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MONETARY STABILITY IN LATIN AMERICA: IS DOLLARIZATION THE ANSWER?
THURSDAY, JUNE 22, 2000
U.S. House of Representatives
Subcommittee on Domestic and International Monetary Policy
Committee on Banking and Financial Services
The subcommittee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. Spencer Bachus, [chairman of the subcommittee], presiding.
Present: Chairman Bachus; Representatives Paul, Ose, Ryan, Toomey, Waters, Watt, Meeks, Lee, Sherman, Inslee, and Moore.
Chairman BACHUS. At this time I am going to call to order the hearing. This is the June 22nd, 2000, hearing on Monetary Stability in Latin America: Is Dollarization The Answer? This is the Domestic and International Monetary Policy Subcommittee of the House Banking Committee. Our procedure will be as follows:
I will give an opening statement. Then Mr. Paul Ryan will give an opening statement for the Majority. And then if the Minority wishes to make an opening statement they will make an opening statement. After we have made opening statements, we will introduce each of the witnesses and then we will have testimony from the witnesses.
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At this time we are going to go ahead and make opening statements. It could be that we will be interrupted. We were told that we would have a vote right before 10:00 o'clock. We were hoping to have that vote and then start the hearing, but now we are told it will be about 10:30. So we are going to go ahead and get started. That was the reason for the delay, and we will get started. We will probably be interrupted quite soon, so I do apologize for that.
The issue of dollarization has important implications both for the United States and for those countries considering an official policy of dollarization. Unofficial dollarization is well underway. More and more countries, particularly in Latin America, are using our dollar as their currency.
A recent IMF study indicates that by 1995, eighteen countries already had high levels of unofficial dollarization and another 34 countries had moderate unofficial dollarization.
In the event that additional nations such as Argentina, Ecuador, Mexico, and El Salvador completely and officially dollarize their currency, how would this affect our economy and the global economy?
This is a new and growing concern. It is time we scrutinized the issue thoroughly. We need to determine as much as possible the potential impacts and unintended consequences, not only for North Americans and our economy, but also the impact on Latin Americans and their economy.
Page 3 PREV PAGE TOP OF DOC The primary questions are:
How will dollarization impact the U.S. economy? Will it provide tangible benefits? Will it mean greater stability for U.S. goods in foreign markets? Should the Federal Reserve have an official role to play in dollarization?
What are the downside risks of official or unofficial dollarization for the United States, its economy, and its people?
The Asian financial crisis left many exporters in the United States with smaller markets, shrinking profits, and lost opportunities. This was especially true with the agricultural sector.
When the Indonesian rupiah or the Korean won lost their value overnight, U.S. exports were suddenly more expensive. This led to a decline in demand for U.S. goods in many Asian nations and aggravated an already lopsided trade deficit. If some of these nations had the U.S. dollar as their official currency, would U.S. exporters have suffered to the same degree?
For decades, Latin American countries have suffered from fiscal deficits, inflation, unstable interest rates, and bouts of deflation.
The recent economic chaos in Ecuador dramatizes the impact that an unstable currency has on a nation. This has created a difficult environment for local savings and economic growth and has resulted in dependency on international capital flows and tremendous sensitivity to fluctuations in U.S. interest rates.
Page 4 PREV PAGE TOP OF DOC There is no question that ordinary citizens and small businesses have suffered greatly from the tendency in Latin American countries to have inflationary monetary policy followed by bouts of deflation.
Therefore, it is important for us to know how dollarization will affect the Latin American countries considering dollarization. It is fair to say that all would agree on the need to solve these problems.
Proponents of dollarization contend that dollarization will decrease currency risk, lower interest rates, and create monetary stability in Latin America. They also argue that dollarization will force countries to achieve fiscal discipline and reduce their budget deficits.
Finally, they contend that it will promote increased trade and investment between the United States and Latin America.
Skeptics of dollarization point out that dollarization is not a cure-all or a panacea. Underlying fundamental economic need, such as a banking sector reform, the need to control deficit spending, to address corruption, and to establish the rule of law must also be addressed.
I look forward to hearing the different views of the panelists regarding these issues. If we decide to officially dollarize, then the United States must carefully study any proposals to share seigniorage, which is the profit a country derives from issuing its own currency.
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Currently the United States earns $25 billion in profits every year. Researchers at the Federal Reserve System estimate that foreign citizens hold 55 to 70 percent of U.S. dollar notes, mainly $100 bills.
The amount of dollar currency in circulation is currently about $535 billion, and therefore about $350 billion of U.S. money is held abroad.
Therefore, any loss of seigniorage would have to be justified by some other benefit that would accrue to the United States.
Policymakers need to be aware of these trends in U.S. currency holdings abroad and need to carefully study and explore the possible ramifications of dollarization in the United States and on its trading partners in Latin America.
These will be critical judgments that can severely and dramatically impact the economic well-being of this Nation and all its people.
It is always challenging to make judgments of this magnitude and then watch the results play out in real life on the world stage.
Chairman BACHUS. Mr. Ryan.
Mr. RYAN. First of all let me thank you, Mr. Chairman, for having this hearing. This is really a very important issue. It is something that we do not often discuss here in Congress, but I am very pleased to have the witnesses here today of such high caliber and I am excited about hearing your testimony.
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Although dollarization is one of those arcane topics that we discuss here in the Banking Committee, and we can joke about how you spell the word ''seigniorage,'' but dollarization is a very important issue for developing countries seeking monetary stability and economic growth in the Western Hemisphere.
