Dollarization in Latin America: seigniorage costs and policy implications

The Quarterly Review of Economics and Finance45 (2005) 662–679

Dollarization in Latin America: seigniorage costsand policy implications

Carsten Lange, Christine Sauer∗a Department of Economics, California State Polytechnic University, Pomona, USA

b Department of Economics, MSC05 3060, 1 University of New Mexico, Albuquerque, NM 87131-0001, USA

Received 1 May 2003; received in revised form 28 August 2003; accepted 29 January 2004Available online 8 February 2005

Abstract

This paper examines the seigniorage costs of official dollarization in 15 Latin American countries.We show that the total costs can be decomposed into two components: seigniorage transferred to theU.S. and seigniorage lost due to greater financial stability in the dollarized country. Results indicatethat seigniorage costs and their components are significant, yet differ considerably across countries.A cluster analysis is performed to sort countries into homogenous sub-groups. At a stage with fivesub-groups we find groups with increasing seigniorage burdens. At a stage with two sub-groups wecan identify candidates for possible seigniorage revenue-sharing agreements with the U.S.© 2005 Board of Trustees of the University of Illinois. All rights reserved.

JEL classification: E42; F36; O54; C14

Keywords: Dollarization; Seigniorage; Latin America; Cluster analysis

1. Introduction

The worldwide turmoil in financial markets during the 1990s, with its devastating effectson emerging market economies in Latin America and elsewhere, has intensified the debate ingovernment, business, and academic circles about the appropriate policies and institutional

∗ Corresponding author. Tel.: +1 505 277 1963; fax: +1 505 277 9445.E-mail address: [email protected] (C. Sauer).

1062-9769/$ – see front matter © 2005 Board of Trustees of the University of Illinois. All rights reserved.doi:10.1016/j.qref.2004.01.002

C. Lange, C. Sauer / The Quarterly Review of Economics and Finance 45 (2005) 662–679 663

arrangements to reduce vulnerability to external shocks and promote overall stability. Abipolar view has emerged regarding the optimal exchange rate regime, with some analystsfavoring complete exchange rate flexibility and others advocating “hard pegs” such as cur-rency boards, full dollarization, or currency unions.1 In Latin America, where many coun-tries have been plagued by decades of hyperinflation, devaluations, capital flow reversals,and banking crises, policymakers seem to have accepted this bipolar view as evidenced bythe move towards fully flexible exchange rates in some countries (e.g., Mexico, Chile, Brazil)and the recent adoption of the U.S. dollar as legal tender in others (Ecuador, El Salvador).2

The literature on the pros and cons of official dollarization is extensive and continues togrow.3 Several authors, includingCalvo (1999a, 1999b, 2000)andMendoza (2001), havemade a strong case for dollarization in Latin America while others (e.g.,Chang & Velasco,2002) have cautioned policymakers against it on theoretical grounds. Recent contributions(e.g.,Journal of Policy Modeling, 2001; Levy-Yeyati & Sturzenegger, 2003a; Salvatore,Dean, & Willett, 2003) provide detailed surveys that can help readers sort out the mainissues in this important and complex policy debate.

While a country’s decision whether or not to dollarize depends on economic as wellas political considerations, the assessment of expected economic benefits and costs oftentakes center-stage in the debate.4 On the benefit side, a dollarizing country stands to gaingreater financial stability (e.g., lower inflation rates, lower interest rates, lower countryrisk, and lower real exchange rate volatility) by enhancing its policy credibility andreducing currency risk and speculative attacks. Another potential benefit is the reduction oftransaction costs with other dollar-based economies. The main costs of dollarization includethe loss of monetary sovereignty (in particular, the loss of the exchange rate instrumentto stabilize the domestic economy in the event of real or external shocks), the loss ofseigniorage revenue from domestic money creation, and the lack of a domestic lender oflast resort.5 From an economic perspective, the net effect of dollarization is essentially anempirical matter that depends on the relative size and importance of the various benefitsand costs.

Concerning the loss of seigniorage revenue, which represents the fiscal cost of dollariza-tion, there is evidence that this is an important issue for many developing countries.Fischer(1982), for example, calculates average seigniorage rates during the 1960s and 1970s fora cross-section of countries and finds that seigniorage accounts for more than 10% of total

1 See, for example,Levy-Yeyati and Sturzenegger (2003b)and the references therein for a summary and dis-cussion of the bipolar view.

2 Ecuador officially dollarized in 2000 and El Salvador in 2001. A third Latin American country, Panama, hasbeen dollarized since 1904 (e.g.,LeBaron & McCulloch, 2000). Other countries such as Nicaragua and Guatemalaare seriously considering full dollarization (e.g.,Levy-Yeyati & Sturzenegger, 2003b).

3 Official or full dollarization refers to the adoption of a strong foreign currency (the “dollar”) as sole legaltender by the home country.Financial or partial dollarization, on the other hand, refers to the holding of “dollar”-denominated assets and liabilities by domestic residents (e.g.,Arteta, 2002; Reinhart, Rogoff, & Savastano, 2003).Several authors argue that the economic benefits of full dollarization depend positively on the initial degree ofpartial dollarization (e.g.,Calvo, 1999b; Levy-Yeyati & Sturzenegger, 2003b).

4 See, for example,Levy-Yeyati and Sturzenegger (2003b).5 Many analysts have argued that the lender of last resort function can be preserved under full dollarization

by adopting alternative ways of providing bank liquidity, including contingent credit lines with private banks, astabilization fund, or seigniorage revenue sharing with the U.S. (e.g.,Calvo, 1999a).

