Dollarization

Currency substitution or dollarization occurs when the inhabitants of a country use a foreign currency in parallel to or instead of the domestic currency.

Currency substitution can be full or partial. Most, if not all, full currency substitution have taken place only after a fatal economic crisis: examples are Ecuador and El Salvador in the Americas and Zimbabwe in Africa.

Partial currency substitution occurs when residents of a country choose to hold a significant share of their financial assets denominated in foreign currency. It can also occur as a gradual conversion to full currency substitution: examples are Argentina and Peru, which were both in the process of converting to the U.S. dollar during the 1990s.

"Dollarization", when referring to currency substitution, does not necessarily involve use of the United States dollar. The major currencies used as substitutes are the US dollar and the euro.

After the gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II, some countries sought exchange rate regimes to promote global economic stability, and hence their own prosperity. Countries usually peg their currency to a major convertible currency. "Hard pegs" are exchange rate regimes that demonstrate a stronger commitment to a fixed parity (i.e. currency boards) or relinquish control over their own currency (such as currency unions) while "soft pegs" are more flexible and floating exchange rate regimes. The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led to currency substitution becoming a serious policy issue.

A few cases of full currency substitution prior to 1999 had been the consequence of political and historical factors. In all long-standing currency substitution cases, historical and political reasons have been more influential than an evaluation of the economic effects of currency substitution. Panama adopted the US dollar as legal tender after independence as the result of a constitutional ruling. Ecuador and El Salvador became fully dollarized economies in 2000 and 2001 respectively, for different reasons. Ecuador underwent currency substitution to deal with a widespread political and financial crisis resulting from massive loss of confidence in its political and monetary institutions. By contrast, El Salvador's official currency substitution was a result of internal debates and in a context of stable macroeconomic fundamentals and long-standing unofficial currency substitution. The eurozone adopted the euro (€) as its common currency and sole legal tender in 1999, which might be considered a variety of full-commitment regime similar to full currency substitution despite some evident differences from other currency substitutions. For more on dollarisation, cf. Fields, David, and Matías Vernengo. "Dollarization." The Wiley-Blackwell Encyclopedia of Globalization (2013).

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