Of course, it is no panacea. However, sound money combined with a sound fiscal policyor I would even put it as a precursor to sound fiscal policyand property rights and a viable rule of law helps to ensure that dollarization can boost development in growing economies.
I have two goals in mind for today's hearing.
The first is to counter the usual arguments against dollarization from the U.S. perspective. The Federal Reserve would be the lender of last resort for dollarized countries. Or, the Fed would become responsible for supervising foreign banks; and the Fed will have to consider a dollarization country's economic condition when formulating domestic monetary policy.
I hope those are things we can address today.
But let me start by saying that today countries can dollarize without consulting the Federal Reserve or the U.S. Treasury. There is no need for the Fed to be the world's lender of last resort by opening up its Discount Window to dollarized countries.
Like Panama, countries can maintain liquidity through the private banking system. I suspect you will discuss this in your testimony, Mr. Moreno, since you are very familiar with this subject.
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The Fed will never be responsible for supervising foreign banks. Not only would sovereign governments disapprove of the U.S. regulating their private banking system, I would imagine that the Fed has no desire to grant foreign banks some of the same privileges that we grant U.S. banks without making foreign banks pay for such protection.
The Fed already takes the international circumstances into account when formulating monetary policy. If we go back just to the end of 1998, the Fed raised interest rates three times to stem contagion, not because of any domestic considerations, because of contagion spreading across the world.
Regardless, with the consistent law outlining dollarization agreements with the U.S., countries understand from the beginning that the Fed will not act as their central bank.
I would also like to point out the added benefits to the U.S. should more countries choose to dollarize.
There would be a decrease of cases of dumping, since foreign countries would loose the ability to devalue against the dollar to gain trade advantages. And the U.S. businesses would find it much easier to invest in these countries since currency risk and inflation risk are greatly diminished with dollarization.
This helps both the U.S. and our citizens of the dollarized countries and the citizens here in the United States.
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The second goal of this hearingand I hope that our panel of witnesses can help me out on this oneis to prove that dollarization lowers monetary instability with dollarized countries and increases the standard of living for their citizens.
During the Senate hearings on dollarization, the economist Judy Shelton eloquently described the entrepreneurial spirit within Mexico, but contrasted this optimism with a scenario with high interest rates and scarce bank loans for businesses small and large.
Indeed, sporadic devaluations and politically derived inflation negate expectations that a domestic currency can be a meaning store of value for future value.
Panama and Argentina are already closely linked with the dollar. Panama is officially dollared, and in Argentina the dollar is legal tender alongside the peso.
A comparison of national interest rates shows that Argentina and Panama's rates have been low and stable compared to their close neighbors.
According to the IMF's international financial statistics, Argentina's interest rates on lending have ranged between 8 percent and 13 percent during 1999 and the first half of the year 2000.
Panama has been steady right around 10 percent for almost a year-and-a-half.
Page 9 PREV PAGE TOP OF DOC However, Bolivia, Argentina's direct neighbor, has seen widely variable rates from 29 percent all the way up to about 52 percent, sometimes changing over 10 percentage points between fiscal quarters.
Venezuela has also been quite rocky. Nicaragua, Panama's neighbor, has less volatility, but rates are still high, between 21 and 22 percent. Overall, most Latin American and South American countries have rates that are higher and more likely to change than the two dollar-linked countries.
Inflation is directly linked to interest rates. Inflation expectations act as an interest rate premium. When inflation is expected to go up, interest rates are high.
As we have seen lately in the U.S. in our own debate over rising interest rates, low rates reduce the cost of borrowing and increase prosperity, while high rates raise the cost of capital and slow economic growth.
For most Latin American countries, dollarization should lower their interest rates to possibly within 4 percent of U.S. rates depending on political and fiscal factors.
But further, because dollarization eliminates the ability of foreign central banks to manipulate the money supply, which I would argue is a benefit of dollarization and not a cost as some analysts do, inflation is tied to the U.S. inflation. And inflation in the U.S. is extremely low, and for many of these countries it will be so as well.
Page 10 PREV PAGE TOP OF DOC Today, I am reintroducing my bill, the International Monetary Stability Act of 2000, which is a companion bill to Senator Connie Mack's legislation.
This bill would give countries who have been seriously considering using the U.S. dollar as their national currency the incentive to do so.
A couple of changes have been made since I first introduced this bill last fall in order to make some changes that take into account concerns raised by the Treasury Department during the Senate hearings.
One important change includes the ability of the Treasury to use money laundering as a factor for deciding whether to certify a country for seigniorage sharing or not.
In general, enacting this legislation would set up a structure in which the U.S. Treasury would have the discretion to promote official dollarization in emerging market countries by offering a rebate of 85 percent of the resulting increase in U.S. seigniorage earnings.
Part of the remaining 15 percent would be distributed to countries like Panama that have already dollarized, but the majority of this 15 percent extra would be deposited in the U.S. Treasury Department as positive Government revenue.
Additionally, this bill would make it explicitly clear that the United States has no obligation to serve as a lender of last resort to dollarized countries, to consider their economic conditions in setting monetary policy, or to supervise their banks.
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I would like to conclude my remarks, Mr. Chairman, by thanking you for hosting this hearing, but I would like to conclude with an old quote from Treasury Secretary Larry Summers.
Back in 1992, when he was at the World Bank, Secretary Summers said, quote: ''Finding ways of bribing people to dollarize, or at least give back the extra seigniorage that is earned when dollarization takes place, ought to be an international priority. For the world as a whole, the advantages of dollarization seems very clear to me.''
I have had numerous conversations with Secretary Summers since that testimony this past year and the year before, and he has had very positive comments with respect to dollarization.
