Dollarization

Dollarization refers to the situation in which a country uses a foreign currency, typically the US dollar, in place of its own domestic currency for most transactions and reserves. It can be official, where the foreign currency is given legal tender status and the central bank cedes monetary sovereignty, or de facto, where the foreign currency circulates widely even without formal legal endorsement.

In official dollarization, a country adopts the foreign currency as legal tender and often eliminates or limits the national currency. This can stabilize prices and reduce inflation, but it also means the government loses independent control over monetary policy and seigniorage. Ecuador adopted the US dollar in 2000, making dollarization official. El Salvador followed in 2001, using the US dollar as legal tender alongside the local currency. Panama provides another example of de facto dollarization, where the US dollar is widely used and the balboa is pegged to the dollar, but the country maintains some local monetary arrangements rather than a full currency replacement.

In de facto dollarization, residents and businesses prefer or insist on using a foreign currency without formal legal replacement of the domestic currency. This can occur through widespread dollar-denominated deposits, loans, and prices, often in response to prior instability or macroeconomic weakness. Panama is a prominent case of extensive currency substitution without full official dollarization.

Impacts of dollarization include greater price stability, lower inflation, and potential lower borrowing costs due to perceived credibility. However, dollarization also entails loss of monetary policy autonomy, reduced ability to respond to domestic shocks, and possible erosion of fiscal flexibility through diminished seigniorage. The overall effects depend on accompanying fiscal discipline, financial sector reforms, and the stability of the global currency issuer.