Zimbabwe could dollarize ......but?

There have been calls for Zimbabwe to dollarize as a solution to the foreign currency shortages. There are signs the country has already somehow dollarized (unofficially).Dollarization occurs when the population of a country use foreign currency in parallel to or instead of the domestic currency. This is mainly a result of total loss of confidence in the local currency. Official dollarization means the dollarised country has relinquished its own independent monetary policy and imported the monetary policy of the issuing nation.

Dollarization can occur unofficially, without formal legal approval, semiofficially (or officially bi-monetary systems), where foreign currency is legal tender, but plays a secondary role to domestic currency. Officially, when a country ceases to issue the domestic currency and uses only foreign currency. Even when people transact in local currency but using multiple or unofficial exchange rate this shows dollarization is now in effect. This is what is now happening in Zimbabwe as citizens find it better to transact in foreign, stable currency whose value is predictable.

Dollarization normally comes due to hyper-inflation which it self was a result of unsound Economic policy supported by printed currency. A society gets better and rich by producing goods and services and by saving money. Printing money and dumping it in the Economy won’t do it. Creating money out of thin air may temporarily seem wise as a historical look will show that eventually the medicine is worse than the disease. The end is very identical worthless currency, destroyed economy and a bankrupt nation. No nation has ever been known to have printed its way to prosperity. When you print money all existing money in circulation rapidly becomes worthless. This situation normally leads to dollarization as to what has happened in Zimbabwe.

The fact that many emerging countries suffer from bad governance, tax evasion, crony capitalism, high political risk, non-functioning bankruptcy laws, corrupt judiciary systems, political strife, etc., also favors polarization as an exchange rate regime. At the core of the vulnerability of some emerging economies lies a lack of credibility of domestic policy-making bodies, and imperfections in the globalized capital markets .
The term dollarization is not only applied to usage of the United States dollar, but also generally to the use of any foreign currency as the national currency. As an example if Zimbabwe was to adopt the Botswana Pula or the South African Rand that would qualify as dollarization.

Until as recent as a decade ago, official dollarization received practically no attention because it was considered politically impossible .Since then it gained prominence after several countries have considered and implemented it as official policy. The major advantage of dollarization is to promote greater financial stability and a lower inflation rate.

Hyper-inflation, brain drain, capital flight, contagion, unstable and sharply depreciating exchange rates, severe foreign exchange speculation, social hardship, political instability and generally lowered standards of living followed such exchange rate crises. Many of the emerging economies lost their access to international financial capital resources because of the decline in their credit ratings, depleted reserve levels, and international debts.

An interesting option regarding an exchange rate system for emerging and developing countries is full or official dollarization. The interest in dollarization is relatively recent, and has increased since the 1990s. With dollarization the local or national currency is replaced by the US dollar or other prominent currency.

The most important officially dollarized economies as of June 2002 were Ecuador (since 2000), El Salvador (since 2001) and Panama (since 1904).As of August 2005, the United States dollar, the Euro, the New Zealand dollar, the Swiss franc, the Indian rupee and the Australian dollar were the only currencies used by other countries for official dollarization. Several countries, among which , Liberia, Monaco, Puerto Rico, Greenland, Micronesia and others, have adopted dollarization as their exchange rate regime as well. In addition, the Turkish new lira and the Russian ruble are used by internationally unrecognized but de facto independent state Countries dollarize because of a lack of policy credibility and to obtain monetary and economic stability by importing it from another country.

For many countries, dollarization seems a natural step because of the large amounts of dollars present in their monetary systems. The primary intention of dollarization is to obtain monetary stability by importing it from another country.

Official dollarization means the national economic agents use a foreign currency, most often the US dollar, as legal tender parallel to or instead of their local currency. This happens when a country legally and officially abandons its own currency (except perhaps coins) and adopts that of another country. The latter country’s currency then serves as means of payment, unit of account and store of value. The money supply is denominated in dollars/foreign currency and is supported by the balance of payments and by a sufficient amount of foreign currency reserves. Since Zimbabwe does not have sufficient foreign currency reserves official dollarization will not be easy to implement. Full dollarization is similar to a complete monetary union with a foreign country whereby the foreign currency becomes the legal tender of the local economy.

Dollarization also may result in the abolishment of the central bank, since most of its functions, notably the monetary policy function, the note issuing and the lender of last resort function, cease to exist. A few remaining departments will probably be transferred to a government body (e.g. Ministry of Finance) together with the assets and liabilities of the former central bank. Given the current power and influence of the Zimbabwean Central Bank official dollarization is out of question as it will curtail most of the activities being driven from the RBZ.

Dollarization does not necessarily mean that only one foreign currency is introduced, although that is generally the case. Bi-monetary systems, where a foreign currency dominates bank deposits, but not wages, taxes and everyday transactions, are variants of dollarization. In this case, the foreign currency plays a subsidiary role, as in Namibia and Lesotho. Such countries are usually located close to a dominant economic and trading partner and are tied to it by their heavy reliance on trade and investment with that specific country.

The reasons why some countries switch to dollarization is that it replaces the domestic monetary authority’s poor policy credibility, which is reflected in violations of exchange rate pegs, a history of easy government finance and large fiscal deficits, as well as high inflation. The latter events cause further expectations of devaluation, inflation and chronic high interest rates, as well as a flight out of local into foreign money and assets.

By dollarizing under such conditions, country imports exchange rate credibility so that financial operators may believe that the country will adhere to it under all circumstances and thus not speculate against the currency. This can bring about currency stability and allow the investment environment to be conducive for increased production and exports.

Countries with volatile exchange rates, high inflation rates, and whose trade and financial flows are integrated with the dominant country, will benefit the most from dollarization. These can be extended to those countries with a track record of poor macroeconomic instability, resulting in high inflation rates and high inflationary expectations. When the internal banking system is fragile and prone to crisis (partly due to unofficial dollarization), it strengthens the argument for dollarization even further.

Dollarization, if it is not supported by the political, social, institutional and economic reforms necessary to create a conducive economic environment, will not suffice. Dollarization is not a solitary monetary panacea to solve all current economic problems in a country. It can never be a soft substitute for other important reforms that may be unpopular but necessary to implement. Indeed, one of the vexing uncertainties regarding dollarization is whether governments, not known for maintaining discipline but rather for reneging on their promises, can be compelled by an external disciplinary force such as dollarization to permanently abandon their old ways and habits such as printing money.

Dollarization is in many ways similar to floating your exchange rate as it leaves the market forces to play out. This means the policy can’t be in isolation but has to be followed up with credible efforts to improve foreign currency earnings and receivables to stabilize the foreign exchange market and the economic environment.

Gilbert Muponda is a Zimbabwe-born entrepreneur. He can be contacted at gilbert@gilbertmuponda.com .This article appears courtesy of GMRI Capital. More articles at www.gmricapital.com