Congressional leadership in exchange rate policy such as dollarization protects our own economy. Every foreign devaluation affects our economy through international trade and through the equity markets.
American companies need reliable currencies to make investment decisions abroad. And the American workers that all of us represent need to know countries cannot competitively devalue in an effort to lower foreign worker wages.
The ramifications of an Asian-style economic collapse in Latin America in our own backyard call for legislation that will help these countries embrace consistent economic growth.
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Again, Mr. Chairman, let me thank you for hosting this hearing. I think this is an issue whose time has arrived. I think it is an issue that is growing in momentum across party lines and I appreciate the fact that you have held this hearing and I look forward to hearing the witness's testimony today.
Chairman BACHUS. We appreciate that.
The lady from California, the Senior Member.
Ms. WATERS. Thank you very much, Mr. Chairman. I would like to thank you for holding this hearing today on dollarization in Latin America.
Official dollarization occurs when a country eliminates its own currency and adopts the U.S. dollar as its official currency. In a dollarized economy, businesses pay wages in U.S. dollars, consumers make purchases in dollars, contracts are settled in dollars, and taxes are paid with dollars.
When unofficial dollarization occurs, the U.S. dollar is widely used for commercial loans, bonds, mortgages, and other financial instruments. This has already occurred in many Latin American countries.
It is important to remember that the United States cannot determine the currency policy of other countries. The choice of currency is a decision which the government of each country must make through the democratic process. However, as Latin American countries consider dollarization proposals, the risk and benefits of dollarization should be studied carefully in the United States as well as in Latin America.
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Supporters of dollarization claim that it will impose fiscal restraint, stabilize the economy, and lower inflation.
A dollarized country could not devalue its currency. It would not be able to print currency in order to finance deficit spending.
Furthermore, the inflation rate in a dollarized country would not exceed the inflation rate in the United States.
Supporters of dollarization also claim that fiscal restraint and economic stability will promote economic growth and stimulate foreign investment and trade.
Opponents of dollarization point out that a dollarized country would not be able to pursue its own monetary policy. Instead the monetary policy of the United States would become its own.
I am also concerned about the possibility that dollarization could leave certain segments of a country's population behind. The poor, self-employed individuals, indigenous people, and people who live in remote areas of a country are less likely to have access to a bank or other source of U.S. currency. It is important for Latin American governments to ensure that dollarization does not leave these people less able to actively participate in the national economy.
Economic policies should not be evaluated exclusively on the basis of their impact on economic growth, trade, or investment.
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Policymakers should also take into consideration the extent to which their policies alleviate poverty and promote an equitable distribution of income within their society.
I am looking forward to hearing the witnesses explain the risks and benefits of dollarization, and I am particularly interested in their views on how dollarization would affect the lives of low and moderate-income people in Latin America. I yield back the balance of my time.
Chairman BACHUS. Are there any more opening statements?
Mr. TOOMEY. Just very briefly, I want to commend the Chairman for conducting this hearing, as well as my colleague, Mr. Ryan, for all the work he has done on this issue.
The increasing extent of dollarization that is occurring already and the many obvious benefits to it certainly warrant a careful investigation by this Committee. So I look forward to hearing the testimony of the witnesses.
Chairman BACHUS. At this time we will introduce the witnesses and then we will proceed with your testimony.
I want to also recognize Mr. Ryan who called for these hearings, and for his leadership in focusing on the issue. I appreciate that very much.
Page 15 PREV PAGE TOP OF DOC So at this time we will go from left to right. The first witness is Michael Gavin, head of Economic Research for Latin America, UBS Warburg LLC.
Prior to this position, Mr. Gavin was with the Inter-American Development Bank where he was lead research economist dealing with economic and financial developments in Latin America.
He served as an Associate Economics Professor at Columbia University where he created and operated a new Masters Degree Program in Economic Policy Management.
He has also worked in the Federal Reserve Board's International Finance Division, and as a visiting consultant to the IMF, Federal Reserve, and World Bank.
His education includes a Ph.D. from MIT. That is very impressive.
Our next witness is Walter Molano. He is head of Economic and Financial Research for BCP Securities where he is responsible for all macro-economic, financial, and corporate research, with emphasis on Argentina, Brazil, Mexico, Ecuador, Colombia, Peru, and Venezuela.
Prior to joining BCP Securities, he was director of economic and financial research at UBS Warburg. He served as senior economist and vice president for Latin America at CS First Boston. He holds a Masters Degree in Economic Administration and International Relations, and a Certificate in International Law. He is a graduate of the U.S. Naval Academy and earned a Ph.D. from Duke University.
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We are glad to have you testifying, Mr. Molano.
Guillermo Calvoor is it Gee-aermo? Right?
Mr. CALVO. Gee-jer-mo.
Chairman BACHUS. OK.
Mr. CALVO. But that is OK. I understand it.
Chairman BACHUS. I am going to try to go that way. Geh-ermo?
Mr. CALVO. Gee-jer-mo.
Chairman BACHUS. Gee-jer-mo?
Mr. CALVO. Right.
Chairman BACHUS. All right. Good.
Page 17 PREV PAGE TOP OF DOC I have got three phonetic pronunciations. None of them were Gee-jer-mo.
Mr. Calvo is Director of the Center for International Economics at the University of Maryland. He is also Distinguished Professor there.
Along with his teachings in the United States, he is an Economics professor at the University, and how do you pronounce that, ''in Argentina''?
Mr. CALVO. DiTella.
Chairman BACHUS. Torcuato DiTella?
Mr. CALVO. Torcuato DiTella, yes.
