Dollarization is a form of currency substitution whereby the US dollar replaces a national currency. This can be done in full or partially. If partial, USD will be used alongside the local currency.
It often happens when a country's currency loses its usefulness as a medium of exchange. In this instant, residents, especially merchants, will opt for the dollar.
Most countries find themselves dollarized. This is due to the fact that the United States is the largest economy, which is consumption based resulting in large trade deficits. The other side of this trade are countries who manufacture and export to the U.S. The dollarization enters since this is how payments are made.
The best example of this is China. While the Yuan is the national currency, the dependence on the US, with excess of $600 billion in annual trade, is impossible to ignore. Both imports and exports between the two countries is US dollar denominated.
Global Debt
Dollarization is becoming more wide spread due to the increase in global debt. There is an estimated $300 trillion outstanding. Most analysis of this concludes that roughly half that total is denominated in US dollars.
Banks across the world are writing loans, even locally, in dollars. The reason for this is risk mitigation. When it comes to selling debt, Wall Street is more receptive when it is priced in USD. Other currencies simply do not have the same demand.
Borrowers are willing to have their loans written in dollars since the banks provide that incentive. Interest rates of USD loans is lower than the same made in a native currency. Again, the reasoning on the banks part is easy to see. USD debt is much easier to get off the balance sheet since Wall Street hedge funds are willing make the investment.
This puts an added burden on central banks. Not only do they see their monetary policy reduced due to transactions occurring in another currency, they are responsible for ensuring the commercial banking system has enough dollars to facilitate repayment. The key to loans being made in USD is that is required, by contract, for payments.
The way central banks often provide for this is by having a holding of US Treasuries. Securities of this nature can be viewed as future dollars. When one purchases a Treasury bond, it is bought with dollars. All interest payments are made in the same currency and, at maturity, the dollars are returned.
Of course, if the bank wants to sell the assets, this is the deepest market with the most liquidity.
Asset Allocation
Another area where dollarization is evident is when it comes to assets.
Investors are finding increasing appeal for owning assets that are denominated in US dollars. Often these are traded on the US exchanges, such as stocks, bonds, and derivatives. We also see real estate carrying great interest.
The reason is having USD denominated securities removes the currency risk (exchange rate) as compared to other assets. This has served to increase demand for the USD based and decrease it elsewhere. Again, we see how liquidity becomes an issue, especially if demand is falling in the non-USD asset classes.
Hedge Against Local Inflation
Inflation is one of the biggest factors when dealing with international currencies. This, along with associated price increases, can devastate an economy, especially in developing countries.
The increase in money supply by a government or central bank is only one factor. This can also occur as a result of the USD strengthening against the currency. What results is risk associated with imports costs, a situation that reverberates throughout the economy.
By dollarizing, the exchange rate risk is removed. At the same time, even under a partial currency substitution, we see the effects of the monetary authority reduced. This ultimately will hedge the risk of inflation.