Dollar Rising over the Caribbean

Most discussion about “dollarization”—adoption of the dollar to replace a national currency—in the Western Hemisphere has centered on Argentina and Mexico. Argentina is already partway there, through a dollar-based currency board, and 90 percent of Mexican exports are for the “dollarland” to the north. This focus, however, distracts from the most compelling dollarization candidates, namely Central America and the Caribbean island economies. They have the most to gain by adopting the dollar and the most to lose from not doing so. Some, such as the Dominican Republic, Haiti, and Panama, have experienced periods of dollarization since the first half of the twentieth century, and the English-speaking Caribbean nations were “sterlingized”—adopted the UK pound sterling—before independence in the 1950s.

The growing interest in dollarization is the result of the accelerated pace of economic globalization since the mid-1980s. International trade and investment have grown rapidly, and capital markets have become highly integrated. The result for exchange-rate policy has been nothing short of revolutionary. As evident from the recent financial crises in Asia and elsewhere, governments now find it exceedingly costly or unfeasible to maintain a fixed or even flexible linkage with the dollar. More countries will have to choose between a floating exchange rate and monetary union, and this choice will become increasingly stark during the decade ahead.

Monetary union comes in two forms: a merger of national currencies, as in the European Monetary Union, and the adoption of a major currency like the dollar to replace the national currency, or dollarization. In the Western Hemisphere, dollarization is the only possible route because the U.S. is not about to merge the Federal Reserve Board with neighboring central banks.

Less-Bad Alternative

For the smaller Caribbean countries, this choice between a floating rate and dollarization involves momentous economic and political consequences. The economic choice is based on various factors related to what economists call an optimum currency area—the most efficient geographic range for a single currency. One general conclusion of such analysis is that small, open economies highly dependent on trade and investment with a major-currency country would be the most likely to benefit from monetary union. For Caribbean nations, this tilts the case toward dollarization, but the devil—or more optimistically the economic white knight—is in the details. The current reality is that the small, increasingly open Caribbean economies are particularly vulnerable to economic disruption under dollar-pegged or even floating exchange rates. The familiar pattern of economic decline—loss of investor confidence in government economic management, private capital outflow, official hard-currency borrowing and higher interest rates to counter disruptive downward pressure on the exchange rate, and financial crisis—is a growing threat throughout the region. Thus, dollarization quickly becomes, at a minimum, the less-bad alternative. But it involves far-reaching structural economic changes that vary in impact from clearly positive, to potentially negative, to highly judgmental.

The principal advantages of dollarization are a predictable exchange rate and the relatively low inflation and interest rates of the U.S. dollar. Long-term loans become far more accessible. Panama, now the only dollarized country in the hemisphere, is also the only country south of the border in which a homeowner can obtain a fixed-rate thirty-year mortgage. Thus, efficient, competitive, private enterprises in all sectors should welcome dollarization. A potential problem, however, is the need for greater labor-market flexibility—including occasional wage cuts—to ensure sustained economic growth. Nonetheless, if the longer-term outcome is more job creation and higher real wages, workers and labor unions could be net beneficiaries. In any event, any downward adjustments in nominal wages under dollarization would simply replace the loss of real wages through high inflation under alternative exchange-rate regimes.

Two principal judgmental consequences of dollarization are the internationalization of the financial-services sector and the budget constraint of tight limits on government borrowing. As dollarization proceeds, high-cost, long-protected national banks, insurance companies, and other financial-service providers will no longer be able to compete and will have to merge with international companies or face bankruptcy. In Argentina, for example, 70 percent of the banking sector is already international. In the Caribbean Basin, financial pressures to move in this direction are evident with or without dollarization. Whether the benefits of a more efficient, international banking sector outweigh those of small national banks more responsive to government direction and control will be a matter for debate.

