What is Dollarization?
Dollarization is the process by which a country decides to use two currencies – the local currency and generally a stronger, more established currency like the US dollar. A dollarization process can either be partially or completely done.
Many times, it is performed because residents no longer believe in the domestic currency and instead prefer to diversify their assets outside of the domestic currency. It is also done to help developing countries encourage foreign direct investment and provide economic stability within their borders.
There are two different dollarization and currency substitution methods. The first being partial dollarization/currency substation, and the second being full dollarization/currency substitution.
- Dollarization is the process by which a country decides to use two currencies – the local currency and generally a stronger, more established currency like the US dollar.
- One of the strongest advantages of dollarization for smaller, less developed countries is the ability to trade in a currency that is stronger and more internationally recognized.
- Dollarization carries with it the risk of a loss of autonomy for a developing country that adopts it.
Trade Advantages with Dollarization
One of the strongest advantages of dollarization for smaller, less developed countries is the ability to trade in a currency that is stronger and more internationally recognized. It will often bring about a positive effect on international trade for the countries, as the outside currency they use is more widely accepted and can be more stable and less prone to market volatility.
Dollarization can promote the long-term effect of encouraging more international businesses to set up localized offices to take advantage of the stable currency and help the local economies to develop quicker.
A developing country can become a larger international player than if it retained its own currency, especially if its economy is in a recession or is experiencing difficulties breaking out of a poverty cycle.
Financial and Investment Industry Benefits with Dollarization
Dollarization can provide the direct benefit of encouraging outside foreign direct investment (FDI). When individual investors or corporations see that the local currency of a region is already established, and they do not need to incur exchange rate fees or monitor currency fluctuations, they may be more likely to invest and expand operations into that country.
Companies will see that the income they incur while conducting operations in a developing country utilizing partial or full dollarization can minimize their risk and give them an income stream in a stable currency.
Risks of Dollarization
Dollarization carries with it the risk of a loss of autonomy for a developing country that adopts it. When a country does not build and develop its own currency, it runs the risk of allowing its monetary policy controlled by a foreign country.
If the developing country and the country whose currency they are adopting enter a politically contentious relationship, it could spell disaster for the developing nation that relies on a currency that is not theirs. It may make it difficult for any country to fully develop if they do not have control over the money supply and currency within their nation.
Further, a country may choose to ban its currency from being adopted in any other country. It would be outside of the developing country’s power to control and could put them in an extremely difficult situation where they may see the foreign currency they primarily utilize restricted and removed from their economy.
It could also turn into an exodus of multinational companies who only set up shop in the developing country because they could use a foreign currency. Such risks must be carefully weighed by any country choosing to adopt dollarization (either partial or full) as a cornerstone of its economic and fiscal policy.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: