Dollarization of Economy

The term Dollarization has been used loosely in reference to how foreign money replaces domestic money in any of its functions. The influence of the dollar in the domestic market is also termed dollarization. The Indian central bank has raised concern about the dollarization of the Indian economy by dollar-dominated cryptocurrencies. Read here to learn more.

The use of a foreign currency in addition to or instead of a domestic one is known as currency substitution.  When the foreign currency is the dollar or the euro, respectively, the practice is also known as “dollarization” or “euroization.”

Full or partial currency replacement is possible. Following a severe economic catastrophe, full currency substitution can take place, as it did in Zimbabwe, El Salvador, and Ecuador.

Some smaller economies, for whom maintaining a separate currency is impractical, utilize the currencies of their larger neighbors; Liechtenstein, for instance, uses the Swiss franc.

Dollarization

The term Dollarization has been used loosely in reference to how foreign money replaces domestic money in any of its functions.

Three different concepts of dollarization are:

Asset Dollarization: The term Asset Dollarization refers to the use of foreign currency in any of the three functions of money: unit of account, means of exchange, and store of value

• Currency Substitution refers to the use of foreign money only as means of exchange. Thus, an economy can be highly dollarized, but not subject to currency substitution. Domestic currency may still be used for transactions.

Liability Dollarization: A key point that has emerged in the recent literature on currency and banking crises in emerging markets is that either the domestic banking system or the government can have relatively large foreign currency debt obligations. This concept is called liability dollarization.

• Therefore, a country can be scarcely dollarized on the asset side, but the loans made by the banking system can be mostly in foreign currency.

Partial and Full Dollarization: Full Dollarization is a situation in which a country abandons its currency and adopts another country’s currency as a means of payment and unit of account e.g., Panama. Few countries in the world have dollarized completely.

How did it originate?

Following the Bretton Woods Conference after World War II and the abandonment of the gold standard at the start of World War I, several nations sought exchange rate regimes to advance global economic stability and, by extension, their prosperity.

Most nations link their currency to a significant convertible currency. In contrast to “soft pegs,” which are more flexible and floating exchange rate regimes, “hard pegs” are exchange rate regimes that show a deeper commitment to a fixed parity (such as currency boards) or give up sovereignty over their currency.

Currency substitution became a significant policy concern in the late 1990s after “soft” pegs in Southeast Asia and Latin America failed.

The decision about which exchange rate system to adopt became more difficult as world trade and capital markets became more integrated.

The newest of the solutions was full dollarization, under which a country officially abandons its currency and adopts a more stable currency of another country- most commonly the U.S. dollar -as its legal tender.

• The main attraction of full dollarization is eliminating the risk of a sudden, sharp devaluation of the country’s exchange rate. This may allow the country to reduce the risk premium attached to its international borrowing.
• Dollarized economies could enjoy a higher level of confidence among international investors, lower interest rate spreads on their international borrowing, reduced fiscal costs, and more investment and growth.

Dollarization of the Indian economy

Most developing countries as well as transitional economies just adopting market mechanisms already have a limited, unofficial form of dollarization.

• To a greater or lesser degree, their residents already hold foreign currency and foreign currency-denominated deposits at domestic banks.
• In high-inflation countries, dollars or some other hard currency may be in widespread use in daily transactions, alongside the local currency.

The Indian economy has the possibility of becoming “dollarized” as a result of cryptocurrencies, according to RBI officials.

Cryptocurrencies are mostly issued by international private companies and are denominated in dollars.

Only 5% of Indian imports and 15% of its exports are from the US, but 86% of imports and exports are invoiced in dollars.

It was recognized that large-scale dollar-denominated assets within a country can disrupt the economy by creating the potential for destabilizing flows.

• India does not allow dollar-denominated transactions between residents. Exchange earners’ foreign currency accounts can be used only for external payments and if such balances have to be used for local payments, they have to be converted into rupees.

The counterpart of dollarisation is the internationalization of the domestic currency.

• For example, there are instances when a currency of a developing country could be officially traded outside the country without any underlying trade or investment transactions.
• When such currencies are held increasingly outside the country and there is a multiplication of such holdings, any expectation that there will be a fall in the currency due to fundamentals or contagion leads to widespread sales which results in a very sharp fall in the currencies especially when the local markets are not well developed.
• India does not permit the rupee to be transacted offshore, i.e., the Rupee is not allowed to be officially used as an international means of payment or store of value.
• Indian banks are not permitted to offer two-way quotes to NRIs or non-resident banks.

A highly conservative approach is adopted to the dollarization of the domestic economy and the internationalization of the domestic currency.

In July 2022, the Reserve Bank of India (RBI) unveiled a rupee settlement system for international trade by allowing special vostro accounts in designated Indian banks, a step towards internationalizing the rupee.

Also read: Effects of Liberalization on the Indian Economy

De-dollarization of economy

De-dollarization means lessening the influence of the dollar on international markets.

The US dollar is being replaced as the unit of account for transactions involving oil and/or other commodities, the purchase of US dollars to cover foreign exchange reserves, bilateral trade agreements, and assets denominated in the US dollar.

Because of the dominance of the dollar in the world economy, the United States has a significant effect on other economies. The United States has historically used sanctions to advance its foreign policy objectives.

De-dollarization is being pushed by the need to protect national central banks from geopolitical threats where the US dollar’s status as a reserve currency could be used as a weapon of mass destruction.

A new Russia-China payment system that eschews SWIFT and combines the Russian SPFS (System for Transfer of Financial Messages) and Chinese CIPS is currently being developed (Cross-Border Interbank Payment System).

Central banks will be forced to reevaluate their reliance on the dollar as a result of the prolonged conflict in Ukraine and the ensuing economic sanctions.

Also read: Basic Concepts of Economics In Simple Language

Way forward

By keeping a larger share of their foreign exchange reserves in other currencies, such as the Euro or the Chinese Yuan, governments can lessen their reliance on the US dollar.

Countries can encourage enterprises to utilize their currencies in international trade by offering incentives.

To lessen their reliance on the dollar, governments might create economic partnerships with other nations. To lessen the risk of currency volatility or to challenge the dominance of the dollar, governments may invest in other currencies.

The US dollar continues to be the preferred trading currency since no other currency is sufficiently liquid.

The world does not want a simple regime change or to be the target of the same manipulations, even if they come from another nation. The currency market must become more varied, with no single currency claiming control, to go forward.

Also read: Economic nationalism

­-Article written by Swathi Satish