This report will focus on the issue of Mexico adopting the US dollar as its official currency.
Dollarization in Mexico
This report will focus on the issue of Mexico adopting the US dollar as its official currency. We will examine the feasibility behind the surrender of the Mexican peso, the replacement of the country’s physical currency with US dollars, and the effects that these actions will have on Mexico from an economic, political and social perspective. In examining these effects, we will determine whether the Mexican government should pursue official dollarization.
I. Requirements and processes.
Some economists have argued that countries wishing to replace their central banking systems through dollarization must first fulfill certain preconditions, such as a high level of dollar reserves, a solvent banking system, sound government finances, and flexible wages (Joint Economic Committee). However, if these conditions already exist within a country, chances are their monetary policy would already be effective, which would negate the need for dollarization (Id.). In Mexico’s case, there would be no preconditions to fulfill in order for the country to consider becoming a candidate for dollarization. However, there are a few important steps that the Mexican government must address once the decision to dollarize has been made.
One of the main issues in dollarization is the exchange of all the Mexican peso currency into US dollar notes. This exchange will be handled by the current Mexican central bank. The central bank will have to exchange all of its reserves for US dollars in order to be able to float the new currency within Mexico. In dealing with this exchange, the Mexican government must address the issue of foreign reserves within its central bank (Id.). The central bank in Mexico will typically have almost no physical foreign notes, because the notes themselves do not pay any interest (Id.). However, the bank will likely hold foreign currency deposits at foreign banks, in addition to foreign government bonds (Id.). Although reserves such as these are not suitable for dollarization (direct exchange for dollars), if the foreign assets are of substantial quality, they will likely be liquid enough to convert quickly once the government begins to dollarize (Id.). Thus, the Mexican central bank must assess the assets that it holds, and determine whether the foreign reserves meet the liquidity requirements necessary in order to dollarize (Id.).
Next, the Mexican government must decide how much of the central bank’s liabilities will be dollarized. In order to achieve the minimum requirement for official dollarization, the government must accept all peso notes and coins that the public wishes to convert into some form of US dollars (Id.). However, other components of the monetary base such as domestic peso denominated bonds, and reserves of commercial banks, need not be dollarized at the outset (Id.). Dollarizing domestic bonds may actually hurt the dollarization process, by putting pressure on the domestic bond market and thus hurting the balance sheets of some domestic commercial banks (Id.). Furthermore, commercial banks that hold their reserves at the Mexican central bank need not convert all their assets into dollars (Id.). Mexico can simply issue government bonds payable in US dollars, or simply give the commercial banks easily marketable securities, such as US Treasury bonds, in place of physical dollar notes (Id.). Therefore, the government must first establish whether or not it has enough peso reserves to be able to convert all or part of the monetary base into dollars.
After the reserve and liability requirements have been established, the Mexican government must set an exchange rate, which will be used to convert pesos into dollars (Id.). It is important not to try to overvalue or undervalue the peso against the dollar when setting the exchange rate, as this could have negative consequences on Mexico’s balance of trade. In overvaluing the peso against the dollar, Mexico’s exporters will be hurt because their products will become more expensive in world markets (Id.). Whereas, by undervaluing the peso relative to the dollar, Mexico would be hurting importers, and consequently hurting consumers within Mexico itself, by making imports more expensive to consume (Id.). Thus, the Mexican government should allow the peso to float cleanly, without any intervention, for a period of no less than thirty days, in order to establish an appropriate, market determined exchange rate (Id.).
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Once the floating period for the peso expires, the government should both declare an exchange rate for the peso relative to the US dollar, and declare the dollar as legal tender (Id.). The central bank will then be required to exchange all peso denominated liabilities, such as the peso notes and coins in circulation, in addition to the amount of the monetary base that the government has determined will be dollarized (Id.). This is the step where the central bank may begin physically exchanging the circulating peso currency for dollars. Depending on the speed with which the Mexican government wishes to implement dollarization, the entire currency could theoretically be replaced within a matter of weeks (Id.). Furthermore, the Mexican government could benefit from a rapid dollarization by reinforcing their commitment towards the new policy of dollarization (Id.).