664 C. Lange, C. Sauer / The Quarterly Review of Economics and Finance 45 (2005) 662–679

government revenue in many less developed countries, especially those with high inflationrates.6 Using more recent data for the 1971–1990 period,Click (1998) reports averageannual seigniorage as a share of government spending for a set of (up to) 90 countries. Theaverage ratio for the thirteen Latin American countries that overlap with our sample is 22%,ranging from a low of slightly more than 5% in Honduras to a high of 62% in Argentina.Our own calculations for the 1995–2000 period indicate that seigniorage continues to bean important source of government revenue in Latin America, contributing an average of12% of revenue in 14 of the 15 countries,7 even though inflation rates in the region havefallen substantially during the 1990s. This evidence suggests that official dollarizationmay impose a significant fiscal burden on these countries, especially during the transitionperiod when alternative revenue sources are either not available yet or too costly. If theseshort-run seigniorage costs are (prohibitively) high, a country with a democratically electedgovernment (where policymakers seek to maximize their chances of being re-elected) maydecide against dollarization even if the economic benefits from greater financial stabilityand policy credibility are expected to outweigh the costs in the long run. One possiblesolution to this policy dilemma is to implement a formal revenue-sharing agreement withthe U.S. since part of the dollarizing country’s seigniorage will be transferred to the U.S.(see Section2.2).

Our paper considers the seigniorage costs of official dollarization in 15 Latin Americancountries. Major contributions include: (1) estimation of the expected seigniorage losses,(2) their decomposition into contributing factors, (3) policy recommendations for possibleseigniorage revenue-sharing agreements with the U.S., and (4) identification of countrieswhere such an agreement would be useful.

The remainder of the paper is organized as follows. In Section2, we estimate eachcountry’s total seigniorage costs and decompose them into two components. One compo-nent reflects the amount of seigniorage redistributed to the U.S. due to the transfer of themoney creation monopoly (redistribution effect). The other component (financial stabilityeffect) is due to greater financial stability and credibility in the dollarized country, leadingto lower inflation and interest rates. This component can be interpreted as the price acountry has to pay for the stability benefits expected from official dollarization. Motivatedby our findings that total seigniorage losses as well as the contributing factors vary widelyacross Latin America, we perform a cluster analysis in Section3 to uncover homoge-nous sub-groups of countries. Section4 then discusses possible policy implications ofsub-groupings at various stages, with specific consideration of possible seigniorage revenue-sharing agreements with the U.S. The paper ends with a summary and conclusions inSection5.

6 In the Western Hemisphere, the ratio of monetary seigniorage to total government revenue averaged about12%, with the highest share of 46% in Argentina. For the eight Latin American countries that are included in oursample (Argentina, Chile, Colombia, Guatemala, Honduras, Paraguay, Peru, and Uruguay),Fischer’s (1982)dataimply an average ratio of about 18%.

7 Paraguay is not included because government revenue data are only available through 1993. Among the othercountries, the lowest ratio of 2.3% is found in Argentina while the highest ratios (23–24%) occur in Venezuelaand Costa Rica. Note that these figures are based on the opportunity-cost concept of seigniorage. The monetaryseigniorage as a share of government revenue is lower on average (9%). See Section2 for a discussion of thevarious measures of seigniorage.


2. Seigniorage costs of dollarization

2.1. Measuring seigniorage

Seigniorage, the revenue that a country’s central bank or government collects from issuingfiat money, is most commonly measured by the monetary or the opportunity-cost concept.8

The opportunity-cost concept measures in real terms the amount of interest that the publicsector or the central bank can potentially earn by investing the monetary base (M) at themarket interest rate (i). For a given price level (P), the opportunity-cost seigniorage for aspecific time period can be written as:

Sopp = iM

P(1)

The monetary concept, by contrast, calculates seigniorage as the real value of newly createdbase money:

Smon = dM

P(2)

Both concepts measure seigniorage in gross terms since the costs of producing, distributing,and maintaining the money stock are not taken into account. These costs must be coveredout of the seigniorage revenue.

In continuous time, we can show some important similarities and differences betweenthese two seigniorage concepts. Under rational inflationary expectations, the Fisher equationimplies that the nominal interest rate equals the sum of the inflation rate (π) and the realinterest rate (r). Consequently, the opportunity-cost seigniorage can be rewritten as:

Sopp = (π + r)M

P(3)

The monetary seigniorage can also be rewritten as:

Smon = dM

P= dM

M

M

P= µ

M

P(4)

whereµ is the growth rate of base money. Assuming that velocity and the money multiplierare constant, the quantity theory of money implies that money growth equals the sum ofthe inflation rate (π) and the real economic growth rate (g). Then monetary seignioragebecomes:

Smon = (π + g)M

P(5)

A comparison of Eqs.(3)and(5) reveals the similarities between the two concepts. First,the two measures are always identical if the steady-state growth rate (g) equals the real inter-est rate (r), as is typically assumed in a standard neoclassical model. Second, both measurestake into account the effects of steady state economic growth, either directly (throughg) in

8 A third concept, which is rarely used for empirical analysis, is the fiscal concept. A detailed discussion of thedifferent seigniorage concepts can be found inBailey (1956), Klein and Neumann (1990), andLange (1995).


the case of the monetary concept or indirectly (throughr) in the case of the opportunity-costconcept.9 Third, cumulative economic growth influences both seigniorage concepts throughthe real monetary base (M/P). According to the quantity theory, when velocity is constant,the holdings of real base money in steady-state will evolve as (M/P)t = etg (M/P)0. Fourth,for the steady-state nominal interest rate (i), it can be shown that the present value of policy-induced changes in opportunity-cost seigniorage is just equal to the monetary seigniorage.Consider the case of a “once-and-for-all” increase in base money (dM0) in the current period0. The monetary concept measures seigniorage at the time of the policy change (see Eq.(2)), implying a present value of dM0/P. Under the opportunity-cost concept (see Eq.(1)),the interest earnings on the increased monetary base accrue over many periods, resulting ina present value of (i dM0)/P 1/i = dM0/P.

