What is Dollarization?

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What is Dollarization?

In the 1990s, many countries, including Turkey, experienced serious economic crises. Examples include the Mexican Crisis (1994), the Asian Crisis (1997), the Russian Crisis (1998), the Brazilian Crisis (1999), the Crises in Turkey (1999 and 2001) and the Argentine Crash (2001). The crises led to a severe questioning of politicians and the economic policies implemented and to the beginning of new searches. While fixed exchange rate regimes were blamed for these crises, various proposals were put forward to reshape the international financial structure. These ranged from abolishing the IMF and imposing controls on capital flows to a global lender of last resort. One of the most prominent proposals is for developing countries to completely abandon their own currencies and adopt the currency of another country as legal tender. This is called dollarization. Some countries seeking to stabilize their economies may adopt dollarization. Dollarization gained popularity especially in the 1990s and 2000s. There were deep debates on this issue in those years. Because many countries experienced crises during these periods and dollarization became an important policy choice. Recent studies on dollarization are mostly in areas such as financial dollarization and liability dollarization.

- Dollarization

- Dollarization features

- Docauses of larization

Types of Dollarization

Dollarization, which means money substitution in Turkish, refers to the substitution of foreign currency for domestic currency after the currency has performed its basic functions such as store of value, unit of account and means of payment. In some foreign countries, this is used to refer directly to official dollarization. In other words, it is explained in different ways based on the types of dollarization. The types of dollarization are as follows:

Informal dollarization:

 In general, informal dollarization occurs when there are foreign stocks and other non-monetary assets held abroad, foreign deposits abroad, foreign deposits in the banking system, foreign banknotes in wallets or under pillows. The concept of currency substitution may correspond to the informal dollarization stage of dollarization.

Semi-official dollarization: In this form of dollarization, foreign currency is legally accepted and its share in bank deposits is high. However, it plays a secondary role to the domestic currency in wages, tax payments and daily expenditures.

Official dollarization (full dollarization):

 Official or full dollarization occurs when the foreign currency has a special and dominant legal status. Thus, the government legally accepts the foreign currency and uses it for its own payments.

Fontaine dollarization:

 This type is divided into official dollarization and spontaneous dollarization. Spontaneous dollarization is a spontaneous process of informal dollarization. Informal dollarization is called de facto by some experts.


Why Does Dollarization Happen?

The reasons for dollarization are varied. Due to recurrent high inflation and devaluation (depreciation) of the domestic currency, the public may not consider the domestic currency as a reliable store of value and instead prefer and hold foreign currency or assets denominated in foreign currency. In addition, the public may be reluctant to carry out long-term debt transactions in domestic currency. Thus, people lose confidence in the domestic currency as a result of their estimates of the future purchasing power of the domestic currency and, as a result, bank transactions are linked to the dollar. When inflation is high and volatile, and reliable measures of inflation are not available, it is more attractive to enter into contracts in foreign currency than to enter into inflation-indexed contracts in domestic currency. When inflation is high, it is easier to set foreign-oriented prices than to adjust prices frequently in local currency. It is important to note that underlying all of these reasons is insecurity. The most important reason for this is the problems created by economic and financial crises and currency crises.

Effects of Dollarization

Dollarization refers to the substitution of the local currency of a country by the dollar or another foreign currency. The effects of dollarization are numerous. First, dollarization is common during periods of economic instability. The use of foreign currency is the result of an effort to keep inflation under control and avoid the risk of currency depreciation. One of the positive effects of dollarization is that it encourages foreign investment. The stability and credibility of the dollar increases the propensity of foreign investors to bring capital into the country. This in turn can stimulate economic growth and increase employment opportunities.

On the other hand, dollarization also comes with disadvantages. For example, with the reduced use of the local currency, the country's monetary policy may become ineffective. The central bank cannot guide the economy using monetary policy tools such as interest rates. This can reduce resilience to economic fluctuations. It can also affect the country's fiscal policy. When the dollar is used instead of the local currency, the country has to repay its debts in dollars. This can increase the external debt burden and make the country's economy more vulnerable. Overall, the effects of dollarization are complex and multifaceted. It has positive effects, such as stabilization and encouraging foreign investment, but also disadvantages, such as ineffective monetary policy and a more fiscally fragile economy. Depending on the country's specific situation and economic objectives, the effects of dollarization may vary. In some cases, it can play a savior role, while in other cases, as mentioned above, it can have negative consequences and lead the economy to evolve into a bigger crisis.


June 22, 2023