Chairman BACHUS. All right, in Buneos Aires. In addition to holding academic posts at the University of Pennsylvania, Columbia University and the University of Chicago, he was Visiting Researcher at the Center for Studies of Microeocnomics of Argentina, the University of Stockholm's Institute for International Economic Studies, and the DiTella Institute's Center for Economic Research.
He is a widely publicized author on macro-economics of capital mobility and transition economics, and additionally serves in editorial positions with several economic journals. He holds a Master's Degree and a Ph.D. from Yale University.
Our next witness is Roberto Salinas-Leon. He is Executive Director of Policy Analysis, TVis that Aztec?
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Mr. SALINAS-LEON. Azteca.
Chairman BACHUS. Azteca?
Mr. SALINAS-LEON. TV Azteca.
Chairman BACHUS. OK. In Mexico. He serves as an Adjunct Professor of Political Economy at the Law School of the National University of Mexico. Is that right?
Mr. Salinas is also the senior advisor and member of the Board of Business Chambers, Companies and Policy Organizations in Mexico, the U.S., and Latin America.
He is a weekly columnist for several publications. He has published more than a thousand editorials on public policy, free trade, monetary and exchange rate policy and economic reform.
He received his education with a BA in Political Economy, History and Philosophy at Hillsdale College in Michigan in 1983. He received a BA and Ph.D. in Philosophy from Purdue University.
Our final witness is Juan Luis Moreno-Villalaz. He is an economic advisor to the Ministry of Economics and Finance in Panama. Prior to this post, he served as a World Bank consultant and a member of a group of international economists that advised the President of Ecuador after he adopted the dollar as Ecuador's national currency.
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He is a professor at the University of Latin America of Costa Rica in their graduate program and business school, and at the University of Panama.
He is the author of several articles on the Panamanian monetary experience relating to the adoption of the dollar as a national currency and also on financial integration.
His education includes receiving a Master's and Doctorate in Economics from the University of Missouri, and a BA in Economics and Accounting from the University of Panama.
That is our panel. We have a vote. What we are going to do at this time is recess. We have one vote. Then we will come back and start the testimony.
Mr. RYAN. Mr. Chairman, might I just add something?
I am just very excited that the witnesses are here today. I have an amendment on the floor to this bill, as well. I am hoping that I can come back as well immediately after the vote, but if I am delayed I just want to up front explain to you that it is because I have an amendment and I will be back shortly after that.
Chairman BACHUS. And that is a common problem we have around here, that we have obligations both on the floor, and those obligations have to come first.
Mr. Ryan, if he is not here, he has some questions that he has asked me to ask, so thank you.
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We will recess for about fifteen minutes and convene again at 11:00 o'clock.
Chairman BACHUS. We will reconvene our Monetary Policy Subcommittee.
At this time we will hear from Mr. Gavin.
STATEMENT OF MICHAEL GAVIN, Ph.D., HEAD OF ECONOMIC RESEARCH FOR LATIN AMERICA, UBS WARBURG LLC
Mr. GAVIN. Thank you, Mr. Chairman, for the opportunity to testify on this.
I thought what I would do is briefly summarize the testimony beginning with two key points about what dollarization means for a dollarizing economy; five red herrings, issues that are not important and should not be considered important problems
Chairman BACHUS. You might pull mike a little closer to you.
Mr. GAVIN. Can you hear me now?
Page 21 PREV PAGE TOP OF DOC Chairman BACHUS. Yes. Thank you.
Mr. GAVIN. And then spend some time on why dollarization might make sense for a Latin American economy and what it would mean for the interests of the United States.
The first and two most important points about dollarization are that official dollarization would not be a revolutionary, but rather an evolutionary change in monetary regimes in Latin America. Many, not all, but many Latin American economies are already highly dollarized in many important dimensions.
Second, dollarization would mean that the dollarizing economy gives up control over monetary policy. That has costs, that has benefits, but that is the essence of dollarization.
However, dollarization would not mean that the United States would have to alter the way that it makes monetary policy or alter the goals and objectives of monetary policymaking.
It would not require that the United States' economy supervise local banks, something which is a misconception, which is in fact quite common in some Latin American countries.
Panama is the clearest example of a country that has been dollarized for some 70 years with no supervision of the banking system by U.S. regulatory authorities.
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Third, there is no requirement that the United States provide lender of last resort facilities to countries that dollarize.
Fourth, it is untrue that dollarization makes it impossible for a government to arrange lender of last resort facilities for the banking system. It does require that the authorities prearrange lender of last resort facilities and pay for them.
In other words, having a lender of last resort has attached to it an explicit fiscal cost since a burst of inflation cannot be used to finance the last-resort lending in the event that banks get into trouble.
Finally, there is no need for dollarizing economies to perfect every dimension of their economic policy institutions and policy environment in order to dollarize.
A number of countries have dollarized quite successfully from weak fundamentals and strengthened their fundamentals as part of the dollarization process.
Why might dollarization make sense for the Latin American economy?
I would say that the two key words are integration and stability. Integration, which encompasses both trade integration and, more importantly in this context I would say financial integration, are key to development.
The eutrophication of credit markets that occurred after the Tequila crisis, and that continues to this day in Mexico, has crippled the capacity of small and medium-sized business people in Mexico to obtain the credit that they need to expand and create jobs, while their counterparts right across the border have the same access to credit that they have had historically.
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This disadvantage really forces Mexican industry to compete with the United States on the basis of low Mexican wages because of the huge competitive disadvantage that they have in capital markets.
This disadvantage would be importantly eroded if dollarization were put in place and, as part of that, financial markets gradually became significantly more integrated than they can be with the kind of wild exchange rate fluctuations that we now see between the Mexican peso and the U.S. dollar.
