the Dominican perspective would be rather high. I don't think it's a question of emotional frisson, but Realpolitik from a small, oft-squashed, nation's viewpoint: a desire to preserve policy flexibility and autonomy in the teeth of neighbors who don't necessarily have one's best interests at heart.

I suppose Denmark vis-a-vis the euro might be another example of this.

[Noel Maurer]

Your political analysis makes sense, although I have a quibble and a question.

The quibble is that the costs to Denmark of maintaining monetary autonomy are far larger than for the Dominican Republic, simply because Denmark religiously fixes to the euro while the D.R. floats against the dollar. Danes pay an extra half-percentage point in interest for the privilege, but (in practice) obtain no autonomy as a result.

That is a quibble: as you say, Denmark is paying to retain an option.

The question regards Panama. Why did the country have so little ability to introduce its own currency? After all, Honduras and the D.R. both pulled that off; it's hard to imagine that Panamanian were less intrinsically capable.

I suspect, rather, that it was endogenous: Panama used the dollar --> developed a sophisticated foreign-dominated banking sector based on the dollar (and implicit Fed support for a chunk of the nation's banking system) --> decided that the costs of abandoning the dollar were huge.

That said, I'll know the answer soon enough. When are we going to meet next about the project?

[Noel Maurer]

Here's an argument against my own position, Carlos: I'm assuming that a drop in local-currency real interest rates and the elimination of exchange rate risk won't have any effect on investment.

My evidence comes entirely from continuing slow growth in El Salvador.

Does that /really/ follow?

[Doug M.]

Some random thoughts.

Remittances closing a current account deficit: this is much more common than people seem to realize. In places like Moldova, Albania and Armenia the macro effect of remittances is huge. It's the reason that (for instance) the Armenian dram has been rising against the dollar instead of collapsing miserably. In extreme cases -- and Armenia is fairly extreme -- you get a variant of Dutch disease: the constant remittances make the currency /too/ strong (the strong dram is killing Armenia's diamond polishing industry) and distort the economy in various other ways.

Exchange rate risk: I note in passing that, over the last few years, making non-dollar investments would have been a good idea much more often than not.

Euroization: it doesn't exactly match, because there are big, big non-economic aspects to joining the Eurozone. For most of the new members, it's a sign that they've almost graduated -- the next-to-final step in becoming Really European. (Schengen borders would be the last.) IMO it's /not/ in Hungary or Romania's interest to join the Eurozone; in fact, I don't think they should even be pegging. Hungary's had to do a couple of surprise devaluations already, and Romania has only avoided it by keeping their float loosey-goosey and doing other stuff with interest rates and sterilization.

BTW, you didn't mention Puerto Rico. How does it fit?

Doug M.

[Noel Maurer]

Hi, Doug,

Re remittances and the Dutch disease: I wrote a case on the Philippines, much of which dealt exactly with that issue.

Re euroization: one of the problems assessing dollarization v joining the eurozone is that for most E.U. members, as you say, adopting the euro is the last stage of integration. The marginal effect of a common currency --- /once all other barriers have been swept away/ --- might be huge. Most dollarized countries, though, don't sweep away any of those barriers before dollarizing: CAFTA is weak gruel compared to the acquis and the right to appeal to European courts.

And that's why Puerto Rico (and to a slightly-lesser extent the TTPI) is different. It's got free labor mobility, huge government transfers, and a common body of commericial law. It's banks are treated as American banks, and the Fed carriers out lender-of-last-resort functions. Finally, Puerto Rican imports of goods and services come to a full 94 percent of GDP --- if the D.R. was at that level, I'd say that dollarization might be a pretty good idea.

In other words, a separate currency for Puerto Rico would merely raise transaction costs without netting much policy freedom --- unlike the D.R., P.R. is fully integrated into the American economy.

Finally, one last bit of food for thought: joining the euro and euroization aren't quite the same thing. When a country joins the euro it gets access to a lot of ECB services (including, in theory, a share of seigniorage revenue), but a country could adopt the euro without officially joining the ECB. Montenegro and Kosovo would be two clear examples. Unilateral euroization (or joining the eurozone) are very different commitments from simply pegging the exchange rate ... so it isn't necessarily wrong to argue that a country is having trouble with a peg and therefore should consider simply adopting the currency to which its money is pegged.

I'd love a related macro post from you ... what is going on in the pegged E.U. countries and in the euroized Balkan outposts?

[Gloria Hunter]

DOUG, Is that you????? If so send an email to me. [email protected] I happened to see this blog with your name and am not sure if it's the Dough Muir I knew...pictures look very different.

gloria

[Carlos]

Regarding Panama, in normal situations, there would be few positive reasons to make a changeover to an independent currency, and a number of negative ones. In my opinion, the most important negative effect is also the least quantifiable: an independent balboa would be considered a negative signal to investors and foreign users of Panamanian services. But there would be subtler effects, having to do with the unusual service-based structure of the Panamanian economy. The easiest way to avoid them would be for the services to remain dollar denominated -- so why change? It would not help Panamanian political stability to have a balboa-dollar exchange rate affect employer-employee relations in their service industries.

The abnormal situation, a monetary embargo, was literally a once in a century event. There, an independent currency -- let us call it the piña -- would have alleviated much of the effects of the Abrams-induced depression. But the benefits of the piña would in my opinion be balanced, and perhaps overwhelmed, by the signal this would send to the foreign users of Panamanian services at that time. It's hard to say, because an undetermined amount of Panama's service economy at the time centered around narcodollars, and one assumes that the risk preference of drug traffickers are a little off the norm. But I'm having difficulty seeing Big Al in Cali seeing the piña as a positive development.

This week is resume hell. Chicken bus next week?

[Doug M.]

Short on time at the moment, but let me throw out a tidbit. Back in February, when Kosovo was about to declare independence, everyone was worried about Serbia closing the border.

Since the majority of Kosovo's imports come from Serbia, and the plurality of its exports too (such as they are), this would have been a major disaster for Kosovo. And not one they could easily deal with, either; Kosovo is kind of a cul-de-sac. The border with Albania is all mountains, with only a couple of crappy two-lane roads, and there's just one not-so-great rail link to Macedonia.

But I said the Serbs wouldn't do it, and I was right. Two reasons. One, most of the trade with Kosovo takes place with southern Serbia -- the most nationalist and conservative part of the country, as it happens. So, an embargo would suck money from the pockets of... the supporters of the parties who'd be pushing an embargo. Politically, they'd be shooting themselves in the foot.

Second reason: Kosovo's on the Euro! Serbia runs a huge trade deficit with the Eurozone, but Kosovo runs a big trade deficit with Serbia. The Kosovo trade doesn't close the deficit, but it makes it a lot less uneven than it would be otherwise. If the border closed, and those Kosovar Euros stopped flowing in, the Serbian Central Bank would find itself in a rather ugly situation.

Okay, must read to little boy now. More perhaps anon.

Doug M.

[Noel Maurer]

Doug, HDTD desperately needs a euroization post from you. Desperately.

At least I'd like one. Or two, maybe three. It's a big topic.