Dollarization: Guide to the Intl Monetary Stability Act

Dollarization:
A GUIDE TO THE INTERNATIONAL
MONETARY STABILITY ACT

February 2000
Joint Economic Committee Staff Report
Office of the Chairman; Senator Connie Mack

This staff report expresses the views of the author only. These views do
not necessarily reflect those of the Joint Economic Committee,
its Chairman, Vice Chairman, or any of its Members.

GENERAL EXPLANATION

The U.S. dollar is the world's dominant currency. About two-thirds of all dollars circulate outside the United States. The dollar is the preferred currency for international trade, central bank currency reserves, and transactions on commodity and foreign exchange markets. Many countries in Latin America already use dollars on an unofficial basis. Citizens of other countries often keep deposits in dollars and use dollars for large transactions. Foreign banks often lend in dollars and investors prefer to earn profits in dollars.

In the past few years there has been a great deal of discussion about what the appropriate monetary system should be in emerging market countries. One of the options is official dollarization, whereby a country would eliminate its own currency and adopt the U.S. dollar as legal tender. Two subcommittees of the Senate Banking Committee have held joint hearings on official dollarization. Ecuador is seriously considering dollarization and officials in Argentina and El Salvador have shown interest in the idea. Panama has been officially dollarized since 1904.

Why are countries considering dollarization? Supporters of official dollarization say it would reduce inflation and interest rates toward the levels of the United States, increase economic growth by encouraging savings and investment, strengthen financial systems, instill fiscal discipline, and eliminate sudden currency-related economic crises. However, critics claim the loss of an independent monetary policy would be too costly and that a country's banking system must be very strong before official dollarization.

Regardless of how countries weigh the relative merits of these economic arguments, official dollarization faces another obstacle. At present, a country that officially dollarizes must forego the profit it earns from issuing a currency. The currency profit what economists call seigniorage is the difference between the value of a currency and the cost of printing it. (For example, a $100 bill is worth $100, but only costs several cents to print.) When a country adopts the dollar, it no longer earns currency profit. The currency profit is transferred to the United States. This loss of revenue can be sizeable. For example, Argentina earns about $750 million per year in currency profit. If Argentina were to officially dollarize, this $750 million would flow to the United States rather than Argentina. This transfer in currency profit makes official dollarization difficult.

The International Monetary Stability Act (the "IMSA") addresses the currency profit issue by letting the Treasury Secretary rebate 85% of the transferred currency profit back to the dollarizing country. The remaining 15% would finance rebates to countries that are already officially dollarized (such as Panama), help pay the costs of operating the Federal Reserve, and still leave a net revenue increase for the United States.

Official dollarization is in the interests of the United States. It would help workers and businesses by stabilizing export markets and getting these markets to grow more quickly. It would help investors by reducing the need to hedge against currency risk when investing in emerging markets. It would help taxpayers by reducing the need to bail out countries due to sudden currency-related economic problems.

The IMSA would not pressure any country into official dollarization. It simply removes the obstacle posed by the transfer of currency profit to the United States. Foreign countries would retain complete discretion over the decision to officially dollarize. In addition, the Treasury Secretary would not be required to automatically rebate currency profit to every country that officially dollarizes. The Secretary would merely have the discretion to do so, thereby guaranteeing that countries considering official dollarization cooperate with the United States.

The IMSA also makes it clear that the United States would not be obligated to act as a lender of last resort to countries that officially dollarize, consider their economic or financial conditions when setting monetary policy, or supervise their financial institutions. U.S. policy would still be made in the United States. These provisions ensure the United States would not become excessively entangled in the economic affairs of countries that officially dollarize.

ANSWERS TO FREQUENTLY-ASKED QUESTIONS

Why is this legislation important now?
A number of countries are already considering official dollarization, including Ecuador, Argentina, and El Salvador. The IMSA would let them know where they stand with respect to U.S. policy.

Would the IMSA force countries to officially dollarize?
No. The decision to officially dollarize would still be each country's to make for itself.

