Dollarization in Latin America: The Experience of Ecuador, Panamá and El Salvador

Dollarization is a process where a country abandons its national currency in order to adopt the U.S. dollar as its own. This process has been of high interest in regions like Latin America, which commonly possess unstable monetary systems and experience recurring periods of high inflation. Countries like Panamá, Ecuador and El Salvador are fully dollarized, therefore, they offer diverse case studies to evaluate economic ramifications and consequences of this policy shift.

Economic analysis has often shown common effects in dollarized economies; including enhanced stability in output and prices, financial system adjustments, promotion of fiscal discipline, accompanied by an increase in vulnerability and dependence to both external and internal shocks due to the reduced flexibility in monetary policy responses.

Ecuador dollarized in January 2000, mainly because of economic instability and high inflationary pressures in the economy. Since the transition from the Sucre (Ecuador's previous currency) to the dollar, evidence has shown that inflation has decreased and interest rates have risen, which are factors that relate with a growing economy.  Before dollarization, the monthly measure of annualized inflation averaged 33%, and after dollarization, it fell to an average of 1.54%. Furthermore, research has shown that even though full dollarization entails a limitation of monetary autonomy and increases vulnerability to United State’s shocks, it's the price to pay for the benefit of importing monetary policy credibility to Ecuador.

Although the reasons behind Ecuador’s dollarization are quite different from those of countries such as Panamá, and El Slavador, it can be seen that effects regarding price stability are quite similar.

Panama was the first country to dollarize in Latin America. It did so after gaining independence from Colombia in 1904, highlighting that the reason behind dollarization was more historical and political rather than economic due to the United States playing a key role in Panama's independence. It is widely believed that the US helped provide diplomatic and financial support with the goal to have control over the Panama canal. After the competition of this architectural innovation, the US had great influence economically and diplomatically in Panama, which contributed to the eventual dollarization.

After dollarization, Panamá has shown an average stable growth rate of 4.4%, which is above the average growth rates of Central American countries, and has also shown to be more stable with prices, with an average inflation rate remaining very low (1.1%). However, it has been argued that even though dollarization had significant positive impacts on Panama’s economy, it did not guarantee fiscal discipline, resulting in unstable budgets and changing debts.

In contrast, El Salvador’s experience with dollarization starting in 2001, was mainly shaped by the goal of boosting investment, as this economy was relatively stable in the years prior. What can be seen in El Salvador’s experience is that the U.S. Federal Reserve policy under official dollarization has been able to stabilize fluctuation in Salvadoran prices. Furthermore, U.S. monetary policy to Salvadoran commercial bank interest rates has been significantly stronger under official dollarization. However, as mentioned earlier, dollarization also has its drawbacks, it limits the ability of a country to control its monetary policy. Also, in order to fix trade imbalances countries use devaluation and with dollarization, they no longer can. 

The dollarization processes of Panama, Ecuador, and El Salvador share commonalities in achieving reduced inflation rates and improved price stability post-adoption of the U.S. dollar. However, challenges in maintaining fiscal discipline persist across all three countries. While Panama and Ecuador faced difficulties in managing budgets and debts, El Salvador aimed to boost investment but now grapples with limited monetary policy autonomy. These experiences demonstrate the complex nature of dollarization and highlight the importance of addressing fiscal governance issues to maximize its well-known benefits.

In essence, even if dollarization offers potential benefits, each country has unique economic conditions that influence its decision to adopt and maintain this policy. On one hand, dependency on the U.S. dollar gives countries a sense of stability. However, it also makes them vulnerable and limits their capacity to independently implement monetary policies. Understanding these trade-offs is essential when analyzing this type of policy, especially for the countries that are looking to improve the living conditions of their peoples. Currently, dollarization has particular relevance in countries like Argentina, which is known for its persistently high inflation rates. With the new government under Javier Milei, Argentina is exploring the possibility of implementing this strategy. Therefore, examination of the advantages and drawbacks of dollarization remains of high importance, enabling countries to implement appropriate measures to bolster their economies and improve societal well-being.