There is also strong evidence that monetary integration improves trade relations. There is an academic paper by Professor Andrew Rose at the University of California at Berkeley, which claims that countries in monetary unions trade with each other six times more than countries that are otherwise similar, but do not have monetary unions.
Both of these are key for economic development in emerging market economies generally.
Stability is arguably an even more important benefit of dollarization for countries that are having difficulty maintaining a stable monetary policy.
Two points there:
First, economic stability means development.
Page 24 PREV PAGE TOP OF DOC Second, economic stability is at least as important, arguably much more important, for the middle and lower classes of Latin America than it is for the upper classes. The upper classes and the upper middle classes in Latin America can protect themselves against monetary instability, but the poor who, as Congressman Waters pointed out, do not have access to formal financial services rely upon the domestic money to save and are hurt much, much, much more severely by monetary disorder.
Key obstacles to dollarization are, first, there is in many countries of the region a fear of the great U.S. power. And the power that the United States has in political and economic terms rankles in some sense and worries Latin Americans, especially when they have to cope with processes like the drug certification process.
As you know, the very word ''certification'' has become a dirty word in Latin America now.
Second, there is the loss of seigniorage that would be implied by official dollarization. That may seem small in a United States context, but it is not small in a Latin American context.
It is estimated that Argentina would lose something like $750 million per year as a result of official dollarization. You say that is very small even in an Argentine context, it is not even one percent of GDP.
Well it is 15, 20 percent of the central government's education budget. It is a big number in a country that is as stressed fiscally as Argentina is now.
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Finally, and I think very importantly, dollarization is impeded by the fact that monetary disintegration, the disintegration that we are living with now, is in some important sense self-perpetuating.
That is because when a country's neighborsfor example, Chile and Brazil in the Argentine caseallow their currencies to be devalued competitively in a sort of beggar-thy-neighbor fashion, the cost of not engaging in such behavior becomes very high.
As well, the stresses that are created for dollarizing economies like Argentina when the United States allows its exchange rate to move as wildly as it has done in the past 18 months also become an important problem. So there is a regional and even a global dimension to this that needs to be taken into account.
If I may address myself to the seigniorage-sharing proposal, it seems to me that it is a complete and utter no-brainer. It costs the United States nothing, and it could conceivably even benefit the country financially if it prevents a country from reversing the dollarization that now exists, for example to take part in a Latin American monetary integration or Americas or Monetary Union, something which I find quite plausible in a 5- to 10-year horizon in the absence of some kind of official support for dollarization from the United States.
The proposal commits the United States to no changes in policy and would be I think a very welcome extension of support to countries, some of whom need it quite badly.
Thank you once again for the opportunity to testify.
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Chairman BACHUS. Mr. Molano.
STATEMENT OF WALTER T. MOLANO, Ph.D., HEAD OF ECONOMIC AND FINANCIAL RESEARCH, BCP SECURITIES
Mr. MOLANO. Thank you very much.
It is an honor and a pleasure to speak at this subcommittee hearing. I believe that dollarization is a subject that is very important, and it is a subject that is not very well understood.
I speak to you on the basis of seven years of Wall Street experience, having lived through several major emerging market crises, including the Asian crisis of 1997, the Mexican devaluation of 1994, the Russian crisis of 1998, and the Brazilian crisis of 1999.
As a Wall Street analyst it is my job to sell ideas and advice to my clients, but I also have a fiduciary responsibility to them. It is not in my interest to sell them an idea that is going to ultimately fail.
Dollarization is definitely a concept that can help improve risk characteristics in the short term, thus allowing us really to sell more bonds and instruments. However, dollarization does nothing to address the underlying fiscal and structural flaws that are present in these countries.
Page 27 PREV PAGE TOP OF DOC In fact, by obscuring some of the flaws in these countries dollarization will lead to more serious problems that will require costly bailouts and costly rescue programs.
I have provided a much more detailed analysis of this argument, and it has been entered into the record.
Dollarization is actually a modern variation of the old fixed versus floating exchange rate debate. Academic economists have discussed this issue for decades.
Most Wall Street analysts and investors, including myself, are really indifferent to the choice of exchange rate regime as long as it is backed by the proper set of policiesspecifically fiscal policies.
In my opinion, floating and fixed exchange regimes are two different paths to the same outcome, which are price stability and growth.
Most Latin American policymakers understand this concept. However, there are important differences in timing and sequencing that can be very attractive to Latin American political leaders who have a very short time horizon.
The proponents of dollarization argued that the adoption of the dollar removes the discretion of many policy variables. In other words, it straitjackets the government into hopefully doing the right thing.
Most policymakers in countries such as Chile, Brazil, Mexico, and Colombia understand the restrictions of dollarization and reject it for the loss of flexibility. However, the concept has been used by some leaders as a way to buy time and obtain relief.
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In 1999 two countries considered dollarization: Argentina and Ecuador. In May 1999, President Menem of Argentina announced the possibility of dollarizing. He was five months away from the end of his term. His government had failed to make the proper fiscal response needed in the aftermath of the Brazilian devaluation.
Menem was clearly trying to buy time. His focus was on the implementation of dollarization, not on the sustainability of the policy. In his case, Menem was successful because he ended his term.
It is interesting to note that his successor and also the economic team that has succeeded him is against dollarization because they have to live with the long-term sustainability of the policy.
In December 1999, Ecuadorian President Mahuad announced the dollarization of his economy. It was also a way to buy time. Mahuad was facing a military coup. The country was in default, and the banks were bust. In his case, he was not successful.
