Financial matters: Dollarisation: Our point of no return?

via Financial matters: Dollarisation: Our point of no return? – The Zimbabwe Independent February 27, 2015 by Perry Munzwembiri

THIS month marks six years since Zimbabwe adopted the multi-currency monetary system, popularly referred to as dollarisation, in response to the chaotic hyperinflationary period that had defined the country’s economy for almost a decade prior to February 2009.

Most Zimbabweans are still haunted by the memories of that era when their legal tender, the Zimbabwe dollar, effectively lost its usefulness as a medium of exchange, store of value, unit of account and means for deferred payments — considered features that give any monetary currency its value.

Looking back in history, it is interesting to note that there has not been any economy that has reverted back to its local currency once it has dollarised. Panama, widely considered as the closest the strategy of dollarisation has come to being successful; Ecuador and El Salvador all still use the US dollar many years after adopting it. The logic behind dollarising is that the government would be aiming to reduce its inflation while reaping the economic benefits of “co-opting” another country’s currency.

However, the effectiveness of the strategy is debatable. Looking at the Latin American countries that have dollarised, their economies still lack notable economic development compared to their peers who have not dollarised. Some scholars have argued that for dollarisation to be effective, it must be accompanied by fundamental macro-economic reforms as well as transformations in financial and banking institutions. Evidence shows however that, in the short-term, partial dollarisation — whereby a country continues to use discretionary monetary policies in maintaining control over their economies, or full dollarisation, is efficient in reducing high inflation.

Consider Ecuador, which dollarised its economy following a severe economic crisis in 1999. At the height of that crisis, Ecuador’s local currency, the sucre, went from an exchange rate of 7 000 to the US dollar to 25 000. Following the approval of the Economic Transformation Act, which prohibited the Ecuadorian government from printing the sucre, and paved the way for the declaration of the US dollar as the country’s official currency, hyperinflation was curbed and there was rapid economic recovery.

However, the benefits were short-lived: in the period after dollarisation, Ecuador still continues to be characterised by poverty and high disparities in income. The financial system continues to be vulnerable due to the limits that dollarisation places on the central bank’s flexibility on policy responses to crises. The climax of Ecuador’s economic challenges perhaps came in the form of a political crisis that eventually triggered the downfall of president Jamil Mahuad.

Similarities can be drawn between Ecuador’s experiences and those of Zimbabwe since 2009. Zimbabwe’s record-breaking inflation was reined in, and the economy grew like it was shot on steroids in the years immediately after dollarisation, though this positive GDP growth appears to have lost steam in recent years.

Zimbabwe too like El Salvador, Panama and Ecuador has found out that adopting the world’s most powerful currency is no stroll in the park.

For one, there is less of sovereignty as the central bank cannot effectively use its monetary policy to respond to local economic challenges.

Another possible pitfall could be brought about if the US dollar depreciates significantly, against other major currencies, as has happened in the past, undermining its importance to the international financial system. Such an event would be catastrophic to economies that have dollarised. A growing American trade deficit could also potentially harm dollarised economies.

So why is it difficult for an economy to revert back to its domestic currency once it has dollarised? The answer lies in whether the people can again manage to trust their local currency again. For Zimbabwe, as has been witnessed with the slow uptake of the recently unveiled bond coins, many locals still harbour reservations as the memories of the losses they suffered when the Zim dollar was suddenly demonetised are still fresh in their minds.

This seems to imply that for Zimbabwe, the re-introduction of the Zim dollar, by whatever name they choose to call it, still remains implausible. This, however, assumes a rational government. — M&G.