Dollarization and Corruption in Latin America

Dollarization and Corruption in Latin America

DOLLARIZATION IN LATIN AMERICA 11

Dollarizationand Corruption in Latin America

LatinAmerican countries have two features: a high level of dollarizationand a high corruption rate that affects the financial system. In thepast few decades, the financial systems of Latin American countriesbecame increasingly dollar-denominated as a result of economic crisesthat hit the region (Garcia, 2001). Denominating the currenciesagainst the dollar was a decision made to encourage residents andcorporations to allow their savings to continue circulating in thedomestic market by withdrawing the incentives that come with highcapital flight. While the monetary and fiscal decisions meant toavert the crisis actually reduced capital flight, they predisposedLatin American financial systems to risks associated with increasedsolvency and liquidity (Frieden&amp Stein, 2001).Thus, it has increasingly become impossible for any Latin Americancountry with a high dollarization rate to initiate independentmonetary policy strategies. The increased emphasis on the benefits ofdollarization when the region experienced an economic downturn in the1990s overlooked the potential effects that excessive polarizationwould have on the financial systems. There have been recent effortsto increase the use of local currency but many countries in theregion are still highly dollar-denominated (Garcia, 2001). The riseof dollarization and increased corruption in Latin American financialmarkets leads pertinent questions on the impact of the two on theeconomy and the probable direction of policy frameworks gearedtowards balancing monetary policy independence and a stable financialsystem that is highly engrossed with other financial systems on theglobal stage. The questions are:

Isthere a correlation between the high levels of corruption andcorruption in Latin American financial systems?

Corruptionand dollarization have no direct relationship in the way they affectthe economy. However, a largely unaccountable government is likelyto take actions that impede financial intermediation. Actions such asoffering depositors an inflationary hedge are not common in LatinAmerica (Gomis-Porquerasetal.2005).In the wake of despotism and corruption, Latin America has been avictim of governments that are concerned with power rather than theinstituting policies that strengthen the financial system. Thedollarization that happened in the 1990s was forced and yet somegovernments in the region are taking a reverse decision of forcedconversion of dollars to local currency. If the corruption was notrampant through suppression of dissent there could be otheralternative governments that are ready to institute measures such asalternative indexation mechanisms that would enable Latin Americancountries to get more value from dollarization and balance it outwith stable local currencies.Otherwise, even in countries where thecorruption index, there has been an efforts to avert regulatory andsupervisory distortions that arise from the offshore intermediationpractices though in a manner that is not open for public scrutiny(Gomis-Porquerasetal.2005.

Isthe on-going fight against corruption target the closure of loopholesarising from entrenched dollarization?

Ahigh level of dollarization is not the only problem that affectsfinancial system of Latin American countries. The region has been avictim of despotic regimes in the recent past. The regimes failed toestablish independent institutions that could check on corruption infinancial systems (LARG,2005).As a result, corruption was entrenched in the financial systemscausing inefficiencies that continue to predispose it to futureeconomic challenges. Policy changes in the region are alsoincreasingly about the need to reduce levels of corruption in thefinancial system coupled with more use of local currencies. Thefactors that caused an increase in dollar-denominated accounts inLatin America are similar across all the countries. Similarly, thehigh solvency and liquidity caused by dollarization in economies thathave weak institutional regulations encouraged corruption to increasebecause players in Latin American financial markets realized theincentives to engage in unorthodoxy such as money laundering andothers.

Whatwere the underlying reasons for the adoption of a highly dollarizedfinancial system in Latin America?

Dollarizationcaused a surge in loans and foreign currency deposits of the mostLatin American countries right after the damaged economies of the1990s began to recover. Nonetheless, the increase in loans andforeign currency deposits occurred when average inflation was at itsall-time low (single-digit levels). With these positive effects inplace, governments declined to take measures that could inhibitfurther dollarization and transactions in foreign currenciesespecially the U.S. dollar continued unchecked (LARG,2005).The other major factors that caused the general increase in thedollarization of financial systems include:

  1. The need to remonetize the economy: During the 1990s, Latin American governments were keen to reverse the capital flight that characterized the economic recession of that period. Hence, individual countries (especially those that were adversely affected by the recession such as Argentina) took measures that encouraged banks and other financial institutions to the use the dollar in major transactions (LARG, 2005). They believed that using the dollar would affirm the credibility of their financial systems and reduce the liquidity squeeze. A country such as Uruguay decided to institute policies such as foreign currency deposit holdings with the aim of promoting the credibility of its financial system.

  2. The absence of strong demand policies that could create confidence in local currencies: Latin American countries that had a highly-dollarized financial system experienced high fiscal deficits as well (Garcia, 2001). Although their GDPs experienced growth due to progressive financial policies, fiscal deficits remained high relative to it. The high fiscal deficit that began during the recession had already caused enough damage to the value of local currencies causing a drop in confidence level among residents.

