1. Dollarization, CBAs and the AEL model

Dollarization has become a popular idea for some economists who want to save battered currencies. Unfortunately, there is a dearth of intelligent analyses. Irrespective of the long-term economic merits of dollarization, its usefulness as a "rescue" measure in a crisis situation has not been underpinned by solid arguments.

A fixed exchange rate regime, including a currency board arrangement (CBA), may be used to solve an internal crisis through compliance with strict monetary discipline. Having said that, I do not support the notion that a fixed exchange rate, chosen on a particular date against a particular currency at a particular exchange ratio, can and should last forever. How can we have so much confidence and faith in a possibly "desperate" choice?

External crises that are out of one's control should not be treated with the attitude of "come what may". An option to "exit" from the fixed exchange rate system needs to be preserved, and the economy should not "over-invest" in such a system, lest the "exit cost" would be unduly high. I think that the AEL (Argentina, Estonia, and Lithuania) model of CBAs, with suitable cushions against extreme interest rate volatility, is about right for Hong Kong under the present circumstances (Tsang, 1998a, b, c). The seven "technical measures" announced by the Hong Kong Monetary Authority (HKMA) on 5 September 1998 (HKMA, 1998) went a long way towards that goal, although tricky problems remain (Tsang, 1998c)

Surely, this "non-purist" stance may lead to "residual doubt", and the fixed exchange rate regime would not be "perfect". There could be opportunities for bureaucrats to meddle and betray. Systematic risks might be enlarged, with bulging risk premia in interest rates, and the forward exchange rate could weaken. In any case, one has to balance short-term "fixity" with long-term flexibility, particularly in times of huge external disequilibria.

Dollarization is obviously more drastic than CBAs: there is simply no "exchange rate" to defend. Nevertheless, the following two issues are separate: (1) whether dollarization is optimal as a relaxed choice; and (2) whether dollarization can be used as a "rescue" measure to "save" a currency or an economy under stress.

2. Dollarization as an optimal choice and as a rescue

Regarding the first issue, it really "depends". US-dollarization might arguably be an attractive proposal in the 1990s, but what about the 1970s? Macau could be regretting about tolerating "Hong Kong dollarization" for so long. And I do not find any good reasons to "dollarize" the Hong Kong economy now, particularly after the partial acceptance of the AEL model on 5 September 1998 (Tsang, 1998c). Dollarization would involve dramatic "exit cost" in the 21st century, should Hong Kong decide that it is optimal to "de-dollarize", re-issue the Hong Kong dollar, float it or peg it with the then fully convertible Renminbi.

Can dollarization serve as a useful rescue? Probably not. The distinction between official and unofficial dollarization is crucial. In lieu of foreign exchange controls, market-driven dollarization is a "natural" process and the government has no role to play. You and I could do it any moment we like. There is no need to "advocate" it. Actually, the government better not do so.

Whether the process of market driven dollarization is beneficial or harmful to the domestic currency is not easy to judge. In Argentina, the currency board system seems to have become more robust as people can freely use and exchange the peso and the US dollar. But the "half-dollarization" phenomenon is a legacy of past hyperinflation, not something that the government promoted. The government just did not, or failed to, stop it.

The CBAs in Estonia and Lithuania, on the other hand, do not allow the parallel circulation of the Deutschemark and the US dollar, but their spot exchange rate stability remains intact. As to Macau (50% plus HK dollarization) and Uruguay (90% plus US dollarization), monetary stability has not been guaranteed. One must not forget that dollarization could mean massive capital flight and panic currency substitution.

Officially dollarized regimes now exist only in very small economies, except for Panama and Puerto Rico, which have a population of 2.5 million and 3.5 million respectively. But they were dollarized in 1904 and 1899. One wonders how "large" their populations and the economies were then.

3. The problems of officially sponsored dollarization

This brings us to the crucial question: can a large international financial centre like Hong Kong "officially dollarize"? Will the process be smooth and stabilizing? I am rather sceptical.

