Given Central America’s geographical proximity to the US and the fact that seven million Central Americans out of a total regional population of 40 million – 17.5% – live and work in the US, it is no wonder that the dollar rests deep in the region’s psyche. Central bankers and policy makers struggle with the implications of this as they try to make their economies perform better.
Economic textbooks talk about two kinds of dollarisation: that with formal legal approval, in which the dollar replaces the national currency; and the unofficial kind, when residents’ use of dollars for a mass of transactions leads to a dual currency situation. Central America has examples of both types and the region’s experience shows that both outcomes bring policy challenges.
Panama and El Salvador are totally dollarised. Dollarisation has a beneficial impact on interest rates and inflation but the advantages can be offset by a lack of flexibility. The banking sector needs to be strengthened to cope with external and domestic stresses.
Dual currency pitfalls
Dealing with a dual currency scenario has its own difficulties. In Costa Rica and Honduras, residents and companies that borrow in dollars, but only have a local currency earnings stream, are a cause for concern. If the exchange rate moved massively against them, widespread repayment difficulties would be expected, creating problems in the banking sector.
In Costa Rica, the dollar accounts for 60% of credit and assets. The country has a crawling peg system and, by carefully managing depreciation and with moderate inflation, dollar borrowers have become accustomed to the idea that inflation will increase their wages by more than the depreciation of the colone increases their debts.
Francisco de Paula Gutiérrez, president of Banco Central de Costa Rica, is trying to move the country slowly in the direction of a market-driven exchange rate policy. The current crawling peg system will move to a crawling band system as a first step.
“On the one hand, I am happy that people believe in the central bank and they trust us [to manage depreciation]. But it’s too certain and once you have that kind of certainty, people [don’t hesitate to] borrow in a foreign currency even though they have earnings in domestic currency and that bothers any central banker,” he says.
Crawling peg
“We have had the crawling peg system for the past 22 years and we have been able to muddle through financial crises without any major difficulty. But this cannot continue in the same way for the next five to 10 years. We have to start creating some way of giving the currency risk to the general public rather than assuming it ourselves,” says Mr Gutiérrez.
“With dollarisation already quite high and because of the lack of independence of monetary policy we [are in the situation of economist] Mundell’s impossible trinity: you cannot have a [independent] monetary policy playing in an open economy [free capital movement] and with a fixed exchange rate. Out of the three we want to have the possibility of conducting monetary policy; we don’t want a closed capital account as this is a very small economy. So we have to start thinking about changing the exchange rate regime.”
Mr Gutiérrez says that, because the country has had a crawling peg system for so long – “with the exception of a small episode in the early 1990s when the currency was floated” – citizens are now accustomed to the currency depreciating a little every day and everyone can predict the exchange rate, which makes it difficult to switch quickly to a flexible exchange rate.
“What we have been doing is looking at the experiences of countries that have had the same situation as us: Chile, Israel, Mexico. And we have started looking at a currency banding system for a transition period to a more flexible approach. With this we feel we can make people understand that the exchange rate can go up as well as down,” he says.
Could dollarising be an alternative solution? Mr Gutiérrez has his doubts. “We have been looking at [dollarisation] – and I don’t want to discourage [the discussion] – but I am not convinced [about the merits] of losing [policy] instruments.”
Taking the plunge
There have been two recent experiences of dollarisation in Central America: Ecuador and El Salvador. In the case of El Salvador, it was done as a natural movement after having a fixed exchange rate for eight or nine years and a consolidated fiscal situation. The decision was to get the country risk premium out of interest rates.
But Mr Gutiérrez is not impressed with the results in El Salvador. “They have had five years with this system. Obviously, they have stability, but they had that before. Interest rates have been declining, which is good, but the economy is not growing fast – although you cannot blame that on dollarisation,” he says.
“The big question mark is that when you face external shocks, the best way to adjust is through exchange rate policy. I would rather have exchange rate policy.” Mr Gutiérrez says that another issue of concern is how to remain competitive against other Central American countries that can devalue their currencies. This could be a problem for El Salvador, he says, and would only be solved if the dollar was adopted by the whole of Central America.
Political thorn
In El Salvador, the opposition political party, the FMLN, has declared its dislike of dollarisation and its intention to reverse it should the party gain power. But Mauricio Samayoa, president of Banco Cuscatlán, one of El Salvador’s leading banks, says: “It’s changed the country for the better. We are a lot better off now than before, since we got rid of the exchange rate risk. The reality of Central America is that it is becoming more dollarised every day.”
