Switching currency, pros and cons

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What is dollarization?

Adopting another country's currency as your sole legal tender is not as unusual as it might sound. It is a process that economists call dollarization – and despite the name, it is by no means limited to the U.S. dollar. It can involve the euro, the Swiss franc, the Australian dollar and even the New Zealand dollar.

Dozens of countries have gone this route since the end of fixed exchange rates. Regardless of which currency is adopted, there are a number of similarities in what happens before a country ditches its own currency: Economies tend to be struggling with big deficits, weak banking systems, volatile foreign exchange rates and high interest rates. These conditions push governments to take drastic action.

Pros and cons

Dollarization can provide a solution, mostly by lowering inflation and interest rates, but also spurring investment because of a more stable financial environment and reduced transaction costs.

There are downsides, of course: Say goodbye to any kind of domestic monetary policy, the cultural prestige of having your own bills, and the revenue associated with owning your own printing press.

Many relatively small economies have opted to accept the pros with the cons. However, the International Monetary Fund notes that some economists have argued that most developing economies, and even some developed ones, should take this route.

Popular currencies

Many countries have opted for the U.S. dollar when dollarizing, given the greenback's liquidity and reputation as the world's reserve currency. Others have decided to embrace the currencies of countries with which they already have a close economic, political or cultural association, not to mention being geographic neighbours.

Islands in the Pacific Ocean tend to have a strong affinity toward the New Zealand and Australian dollars. European countries gravitate toward the euro and the Swiss franc – which makes Iceland's interest in the Canadian dollar stand out as being very unusual.

Some examples of full dollarization: Kosovo (euro), Cook Islands (New Zealand dollar), Lichtenstein (Swiss franc), Nauru (Australian dollar), Panama (U.S. dollar), Ecuador (U.S. dollar), East Timor (U.S. dollar).