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Floating, Fixed, or Super-Fixed? Dollarization Joins the Menu of Exchange-Rate Options

Debate on relative merits of alternative exchange-rate regimes was revived in the 1990’s by a succession of exchange-rate crises and associated global contagion. Despite waning enthusiasm for market-determined rates, most developed countries continued to float with only limited intervention. The major exception is the European Union. After a period of crises that accompanied attempts to keep rates within predefined bands, 11 EU members opted for a common regional currency issued by a regional central bank—a choice not even on the policy menu at the start of the decade. Developing and transition economies were likewise divided between those willing to cope with a marketdetermined rate and those choosing to fix rates. The newest twist for countries with fixed rates concerns minimizing the risk of crisis, especially crisis via contagion. Traditional crisis prevention emphasizes sound macroeconomic fundamentals bolstered by adequate international reserves and emergency lines of credit. Indeed, the International Monetary Fund’s original mandate was to provide supplementary balance-of-payments finance as needed to maintain official par values, including defense against speculative attack while countries get their fundamentals back in order. But the crises of the 1990’s delivered a disheartening message. Neither sound fundamentals nor seemingly adequate reserves and credit lines offered reliable protection against determined speculators. Hence, there has been increased attention to an alternative approach to crisis prevention: making a fixed rate entirely credible, and thus uninteresting to speculators in search of targets for attack, by establishing a currency board or even dollarization (i.e., official adoption of another country’s currency). These options are hardly new. The U.S. dollar has been Panama’s official currency since 1904. Unofficial dollarization, also known as currency substitution, is common in developing and transition economies whose national currencies are subject to a high inflation tax. Currency boards were once standard arrangements in British colonies; Mauritius had the first in 1849 (John Williamson, 1995). However, currency boards and dollarization are now increasingly promoted as tools for reducing the risk of exchange-rate crises for countries with fixed exchange rates. Our purpose is to clarify this new role and to recast the familiar fixed versus flexible rate discussion by distinguishing adjustable pegs from rates that are more permanently fixed through a currency board or dollarization. The decision to create the regional Euro raises many of the same issues. However, the Euro is already the subject of an enormous literature. We therefore focus on the considerations most relevant for developing and transition economies.