His successor came in very weak and actually continued with the dollarization initiative. So far, the initiative has failed. The IMF required three things from the Ecuadoran government in order to sustain dollarization and it allowed them one thing.
They demanded a 140 percent increase in gasoline prices, a 100 percent increase in cooking gas prices, a 100 percent increase in electricity prices, and in return they would allow them to raise salaries and wages by 100 percent.
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So far, the Ecuadorans have only accomplished one thing. They raised salaries and wages by 100 percent. Gasoline prices were only raised by 60 percent, less than one-half of what was ordered. Cooking gas was raised by zero. And Electricity is still somewhere off on the horizon.
In 2000 the inflation rate that is expected is about 100 percent. So much for the low inflation promise of dollarization.
The fiscal deficit this year is going to be somewhere in the order of 5 to 6 percent of GDP, most of it paid with arrears that are owed to foreign bondholders, many of which include U.S. pension funds and U.S. insurance companies.
The country continues to delay its debt restructuring program, and GDP is expected to contract this year between 2 and 3 percent.
In fact, the whole process of implementation has been a complete failure. Sucres are in circulation. Dollar bills are in circulation. U.S. coins are in circulation, as well as color photocopies of dollars are being used as legal tender in some of the more rural areas.
It seems that the economic straitjacket has not really forced the hands of the politician to do the right policies.
In conclusion, dollarization has been heavily marketed in Washington, but there has been a lack of truth in advertising.
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The proponents of dollarization argue that it is a, quote/unquote, ''no brainer.'' They talk about 30-year mortgages in Panama, but they do not talk about the policies needed to sustain dollarization, which is fiscal discipline, which does not exist in most Latin American countries.
In a way, they do not have to do this since it is an academic exercise, but we bondholders do care about this since we get paid over the long term and then we have to live with the sustainability of these policies.
Thank you, very much.
Chairman BACHUS. Mr. Calvo.
STATEMENT OF GUILLERMO A. CALVO, Ph.D., DIRECTOR, CENTER FOR INTERNATIONAL ECONOMY, UNIVERSITY OF MARYLAND
Mr. CALVO. Thank you very much, Mr. Chairman. It is an honor for me to be here and to participate in this debate.
I had to restrain myself not to get out of what I prepared, because I must say I strongly disagree with Mr. Molano, but let me reserve that for the discussion period.
Chairman BACHUS. In fact I would say that is part of the reason we have more panelists. We love strong disagreement.
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Mr. CALVO. OK. Great.
Chairman BACHUS. We encourage that.
Mr. CALVO. You succeeded.
Mr. CALVO. This is a very delicate issue, undoubtedly. I will read a little bit from my prepared notes.
One point that is worth mentioning is that I fully agree this is a major economic and political decision for a country.
By default, you adopt a U.S. monetary policy so the U.S. could be going through a boom and this country is going through a recession and the interest rate that you get is that corresponding to a boom and not a recession. So that is in principle an important consideration.
Besides, the dollarized country gives up the option of assisting banks by printing money. It's not the lender of last resort. It's just that activity. And I will address those activities and the plus and minuses of those activities.
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I will focus my presentation on two key issues.
The first one is an issue that we call ''fear of floating.'' It reflects a recent analysis that I been carrying forward with my colleague, Carmen Reinhart.
The second is the famous issue of lender of last resort. The second one I do not have much to add to what Mike has said already.
Let me start with fear of floating. What that means is that, simply put, very few countries really let their currencies float vis-a-vis the dollar, or any other currencies. Even countries that are listed as floaters by the IMF do not float, or float very little.
Examples are El Salvador, fixed exchange rates; Bolivia, practically fixed, even though they claim officially that they are floaters.
Now there are two reasons why are countries like that. Why would they behave as if they did not float? Right? Now there are two reasons that we identified is that in most emerging countries when you devalue you get more inflation.
And second, which is very important, too, is that in most of these countries the dollar is used as a means of account for financial transactions.
So wage earners make their money in pesos, say, and they have dollar loans. So if there is a devaluation, the wage earner cannot pay and he goes bankrupt. One never thinks about that in the U.S., because the wage earner is earning dollars and it is in dollars.
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Well that is not the way it is in many important countries, especially in Latin America, and you can cite the examples of Argentina and Peru, just to cite two of them.
So there you are in a world where the countries do not really float much and they have this very delicate financial structure where people call dollar debts, but they have peso income. That is one consideration.
The other is the business of lender of last resort. This is typically done by central banks. So if you cannot print money, you cannot throw money into that problem. You usually do it when there is a bank crisis. So you cannot throw in money into that problem.
Well the point is very simple, that that is not what we do here in the U.S. In the U.S. we don't print money. We may print money for a few hours, but we map it out very quickly by open market operations. So we don't reallymoney supply, the money supply policy is not threatened in this country by the Fed assisting the banks.
What the Fed does at the end of the day is to go to the market and borrow and lend to the banks in trouble. In emerging markets, precisely because they are emerging markets, they cannot do that.
When there is a crisis, the central bank cannot borrow. So the only thing that they can do is to throw pesos into the problem. So what do you do? What do you get? A big devaluation, and then inflation.
Page 34 PREV PAGE TOP OF DOC Now the big devaluation, when the wage earners earn in pesos, earn their income in pesos, and they have the debts in dollars it creates a mess in the financial sector right away. People say ''I can't pay.''
We have seen that for different reasons in Mexico in 1995. There was El Person, that was a group of debtors that got together and said we cannot pay our mortgages, for different reasons, but still. So if you do that in Argentina, now people will just say, ''Well simply, I can't pay,'' and they don't pay.