  3. The pro-dollarization banking system that developed in the 1990s: The main players in the credit market of Latin America countries such as Brazil, Argentina, and Mexico can independently access credit lines abroad (Garcia, 2001). They also lend in foreign currency to retain their market positions amid competition from local creditors.

  4. Slow reforms in individual country exchange rate regimes: Before, during and after the economic crisis of the 1990s, Latin American countries have not expedited reforms on their foreign exchange regimes. Some, such as Venezuela, maintained a managed float as a way to control the cost of paying loans in dollars (Garcia, 2001). The result was a limited exchange rate volatility that made it plausible for residents to maintain their savings in foreign currency.

Whatwere the macroeconomic effects of the dollarization to Latin Americanfinancial systems?

Currently,Latin American financial systems are fully-recovered. However,continued dollarization had several effects that require prudentmonetary policy interventions to shield the system from ismacroeconomic effects. The effects of dollarization on the economyare:

Under-pricingof credit risk in the capital market: A country such as Argentinaapplies the same regulatory framework for both foreign currency andlocal currency transactions. The general effect is that investorsdoubt the convertibility of assets in either currency leading to anunder-priced credit risk (Garcia, 2001).

Liquidityrisks: Dollarization causes huge dollar withdrawals of foreigncurrency deposits because they are not sufficiently backing by U.S.dollar assets. Whenever depositors want to service their liquidityneeds at home, they withdraw their deposits in large amounts due tolack of U.S. asset backing. It happened in Uruguay from 2001 whendepositors from Argentina withdrew their deposits to meet theirliquidity demands at home (Garcia,2001).

Limitedindependence in monetary policy: The dollarized economies of LatinAmerica have high capital flows that often undermine the possibledrift to local currency by residents.Two factors restrict themonetary policy makers from making independent decisions about thefinancial system: the willingness of the private sector to acceptliabilities valued in foreign currency and the sufficiency of theindividual country’s international reserve position (Garcia,2001).

Towhat extent has dollarization caused volatility in the financialsystems of Latin American countries?

Gomis-PorquerasCarlos Serrano and Alejandro Somuano (2005) (contributors on thejournal of the economic and finance observed that dollarization makesLatin American financial systems more volatile. The observationswere factual because the dollar is widely used as a store of valuerather than a medium of exchange. The result of such an arrangementis that the deposits denominated in dollars have ambiguous effects onthe financial system. The ambiguity increases the exchange rate riskfor financial institutions especially banks because they are involvedin providing capital in the economy more than any other financialinstitution.Banks take deposits in dollars yet they lend in localcurrencies or lend in dollars to corporations that do not have highdollars cash-inflows. Such an arrangement causes short-run volatilityin the GDPs and inflations in countries that have a high level ofdollarization (Gomis-Porquerasetal.2005).The phenomenon has affected Latin American financial systems for avery long time.

Whatfactors shape the effect on exchange rate on business?

Inrelation to discount rate, the input that is prominently swayed bycurrency choice is the riskfree rate. In an individual works with ahigher inflation currency, the riskfree rate will be higher. Forexample, in the case of Colombia, if the peso riskfree rate was 6.5%and the United States dollar riskfree rate was 4% in 2010. Thedifference of 2.5% is exclusively attributable to the difference inanticipated inflation. It is also important to note that while it isrelatively easy to get a USD riskfree rate, it is a bit difficult toget the same for the peso. This is contributed by the fact that thepeso dominated Colombian government bonds do not have default riskattached to it. Other inputs remain fairly stable. Betas should gaugethat business risk that a firm faces.The cost of debt used should also be the same currency as the cost ofequity, irrespective of whatever currency the compaby uses toborrow.

Isthe resultant volatility a significant issue in the portfoliodecisions of depositors in Latin American financial systems?

Depositorsin Latin American countries that are highly-dollarized face decisionmaking challenges as a result of the many uncertainties and economicfriction that characterizes a financial system that the dollar as thestore of value rather than a medium of exchange market (LARG,2005). The main reason for the uncertainties that depositorsface is thelack of meaningful reform in the banking sector and the entirefinancial system.

Doesthe entrenched dollarization affect the valuation in Latin Americancountries?

Valuationis the only aspect that remains unaffected by dollarization in LatinAmerica. Although the value of assets or inputs does not change whenvalued in either dollars or domestic currencies, the process can betedious for a company investing in a Latin American country (Dumrauf,2012).Forinstance, a foreign company that intends to invest in the localeconomy has to make cash flow forecasts in a single currency. Theprocess is rather tedious for a company that already has itsfinancial statements prepared in another currency other than thedollar. Apparently, the dollar is the currency of choice for suchvaluations because it is the strongest and is used widely in LatinAmerican economies.