Is official dollarization right for all emerging market countries?
This issue is not addressed by the IMSA. The bill merely removes the obstacle of the currency profit transfer to the United States. Countries would still refrain from official dollarization if they didn't think it was in their best interests. In addition, if a country thinks official dollarization is in its best interests but the Treasury Secretary disagrees, the Secretary could refuse to rebate currency profit.

Wouldn't dollarization eliminate the ability of countries to run an independent monetary policy?
Yes. Countries that dollarize would adopt U.S. monetary policy as their own. Independent monetary policies in emerging market countries have often tended to aggravate rather than ease economic problems. Historically, the discretionary use of monetary policy has been a major source of instability in many countries.

Would other countries have a say in U.S. monetary policy?
No. The IMSA would not alter the structure of the Federal Reserve or the procedures or goals of U.S. monetary policy.

Wouldn't officially dollarized countries put pressure on the Federal Reserve to conduct monetary policy in their interests regardless of the U.S. economic situation?
According to Chairman Alan Greenspan, the Federal Reserve is already under foreign pressure, but this pressure does not lead the Federal Reserve to do things that benefit foreign countries to the detriment of the United States. Greenspan testified that official dollarization would not make the Federal Reserve more readily take such actions. He also noted that all of the monetary policy stances the Federal Reserve takes within its ordinary range of looseness to tightness would be improvements compared to what many countries have now.

Official dollarization would leave countries without a central bank that can serve as a lender of last resort during a banking crisis. Won't this pressure the United States to adopt this role for these countries?
First, the IMSA explicitly states that the United States is not obligated to serve as a lender of last resort to officially dollarized countries.

Second, before granting certification that a country is officially dollarized, the IMSA requires the Treasury Secretary to consider whether a country has opened its banking system to foreign competition or met international banking standards. Either of these would greatly diminish the risk of a bank crisis. The presence of international banks has made Panama's banking system very stable.

Third, a country could establish a lender of last resort facility outside its central bank. For example, Argentina has a $7 billion emergency line of credit with international banks. Officially dollarized countries can use rebates of currency profit to collateralize such emergency lines of credit. If concerned about a banking system's stability, the Treasury Secretary may hinge certification on establishment of this kind of line of credit.

How would dollarization affect budget deficits in emerging market countries?
Dollarization would mean countries could no longer finance government spending by printing money. Like U.S. states, countries that dollarize would be sensitive to how their fiscal policies influence their credit ratings. This would exert downward pressure on spending, thereby reducing budget deficits.

How would official dollarization be implemented?
If a country decides to officially dollarize, its central bank would take the assets that back up its currency and convert them into U.S. Treasury securities. It could do this in the financial markets. The central bank would then sell the Treasury securities to the Federal Reserve in exchange for dollar notes and coins. The country would then use the dollars to repurchase and retire the local currency from circulation. In the meantime, the country must cease issuing the local currency and cease accepting local currency for payments (except in exchange for dollars). Dollars would be used for taxes, wages, debts, and bank deposits, just like in the United States.

How would the IMSA effect federal revenue?
The Federal Reserve controls the amount of dollars in circulation by selling currency in exchange for U.S. Treasury securities. The Fed then earns interest on the securities. The Fed then uses a small portion of the interest to finance its operations and sends the rest back to the Treasury Department.

If a country officially dollarizes, the Federal Reserve would issue more dollars in exchange for more Treasury securities, resulting in more interest ultimately handed back to the Treasury Department. This extra revenue will not occur in the absence of official dollarization. The IMSA would rebate 85% of the extra revenue, thereby still leaving the Treasury Department with an extra currency profit.

By making rebates of currency profit to countries that dollarize isn't the United States, in effect, paying twice for the Treasury securities it acquires from the dollarizing country?
No. The Federal Reserve pays for the Treasury securities by issuing dollars to the dollarizing country. That is one complete transaction. The country then receives rebates of currency profit only if it uses these dollars as its official currency. That is a second transaction. If the country simply holds the dollars on reserve it doesn't get currency profit rebates. If it trades the dollars for some other securities and holds them on reserve it doesn't get rebates. If it uses the dollars to purchase some other currency such as the Euro and then adopts this as its official currency it doesn't get rebates. The currency profit rebates are compensation for using the dollar as the country's official currency, not extra compensation for the dollars purchased from the Fed.

