Dollarization is the tendency for countries to use the US Dollar (USD) or another foreign currency in local transactions. It can take place unofficially or officially, directly or indirectly. Pegging a local currency to a foreign one is a method of indirect dollarization. The advantages of dollarization are typically seen as stability of the local currency and a reduction of risk. The disadvantages include the inability to administer monetary policy and other controls over the local economy.
The incentive for dollarization is apparent in the case of a developing country. With a more stable currency, such countries are in a better position to attract foreign investment in their infrastructures and economies. Long-term investors are generally weary of unpredictable currencies. With larger risk, the chance of receiving no return on one’s investment is significant.
First of all, dollarization can occur unofficially. When a local currency tends to have high inflation or fluctuating value, people often prefer to use a more stable foreign currency. This can be seen in many border towns or regions in countries adjacent to a more developed country. Seeking the stability of the foreign currency, sellers of goods and services may accept or demand the foreign money for their transactions. Official policy may ignore the use of foreign currency, but if it is frequent enough, this is considered one form of dollarization.
Official dollarization can also occur. In this case, a country’s monetary authorities cease to produce local currency and adopt a foreign one. The countries of Panama, Ecuador, El Salvador and others have adopted the US Dollar in this way. Official dollarization is perhaps the most direct way of reducing monetary risk in a country. On the other hand, it causes a country to lose out on the benefits of monetary policy. Monetary policy is a tool available to governments to manipulate interest and inflation rates, which in turn affects overall economic activity.
One type of indirect dollarization is to peg a local currency to a foreign one. Pegging is essentially “anchoring” the value of local currency to that of a foreign one by locking in a fixed exchange rate. In this way, local currency notes are still used, but their value will remain tied to a foreign currency. The currencies of both Saudi Arabia and Cuba have recently been pegged to the US Dollar, while the currencies of many West African countries have been pegged to the euro.