An important difference between the two concepts is their response to an erratic tran-sitory increase in the monetary base (dM). Under the opportunity-cost concept (see Eq.(1)), seigniorage would initially change by dSopp/dM = i/P > 0, followed by a change inthe opposite direction of dSopp/−dM =− i/P < 0 when the impulse is offset. Under themonetary concept (see Eq.(2)), seigniorage would fluctuate by dSmon/dM = 1/P > 0 anddSmon/−dM =− 1/P < 0. Thus, the monetary seigniorage is much more volatile in the pres-ence of erratic monetary shocks. With an interest rate of 5%, for example, the monetarymeasure of seigniorage is 20 times more sensitive to a transitory shock in the monetary basethan the opportunity-cost measure.

The greater year-to-year volatility in the monetary measure of seigniorage is the pri-mary reason for adopting the opportunity-cost approach in this study. Several of the LatinAmerican countries in our sample experienced extreme monetary fluctuations during thetime period considered, thus leading to large fluctuations in their monetary seignioragethat make subsequent calculations less reliable. To facilitate cross-country comparisons,the opportunity-cost seigniorage is expressed as a share of real GDP (Y/P), resulting in theseigniorage rate (Lange & Nolte, 1998):

s = (iM/P)

Y/P= iM

Ywhere 0< s < 1 (6)

Since data on government bond yields (i) are not uniformly available, we use the Fisherequation for discrete time (i = r +πe + rπe) to calculate each country’s nominal market inter-est rate10 from the rationally expected inflation rate (πe =π) and the real government bondyield. The latter is proxied by the U.S. real rate plus a very conservative risk premium of 2%(r = rUS + 2%). Using the same risk premium for all countries guarantees that cross-countrydifferences in nominal interest rates solely reflect differences in inflation rates. Further-more, the resulting estimates of seigniorage losses due to dollarization tend tounderstate

9 The neoclassical model emphasizes long-term economic growth (g) as the sole determinant of the real interestrate (r). However, other variables such as inflationary expectations, exchange rate expectations, and/or risk premiaare also important and can contribute to differences betweenr andg.10 In the dollarization literature, the central bank’s opportunity cost is alternatively measured by the interest

rate on foreign bonds (i*). For example,Salvatore (2001, p. 350)uses bothi* and i to calculate “low-end” and“high-end” estimates of opportunity-cost seigniorage in Latin America sincei* < i for most countries. We willshow later that a measure ofi* is included in our study (see footnote 13 in Section2.2).


the true losses because the risk premium is likely to exceed 2% for many Latin Americancountries. A higher risk premium would lead to higher seigniorage losses (see Section2.2for a robustness test).

Using annual data (1995–2000) for 15 Latin American countries,11 the seigniorage rate

s = (r + π + rπ)M

Y(7)

is calculated as a benchmark for the subsequent estimation of the seigniorage costs ofunilateral official dollarization. The resulting average seigniorage rates range from a low of0.4% of GDP in Argentina to a high of 4.4% in Venezuela and Chile.12 Note that Argentina’sseigniorage rate was relatively low under the currency board that fixed the dollar–pesoexchange rate during 1991–2001.

2.2. Decomposing the seigniorage costs of dollarization

When a country officially dollarizes, the U.S. dollar becomes the sole legal tender.Domestic currency is withdrawn from circulation and replaced by dollars at a fixed exchangerate. Nominal GDP (Y) and prices (P) are converted to dollars at the same time. The newseigniorage rate in the dollarized country (s$) is now given by:

s$ = iαM/P

Y/P= iα

M

Y(8)

whereα ≥ 1 allows for the potential once-and-for-all increase in real money holdings afterdollarization. The monetary base (M) consists of currency in circulation (C) and total bankreserves (R), which are a fraction (rr) of bank’s total deposit liabilities (D), i.e.,R = rr × D.Consequently, the new seigniorage rate can also be written as:

s$ = iαC + rr × D

Y= iα(c + rr × d) (9)

wherec = C/Y is the currency–GDP ratio andd = D/Y is the deposit–GDP ratio.Under full dollarization, the currency–GDP ratio must be set to zero (c = 0) since the

seigniorage revenue for dollars in circulation is now collected by the U.S. rather than thedomestic central bank. The deposit–GDP ratio (d), on the other hand, will not change aslong as bank deposits and GDP are converted to dollars at the same fixed exchange rate at

11 The 15 countries, selected on the basis of data availability, are: Argentina, Belize, Bolivia, Brazil, Chile,Colombia, Costa Rica, Guatemala, Honduras, Mexico, Nicaragua, Paraguay, Peru, Uruguay, and Venezuela. Alldata are taken from theInternational Financial Statistics (IMF). The monetary base (M) is measured by “reservemoney” (line 14); nominal GDP (Y) is reported in line 99b or line 99b.c. The real U.S. interest rate (rUS) iscalculated from the Fisher equation, using the rationally expected inflation rate (πe =πUS) and the governmentbond rate (line 61). Inflation rates for all countries are based on the consumer price index (line 64.a and/or line64.b).12 Complete results for ex-post seigniorage rates are available atwww.csupomona.edu/∼clange/dollarization.htm.

