Is the dollarization of Mexico warranted?

Leavell, Hadley ; Maniam, Balasundram ; Toombs, Leslie 等

ABSTRACT

The adoption of the dollar as the primary currency by a country is termed dollarization. This paper examines some of the general qualities that make a country a candidate for dollarization. Some of these qualities include being a part of an optimum currency area, having high inflation and devaluation, and having unstable prices. This paper then goes on to specifically evaluate Mexico as a candidate, and the related factors associated with dollarizing

Mexico. It was found that theoretically Mexico is an excellent candidate for dollarization. However, due to complicated political and social factors and the lack of long-term evidence in other countries, dollarization is not yet warranted for Mexico.

INTRODUCTION

There has been a great debate regarding the implications of countries adopting the U.S. dollar as their currency. Under dollarization, a country would give up its control over its money supply and its ability to conduct an independent monetary policy. In exchange, the country would enjoy the stability and credibility of the dollar (Salvatore, 2001). Dollarization, like any economic and financial change, has its benefits and costs which are country-specific. The implications of dollarization are extremely complex. Each country that evaluates dollarization will be faced with a vast array of challenges. Mexico has had a very volatile past in regards to its monetary position. Recurrent devaluation has plagued Mexico's peso for the past three decades (Garza, 1999). This in turn has been accompanied by severe price instability. Mexican leaders are currently seeking a solution to this problem. Dollarization is a possible solution, but it may lead to other social, political, and economic complications. This paper will address the criteria for dollarization, and its general implications. Then it will address Mexico fit for dollarization. Next, the position of the stakeholders will be addressed. Estimated benefits and costs associated with Mexico's dollarization will be addressed. Next, opposing viewpoints of Mexico's dollarization will be discussed. Finally, a conclusion will be made as to whether dollarization is recommended for Mexico.

LITERATURE REVIEW

The term dollarization refers to using U.S. dollars instead of domestic currency as a unit of account, store of value, or medium of exchange (Melvin & Peiers, 1996). It can also be viewed as the most extreme form of a fixed exchange rate (Velde & Veracierto, 2000). In its most basic form, dollarization occurs when a country willingly replaces its own currency with that of the U.S. dollar. In the case of Argentina, which has proposed to implement a full dollarization regime, it eliminates of the Argentina peso and adopts the U.S. dollar in all day-to-day Argentine transactions (Spiegel, 1999). Not only is the currency replaced, the adopting country must also relinquish its control over its own monetary policy and eliminate primary functions of its central bank. Lastly, it can no longer print its own currency and cannot function as a lender of last resort.

The various forms of dollarization can be explained by the following three general categories obtained from the U.S. Senate Joint Economic Committee, 2000 (Hansen, 2000):

1. Unofficial Dollarization which generally means that at least 30%
 of a country's money supply is in U.S. dollars. These countries
 include most of Latin American and the Caribbean, especially
 Argentina, Bolivia, Mexico, Peru and Central America; most of
 the former Soviet Union; and various other countries including
 Mongolia, Romania, Turkey, and Vietnam.
2. Semiofficial Dollarization, countries identified by the
 International Monetary Fund (IMF) who are using U.S. dollars as
 another legal tender in addition to their own domestic currency.
 In these countries, the U.S. dollar is widely circulated but
 plays a secondary legal role to the home currency. Countries in
 this category include the Bahamas, Cambodia, Haiti, Laos, and
 Liberia.
3. Official Dollarization which is full dollarization. This group
 of countries includes Guam, Marshall Islands, Virgin Islands,
 East Timor, Samoa, Turks, Puerto Rico, Panama, and Ecuador.