Next, the central bank should announce that, effective immediately, all peso assets and liabilities are dollar assets and liabilities as per the new exchange rate (Id.). It is important for the government to establish a transition period, preferably one that would last 90 days, in order to allow the smooth replacement of quotations of wages and prices in pesos with quotations in dollars (Id.). The 90 day transition period allows merchants and financial institutions ample time in order to update their systems and records to handle transacting business in dollars. All commercial bank assets and liabilities (bank loans and deposits); will become denominated in dollars during this period (Id.). Furthermore, the central bank must ensure that commercial banks do not charge a commission, or conversion fee for converting pesos to dollars once the dollarization process begins (Id.).
Subsequently, the government must make a decision about coins in the new monetary base. Depending on the exchange rate, US dollar coins may not convert easily into a whole number relationship with the dollar. Hence, the government may either choose to devalue or revalue coins, and only coins, to a nearby whole number equivalent that matches the new dollar rate (Id.). Otherwise, Mexico may simply choose to follow in the footsteps of Panama, and issue its own coin currency, which may float alongside the dollar (Id.). Since coins are a relatively tiny part of a country’s monetary base, the overall economic effects of choosing either revaluing or issueing coins will be insignificant.
Following the successful completion of the above steps, the government may then choose to redefine the role of the central bank. Once dollarization has been completed, the central bank will cease to be a monetary authority within Mexico (Id.). Thus, the central bank’s role should be redefined towards the monitoring and regulation of financial institutions within Mexico (Id.). Thus, Mexico would be able to leverage the expertise and organization that exists within the current central bank.
II. Sociopolitical effects
Dollarization will serve to enhance the economic and political stability of Mexico. By replacing the peso with the US dollar, the Mexican government will remove the stigma of having a currency that has lost over 98 percent of its dollar value in the past twenty-five years (The Cato Journal). The reestablishment of economic stability within the country would help to rebuild the Mexican people’s faith in the administration (that adopts dollarization), and would strengthen the people’s confidence in their own economic and political prospects. This, in turn, could lead to more domestic investment within the country.
Another issue is that many of Mexico’s northern border states are already unofficially dollarized (CNN). This means that there is already widespread use of US dollars in these states. Furthermore, many large companies throughout the country use dollars to conduct business, especially companies that engage in exports (Id.). While these larger firms are able to secure dollar financing, at low rates, most other Mexican businesses are forced to have to deal with high cost peso loans (Id.). Dollarization would help to level the playing field between these businesses by making low rates available to all firms that seek financing (as long as they meet the loan requirements).
One major obstacle toward dollarization is the political fear that the Mexican people will experience a decrease in national pride resulting from the loss off the peso (The Dallas Fed). From a political standpoint, this could be very dangerous for the administration that ratifies dollarization (Id.). Angry Mexicans could use elections to retaliate against the administration if the economy does not immediately show signs of growth from the dollarization (Id.). However, if positioned properly, dollarization could be marketed as a return to Mexico’s original currency (Id.). Originally, the US dollar was based on the Spanish/Mexican dollar, both in terms of silver content and in the symbol that is now the dollar sign (Id.). The current dollar sign symbol that is used originally came from the Spanish royal family’s shield (Id.). The government should use marketing and public awareness campaigns to proliferate the spread of this information in order to build solidarity between the Mexican people and the proposed new currency. Furthermore, the government could also issue coins, as discussed in the previous section, as another potential solution to this problem (Joint Economic Committee).
Another major obstacle is the loss of monetary control that would result from dollarization. This issue will be covered in the next section in terms of its economic cost, but it is also important to note that there is a political and emotional cost here as well. Losing monetary authority may be viewed by some Mexicans as an admission of government inability to manage the currency. Politically, this could hurt the administration that tries to adopt dollarization because some of the population may view that administration as inept. However, given Mexico’s history regarding the mismanagement of monetary policy over the past 25 years, we feel that most Mexicans will likely welcome a change towards a more stable monetary system (The Cato Journal).