Compared to the opportunity-cost measure, average seigniorage rates based on the monetary concept range from−0.9% of GDP in Argentina to 3.6% in Chile over the same time period.

http://www.csupomona.edu/~clange/dollarization.htm


the time of dollarization. This implies that the seigniorage rate after dollarization simplifiesto:

s$ = iα × rr × d where i = r + πe + rπe andπe = π (10)

Thus, as long as the reserve-deposit ratio is positive (rr > 0), a dollarizing country loses theseigniorage for currency in circulation, but not the seigniorage from deposits.

To assess the seigniorage costs of dollarization, the new seigniorage rate (s$) needsto be estimated, which in turn requires information about the expected behavior of themarket interest rate (i), the real balance shift parameter (α), and the reserve-deposit ratio(rr) after successful dollarization. We consider the following plausible scenarios for thethree variables.

• Nominal interest rates (i) can be expected to change after dollarization. Due to greaterstability and credibility in financial markets, variables such as real interest rates, expectedinflation rates, and country risk premia are likely to fall. We consider three scenarios eachfor the real interest rate (r) and the inflation rate (π): an optimistic value (convergenceto the U.S. level), a pessimistic value (no change from the current domestic level), andthe average of the two. The combination of these values thus generates a total of ninedifferent interest rate scenarios.13

• Real money holdings may increase after dollarization due to lower inflationary expecta-tions. This possibility is captured by allowing three scenarios for the real balance shiftparameter (α): an optimistic value (a 20% once-and-for-all increase, i.e.,α = 1.2), a pes-simistic value (no change, i.e.,α = 1), and the average of the two (α = 1.1).

• Reserve-deposit ratios (rr) may also change (Haslag & Young, 1998), possibly converg-ing to U.S. levels, due to greater competition and increased efficiency in the financialsystem of the dollarizing country. Again, we consider three scenarios: an optimistic value(convergence to the U.S. ratio), a pessimistic value (no change from the current domesticratio), and the average of the two.

Combining the ninei-scenarios with the threeα-scenarios and the threerr-scenarios yieldsa total of 81 values for the post-dollarization seigniorage rate (s$) as determined by Eq.(10).14 We calculate these 81 values for each of the 15 countries, using the averages of the

13 These nominal interest rate scenarios include the alternative measure of the central bank’s opportunity costi* (our optimistic value) that is discussed in the dollarization literature (e.g.,Salvatore, 2001) as well as thedomestic ratei (our pessimistic value). Consequently, we can calculate both “low-end” and “high-end” estimatesof seigniorage revenue.14 The available evidence for Ecuador and El Salvador, the two Latin American countries that have recently

dollarized, is supportive of these post-dollarization scenarios. In Ecuador, nominal interest rates have droppedfrom 32.5% prior to the adoption of the U.S. dollar (1995–1999 average) to an average of 6.8% since dollarizationin 2000. El Salvador’s experience is similar, with nominal interest rates that have fallen from the 1995 to 2000average of 11.7% before dollarization to an average level of 4.4% since then. Inflation rates are also lower inboth countries, especially in Ecuador. The reserve-deposit ratio has evolved differently in the two countries. It haschanged only marginally after dollarization in Ecuador, falling only slightly from an average of 13.8% to 13.2%since 2000. In El Salvador, on the other hand, the ratio has fallen significantly from its pre-dollarization averageof 30% to the current 11.4%. However, for both countries, this ratio is still considerably higher than the U.S. ratioof 2.4%.


1995–2000 benchmark period as proxies for the current state values of the U.S. and LatinAmerican variables. The new seigniorage rates (s$) are then used to estimate the changesin seigniorage revenue due to official dollarization as a share of GDP:

�s = s$ − s (11)

where s is the average seigniorage rate for the 1995–2000 benchmark period. A loss ofseigniorage revenue is indicated by�s < 0.

Complete results of these calculations for one of the 15 Latin American countries (Bo-livia) are presented inTable 1, where each cell corresponds to one of the 81 post-dollarizationscenarios described above.15 In the case of Bolivia, official dollarization would impose aloss of seigniorage (�s < 0) that is expected to range from 0.48% to 1.26% of GDP. Theaverage across all 81 scenarios amounts to 0.99% of GDP. Note that these figures includethe estimates of�s that are based on the “low-end” and “high-end” interest rate measuresdiscussed earlier (see footnotes 10 and 13).

Table 2below summarizes the results for all 15 countries (see columnTotal Effect,TE). These figures are the averages of the 81�s-values that we estimated for the 81 post-dollarization scenarios in each country. Thus, they reflect the average change in seignioragerevenue that the Latin American countries in our sample can expect if they were to dollarizeofficially. In general, our calculations indicate that all 15 countries would suffer a loss ofseigniorage due to official dollarization. In terms of magnitude, the average seignioragecosts range from a low of 0.27% and 0.53% of GDP in Argentina and Belize, respectively,to a high of 2.61% and 3.42% of GDP in Chile and Venezuela. Recall that the estimatedseigniorage losses tend tounderstate the true losses since the assumed country risk premiumof 2% is very conservative (see Section2.1). This is confirmed by a robustness test: if therisk premium increases by one percentage point, the estimated seigniorage losses increaseby an average of 0.12 percentage points across all 15 countries. Detailed test results areavailable on-line (www.csupomona.edu/∼clange/dollarization.htm).