The Hong Kong government has actually considered the problems of official dollarization in its Report on Financial Market Review issued in April 1998 (FSB, 1998, paras. 3.60-3.63). It listed four difficulties: (1) transitional issues: huge legal and practical problems concerning existing HK$-denominated contracts under force majeure and the possibility of people shifting even US$-denominated assets out of Hong Kong, leading to a serious leakage of local liquidity; (2) the loss of seignorage; (3) operational issues such as the lack of liquidity provision in Hong Kong while the US market closes because of the difference in time zones; and (4) implications for "one country, two currencies".

I think difficulties (1) and (3) are crucial for an international financial centre such as Hong Kong, especially (1). Again back to the distinction between official and market-driven dollarization, how can a government officially dollarize? Remembering that dollarization means the abolition or demise of the domestic currency, there are obviously three options for the government: (1) overnight legislation: (2) announcing a "transitional period"; or (3) "parallel dollarization".

During a currency crisis, like the one that many East Asian economies are now caught in, option (2) is highly problematic, if not exactly suicidal. To announce that the government is going to abolish the domestic currency one year from now might generate a financial earthquake: people would run for cover, the unofficial exchange rate of the domestic currency would plunge whilst interest rates rocket. It is likely that the real economy would suffer even more under this process of currency substitution.

As to option (3), i.e. "parallel dollarization", the government can simply announce that it will accept the US dollar as a legal tender, alongside the local currency, without giving any deadline for the latter's demise. Like option (2), such a pledge amounts to an admittance by the government of serious weakness in its own currency. All the problems related to option (2) will occur.

4. Overnight dollarization?

If a transitional period or parallel dollarization is destabilizing, can a modern financial economy "officially" dollarize overnight? My view is again "probably not". The gist of the problems is not the supply of US dollar notes and coins, which can be arranged in confidentiality with the US Fed before hand (whether the Fed likes it or not is another story). It is rather that financial developments have drastically complicated everyone's balance sheet, and an overnight shift of currency denomination would cause havoc.

Unlike a tiny economy dominated by cash transactions, there are all kinds of financial contracts denominated in the domestic currency that stretch our rights and obligations to a lengthy time horizon ahead. That is in the nature of a modern economy, not to mention an international financial centre like Hong Kong. People borrow mortgage loans and issue debt instruments in Hong Kong dollars at rates substantially different from the US dollar counterparts, whilst making various Hong Kong dollar investments for different rates of returns.

An overnight abolition of the Hong Kong dollar (which is what overnight dollarization means) will throw all our plans into chaos: some will gain, others will suffer, perhaps very significantly. The consequence is a huge re-allocation of fortunes and misfortunes. Any government that dares to engineer such an "overnight overhaul" must be a very brave one!

Should dollarization evolve "naturally" and through voluntary private agreements and contracts, there will be no such dramatic impact. However, given the complex webs of existing obligations denominated in the local currency, it would take a long time for complete dollarization, if ever.

In sum, if dollarization is a market driven process, let it be. But if it is to be a government-sponsored project with the objective of rescuing a currency or an economy during a crisis, I will be very wary of such a proposal. Moreover, don't forget about the exit cost!

References

Financial Services Bureau (FSB) (1998), Report on Financial Market Review, Hong Kong Government.

Hong Kong Monetary Authority (HKMA) (1998), Strengthening of Currency Board Arrangements in Hong Kong, A Technical Note, 5 September.

Tsang Shu-ki (1998a) "The Hong Kong Government's Financial Market Review Report: An Interpretation and A Response," article at web site: www.sktsang.com/ArchiveI/web985.htm

Tsang Shu-ki (1998b) "Is a Currency Board System Optimal for Hong Kong?" article at web site: www.sktsang.com/ArchiveI/web986.html.

Tsang Shu-ki (1998c) "Welcome on Board the AEL Model, Hong Kong, but.....", article placed at web site: www.sktsang.com/ArchiveI/web989.html