The adoption process of dollarization can either be accomplished unilaterally, whereby a foreign country adopts the U.S. dollar with no support and/or cooperation from the U.S., or bilaterally, which involves forming an official monetary agreement / association with the U.S. (Velde & Veracierto, 2000). An additional type of dollarization, referred to as a multilateral agreement would involve creating an accord between several countries and the U.S. In addition, the citizens of a given country can also bring about dollarization with or without the help of their government. This can be done through de facto dollarization, where citizens make an individual choice to swap their home currency for the U.S. dollars, or by de jure dollarization, which requires the citizens in a country to utilize their political process to effect a smooth and coordinated currency substitution toward the dollar (Taylor, 2000). De jure dollarization may be a preferred method in adopting dollarization since this would allow the government of the foreign country to make changes to their monetary and fiscal policies in conjunction with the conversion process to facilitate a coordinated transformation. However, for a country that wants some of the benefits of dollarization without having to openly commit to it, de facto dollarization may actually be preferred by a government. Since this form of dollarization is subject to the will of the people and lacks government interaction, it can actual exacerbate a troubled economy if the populace perceives things are going to get worse before getting better.

For a country to consider dollarization, several criteria should be met. The country should be an optimum currency area. It should be unstable fiscally, and have a record of financial volatility. The country should also have the bulk of its trade with the U.S. The country should be socially and politically willing to change. The citizens of the country must also accept the replacement of the local currency with the dollar. These criteria must be intensively investigated before dollarization is implemented (Salvatore, 2001).

The theory of optimum currency areas (OCA) is a useful tool in determining the feasibility of dollarization. "An OCA is a region for which it is optimal to have a single monetary policy and a single currency" (Dellas, 2001). There are two main ways in which to assess the appropriateness of countries forming an OCA. One is on the conditions that warrant a country's adoption of another country's currency, and the other is by the costs and benefits of forming an OCA (Dellas, 2001).

DO THE U.S. AND MEXICO FIT THE OCA CRITERIA?

There are a number of conditions that must be compared to evaluate a successful OCA. There should be a high degree of fiscal integration. High levels of fiscal integration tend to smooth out the shocks of fiscal transfers between high unemployment regions to low unemployment regions. Integration is very highly related when evaluating the border of Mexico. However, when viewed as a whole, Mexico is significantly under-employed, and therefore will not correlate with the U.S. Also highly diversified economies are typically better candidates for OCA than less diversified economies. The diversification acts as a buffer to the myriad of shocks in a complex global economy. This buffer action helps to limit the need for excessive changes in the terms of trade. The U.S. is highly industrially diversified across the nation; Mexico is not.

Trade integration is an important part of being deemed an OCA. With the advent of NAFTA, Mexico and the U.S. increased their trade integration along the border. This should translate into lower costs to dollarize. With a very open economy, the two countries will limit their exchange rate risks.

With two countries with parallel production structures, symmetric trade shocks will also parallel. Exchange rates cannot then fluctuate to help ameliorate the effects of economic shocks. Therefore, the two countries would fit that OCA criterion. However, Mexico and the U.S. are dissimilar in their production structures--other than along the border. With dissimilar structures, dollarization would not provide Mexico with any flexibility during economic shocks.

The benefits of the OCA for Mexico and the U.S. can also be linked to the credibility hypothesis. This hypothesis focuses on the use of a common currency as an anchor to discipline policy makers and private enterprises. In effect, the exchange rate equals a fixed rate when using a common currency. Dollarization would permit policy makers in Mexico and the U.S. to focus on problems other than monetary policy in their economies. This should lead to a more stable and productive environment for Mexico.

For dollarization to succeed in Mexico it must facilitate fiscal and financial stability and economic reform. This reform would then lead to a more balanced budget and stability in the banking industry for Mexico. Mexico would consider dollarization because of past serious economic problems. Otherwise the costs associated with dollarization could outweigh the benefits.

Mexico has been faced with an ill banking system making it a candidate for dollarization. By dollarizing, Mexico's central bank may not be as likely to lend in last resort due to additional constraints. The financial safety net would tighten thereby precipitating more prudent banking decisions. This would help reduce the potential for moral hazard in the banking industry.