It is important to realize that the seigniorage costs suffered by the dollarizing countriesreflect several factors. One effect of unilateral dollarization is the transfer of the moneycreation monopoly and the subsequent redistribution of seigniorage from the dollarizingcountry to the U.S. (redistribution effect, denoted as RE). This effect can be calculated asthe product of the market interest rate (i) and the pre-dollarization currency–GDP ratio (c);it is also a proxy for the additional seigniorage revenue collected by the U.S.:

RE = ic wherei = r + π + rπ (12)

On the other hand, dollarization brings benefits to the dollarizing country in the form ofgreater financial stability and credibility, which influence the post-dollarization seignioragerate through various channels (financial stability effect, denoted as FE). Greater stabilityand credibility contribute to lower inflationary expectations and lower risk premia, resultingin both lower nominal and real interest rates, so that seigniorage tends to fall. At the sametime, however, real money holdings probably rise after dollarization, which tends to raiseseigniorage. Finally, reserve-deposit ratios are likely to fall due to greater competition

15 Complete results for the other 14 countries are available atwww.csupomona.edu/∼clange/dollarization.htm.



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Table 1Estimated change in seigniorage in % of GDP (Bolivia)

Real interest rate Inflation U.S. reserve deposit ratio 2.14% Medium reserve deposit ratio 7.92% Bol. reserve deposit ratio 13.70%

α low1.00

α med1.10

α high1.20

α low1.00

α med1.10

α high1.20

α low1.00

α med1.10

α high1.20

U.S.3.52%

U.S. 2.53% −1.26 −1.26 −1.25 −1.12 −1.10 −1.08 −0.98 −0.95 −0.92Medium 4.74% −1.24 −1.24 −1.23 −1.05 −1.02 −1.00 −0.86 −0.81 −0.77Bol. 6.96% −1.22 −1.22 −1.21 −0.98 −0.95 −0.91 −0.73 −0.68 −0.62

Medium4.52%

U.S. 2.53% −1.25 −1.25 −1.24 −1.09 −1.07 −1.05 −0.93 −0.89 −0.85Medium 4.74% −1.23 −1.23 −1.22 −1.02 −0.99 −0.96 −0.80 −0.75 −0.70Bol. 6.96% −1.22 −1.21 −1.20 −0.95 −0.91 −0.87 −0.68 −0.61 −0.55

Bol.5.52%

U.S. 2.53% −1.25 −1.24 −1.23 −1.06 −1.03 −1.01 −0.87 −0.83 −0.78Medium 4.74% −1.23 −1.22 −1.21 −0.99 −0.95 −0.92 −0.74 −0.69 −0.63Bol. 6.96% −1.21 −1.20 −1.18 −0.91 −0.87 −0.83 −0.62 −0.55 −0.48

Average −1.23 −1.23 −1.22 −1.02 −0.99 −0.96 −0.80 −0.75 −0.70


Table 2Decomposition of seigniorage costs: five sub-groups

Group Country TE (%) FE (%) RE (%) π (%) rr (%) c (%)

1 Argentina −0.27 0.00 −0.27 0.49 6.72 4.491 Belize −0.53 −0.16 −0.37 1.47 11.30 5.66

1 Average −0.40 −0.08 −0.32 0.98 9.01 5.08

2 Bolivia −0.99 −0.54 −0.45 6.96 13.70 4.752 Brazil −1.13 −0.79 −0.34 17.32 16.22 2.312 Colombia −1.28 −0.72 −0.56 16.84 16.31 3.832 Guatemala −0.90 −0.43 −0.48 7.76 19.80 4.812 Mexico −1.14 −0.59 −0.55 22.00 7.06 3.202 Paraguay −1.45 −0.87 −0.58 9.57 28.93 5.312 Peru −0.98 −0.73 −0.24 7.61 36.24 2.45

2 Average −1.12 −0.67 −0.46 12.58 19.75 3.81

3 Costa Rica −2.09 −1.62 −0.47 14.44 37.08 3.533 Honduras −2.41 −1.56 −0.86 18.32 24.14 5.563 Nicaragua −1.99 −1.30 −0.70 11.15 20.71 5.973 Uruguay −2.21 −1.72 −0.50 18.60 25.65 3.20

3 Average −2.18 −1.55 −0.63 15.63 26.89 4.56

4 Chile −2.61 −2.33 −0.27 5.81 81.79 3.09

5 Venezuela −3.42 −2.68 −0.74 47.58 34.55 2.42

and increased efficiency in the financial system, thus lowering the monetary base in thedollarized country and reducing seigniorage. Note that the financial stability effect (FE) iscalculated as a residual by subtracting the redistribution effect (RE) from the total changein the seigniorage rate (�s) due to dollarization:

FE = �s − RE (13)

The results from decomposing the total seigniorage costs into these two factors are alsoreported inTable 2above (see columns RE and FE). The redistribution effect tends to berelatively small, ranging from 0.24% of GDP in Peru to 0.86% in Honduras. The financialstability effect, on the other hand, shows more variability across the 15 countries, withBelize exhibiting the lowest loss (0.16% of GDP) and Venezuela the highest (2.68% ofGDP); for the 1995–2000 sample period, Argentina is the only country showing no loss.Furthermore, the shares of the redistribution and financial stability effects differ significantlyacross countries. In Argentina and Belize, for example, the redistribution effect is the majorcomponent of the total seigniorage costs while the financial stability effect is negligible.The opposite is true for countries such as Chile and Venezuela (FE/RE-ratios of 8.63 and3.62, respectively). In the other countries, both effects are significant components of thetotal seigniorage costs. These observations raise the question whether the 15 countries canbe arranged into homogenous sub-groups using formal statistical methods.


3. Cluster analysis of seigniorage costs

The results in Section2 indicate that official dollarization would impose significantseigniorage costs on almost all 15 Latin American countries included in the sample. How-ever, the dollarization losses differ significantly across countries both in terms of the totalcosts as well as the decomposition into the financial stability and redistribution effects. Toanalyze more formally whether the countries with apparent similarities form identifiable,homogenous sub-groups, we now perform a cluster analysis on the seigniorage cost data.

