Dollarization, in a nutshell, transpires when a nation uses foreign currency to substitute theirs. Although the terminology may have different interpretations, officially what happens is a country ceases the use of their own domestic currency and opts for a much stabile foreign currency, usually to help aid their already ailing economies. Although similar in effect, dollarization is another slow but sure-fix alternative to pegging or maintaining a floating currency, which are all efficient methods in endowing a much steady and secure economic and investment environment.

So far, currencies that have been officially used for dollarization are the United States dollar, the Euro, the Australian dollar, the Russian ruble, the Swiss franc, the Indian rupee, the New Zealand dollar, and the Turkish new lira.

Today, more countries in the world have dollarized their currencies to the US dollar as compared to any other foreign money. Amongst some of the countries that have adopted the US dollar as legal tender are British Virgin Islands, East Timor, Marshall Islands, Ecuador, Federated States of Micronesia, El Salvador, Turks and Caicos Islands, Palau, and Panama. These countries may have opted for dollarization due to its emerging and transitional economies, or could also have had owing issues with rising inflation.

Dollarization wasn’t always an approachable option though, as it was previously believed to be not viable on a political stand point. However this changed in 1999, when it began gaining a reputation as an implementable strategy by a number of countries in dire need of an economic surge. This was probably because it was thought to be the most instrumental strategy in lowering inflation and promoting better financial strength.

Many of these countries may have also already been using US dollar informally in prior to fully engaging in dollarization, probably in private or public transactions, banks accounts or even contracts. The full switch to foreign legal tender would mean that individuals and institutions were beginning to desperately protect their interests against an imminent and fore-seeable devaluation of their local exchange rate. Dollarizing their economies would also mean that their financial markets become more credible, ending any further damaging financial speculations and further stifling capital markets. The fact that the disparities in exchange rate is no longer a threat is also a driving factor behind the reduction of interests on foreign lending.

Apart from many of its advantages, dollarization also has its short-comings. One of the main disadvantages of dollarization is a nation virtually gives up its right to directly control its own economy or administer any monetary policies, and its ability to manage exchange rates. This is primarily because with dollarization the country no longer prints its own currency.

Another drawback to dollarization is the practicing country will no longer be able to collect any profits from the issuing of currency. This happens when the cost of producing the currency is lower than the actual currency itself. The US Federal Reserve collects all profits in this instance. Apart from the negative impact this has on GDP, the country in its entirety also suffers a significant loss of income.

Dollarization also robs a nation of its sense of individualism, due to the autonomous financial and economic policy that’s conditioned with it. Whatever the pros and cons of dollarization may be, experts say that it is only to be used as an extreme alternative, as most countries that have adopted it finds it a process that is almost impossible to reverse, without causing long lasting financial repercussions that is.

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Tags: Dollarization, Economy, Exhange Rate, Financial Policy, US Dollar

This entry was posted on Wednesday, September 24th, 2008 at 10:47 am and is filed under Economy, Facts. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.