Some analysts have postulated that El Salvador’s banks were slow in catching up with dollarisation. In a report last year, Fitch said: “Because of dollarisation, the Salvadoran banking sector needs to strengthen further. Panama (a dollarised economy) has a much stronger banking sector, which has been able to cope with the external and domestic stresses relatively well over a number of years. The trend in cross-border lending by the Salvadoran banks needs to be monitored closely, as it could be a source of risk.”
In Honduras, the banks are strictly regulated on their dollar loans and deposits. There are extra capital requirements for dollar loans (150% weighted against 100% for loans in limperes) and reserve requirements of 42% against dollar deposits compared with 12% against limperes deposits.
“US dollar deposits are about 30% to 35% [of total deposits] and we are not moving towards dollarisation,” says Gabriela Núñez de Reyes, president of Banco Central de Honduras. “We are watching the loans made in the US currency in the country. And to make sure we don’t have any risk in the future, the country has a very high reserve ratio for US dollar deposits of 42%, whereas for the rest of the Central American countries it is 25%. It’s our objective, however, to have a competitive banking sector in the country so we will have to reduce this towards 25% over time.”
Regulated system
Honduras has a regulated exchange rate but one that seems to work with less stress than that of Costa Rica’s. “We have a bidding process [for foreign exchange] and we supply 100% of the demand so there is no shortage of foreign exchange. This system was put in place in 1994 so we have had more than 12 years of this system. We have had less than 1% devaluation in the past 12 months,” says Ms Núñez.
“This is due to very strong inflows of remittances, which have been growing during the past three years at 30% per annum, and we expect this to continue over the next few years. At the same time, we are having strong exports, especially in the maquila sector. The Central American Free Trade Agreement consolidates the maquila sector and gives the opportunity for investment expansion and also for new investment.”
Yet for all this, Ms Núñez considers that controlling inflation is the number one priority of the central bank. “Our main objective is to control inflation and promote growth. During 2006, we expect 5.6% growth, the highest in Central America.”
Flexible regime
Guatemala is probably the least dollarised of the Central American countries. It has a flexible exchange rate regime, allowing the central bank to engage in an inflation-targeting approach. “The central bank has been implementing an inflation-targeting approach to achieve price stability since 2005 and our goal for inflation in 2006 is 6%,” says Oscar Roberto Monterroso Sazo, an economist at Banco de Guatemala.
“Good monetary policy and credibility at the central bank has helped to keep dollarisation low in Guatemala; and dollars make up only 10% of money supply, compared with 25% in Honduras, 45% in Costa Rica and 55% in Peru.”
Guatemala’s size in relation to the other Central American countries – 12 million out of the total regional population of 40 million and 32% of regional gross domestic product (GDP) – give it different characteristics from the other countries. It has a very low debt-to-GDP ratio, at 16.6%, and good macroeconomic fundamentals and stability.
Senior Guatemalan bankers and executives say that the country is underrated and attracts less foreign direct investment than it is due, given this solid underpinning. The country is rated BB+ by Fitch, alongside El Salvador and Panama.
“We think that with our numbers we deserve a better rating,” says Ivar Romero of the central bank’s international relations department. However, he accepts that Guatemala is let down by political and social issues, such as high crime, poverty, corruption and poor tax collection, which prevents the issue being solved. “We know we have to work on these structural issues,” he adds.
Structural problems
Dollarisation or no dollarisation, the typical characteristics of Central American economies that are deterring investment are poverty (59.9% in Guatemala, 53% in Honduras and 50.3% in Nicaragua), low tax takes (10% of GDP in Guatemala) and corruption. Guatemala ranks 120th out of 159 countries in Transparency International’s Corruption Perceptions Index in 2005, with Paraguay and Venezuela the only Latin American countries ranking lower.
Luis Prado, international division manager at Banco Industrial in Guatemala, says: “The country is working towards improving transparency in the public sector, and the private sector is willing to pay more tax. But we would like to see more transparency in government.”
Ultimately, solving these structural issues in Central America will determine the region’s future, although the question of whether or not dollarisation is the best way of creating economic stability will continue to be a lively debate.
