Home Economics & PolicyComment The case for full dollarization once and for all

The case for full dollarization once and for all

by Layal Mansour

In November 2023, four years after the start of Lebanon’s severe financial crisis, Harvard Growth Lab suggested that Lebanon consider adopting full dollarization among other economic and financial restructuring and reforms. In practice, a full dollarization consists of renouncing both the Lebanese central bank, Banque du Liban, and its monetary policy, and replacing the local currency—Lebanese pounds—with a foreign one, namely the US dollar. Such a suggestion has always been criticized and rejected by the public, the media, activists and non-experts who argue that dollarization would undermine the sovereignty of the state. 

Indeed, it was not the first time that this subject was raised. Since 2019, I have proposed shutting down the central bank and burying the Lebanese pound. In June 2020, I coordinated with Member of Parliament Paula Yaacoubian to propose a law (N° 697/2020) urging the Lebanese parliament to vote in favor of a currency board system, that is, a softer version of full dollarization that would protect the state’s sovereignty. A very highly dollarized country such as Lebanon, must sacrifice its central bank and exclusively adopt either full dollarization or currency board. The argument for full dollarization can be traced back as far as October of 1994, when an IMF working paper analyzed the usefulness of the Lebanese pound as well as the likelihood of restoring trust in the local currency and suggested considering full dollarization for Lebanon.

I have argued that the roots of Lebanon’s financial crisis began four decades ago with the introduction of unofficial dollarization. Accordingly, the current phenomena of exorbitant and unabating inflation, a high poverty rate, the banking sector solvency problem, the depletion of foreign reserves, and the multiple currency rates are not the main economic problems but rather the expected and unavoidable consequences of partial dollarization.  

Dollarization: the root of economic evil

The rate of dollarization expresses the extent of the economic agents’ preferences to hold foreign currency (cash and/or deposit) instead of local currency, because it provides trust, confidence about future purchasing power, and stability. In other words, the rate of dollarization is equal to the rate of local currency rejection by economic agents. Unfortunately, there is economic proof that dollarization doesn’t exist in isolation but travels in tandem with its inseparable siblings: corruption and weak financial institutions. Moreover, empirical studies show that dollarization affects all sectors. Not only does it pose a challenge to the pursuit of a coherent and independent monetary policy, but it also leads to downgrades from credit rating agencies and exposes a country’s banking sector to an asset/liability currency mismatch. Dollarization consequences are so deleterious that economists have referred to it as the original sin.  

Rather than prescribing temporary relief in the form of loans or grants to extend its expiry date, Lebanon is in dire need of addressing its economic problems at the epicenter, which begins with de-dollarizing. 

If dollarization refers to the simultaneous use of at least two currencies, de-dollarization is simply the use of one currency: either the local one or the foreign one. In other words, the two ways to de-dollarize Lebanon are by forcing the exclusive use of either the local Lebanese pound or the foreign US dollar, or full dollarization.  

Addressing “fear of floating” with a managed float?

The fear of floating is a phenomenon that refers to averseness towards floating exchange rate regimes and their high fluctuations. Many Lebanese economists, to avoid the fear of floating, suggest the managed float regime, also coined the “dirty float.”  In a managed float, the exchange rate is not totally pegged, not entirely based on free capital mobility, and not entirely monetarily independent. Put simply, it involves frequent central bank interventions that are only possible when those central banks hoard excessive foreign reserves (from trade surplus rather than debt or required reserves), to hedge against future shocks. The smallest exchange rate fluctuations under a managed float translate to severe balance sheet problems for borrowers with liabilities in foreign currency and income in the local currency. Accordingly, banks suffer from exchange rate distortions under a dirty float, even if their portfolio has a nationally matched currency position. Moreover, it has been verified by economists and admitted by several IMF studies that there is a strong positive correlation between fear of floating and an increased dollarization rate. The higher the dollarization rate, the more the fear of floating is expressed. Consequently, fluctuations of exchange rate are less tolerated under the managed float.

Increased rates of dollarization translate to decreased acceptance of the local currency, especially regarding one’s dollarized holdings. The fear of floating, which manifests strongly in dollarized economies, has been proven to have severe negative effects in all studied cases. Since the 1980s, Lebanon has been ranked amongst the most highly dollarized countries in the world with a dollarization rate of 70 percent and above, along with Nicaragua, Zambia, Mozambique, Cambodia, Guinea Bissau, Angola, Congo Dr, Ecuador, Bolivia, Bulgaria, Estonia, EL Salvador, Hong Kong and others. None of these countries could escape severe financial crisis. None of these countries succeeded in de-dollarizing by stabilizing or strengthening their local currencies. The only very highly dollarized countries that found a second chance toward a new economic recovery plan were those who shifted toward full dollarization or a currency board arrangement such as Ecuador, Bolivia, Bulgaria, Estonia, EL Salvador, Hong Kong. In fact, at a certain level, dollarization seems irreversible. 

