Global Policy Forum

By Larry Rohter

Quito, Ecuador, Jan. 16 -- Even in the rest of Latin America, this country of 12 million has never been regarded as much of an economic leader. But by deciding to replace Ecuador's currency with the American dollar, President Jamil Mahuad has thrust his nation onto center stage of a heated, continent-wide debate about monetary policy and economic relations with the United States.

Mr. Mahuad's unexpected move, announced on Jan. 9 amid a political crisis that threatened to topple him, is a textbook example of what economists call dollarization, and provides the test case long sought by advocates of that policy, once considered as much a fringe notion across the hemisphere as the flat tax still is in the United States.

So for the next few months, both the Clinton administration and its trading partners from Canada to Chile will be watching the experiment here intently -- and with a healthy dose of skepticism.

At the moment, the only country in Latin America that uses the dollar as its currency is Panama, which took that decision almost immediately after breaking away from Colombia in 1903. Because Panama is so small and was so closely linked to the United States by the Panama Canal Zone, the rest of Latin America has traditionally viewed it as a unique and not especially attractive case in which national sovereignty was traded for stability.

But the trend toward regional trading blocs, including the possibility of forming a Free Trade Area of the Americas as early as 2005, has forced a re-examination of that attitude. The success of the euro, especially as it affects the mother countries of Latin America, has also made the notion of a single currency for the hemisphere more plausible and attractive. "Joining the euro group has been a more secure arrangement for Spain and Portugal, with lower inflation rates" and rapid growth, said Ricardo Hausmann, chief economist of the Inter-American Development Bank. "If a monetary treaty can be negotiated, it could be attractive for Latin America."

Economists and government officials say the nations that would be most tempted to follow Ecuador's example are those of Central America, which already conduct the bulk of their trade with the United States. In El Salvador, for instance, dollar remittances from Salvadorans in the United States are now the principal source of foreign exchange. In reality, many Latin American nations already rely on dollars, to one degree or another. At the checkout counters of many supermarkets in Peru, for example, the bills given to shoppers are calculated both in dollars and Peruvian soles. Customers pay in either currency.

Other Latin American countries, most notably Argentina, have formally adopted mechanisms that tie the exchange rate of their pesos to the dollar and have made the two currencies fully convertible at that fixed rate. And beyond Latin America, Liberia in Africa and a few tiny island nations in the Pacific have embraced dollarization, while Hong Kong has followed an approach similar to that of Argentina and its currency board since 1983.

Indeed, the consistent popularity of the currency in world markets has meant that most United States dollars can be found in other countries. The Federal Reserve estimates that about $580 billion is in circulation globally, two-thirds outside of the United States. "Most countries have a large amount of their debt in dollars, maintain a large percent of their reserves abroad in dollars, and write contracts indexed to the dollar," said a World Bank official. "In a country like Argentina, a lot of the costs of dollarization have already been incurred, so the step to full dollarization would not be that great."

Countries adopting the dollar "may lose some flexibility in domestic policy issues," John S. Reed, the co-chairman of Citigroup, acknowledged in a speech to a Mexican bankers' group last year. But he and several other analysts argue that any relinquishing of autonomy would be offset by increased investment and capital flows and other gains.

"Full dollarization, if credible, eliminates devaluation risk, and, consequently, will likely result in interest rates which are both lower and less sensitive to crisis in other countries," Guillermo Calvo, director of the Center for International Economics at the University of Maryland and a former adviser to the International Monetary Fund, said in recent testimony before Congress. "In other words, the incidence of contagion will diminish."

Those who advocate formal adoption of the American dollar argue that it would also benefit countries in which wage-earners are used to seeing their purchasing power eroded by high inflation and a weak currency. "I don't know of a single worker who would complain if he were paid in dollars," Alberto Fernández Garza, president of the Mexican Employers' Federation, said recently. Indeed, some analysts even suggest that dollarization could be a tool to reduce income inequality. Today, Mr. Hausmann said, "workers are paid in pesos and executives in dollars, and workers can see the advantage of that; they want exchange-rate stability, too."

The United States position on the issue is one that former Treasury Secretary Robert E. Rubin once described as "agnostic." While the Clinton administration sees potential advantages and opportunities to extend American interests and power, it has also expressed concern about the mechanics of the process and the added burdens it might generate.

"We would never put ourselves in a position where we envisioned actions that we would take would be of assistance to the rest of the world but to the detriment of the United States," Alan Greenspan, the chairman of the Federal Reserve, told a Congressional panel last year. To Latin American economists, that meant Washington is unwilling to extend the safety net of the Federal Reserve system to any dollarized countries that get into economic trouble. Nor would the Fed conduct monetary policy to take account of cyclical differences between Latin America and the United States.

One clear benefit to the United States would come from "seignorage" fees that would have to be paid by countries that abandon their own currencies. Though it costs only pennies to manufacture paper bills, those notes would be sold at face value to nations adopting the dollar, resulting in a substantial profit for the American Treasury. "By acquiring dollars for use in their domestic economies, dollarizing countries would be extending an interest-free loan to the United States," Treasury Secretary Lawrence H. Summers told the Senate Banking Committee last year.

If the entire region were to adopt the dollar, that would amount to several billion dollars a year, unless treaties waiving such fees could be negotiated, which Latin American countries have said they would want. In Washington on Friday, Mr. Summers said there was no likelihood of a monetary treaty or any other official accord with Ecuador regarding its dollarization. "No formal agreement is in prospect," he said after a speech at the Institute for International Economics.

Creating a dollar zone would also be likely to accelerate the integration of Latin American economies with the United States and create trade opportunities for American companies. "The United States has a lot to gain, given that these countries are fertile ground for absorbing U.S. exports," Mr. Calvo said.

In times of conflict the United States might even be able to use the dollar as an economic weapon, withholding currency from an intractable government to bend it to Washington's will. Indeed, the Bush administration took just that step against Panama as part of its effort to overthrow Gen. Manuel Antonio Noriega.

But Clinton administration officials have made it clear that given the region's long history of political and economic instability, they worry the relationship could become too close. Dollarization in the Americas stands in sharp contrast to the experience of Europe, where a group of countries at similar levels of economic development created a new currency and established a new common central bank to manage it.

"The Federal Reserve would be buying the problems of places like Colombia and Argentina" if those countries were to give up their own monetary system and adopt the dollar as currency, said a senior official of an international lending agency who talks often with American policy makers. "They don't want that headache. Their attitude is 'use your own aspirin.' "

In his testimony to the Senate Banking Committee last year, Mr. Summers suggested as much, saying that "given the political dynamics that play out in those societies at times of economic frustration," resentment "could be vented at us." He added that if dollarization "led to that kind of sense of eroding national responsibility, it might be unfortunate for the countries involved, and it might be unfortunate for their relationship with us."

Though American officials have thus far refrained from saying so publicly, nothing about the way or the reasons Ecuador has dollarized makes them view it as a model. The economy here is in a deep recession, and output fell by 7.5 percent last year. The nation's inflation was the highest in Latin America, at more than 60 percent, and in September, the Mahuad government defaulted on about half of Ecuador's $13 billion in foreign debt, not exactly a move to build confidence among investors.

Not only is the country's economy in terrible shape, but the decision to dollarize was taken hastily and unilaterally, for reasons more political than economic, catching Washington and international lending agencies completely by surprise. That creates a risk that if the experiment here fails, it will damage the concept's credibility elsewhere in the region.

"Countries can obviously choose to adopt the dollar as legal tender without our assent," Mr. Summers said in his 1999 testimony. "However, such a decision has some consequences for the United States, and we hope and expect that countries would consult with us in advance."

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