We use an agglomerative hierarchical procedure to form homogenous groups on thebasis of the redistribution effect and the financial stability effect. The total effect is notincluded since it is highly correlated with the financial stability effect.16 In general, anagglomerative hierarchical procedure works in stages. In stage one, each group consistsof only one member. Thus, our analysis starts with 15 groups each consisting of a singlecountry. In every subsequent stage, the two most homogenous (least diverse) groups aremerged until all 15 countries are in one group after the final stage. The merging process isthen analyzed to interpret the sub-groups generated at different stages.

In the first stage, where each group consists of only one country, the squared Euclideandistance can be used to find the least diverse match of pairs of countries (Johnson & Wichern,2002, pp. 30 and 670). Using the financial stability effect (FE) and the redistribution effect(RE) as criteria to measure diversity between a pair of countriesi andj, the squared Euclideandistance (dij) can be calculated as:

dij = (FEi − FEj)2 + (REi − REj)

2 (14)

In subsequent stages of the analysis, at least one of the clusters will consist of two ormore countries. This raises the question of how to measure the distance (diversity) betweenclusters (groups) in order to identify the least diverse pair of groups, which will be mergedat the next stage. Various methods are discussed in the literature; here we adopt the methodAverage Linkage. Under this method, the distance between two clustersk andl consistingof K andL countries, respectively, is determined by the mean of the distances of all possiblepair-wise combinations of countries in clusterk with countries in clusterl.17

d(clusterk, clusterl) =∑

i

∑jdij

KLfor i = 1, . . . , K andj = 1, . . . , L (15)

16 The Pearson correlation coefficient is 0.981 (significant at 1%) between the total and the financial stabilityeffect, and 0.578 (significant at 5%) between the total and the redistribution effect. The correlation between theredistribution and the financial stability effect only amounts to 0.411 (insignificant even at the 10% level). Thesignificance levels for all three correlation coefficients are based on one-sided tests since negative correlationsseemed highly unlikely.17 Johnson and Wichern (2002, pp. 679–694)discuss three other methods, includingSingle Linkage, Complete

Distance, andWard. Single Linkage (or Nearest Neighbor) uses the pair (one member from each cluster) with thesmallest distance to calculate the distance between two clusters; by contrast,Complete Distance uses the pair withthe greatest distance. The third methodWard is based on a squared error criterion: for a given number of clusters ata certain stage of the analysis, the items (countries) are grouped so as to minimize the sum of all squared Euclidiandistances between the items and the corresponding cluster mean.


Fig. 1. Dendogram of the clustering process.

The reasons for adoptingAverage Linkage are that this procedure uses more than one pairof countries from each cluster and is not biased towards a certain type of group building(Jobson, 1992, pp. 523–552).18 As mentioned earlier, the two clusters with the smallestdistance are merged until only one cluster is left over. The resulting merging process isshown graphically in the dendogram inFig. 1, which should be read from left to right. Thehorizontal axis shows the standardized measure for the average distance for the mergedclusters at a certain stage.

Five sub-groups emerge after 11 stages of the clustering process:19 (1) Argentina andBelize; (2) Bolivia, Brazil, Colombia, Guatemala, Mexico, Paraguay, and Peru; (3) CostaRica, Honduras, Nicaragua, and Uruguay. Groups 4 and 5 are outliers,20 consisting of onlyone country each, Chile and Venezuela. In the next stage, these two countries are groupedtogether. After another stage, groups 1 and 2 are joined. Finally, the group consisting of

18 This avoids several problems associated with the other three methods mentioned byJohnson and Wichern(2002). A disadvantage of theSingle Linkage andComplete Distance procedures is that they use only one pairfrom each cluster to determine the distance between clusters, thus ignoring information provided by all other pairs.In addition,Single Linkage is biased toward building one large and many small groups whileComplete Distanceis biased toward building groups of equal size. The approachWard exhibits a small bias toward groups with asimilar number of members (Jobson, 1992, pp. 523–527).19 It might be surprising to find economically diverse countries like Argentina and Belize, or Brazil and Guatemala,

in the same group. However, this is due to the fact that the cluster analysis is based only on the two componentsof seigniorage (FE and RE) rather than any other economic factors.20 This is confirmed by the results from theSingle Linkage method, which is biased toward generating one large

and many small groups and, thus, can be used to identify outliers (Backhaus, Erichson, Plinke, & Weiber, 2000,p. 313). These results are available upon request.


Chile and Venezuela is merged with group 3, resulting in two large sub-groups—groups Iand II. An analysis of the clustering process suggests some interesting interpretations forthe stages that generate five and two sub-groups, respectively.21

4. Policy implications

To analyze the stage with five sub-groups we consider the information inTable 2(seeSection2.2), which presents each group’s average seigniorage costs as well as average in-flation rates (π), reserve-deposit ratios (rr), and currency–GDP ratios (c) for the underlying81 scenarios. Inter-group differences in these three variables are responsible for differencesin seigniorage costs across groups. For the redistribution effect (RE =ic), inter-group dif-ferences are caused by differences in only two variables: the inflation rate, via its effecton the nominal interest rate, and the currency–GDP ratio. For the financial stability effect(FE= �s − RE), inter-group differences are driven by differences in all three variables.