Dollarization should also enhance Mexico's financial stability by promoting the growth of domestic financial markets. Mexico's current weak financial standing forces it to have to borrow from foreign banks. Their assets, on the other hand, are in pesos. When faced with depreciating peso currency, the banks and firms are hurt. This contributes to an even weaker financial position, and the cycle continues. Dollarization would combat this problem because the bank's and the firm's assets would both be in dollars (Eichengreen, 2001).

According to Eichengreen (2001), dollarization is most effective for countries whose fiscal policy is controlled centrally. Dollarization would lead to a relative consolidation of public finances which should lead to fiscal reform for Mexico. Dollarization would eliminate excessive inflation and interest rates which have been so problematic for Mexico in recent years. The interest rates would stabilize at U.S. levels, thereby reducing costs of debt.

Salvatore (2001) delineates that a dollarizing country should have very close ties to the U.S. He claims that trade between the two countries should represent a significant proportion of the dollarizing country's Gross Domestic Product (GDP). Since the U.S. is the largest importer of Mexican products, the close ties are apparent. This should ensure that the maximum benefits can be attained through dollarization. Otherwise, Mexico would not want to give up its control over its monetary policy if it was not going to receive substantial benefits for doing so.

In addition, both countries must be politically and socially accepting to the idea of dollarization. In effect, de facto dollarization may occur if Mexico continues to use the dollar domestically. It literally may only take one side, the government or society, to make dollarization occur. (Pruitt, 1998). For example, if firms in a country demand dollars for their goods and services they are essentially dollarizing the country, albeit, through a very slow process. Similarly, small businesses may also demand dollars from the citizens. It may not be long before the national pride of having the peso as a sovereign currency will be eroded away by necessity of the dollar.

PROPONENTS OF DOLLARIZATION

Mexico, with two main exceptions, fits the mold of what many economists consider as an appropriate candidate for dollarization. The exceptions to this fit are the size of Mexico and its deeply rooted economic past. Mexico and U.S. would be considered by many to be an OCA by definition. The two countries share a high degree of economic diversification. This diversification would help to buffer the transitional shocks of implementation. Mexico and the U.S. are also highly trade-integrated. The more integrated two countries are, the smaller the transition costs when a single currency is adopted.

Mexico and the U.S. have a very open trade agreement. This openness spawns frequent exchange rate adjustments. These exchange rate adjustments result in price instability which then calls for a common currency

Mexico experienced four maxi-devaluation periods from 1976 to 1998, which have been followed by massive price instability. In 1995, Mexico experienced a 637% increase in the price level. This was joined by a year-to-year inflation of 7% to 52% (Prepared..., 2000). Mexico has been historically unstable financially, fiscally, and politically, thereby making Mexico a textbook example of a candidate for dollarization.

Mexico is deemed ready for dollarization by many economists, business leaders, and financial experts. Leading Mexican business associations, like Business Coordinating Council, the National Chamber of the Manufacturing Industry, and the Mexican Employers Confederation are in support of a dollar-based economy (Crane, 1999). Many of these groups have lost their confidence in the central banks' ability to keep Mexico out of crisis. The American Chamber/Mexico conducted a survey in 1999 and a small majority 58 percent out of 48 U.S. and Mexican companies operation in Mexico) were in favor of dollarizing the Mexican economy (Crane, 1999).

Mexico's high inflation rate fueled a significant level of price instability. Inflation is the result of both a monetary and an exchange rate problem in Mexico. Dollarization would help end inflation and devaluation. It would also allow the price level to fall to the U.S. level. This could persuade more investors to look to Mexico for investment opportunities. The CCE states with regards to Mexico that "to adopt a strong foreign currency as legal tender stops the problem of recurrent instability, diminishes country risk, and lessens the cost of capital, and eliminates many of the transaction costs." (Crane, 1999).