Why the dollar over the pound?

Economic research studies have shown that when a country becomes accustomed to a foreign currency like the US dollar over decades, it leads to an irreversible dependence. In economics, the “hysteresis effect” or “dollarization hysteresis,” refers to the addiction-like phenomenon that affects people who become greatly inured to use of dollars (or other foreign currencies) to protect themselves against possible future inflation. Hence, it becomes difficult and even impossible for the authorities to force people to give up dollars and use their local currency even if inflation drops and economic conditions improve. In worst-case scenarios wherein “addicted to dollar” countries are forced not to use the dollar, mass hysteria, strikes, and bank attacks occur. Lebanon saw such events in early 2020 when residents were forced to earn, withdraw and spend exclusively LBP. Many studies have assessed the hysteresis effect in Lebanon and found that the high dollarization has even persisted after successful stabilization periods and multi-year economic growth. Econometric proof of the hysteresis effect is one of the most important arguments in support of giving up the central bank of Lebanon.

Restoring trust in local currency in a very highly dollarized country such as Lebanon seems extremely challenging if not impossible. Accordingly, it would be better to regulate and officialize the use of the dollar, which many economists consider to be the next step to economic recovery.

Addressing the issue of sovereignty

The higher the demand on the dollar as a means of payment, the lower the central bank monetary policy efficiency, and the higher the exchange rate risk and banking sector instability. In fact, the central bank is not able to manage or manipulate a money supply composed primarily of dollars through monetary policy (interest rate). In sum, the central bank monetary policy in a very highly dollarized country is ineffective and thus giving up the central bank in Lebanon would not cost a fortune. It would, however, affect the country’s sovereign image. To salvage that image, there is a second option: the currency board arrangement.

Currency Board Arrangement (CBA) and full dollarization are largely equivalent. The two main differences are in the name of the currency itself and the seigniorage. Under a full dollarization system, the domestic legal tender is the foreign currency. For Lebanon or any Middle Eastern country, obvious challenges arise with any attempt to associate the US dollar with the country’s sovereign image. This is the main argument against full dollarization by Lebanese authorities and public. Under the currency board regime, the country adopts its own new currency—the Lebanese dollar or Cedar dollar or Middle East Dollar—which mirrors the foreign anchor currency. While entering a CBA absolutely requires giving up monetary policy independence and fully backing liabilities with reserves in the anchor currency, the new currency name could protect the country’s sovereignty.

On the other hand, under the full dollarization where the local currency is totally replaced by the foreign one, the government gives up seigniorage, which is the profit derived from the difference between freshly printed banknotes and their production costs. As the sole authority controlling the printing of US dollars, the United States collects all seigniorage income on the US dollar. Seigniorage is thus the most visible and quantifiable element in the cost-benefit calculus of full dollarization.

No single currency regime is right for all countries or all times (Frankel 1999)

A full dollarization or a currency board is never appropriate for a systemically transparent country with a developed economy. Such a country can rely on the market power to adjust any economic disequilibrium and its central bank can also adjust the interest rate up or down to manage the inflation rate, help accelerate economic growth or decelerate worrying economic trends. These solutions are rather an inevitable last resort for  highly dollarized countries that lack governance and strong and independent legal frameworks. It appears inescapable for those all too familiar cases where countries whose citizens are deprived of their democratic participation in day-to-day governance by politicians who always promise and never deliver, face institutions that have lost any sense of responsibility, and have rulers who evade accountability and have zero will of ever enacting structural economic reforms.

In choosing the exchange rate regime, the main economic factors to consider are dollarization, government temptation to inflate, and exposure to exchange rate risks. Considering the implications of Lebanon’s extreme dollarization, which not only exceeds 80 percent today, but has also been deeply rooted for decades, full dollarization is of utmost importance. Any exit strategy that seeks resolution of Lebanon’s economic crisis through a soft pegged arrangement or flexible exchange rate regime will indubitably lead to a more severe financial crisis that could last forever. 

Choosing full dollarization, once and for all, conceptually represents a radical, extremely credible, and more importantly, irreversible arrangement. This is simply because reversing dollarization is much more difficult than modifying or unilaterally abandoning a CBA. Lebanon needs a currency system that eliminates the risk of a sudden sharp devaluation of the country’s exchange rate. Yet, because of the serious constraints that application of full dollarization is bound to face in Lebanon, I advise taking recourse in its twin, the currency board arrangement.

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Layal Mansour

An expert in monetary policy and financial crises in dollarized economies.

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