Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency as a store of value, unit of account, and/or medium of exchange within the domestic economy. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. There are two common indicators of dollarization. The first one is the share of foreign currency deposits in the domestic banking system in the broad money including of FCD. The second measure is the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets. The term "dollarization" has at least two different meanings. In the narrow sense, it refers to massive currency substitution, in which a country, most likely a developing one, supplements its domestic reserve assets with a foreign currency, more often than not the United States dollar or, in some cases, the euro. Note that currency substitution could be complete and might even imply the elimination of a domestic token as legal tender. Full dollarization in that sense has taken place in small countries, mostly in Latin America, the Caribbean and the Pacific which are heavily dependent on the United States. Dollarization, in this sense, is the exemplification of a country foregoing its national "monetary sovereignty". In the broader sense, dollarization can refer to US hegemony in the world economy as a result of the US dollar being the medium of exchange and unit of account in international markets. Of particular importance in this context is the fact that the key international commodities, including oil, are priced in US dollars in international markets. The biggest economies to have officially dollarized as of June 2002 are Panama (since 1904), Ecuador (since 2000), and El Salvador (since 2001). As of August 2005, the United States dollar, the Euro, the New Zealand dollar, the Swiss franc, the Indian rupee, and the Australian dollar were the only currencies used by other countries for official dollarization. In addition, the Armenian dram, Turkish lira, the Israeli shekel, and the Russian ruble are used by internationally unrecognized but de facto independent states. Origins After the gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II, some countries were desperately seeking exchange rate regimes to promote global economic stability and hence their own prosperity. Countries usually peg their currency to a major convertible currency. "Hard pegs" are extreme exchange rate regimes that demonstrate a stronger commitment to a fixed parity (i.e. currency boards) or relinquish control over their own currency (such as currency unions and dollarization) while "soft pegs" are more flexible and floating exchange rate regimes. When countries choose to use a major convertible currency parallel to or in place of their national currency, this is called the process of dollarization. The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led dollarization to become a serious policy issue. A few cases of full dollarization prior to 1999 had been the consequence of political and historical factors. In all long-standing dollarization cases, historical and political reasons have been more influential than an evaluation of the economic effects of dollarization. Panama, the most salient dollarization example, adopted the U.S. dollar as legal tender after independence as the result of a constitutional ruling. Ecuador and El Salvador became fully dollarized economies in 2000 and 2001 respectively with different influential factors. Ecuador underwent the process of dollarization to deal with a widespread political and financial crisis resulting from massive loss of credibility in its political and monetary institutions. By contrast, El Salvador's official dollarization was a result of internal debates and in a context of stable macroeconomic fundamentals and long-standing unofficial dollarization. The euro area adopted the euro (€) as its common currency and sole legal tender in 1999, which might be considered a variety of full-commitment regime similar to full dollarization despite some evident differences from other dollarizations. Types Dollarization can occur in a number of situations. The most popular type of dollarization is unofficial dollarization or de facto dollarization. Unofficial dollarization happens when residents of a country choose to hold a significant share of their financial assets denominated in foreign currency although the foreign currency lacks the legal tender. They hold deposits in the foreign currency because of a bad track record of the local currency, or as a hedge against inflation of the domestic currency. Attribution: Article text available under CC-BY-SA Public domain image source in video

• published: 18 Nov 2013
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