The importance of the dollar to Mexican business interests has never been stronger. There are many companies that already adopted the dollar for payment of their invoices. The dollar is extensively used, especially in the border-states, for the sale of luxury items, computers, office equipment, trucks and furniture. Capital investments have also been demanded to be in dollars (Garza, 1999). Therefore, de facto dollarization is already occurring.

OPPONENTS OF DOLLARIZATION FOR MEXICO

The outcome for officially dollarizing Mexico would seem to have many positives, but those are primarily speculations. Mexico has a relatively large economy when compared to Panama or Ecuador, two of the other nations that have dollarized. Dollarization has not been a clear-cut success for them and it is still too early to conclude the end results.

Opponents to dollarization have made some strong points. One opponent claims that dollarization is a false solution that only addresses the symptoms and not the root cause of the problems (Puertas, 2000). It is also postulated that many Mexicans fear that converting to dollars will surrender Mexico's control over its monetary policy, thus, putting itself at the mercy of the U.S. and the Federal Reserve (Garza, 1999). Historically, Mexico's monetary policy has been very volatile; however, there is no evidence that the Mexican government would be willing to surrender monetary decision making policy to the U.S. A Mexico more optimistic about a more stable future could find its leaders preferring to rely on supply and demand to determine the currency exchange rate.

Floating exchange rates have two advantages over dollarization: (1) Exchange rates can depreciate (appreciate) and act as the classical "shock absorber" for an economy and (2) What is considered appropriate policy for the U.S. might not be good for other countries. When a country undertakes a pegged exchange rate, it is only promising a conditional action and not an unconditional guarantee of staying with the peg. Thus, governments are not prevented from backing out of the pegged rate nor does the pegged rate prevent the exchange rate from collapsing (Sachs, 1999). A unilateral monetary policy by Mexico would have no formal treaty relationship between the two countries and be predicated on the convenience of Mexico (von Furstberg, 2000). Except along the border, Mexico's economy is relatively inflexible and still commodity dependent. Any policy to preserve the pegged exchange rate by contracting the economy would probably result in costly high unemployment and falling domestic output. Any real devaluation would be achieved via a fall in nominal wages and prices, aggrevating any economic recession.

The Fed (U.S.) could not be expected to open its discount window to Mexico's banks to assist in difficult times. Additionally, U.S. politicians would be expected to be most concerned with domestic issues over international issues as these would be the issues at election time (Falcoff, 1999). Mexico also needs to consider that it is at a different economic and fiscal development point than the U.S. This difference in the productivity growth rate can be best accommodated by changes in relative prices (Mann, 1999).

Berg and Borenzstein (2000) postulate the debate is no longer centered on inflation stabilization as this problem has abated over the 1990's. Today the problems are the degree of capital mobility and scale of capital flows as well as the apparent frequency and severity of currency crises.

Dollarization supporters rarely address the needed policies that must accompany dollarization to make it feasible and effective. Often, potential costs to both the dollarizing country, in this case Mexico, and to the U.S. are overlooked.

CONCLUSION

Most people would agree that Mexico needs economic reform. Mexico has had a history of inflation, unstable prices, and devaluation. One possible solution to these problems is dollarization. Mexico has many of the characteristics necessary for dollarization. Mexico and the U.S. can already be considered an OCA, a precursor to dollarization. Certainly Mexico's historically unstable financial status would theoretically benefit from the conversion to the stable dollar.

Dollarization would hypothetically benefit Mexico's current state. It should help halt inflation, devaluation, and help set stable prices. This should in turn, result in economic growth and prosperity.

However, there is no substantive proof that these outcomes will occur. Evidence from past dollarizers, such as Panama and Ecuador, do not support the claims made by proponents of dollarization. At this time, dollarization would not benefit either the U.S. or Mexico. The added knowledge from evaluating the results of other nations will allow both Mexican and U.S. stakeholders to re-visit this issue in the near future.

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Hadley Leavell, Sam Houston State University

Balasundram Maniam, Sam Houston State University

Leslie Toombs, Rockhurst University

Louis Kuhn, Sam Houston State University