The balanced-budget constraint reflects the fact that a government without a central-bank printing press (affectionately known in Latin America as “La Maquinita”) has to compete with private borrowers to finance a budget deficit—and can quickly get “rationed out of the market.” State governments in the United States are in a similar position: without currencies or central banks of their own, they tend to be rationed out of the market when their debt-to-state-product ratio exceeds 10 percent. This ratio would probably be considerably lower in Caribbean Basin countries because the perceived threat of government default would be higher. Countries considering dollarization have to decide between the benefits of a flexible fiscal policy, including large deficit financing, and those of fiscal restraint and a balanced budget.

The economic consequences, on balance, appear to favor strongly the dollarization option. But there is also a political dimension. Terminating the national currency, shutting down the central bank, and internationalizing the financial services sector all involve highly visible curtailment of national economic sovereignty. Indeed, the whole process of rapid globalization imposes increasing constraints on economic sovereignty, especially in small, more-dependent economies. Stating it positively, we can call this phenomenon the Luxembourg syndrome, after a country that is one of Europe’s most prosperous although it has precious little remaining economic sovereignty and even less autonomy with which to exercise it. Nevertheless, strong nationalist feelings, especially in the Caribbean island economies, have kindled opposition to dollarization on grounds of maintaining national sovereignty.

These are the factors bearing on the momentous and increasingly urgent choice facing Caribbean Basin nations, and it is now for them and them alone to decide. Thus it is encouraging that the Central American group of nations met in July 1999 in dollarized Panama to discuss the dollarization option and all its ramifications. Addressing the issue jointly will have political and economic advantages over the alternative course of pursuing competitive advantage through individual currency strategies.



U.S. Role Critical

The role of the United States, of course, will be important, if not critical, to the outcome. The U.S. position is that dollarization is the sovereign choice of other countries and should be carried out unilaterally, without U.S. commitments on matters such as recourse for banks in dollarized economies to Federal Reserve Board facilities. This is the proper approach and should be sustained. There is a role for the United States, however, in assisting the transition to dollarization for Caribbean Basin nations that decide to pursue it. The United States has important interests in the Caribbean region, including the reduction of international drug trafficking and large-scale illegal immigration. More stable and prosperous Caribbean economies are fundamental to countering these threats, and if dollarization serves this purpose, the United States should help to ensure a successful launch.

What is called for is a new Caribbean Basin Initiative (CBI), or, more precisely, a Caribbean Dollarization Initiative (CDI). It would consist of two principal parts. The first element would be wide-ranging technical assistance during the transition, particularly for banking regulation and other financial-sector reforms. Most of this can and should be provided by competent private-sector organizations, though the United States could pay for all or much of it. The financing, in fact, could derive from seigniorage benefits—the de facto interest-free loans that result from the use of the dollar as cash currency—accruing to the U.S. Treasury from dollarization of the Caribbean economies. The second part of such an initiative would be help in restructuring and, to some extent, writing down the accumulated debt burdens of governments that would have to begin anew with balanced budgets under dollarization. Otherwise, governments would quickly become bogged down in unmanageable debt rescheduling when attention should be centered on the difficult structural reforms necessary to make dollarization work. In effect, this would be a Brady Plan Two, similar to the debt-reduction initiative of Treasure Secretary Nicholas Brady during the Bush administration, as a one-time transition to a new and more fiscally sound relationship.

These are the principal issues that will need to be addressed as the dollar rises, one might even say inexorably, over the Caribbean regional economy. The picture would not be complete, however, without some comment about Cuba, the largest island economy at the center of the region. Cuba already has a dual-currency economy. The dollar portion, concentrated in the external sector (especially tourism and the informal economy driven mostly by dollar remittances from the Cuban diaspora), is the more buoyant. The peso-based portion, in contrast, centers on the largely moribund, centrally planned sectors of the economy. The economic forces at play, above and below the surface, tend toward further dollarization. Nothing official will likely change in Cuba as long as Fidel Castro maintains political control. But when the inevitable political and economic change takes place, Cuba will be ideally positioned to move quickly to dollarization, for all of the reasons stated above. At that point, Caribbean Basin dollarization could become a reality of transcendental importance, with sweeping benefits throughout the region.