Dollarization: Policies and Politics

Whether Argentina and Mexico should replace their currencies with the dollar has become a prime topic for debate.
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Policymakers in developing countries are groping for ways to avoid -- or at least minimize -- the risk of a paralyzing currency crisis. The most recent global crisis, which started in mid-1997 and continued through the Brazilian devaluation early this year, was on one level precipitated by the house of finance's realization that many countries had inappropriate currency regimes.

There are essentially two general types of currency regimes, or systems: fixed and floating. Within each is a variety of schemes. The countries that seemed to have been hit the hardest by the latest financial crisis were those that had some variety of fixed exchange rate, including Thailand, Korea, Russia and Malaysia. In these and many other cases, the currencies were tied in some way to the dollar.

Even in countries like Brazil, which used the aptly named crawling peg system to adjust rates, these systems were perceived as too inflexible. If the external value of the currency (i.e., its foreign exchange price) could not absorb the pressures created by a market economy, then interest rates or the real economy must bear the burden, usually as a higher domestic cost.

This was one of the lessons that policymakers appeared to learn from the global financial crisis and what lay behind

Treasury

Secretary

Robert Rubin's

"suggestion" that

International Monetary Fund

resources no longer be used to defend a fixed currency regime.

However, a number of Latin American officials seem to be going in the other direction. Recently, Argentine and Mexican officials have discussed the possibility of replacing their currencies with the dollar. This process, called dollarization, is a variant on a fixed exchange-rate system and thus has all that system's advantages and disadvantages.

Why would a country voluntarily give up its own currency, one of its most potent symbols of sovereignty? Because by adopting the dollar -- or any other established strong currency, for that matter -- it minimizes the risk of devaluation, encouraging trade and capital flows. That helps to lower interest rates, which in turn stimulates the economy and minimizes the country's exposure to contagion in the future. In essence, the country outsources its monetary policy, allowing the "dollarized" country to share the credibility of the

Federal Reserve

.

Argentina currently has a variation of a fixed exchange rate in the form of a currency board, which limits the issuance of local currency to the supply of dollars Argentina holds in its reserves and thus pegs the peso one-to-one with the dollar. This prevents the central bank from boosting the economy -- and inflation -- by printing money.

Mexico has pursued a variation of a floating exchange-rate system ever since the last of the peso's many crises in 1994-1995. It largely lets the market determine the value of the peso, but it has made clear the magnitude of a peso move that would elicit intervention, and how much officials were prepared to spend at any one time to stabilize the peso's value. This may have helped the support the peso -- up 5.6% against the dollar since Jan. 1 -- at a time when close ties to the U.S. economy and net capital inflows have made it one of the better-performing currencies against the greenback this year.

One of the risks of dollarization is that monetary policy appropriate for the U.S., an advanced industrial country, may not be appropriate for Mexico, Argentina or other industrializing countries. However, Argentine officials, for example, think adopting the dollar will underscore their commitment to maintain the value of their currency, thereby reducing the risk premium -- currently around 2 percentage points -- that global investors demand from Argentina. In fact, Argentina's president,

Carlos Menem

, argues that dollarization would add 2% to the underlying growth rate.

Among the possible objections is loss of sovereignty. Few have complained about this because monetary sovereignty is mostly a figment of the imagination. Surely no one seriously believes that Argentina enjoys much independence in monetary matters with its currency board. On paper, it may appear as though Mexico can pursue independent monetary policy, but in practice, it is circumscribed by U.S. policy. With the Fed apparently giving greater weight to international variables in its policymaking equation, even the independence of U.S. monetary policy may not be as great as often thought.

In any event, almost 30 generally small countries currently use the U.S. dollar as legal tender, including Panama and Puerto Rico. Some U.S. officials acknowledge that Panama's dollarization has helped it to develop its capital markets.

By and large, dollarization has taken place with U.S. approval. However, there is no commitment from the U.S. to take those countries' interests into account when setting policy. Nor will the Federal Reserve act as the lender of last resort for those countries. The measurable cost to the U.S. is negligible, though there would seem to be some operational issues arising from the fact that more dollars are in circulation outside the U.S. than inside.

The decision to dollarize is ultimately a political decision. Argentina holds its presidential election later this year, while Mexico will hold national elections next year. Consensus has not clearly been reached in either country to dollarize. There are some practical difficulties, and both countries will want to confer with the U.S. So dollarization, if it comes at all, appears to be years away. Nevertheless, by simply indicating in public that dollarization is being discussed, officials earned goodwill from the market, helping rally local debt and equity markets.

Do you think dollarization might help to prevent future currency crises?

Yes

No

Do you think allowing other countries to use the dollar as their currency poses risks to the US?

Yes

No

Would other currency regimes be more effective in promoting more stable currency values, particularly in the emerging markets?

Yes, currency boards seem to be a good compromise between floating currencies and dollarization.

Yes, "crawling pegs" work to aim a currency toward its long-term equilibrium value.

Yes, despite all the problems, I still think fixed exchange rates are the best.

Yes, there is no long-term alternative to freely floating currencies.

No, dollarization seems to offer the most promise.

Marc Chandler is an independent global markets strategist who writes daily for TheStreet.com. At the time of publication, he held no positions in the currencies or instruments discussed in this column, although holdings can change at any time. While he cannot provide investment advice or recommendations, he invites you to comment on his column at

commentarymail@thestreet.com.