So you have right away a problem in the banking system that affects all the banks. So you go to the Central Bank, assuming that the Central Bank could do something. The only thing that the Central Bank can do in those countries is to print money.
So it does not solve the problem. The depositors will run faster than before. And then you will have an even bigger inflation that will go out of control.
So that is why I conclude in my formal presentation that when you have a lender of last resort that relies on the printing press, then that individual or institution could actually magnify the banking problem, not solve it, and cause high inflation.
So that is why there is this fear of floating. It is not irrational. It is perfectly rational because you have these conditions that do not apply in the United States. They do not apply in advanced countries in general. But it applies very generally in those countries, in emerging countries.
Page 35 PREV PAGE TOP OF DOC So in summary of all of this, there is a tendency to peg in all the emerging markets, which generates high and volatile interest rates. And this has been said, this is detrimental for growth, and dollarization in that context, and I believe especially in the context of the treaty with the U.S. as suggested by Senator Connie Mack's bill, will lower and stabilize interest rate stimulating growth.
Now this is the central point that I wanted to make. And that is the reason why, if you wish, I have become, or I am becoming a dollarizer myself. I can see all the sides that are going to make other economies mentioned. I can see the side. I can see the problem. But I can also see that we live in a world that is already virtually dollarized. And without a commitment, without the leadership of the United States, those countries may be more as stable than they would be under dollarization.
Now I agree dollarization is not the panacea. I mean it would be silly. We know in the United States that you can have very good monetary policy, but if we have wrong fiscal policy then certainly problems will arise, and very serious problems.
So nobody is claiming that dollarsor at least I am not claiming that. Now why are there so few dollarized countries? I can think of two reasons.
One is the seigniorage reason, and that has been tackled already. And the beauty of the seigniorage problem is that the United States can do a lot about it, because the seigniorage sharing is an agreement that is not fiscally costly for the United States. It is peanuts for the U.S. anyhow, but it is very important and can give the extra push to these countries.
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The second is nationalistic. I mean some people like to see their patriots. I claim that that is not the way to honor your patriots, to keep them in your pocket. You should put them up on the wall and think about them and not have them in the pocket.
I wonder how many people know who is a patriot in a $20 bill? So I think that is not really a serious consideration. And my feeling is that in Latin America at least people are not taking this as a serious point because, after all, they holdand, Mr. Chairman, you mentioned that in your opening remarksthat a very large share of dollar bills are circulating outside the United States. So people are voting with their pockets already.
Now I end with two considerations.
The first is, this is done at the regional level. I fully agree with Michael Gavin. It would be great benefits for a region like Latin America. It will increase growth, and that certainly is good for the United States.
Now the question is: Is it good for the United States? Why should the U.S. get involved in this? I believe truly that I can only see this as a win/win proposition for the U.S.
In the first place, it carries no cost.
Second, it helps entire regions to increase growth and stability. That is always good for the U.S..
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Now some people worry that that might make the monetary policy in the U.S. more complex than it is already. Well, but let's remember countries are already dollarized. A large number of dollars are circulating outside the United States.
So whether we like it or not, the Fed is dealing with the whole world now.
What is the advantage of dollarization in that context? It is that now the countries that use the dollar will be more stable. So you will have a more stable amount for dollars, and that is always good for a monetary policy.
So I do not see that as really an addition to the programs that we already have from the standpoint of this country.
Now the role of the U.S., and with this I finish, I think certainly the U.S. plays a pivotal role here as the manufacturer of dollars. So certainly you are at the center. We are at the center here.
Seigniorage sharing cannot be done without the collaboration of the Fed. Besides, one has to realize that dollarization is catching in the sense that the larger number of countries that adopt the dollar, the more attractive it will be for the others to join in the club.
And the U.S. can play a very key role in coordinating this process. I mean, it is very hard for Argentina and Brazil to get together and say we are going to dollarize, which is a third countries' currency.
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If the U.S. is also in the room, that would make a big difference, just the presence of the U.S. in the room. So what is to be done from here on?
I think seigniorage sharing, Connie Mack's proposal, is a very big step forward and really, as Michael said, is a no-brainer.
Another, which would be much more controversial certainly, is to offer EM a seat at the Federal Reserve Board. I know that that is going to make many people wince, and especially Chairman Greenspan, but I think that could be done first as observers, and maybe eventually in the context of a free trade agreement as voting members.
I don't mean to say one country/one vote, but there could be clusters of countries. I think that is something to be thought. I do not know if that is the most adequate, the politically more palatable way to proceed, but I think it would be very, very useful to go beyond Senator Mack's proposal in that direction.
So while this is basically what I have to say, once again, Mr. Chairman, thank you very much for the invitation.
Chairman BACHUS. Thank you, Mr. Chairman.
STATEMENT OF ROBERTO SALINAS-LEON, Ph.D., EXECUTIVE DIRECTOR OF POLICY ANALYSIS, TV AZTECA, MEXICO
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Mr. SALINAS-LEON. Thank you, Mr. Chairman.
It is an honor and a privilege to be testifying before the Subcommittee on a topic that I think is of fundamental importance to the future stability of Mexico and Latin America.
For obvious reasons I will restrict my remarks to the Mexico-United States case, but I would also like to approach the issue of dollarization in far broader terms, whether we need adequate fiscal policy to complement it or not, or the technical details surrounding dollarization procedures.
That is, I see dollarization as an opportunity to re-establish the integrity of the monetary contract in Mexico, a monetary contract that has been systematically violated for the past 30 years.
