Dollarization
"Gresham’s Law Working in Reverse"
By: Amal Younis
“Bad money drives out good,” Gresham’s Law states; however, in modern-day economics, bad (unstable) currencies can never be favored over good (stable) currencies. As hyperinflation and unstable exchange rate patterns weaken several developing countries’ currencies, Dollarization or generally Currency Substitution takes place gradually.
Currency substitution is the usage of a stable foreign currency instead of, or in addition to, a country’s domestic currency, whether officially or unofficially as a means of exchange or a store of value. Currency Substitution or “Dollarization” gradually occurs over time through assets or liabilities dollarization. In other words, either the country’s residents choose to buy foreign currencies as a store of value, or the banking system in a country has a huge percentage of its debt obligations in dollars. Thus, it is rational to say that almost all developing countries, including Egypt, have a form of Liabilities dollarized officially and a form of Assets dollarized unofficially.
Indeed, full dollarization, by which a country completely abandons its currency and uses another country’s currency as its legal tender, has been viewed by economists as a form of a fixed exchange rate regime. In an official full dollarization regime, the central bank sets the rate at which all the private and public accounts will be converted to dollars. Following such a radical transformation, the country is completely passive towards its monetary authority by which the federal bank has the proxy to decide the best for the US solely.
Consequently, this passiveness provides the country with stability, yet in critical moments of recession or inflation, the central bank would have no monetary tools to use. It has no power to intervene through interest rate modifications, money printing, or even foreign reserve manipulation. Although using a stable currency decreases the country’s risk premium, allowing developing countries to borrow loans at lower rates, it doesn’t decrease its sovereign risk, i.e. its default risk. In other words, a country using the dollar or any other stable currency decreases the likelihood of devaluation, thus decreasing its devaluation risk premium on its borrowing bonds; however, dollarization can not guarantee developing countries’ market stability versus industrial markets. Therefore, the sovereign, “ or tendency to default on debt,” risk premium is not guaranteed to be lowered by dollarization.
On the contrary, dollarization is the perfect tool to guarantee better economic integration in the international market by boosting both international trade and real investments. By lowering the risk premiums, thus, interest rates, emerging investors in the market flourish in the long run. Similarly, not necessarily dollarization, but even other forms of currency substitution, especially neighboring currencies, is a perfect way to reduce transaction costs in international trade, similar to the Eurozone trading block.
Thinking about different forms of exchange rate regimes as a spectrum, dollarization, similar to a currency board, would be on the radical far left while floating exchange rate would be on the capitalist far right. Egypt has been moving in the right direction recently with high frequency and amplitude waves leading to real inflation shocks that could definitely backfire. While the government gives no space for Egyptians to deposit money in foreign currency without harsh regulations, and even limiting foreign reserves to dollarize its accounts or even set any form of fixed exchange rate regime, the Egyptians are gradually finding ways to buy dollars with radical exchange rates establishing the firm base for the black market or discovering different methods to invest in foreign markets to afford foreign accounts in dollars. Thus, the potential for dollarization is greater than realized and can never be measured by the government. What can be pledged? If the government loosens the regulations of dollar flow into the economy, no one will hesitate before performing daily transactions using dollars or any other form of stable currency. The sudden float toward the capitalist right would backfire on the far left, at least unofficially.