The five sub-groups reflect the rising burdens that official dollarization would imposeon the group members. Group 1 (low FE and low RE) is expected to experience relativelylow seigniorage costs.22 This primarily reflects the fact that group 1 exhibits the lowestaverage inflation rate (0.98%) and reserve-deposit ratio (9.01%), both of which contributeto the low financial stability effect. The low inflation rate also offsets the relatively highcurrency–GDP ratio (5.08%), leading to the low redistribution effect. In group 2 (mediumFE and medium RE), total seigniorage losses are almost four times larger than in group 1.This group is characterized by much higher inflation rates (12.58% on average) and reserve-deposit ratios (19.75% on average), leading to a financial stability effect eight times largerthan for group 1. However, the redistribution effect is only slightly larger than for group1 due to the lower average currency–GDP ratio (3.81%). Group 3 (high FE and high RE)would suffer a higher burden still due to the high average inflation rate (15.63%), reserve-deposit ratio (26.89%), and currency-deposit ratio (4.56%). Finally, the outlier groups 4 and5 would suffer severe and very severe seigniorage losses, respectively. In Chile (very highFE but low RE), the financial stability effect is mostly due to the extremely high reserve-deposit ratio (81.79%).23 The redistribution effect, on the other hand, is relatively low sinceit is independent of this ratio. Venezuela’s burden (extremely high FE and high RE) is verysevere. Despite the relatively low currency–GDP ratio (2.42%), the very high inflation rate(47.58%) and reserve-deposit ratio (34.55%) trigger this outcome.

The results of the clustering exercise at this stage raise two interesting issues. Oneconcerns the possible relationship between the seigniorage costs of official dollarizationand the degree of current financial (partial) dollarization, as measured by the share of

21 The results of the clustering analysis at these stages are also remarkably stable. The same groups of countriesare formed regardless of the procedure used to calculate the distance between two clusters. For theSingle Linkage,Complete Distance, andAverage Linkage methods, this is also true when the original Euclidean distance is usedinstead of the squared distance. Note that in the case ofWard, the squared distance is the only appropriate measure.22 Note that our sample period ends before the collapse of the Argentine currency board in December 2001.23 The high reserve-deposit ratio partially reflects the reserve requirements (“encaje”) that Chile imposed on

short-term capital inflows during 1991–1998 (e.g.,Edwards, 1999).


dollar-denominated deposits in total bank deposits or a more comprehensive index devel-oped byReinhart et al. (2003). Using recent data on financial dollarization (Arteta, 2002;Reinhart et al., 2003),24 we find no clear link between unofficial dollarization and the risingseigniorage costs of official dollarization across the five sub-groups. On one hand, group 3with relatively high seigniorage losses due to official dollarization consists of four highlydollarized countries (Costa Rica, Honduras, Nicaragua, and Uruguay). On the other hand,countries with a high degree of financial dollarization (Argentina, Bolivia, Paraguay, andPeru) can also be found in groups 1 and 2, where the estimated burdens from official dollar-ization are relatively low or moderate. However, this finding is not surprising since unofficialdollarization is only one of several factors (i.e., inflation rates, reserve-deposit ratios, andcurrency–GDP ratios) that determine seigniorage.

More importantly, it is necessary to consider the budgetary consequences of official dol-larization since seigniorage is an important source of government revenue in Latin America(see Section1). The estimated average seigniorage costs (ranging from 0.40% of GDP forgroup 1 to 3.43% of GDP for group 5) will influence each country’s government budget viasmaller central banks profits, which have to be offset somehow. In general, there are threeoptions: increased government borrowing, tax hikes, or spending cuts. The first is unlikelysince many Latin American countries are close to reaching their borrowing limits. Tax hikesare also problematic for many countries due to a small tax base and/or a high incidence oftax evasion. Finally, cuts in government spending are highly unpopular and may result inpolitical upheaval or even riots. Without external help, these short-term budgetary problemsmight prevent a country from dollarizing even if it would be beneficial for its long-termeconomic welfare. Taking into account political economy considerations, such a negativedollarization decision is even more likely since a government facing re-election will putmuch more emphasis on the short-term budgetary problems than on the expected long-termbenefits from official dollarization.

For cases in which dollarization benefits both the dollarizing country and the U.S., thequestion can be raised whether the Federal Reserve should compensate officially dollarizedcountries for their seigniorage losses. However, compensation for the financial stabilityeffect is unrealistic for two reasons. First, the Federal Reserve is not charged with sub-sidizing economic development in other countries. Second, the seigniorage costs due tothe financial stability effect must be weighed against the overall benefits from increasedstability and credibility in financial markets of the dollarized country. Compensation forthe redistribution effect must be viewed differently because official dollarization not onlytransfers the country’s money creation monopoly but also the corresponding seignioragerevenue (proxied by redistribution effect) to the U.S. Therefore, U.S. compensation wouldsimply reimburse the dollarizing country for the redistribution effect.

Even with U.S. reimbursement, it is questionable whether compensation for the redistri-bution effect would reduce total seigniorage costs enough to make dollarization viable. This

24 The data compiled byArteta (2002)andReinhart et al. (2003)indicate that eight of the 15 Latin Americancountries in our sample (Argentina, Bolivia, Costa Rica, Honduras, Nicaragua, Paraguay, Peru, and Uruguay)exhibit a (very) high degree of financial dollarization. These countries typically hold at least 40% of total depositsin foreign currency and/or are classified as highly or very highly dollarized on the basis of the comprehensiveindex.