Whatis the effect of dollarization on real exchange rate and in effect,the business value?

Theapparent state of hysteresis: There are some aspects of the financialsystem that remained permanent even though they were meant to controlinflation (Dumrauf,2012).They include the high switching costs from the dollar to foreigncurrency and the development of financial instruments. They becamepart of the money market and entrenched dollarization even afterinflation dropped during periods of economic recovery. The realexchange takes into consideration the cost of conversions as well.

Hasdollarization coerced some developing states to give up a big chunkof the autonomy

Dollarizationis a term the describes the adoption of the United States dollar asthe national currency has deliver a varied results to Latin Americastates. In the 21stcentury economic integration precipitated by globalization and fueledby digital technologies has led to increased economic interdependenceand transnational competition in the production of goods and services(Garcia, 2001).National currencies have not been spared by these changes in theglobe that have impacted all aspects of human life. Based on theresearch carried out by Cohen Benjamin, market control and dominancein the realm of international currencies exclusively belongs to thedeveloped nations of the Northern hemisphere. Such dominance has alsobeen witnessed in other aspects of global commerce (Garcia,2001).

Itis not surprising that U.S dollar the most widely used internationalcurrency owing to the its traditional dominance in the world economy.Economic integration together with capital flows and the weakfinancial entities in third world nations has sent more nations intoeconomic periphery of the global financial system (Garcia,2001). The dominanceof United States in the global commerce has been harmful to thedomestic currencies of Latin America’s less developed countries.Less developed countries in Latin America which like in other fieldsof global trade, find it hard to participate in the world economy(Garcia, 2001).The loath economic domination by the countries in the Northernhemisphere often leads to currency crises in third world countries.It is important to note that countries in Latin America are notimmune to the widespread currency instability that has seized manythird world countries. The dollar also offers a structure offinancial measurement for states vulnerable to patchy fiscal policies(Garcia, 2001).Dollarization not only affords countries in the Latin America thefinancial authority required to draw foreign investment and stabilitybut also reduces the transaction costs connected to currencyexchange. Nonetheless there are concerns whether the benefits reapedfrom dollarization are worth of loss of economic independence for thecountries in Latin America (Garcia,2001).

Whatare costs and Benefits of Dollarization in Latin America

Dollarizationcan confer immense benefits as well as costs to the economies anddomestic operation of financial institutions. Dollarizationencourages the central banks to ensure efficiency of the generalfinancial system (Garcia, 2001).This goal is attained through discouraging from lending money toinefficient banks because of their role as a currency dispenser. Inaddition, due to the fact that under this structure the governmentdoes not print its own currency, it is coerced to diversify itseconomy by covering its public debt via alternate means (Garcia,2001).

Conversely,some scholars have indicated that dollarization is not sustainable inthe long-run, especially since the dollar has also witnessed bouts ofdevaluation relative to other key world currencies such as the Yenand the euro (Garcia, 2001).In the occasion that the dollar were to lose value, its significancein the global financial system would reduce substantially, and othercurrencies such as the euro would gain weight. Even though such asscenario would profit developing states whose monetary units arehinged on group of currencies other than the USD, it would bedisastrous to the economies of states that have adopted the dollar asthe main currency (Cohen, 2003).

Anotherperil for dollarization rests in the immense trade deficits in theUnited States that potentially could destabilize the financial systemin the globe. In the event that United States would mull overdefaulting its debs, a global currency crisis tantamount to the 1930sslump would occur, wrecking havoc to the dollarized economies inLatin America and other developing countries (Cohen,2003).

Mostnotably, the benefits that emanates from seigniorage would be wipedout in countries that have dollarized. This means that countries thathave adopted the USD would forfeit this crucial source of revenue andmove it to the United States. Inadvertently, such Latin countriesalso transfer monetary decision making authority to the FederalReserve, which might never consider how policies will affect thedollarize states (Cohen, 2003).

References

Dumrauf,G.L.(2012). Currencychoices in Valuation: An approach for emerging markets.Universidad del CEMA

Cohen,B. J. (2003). “Monetary Governance in a Globalized World.”InternationalPoliticalEconomy.

Frieden,Jand Stein, E. (2001). TheCurrency Game Exchange Rate Politics in Latin America.Washington,D.C. JohnsHopkins University Press.

Garcia,M. (2001). DolIarization:The recolonization of Latin America.Retreived from: International Socialist Review

Gomis-Porqueras,P., Serrano, C and Somuano, A. (2005). Dollar-Denominated AccountsIn Latin America During The 1990s. Journalof Economics and Finance, 29 (2): 259

LARG(2005). Dollarizationin Latin America.” Latin America Research Group.Federal

ResearchBank of Atlanta.