SECTION-BY-SECTION EXPLANATION

Section 1. Short Title
Section 1 provides that the bill may be cited as the "International Monetary Stability Act of 1999."

Section 2. Findings and Statement of Policy
Section 2 sets out the findings and statement of policy of the Act. The "findings" of the Act state the importance of monetary stability to emerging market countries, the deficiencies of certain methods of achieving monetary stability, the benefits of official dollarization, and the ability of the United States to encourage official dollarization by offering to share the extra currency profits it would earn with countries that officially dollarize. The "statement of policy" provides that the United States is not obligated to act as a lender of last resort to officially dollarized countries, consider their economic or financial conditions in setting monetary policy, or supervise their financial institutions.

Section 3. Certification
Section 3 provides the Secretary of the Treasury (the "Secretary") with authority to certify a country as officially dollarized upon the issuance of a written statement explaining why that country has been certified. The Secretary may certify a country as officially dollarized after considering whether it has in fact officially dollarized, opened its banking system to foreign competition or complied with internationally-accepted banking principles, and consulted with the Secretary prior to certification.

Section 4. Consol
Section 4 provides that upon certification the Secretary will issue to the certified country a consol that will pay interest quarterly. A consol is a debt instrument that pays interest but never matures.

Section 4(a) provides that the face value of the consol will be the lesser of the amount of dollars the country obtained from the Federal Reserve System in exchange for U.S. Treasury securities for the purpose of official dollarization or the dollar value of the local currency in circulation prior to certification. By so limiting the face value of the consol, countries seeking certification are encouraged to cooperate with the Federal Reserve and are restrained from artificially increasing local currency in circulation prior to certification to try to manipulate the amounts of the currency profit rebates.

Section 4(b) provides that starting four months after certification, the owner of a consol will receive interest payments every quarter year. These payments will be 85% of the currency profits the country would have earned had it not officially dollarized. The amount of interest will fluctuate with short-term U.S. interest rates and the change in worldwide dollars in circulation, a share of which is presumably due to changes in dollar circulation in the officially dollarized country.

Section 5. Previously Dollarized Countries
Section 5 provides the circumstances under which countries that were officially dollarized prior to introduction of this Act can be certified as officially dollarized and issued a consol. Panama, the Marshall Islands, Micronesia, Palau, Turks and Caicos, and the British Virgin Islands may not be certified as officially dollarized until 10% of the face value of consols issued pursuant to section 3 certifications equals or exceeds the face value of consols that would be issued to all these countries upon their certification. This ensures interest payments to countries that were already officially dollarized will be less than the net increase in revenue for the United States due to official dollarization elsewhere. The face value of consols issued to Panama, the Marshall Islands, Micronesia, Palau, Turks and Caicos, and the British Virgin Islands will be proportional to their respective gross domestic products in 1997. Otherwise, interest payments on these consols will be made in accordance with section 4, with the amount of interest fluctuating with short-term U.S. interest rates and the change in worldwide dollars in circulation.

Section 6. Rights and Obligations
Section 6 provides that, in general, owners of consols issued under this Act have the same rights and obligations as other owners of privately held obligations of the U.S. Treasury. However, a consol is rendered null and void upon a U.S. declaration of war on the country to which it was issued or a public statement by the Secretary that the country is no longer officially dollarized.

Section 7. Repurchase
Section 7 provides that the Secretary may repurchase a consol issued under this Act, but no fewer than ten years after issuance. The consols are not callable. Purchases must be made upon the joint agreement of the Secretary and the owner of the consol.

Section 8. Exchange Stabilization Fund
Section 8 provides that payments on consols issued under this Act to countries that are in default or arrears on loans from the Exchange Stabilization Fund will be applied toward such debts.

Section 9. Regulations
Section 9 provides that the Secretary and the Federal Reserve System may issue regulations to carry out this Act.