Table 3Decomposition of seigniorage costs: two sub-groups

Group Country TE (%) FE (%) RE (%) π (%) rr (%) c (%)

I Argentina −0.27 0.00 −0.27 0.49 6.72 4.49I Belize −0.53 −0.16 −0.37 1.47 11.30 5.66I Bolivia −0.99 −0.54 −0.45 6.96 13.70 4.75I Brazil −1.13 −0.79 −0.34 17.32 16.22 2.31I Colombia −1.28 −0.72 −0.56 16.84 16.31 3.83I Guatemala −0.90 −0.43 −0.48 7.76 19.80 4.81I Mexico −1.14 −0.59 −0.55 22.00 7.06 3.20I Paraguay −1.45 −0.87 −0.58 9.57 28.93 5.31I Peru −0.98 −0.73 −0.24 7.61 36.24 2.45

I Average −0.96 −0.54 −0.43 10.00 17.37 4.09

II Costa Rica −2.09 −1.62 −0.47 14.44 37.08 3.53II Honduras −2.41 −1.56 −0.86 18.32 24.14 5.56II Nicaragua −1.99 −1.30 −0.70 11.15 20.71 5.97II Uruguay −2.21 −1.72 −0.50 18.60 25.65 3.20II Chile −2.61 −2.33 −0.27 5.81 81.79 3.09II Venezuela −3.42 −2.68 −0.74 47.58 34.55 2.42

II Average −2.46 −1.87 −0.59 19.32 37.32 3.96

question can be addressed with the help of the second-to-last stage of the cluster analysis,forming groups I and II. Information for these groups is presented inTable 3. The two groupsare relatively similar in terms of their average currency–GDP ratios (4.09% and 3.96%) andthus, their average redistribution effects (GDP-costs of 0.43% and 0.59%, respectively).The major difference between groups I and II is the size of the financial stability effect,both in terms of GDP-costs (0.54% for group I and 1.87% for group II) and relative tothe redistribution effect (FE/RE-ratio of 1.26 for group I and 3.17 for group II). This hasimportant implications for possible seigniorage revenue-sharing agreements with the U.S.

Realistically, as discussed above, the U.S. would at best reimburse these countries fortheir seigniorage losses due to the redistribution effect.25 For the Latin American countriesin group II, compensation by the U.S. would be a “drop in the bucket” in terms of the overallseigniorage costs of dollarization, given that these countries still face a considerable short-term burden due to the financial stability effect (seigniorage loss of 1.87% of GDP). For thecountries in group I, on the other hand, U.S. compensation for the amount of seigniorageredistributed would significantly reduce the seigniorage costs of official dollarization. Froman international monetary policy perspective, this can be a “win–win” scenario for both thedollarizing country and the U.S. as long as their overall net benefits are positive. Unilateraldollarization with U.S. compensation for the redistribution effect allows both parties toenjoy the expected stability effects at relatively low costs (or even negligible costs in the

25 Such a formal rule “. . . to share seigniorage with officially dollarized countries” was discussed in committeehearings on theInternational Monetary Stability Act of 1999 – S. 1879 (U.S. Senate Committee on Banking, Hous-ing, and Urban Affairs, 2000, pp. 7/12–8/15). However, the proposed legislation is no longer under considerationby theU.S. Senate.


U.S. case). It can thus be concluded that it could be advantageous for the U.S. not only topromote unilateral dollarization in Latin America, but also to consider some type of bilat-eral seigniorage revenue-sharing agreement with group I partners who decide to dollarizeofficially.

It should be noted that the arguments above apply in the context of partial equilibriumanalysis, where individual countries decide to dollarize one-by-one (like Ecuador and ElSalvador) rather than all at once.26 Furthermore, the “win–win” scenario for membersof group I reflects an assessment of theeconomic net benefits of dollarization. A coun-try’s decision whether or not to dollarize will also depend onpolitical factors such asthe loss of the own currency as a symbol of national sovereignty and the lack of directinfluence on monetary policy decisions made by the U.S. Federal Reserve. These politi-cal considerations are important since they can potentially reverse the results of the eco-nomic cost–benefit analysis of dollarization. However, they go beyond the scope of thispaper.

5. Summary and conclusions

This paper makes a contribution to the debate about the economic costs of official dollar-ization by examining the expected seigniorage losses in 15 Latin American countries. Usingthe opportunity-cost definition of seigniorage and various post-dollarization scenarios re-garding interest rates and other monetary variables, we decompose the total seigniorage lossinto two components that reflect the cost of transferring the money creation monopoly tothe U.S. (redistribution effect) and the effects of lower risk premia and greater price stabilityin the dollarized country (financial stability effect). Next, a cluster analysis is performedto sort countries into sub-groups with similar underlying characteristics and interpret theresults in terms of their policy implications.

Our calculations indicate that dollarization would impose significant seigniorage costson almost all countries in the sample. However, the dollarization losses differ considerablyacross countries, both in terms of the total effect as well as the relative shares of the twounderlying components. A cluster analysis is performed on the basis of the financial stabilityand redistribution effects. Five homogenous sub-groups are formed after 11 stages of themerging process, exhibiting different seigniorage burdens of official dollarization rangingfrom low to very severe. The differences in fiscal burdens can be attributed to differencesin the underlying inflation rates, reserve-deposit ratios, and currency–GDP ratios, but notthe degree of financial dollarization. The two large groups emerging at the second-to-laststage allow us to make policy recommendations regarding possible seigniorage revenue-sharing agreements with the U.S. Leaving political economy considerations aside, it couldbe advantageous for the U.S. to actively promote unilateral dollarization in Latin Americaby agreeing to share seigniorage revenue with the countries whose losses due to the financial

26 This is the model chosen by the founding members of the European Monetary Union (EMU), who abandonedtheir national currencies and central banks to adopt the euro in January 1999. In the case of Latin America, such acoordinated move to unilaterally adopt the dollar as a common currency is highly unlikely due to political as wellas economic factors.


stability effect are relatively small (“win–win”), but not with the countries that have a largefinancial stability effect (“drop in the bucket”).

Acknowledgments

The helpful comments and suggestions of two anonymous referees are gratefully ac-knowledged. We thank Sara Saulcy for her research assistance. The usual disclaimer ap-plies.

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Dollarization in Latin America: seigniorage costs and policy implications