III. Costs and benefits of dollarization
One important cost that Mexico will realize as a result of dollarization will be the loss of seigniorage. Seigniorage is the revenue that a country realizes from issuing currency (Joint Economic Committee). The difference between the cost of putting money into circulation and the value of the goods the money will buy is called net seigniorage (Id.). In losing the ability to print its own currency, Mexico will lose the revenue that would have occurred from replacing their peso currency with US dollars (Id.). This loss is called the stock cost and refers to the cost of obtaining enough foreign reserves necessary to replace domestic currency in circulation (Id.).
A study conducted by Stanley Fischer, who today is the First Deputy Managing Director of the IMF, determined that the stock cost of official dollarization for an average country would be somewhere between 4 to 5 percent of GDP (Fischer p. 305). However, the International Monetary Stability Act of November 1999, allows the Secretary of Treasury to certify officially dollarized countries as eligible to receive rebates of seigniorage from the US (Joint Economic Committee). These rebates would amount to 85 percent of the seigniorage the US realizes, as determined by a formula stipulated in the act (Id.). These rebates would serve to substantially lessen the impact of lost seigniorage for the Mexican government.
Once dollarization has been adopted, conversion costs must also be taken into account. In addition to the seigniorage costs which we’ve discussed, there will be one time costs to dispose of old currency, as well as to convert prices, computer programs, cash registers and vending machines to the new dollar currency (Id.).
Another issue is the cost of losing Mexico’s central bank as lender of last resort (Id.). The International Monetary Stability Act plainly states that the US will not act as a lender of last resort to countries that officially dollarized (Id.). This could cause potential problems for Mexico’s banking system in the event that a crisis should occur. However, there are a few possible solutions to this problem. First, Mexico could use the rebated seigniorage in order to build up a reserve for use in the event of a banking crisis. As we had suggested earlier, reforming the central bank to act as a regulator of financial institutions would be one way to implement this process. Another alternative would be to secure credit from foreign banks that would be willing to extend credit to Mexico if a crisis does arise (Id.).
One more major cost of dollarization would be the loss of Mexico’s power to control its own monetary policy (Cross Border). Mexico will not have the power to create dollars, make changes in the money supply or the exchange rate (Id.). Thus, if Mexico were hit by a crisis that developed outside the country, the government would have fewer options regarding the management of the economy (Id.). However, given Mexico’s history of mismanagement over the past 25 years (the peso lost 98 percent of its value vs. the US dollar during this time), losing control of monetary policy may be a blessing for the economy in the long run. History has shown that Latin American countries that have exercised greater flexibility in monetary policy have made interest rates more rather than less volatile in response to changes in U.S. interest rates (Joint Economic Committee). Thus, in losing the ability to shift its monetary policy, Mexico will be able to take advantage of the United States’ interest and inflation rate stability.
One advantage of dollarization is that it would serve to eliminate the need to continually support the peso (Id.). Although Mexico has relied on a floating exchange rate since 1994, the system is not a pure floating rate (The Cato Journal). Thus, Mexico has had to occasionally intervene in order to support the peso. Eliminating the need to support the peso would remove one policy that could potentially result in a recessionary environment for the country (see graph 1). In addition, by eliminating the Mexican government’s power to print money, dollarization will foster budgetary discipline (Joint Economic Committee). Simply put, the Mexican government will no longer be able to hide deficits by printing more money (Id.). They will now have to use more transparent methods to resolve budgetary issues, such as raising taxes or taking on debt (Id.).
