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There are times in the life of a nation’s economy when its currency is undergoing unhealthy volatility.   Usually, volatility is harmful to the overall strength of an economy, especially since companies need a stable environment in order to do business.

For investors, certainty needs to be relatively proportionate to risk, meaning that an economy needs stability in order to grow.   It is when a currency is subject to chronic speculation and manipulation that dollarization is considered to be one possible solution.

Guest post by  FXTM

Dollarization Defined

Dollarization occurs when the citizens of a country adopt a foreign currency, either officially   or unofficially, as their legal tender for conducting transactions.

Basically, there are two different types of dollarization.   The first is what is known as, ‘unofficial currency substitution’.   This is, perhaps, the most common form of dollarization, where a nation will hold a foreign currency to provide a hedge against inflation of its native currency.   In addition, that nation will ‘unofficially’ accept the foreign currency for transactions, but not necessarily use it as ‘legal tender’.

‘Official currency substitution’ or full dollarization happens when that country abandons its own native currency, and ceases to issue it.   At which time, the country will accept the foreign currency as legal tender.   There are a few advantages and disadvantages to full dollarization.

Pros and Cons

Full dollarization can become quite a complex ordeal, as there are often unintended consequences to the transition.   However, here are a few advantages:

A nation can enjoy the full benefits of having the same currency stability as the nation who issues it.

Especially for developing countries, it becomes much easier to trade with the foreign country issuing the currency.

Usually, the switch to the foreign currency will attract investors, since there will be fewer problems with the exchange rate and better stability.

The disadvantages?

Often, this can have adverse economic and political effects on a country, as the currency issuing nation now holds quite a bit more power over the dollarized country’s sovereignty.

If a nation’s economy continues to falter after full dollarization, then they will end up going into debt with foreign central banking systems.

In dollarization, the investment has to be a good one.   If the foreign currency also takes a dive, or experiences volatility, then this can make the country worse off than it was before.

Dollarization Isn’t Only For the Dollar

Since countries are no longer using the gold standard, and since the 1944 Bretton Woods Agreement, the most common form of dollarization has been for the US dollar.   However, countries have also commonly moved to full dollarization through the euro.

In recent years, there has been shaky confidence in the US dollar and the euro.   Since inflation has picked up its pace in the last two decades, nations aren’t as convinced in the dollar’s ability to protect their interests.   This is why some are predicting a reversal of Bretton Woods and rejection of the US dollar as the world reserve currency.   If the new ‘reserve currency’ is to be a ‘basket of currencies’, then the practice of dollarization may soon be coming to an end.