Dollarization would also bring Mexican price levels on par with US price levels. By adopting the US dollar as its official currency, Mexico will be able to lower its notoriously high inflation rate down to US levels (see graph 2) (Joint Economic Committee.). The reduction in inflation would lead to a stabilization of interest rates within Mexico (Id.). These conditions would lead to an improvement in Mexico’s credit rating on the bond market (Id.). The higher credit rating, elimination of exchange rate risk (from dollarization), and stabilization of interest rates would lead to more foreign direct investment, which would spur growth within the country (Id.). In addition, lower interest rates would make it easier for smaller businesses to obtain lending, which would increase competition, create more jobs and increase consumer surplus through lower prices. Economic stability would also make it easier for Mexico to secure foreign credit for use in the event of a banking crisis (as we had suggested earlier).
Additionally, the economic growth that would result from the stabilization of inflation and interest rates should help to create and maintain an environment of political stability within Mexico. This would benefit both politicians and ordinary people by giving the controlling administration a chance at holding on to power long enough to implement policies that could be beneficial for the prosperity of the country.
Finally, dollarization would eliminate both transaction costs and exchange rate risks with regard to trade between the US and Mexico (Id.). Mexico is currently the US’s second largest trading partner in terms of combined imports and exports, second only to Canada (see graph 3) (US Census). Removing the transaction costs associated with converting from one currency to the other and the elimination of exchange rate risks will help to strengthen and increase Mexico’s trade status with respect to the US. Furthermore, the elimination of exchange rate risks will also encourage foreign direct investment within Mexico, which should add to the growth of the economy.
The benefits of dollarization outweigh the proposed costs to the Mexican government. Mexico has a history of monetary policy mismanagement, high inflation, and unstable exchange rates. Dollarization would create economic stability for Mexico by lowering the inflation rate, which would lead to more stable interest rates. Furthermore, exchange rate variability would be eliminated. In order to minimize the potential costs and risks involved with the dollarization process, we recommend that the Mexican government follow all of the steps we have outlined in section one of this report.
In addition to the steps in section one; the Mexican government should reform their central bank into a regulatory agency to monitor financial institutions, once dollarization has begun (Joint Economic Committee). This would eliminate the costs of setting up an entirely new organization to monitor financial institutions, and could also leverage off of the existing expertise that the current organization has with regard to the country’s banking system. Furthermore, the government should enable the new central bank to collect rebated seigniorage from the US, and to secure lines of credit from foreign banks. These monies should be used as reserves in case the banking system in Mexico experiences some sort of financial crisis. Thus Mexico would be able to retain some limited form of lender of last resort ability, which negates one of the major costs of dollarization.
We feel that implementing these steps will ensure a successful transition for Mexico towards dollarization. Although the benefits of dollarization may take time to materialize, we strongly feel that in the long run, dollarization is the best way to stabilize and strengthen the Mexican economy.
- The excess supply of pesos creates downward pressure on the currency (towards the equilibrium level).
- The Mexican government steps in by selling US $ (from reserves) and buying pesos (in order to fill the excess supply).
- If executed correctly, this shifts the demand curve to the right (D’), eliminating the excess supply and the downward pressure on the peso.
- Mexican money supply decreases and Mexican interest rates rise.
- This reduces spending because there are less pesos floating around and the higher interest rates encourage saving.
- These conditions could lead to a recession.
Top Ten Countries with which the U.S. Trades
For the month of August 2002
The values given are for Imports and Exports added together.
These Countries represent 69.92% of U.S. Imports, and 66.95% of U.S. Exports in goods.
Year To Date
Total in Total in
Country Name of U.S. $ of U.S. $
The Cato Journal. Article by - Roberto Salinas-Leon
Cross Border Economic Bulletin
The Dallas Fed – 19th Annual Monetary Conference
Economia Y Sociedad.Com
Fischer, Stanley. 1982. "Seigniorage and the Case for a National Money." Journal of Political Economy, v. 90, no. 2, April, pp. 295-313.
Graphs - from The Dallas Fed
Joint Economic Committee Staff Report, Office of the Chairman, Senator Connie Mack http://users.erols.com/kurrency/basicsup.htm
US Census Trade Statistics