In fact, all my life as a rational being, as a human being that has had the use of reason, all my life I have heard of nothing but devaluation, debt, deflation, inflation, economic devastation, crisis, and contraction.
Contrary, I also have strong disagreement with Walter Molano on this issue, but contrary to those who have had the privilege of living under a regime of price stability, under a climate of price stability where issues are whether inflation is going to be 1 or 2 or 3 percent. That is a privilege that I have never had throughout my life as a rational being, and there are 65 million other Mexicans who also have not had that opportunity.
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The ghost of six-year devaluations that began in 1976 is already playing a terrible game of expectations in Mexico. We are ten days away from the most contested, the most important electoral episode in the history of modern Mexico, and yet, the currency and the financial markets are behaving in a very irrational fashion simply because these markets have a memory, because human beings, Mexicans, have a memory that every six years at the end of a Presidential cycle there has been a massive devaluation.
I remember back in 1975, 14,000 pesos was sufficient to buy a brand-new Volkswagen. Today, 14,000 pesos, if we lop three zeros off the peso, because that is what we had to do because of the inflationary devastation that Mexico has suffered as a result of devaluation, today would not be sufficient to buy you a McDonald's and a coke.
The peso has lost 99.8 percent of its value in the past 25 years, and the increase in accumulated inflationplease hold your breath on this275,000 percent.
Not surprisingly, growth has been minimal. Approximately 1 percent per year growth per capita income in the past 25 years.
My colleague, Javier Bonilla, in Mexico, a respected economist, estimates, even though he is not a supporter of dollarization, but he estimates that there has been a loss of 2 to 3 percentage points per year in annual output as a result of extreme exchange rate variations.
So there is definitely a connection here between price instability, monetary instability, and lack of growth. And I think this is the rationale that feeds the idea of radical monetary reform, whether dollarization comes in the formweak formas a currency board, or as a first step toward negotiating some common unit of account, or whether it comes in the form of unilateral dollarization, or what some of my colleagues in Mexico call cohabitation.
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I actually prefer this alternative, because it involves eliminating legal tender monopoly privileges of the peso and allowing currencies to compete freely in Mexico.
I think that, contrary to what Mr. Molano has testified, there is much to be said about the low inflation benefits of dollarization. If you consider what the 1994 devaluation did to our price system, 1994 was the first year in 25 years that Mexico enjoyed a single-digit inflation rate, and it was 7 percent as such; 7 percent would be outrageous in industrialized countries.
As a result of the peso devaluation in 1994, the price level increased to 52 percent. That is a 637 percent increase in one single year, concomitant with a 6 percent contraction in economic growth.
I also believe that interest rate variability and high interest rates, a high cost of capital in Mexico, has been mostly a function of exchange rate risk; that if dollarization is implemented and exchange rate risk is eliminated, thereby then interest rate variability or the level of interest rates would merely be a function of institutional arrangements, of our bankruptcy laws, of the development and integration of our financial system.
So contrary to what some opponents of dollarization say, I believe that a policy of dollarization, of radical monetary reform, constitutes one of many steps to establish greater transparency in our monetary and in our financial system.
As Steve Hankey says, it invites international scrutiny into other areas of public policy such as fiscal policy, such as labor market reform, banking reform, and other areas of structural reform.
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In fact, Mexico during the past five years has had an experience with floating exchange rate regime. Much has been made about the fact that this is the first time in Mexico's history that we enter into the end of a Presidential cycle with a floating exchange rate regime. And yet it is significant to note that, despite the favorable growth profile during the past five years, we still have an inflation rate that is 24 percent on average for the past five years, annual average.
Compare that to industrialized countries where the annual average during the past five years has been 2 percent percent, and even emerging market economies 11 percent. So the inflationary tax has been both a source of tremendous competitive disadvantage and of economic contraction.
The dollarized portion of the Mexican economy has been growing, the maquelara sector, the tradable sector, has been growing at spectacular rates of 14, 16, 20 percent, whereas the non-dollarized part of the Mexican economy has been growing at 3 percent, 2 percent, 1 percent per annum.
The north, the border region, the robust, commercially robust border region between Mexico and the United States is one of the most economically explosive areas, one would venture to say, even in the world. The unit of account there is, no question about it, is the dollar. The adjustments are extremely quick.
Mortgages are dollar-denominated. Real estate transactions are dollar-denominated. Debts in corporations are dollar-denominated. Even payroll is dollar denominated. Eugenio Clairond's remarks to the matter of famous Monterey businessmen are included in greater detail in my testimony, but before a meeting of the Federal Reserve Board of Dallas he said that, he stated that in fact dollarization is not so much an ideological debate, but a question of time, at least for the north of Mexico.
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Four out of every five transactions by the year 2003 or 2004 are going to be dollar denominated simply because that will be the size of the proportion of the tradeable sector of the Mexican economy. Then dollarization will be taking place de facto, spontaneously, as it has in the border region, in Maritime Boards, and in the real estate sector.
I think that many of the objections to dollarization have been discussed already. Aspects concerning the loss of seigniorage, lender of last resort, and even labor market reform I think are technical obstacles to surpass and cannot be seen as objections.
National sovereignty I think is a very weak argument. Certainly portraying our national heroes, the very same ones that have debased the value of our currency by such a dramatic amount, is no source of national pride.
And the idea that a floating exchange rate has functioned as an adequate shock absorber in the face of external shocks I think is a rhetorical way of begging the question, the fundamental question about stability, because in truth it is not the exchange rate that absorbs any negative external shock as in 1998, it is the Mexican peso wage earner that absorbs that external shock.
That has been the real shock absorber, the variable of adjustment, and it is simply unfair to ask the peso earner once again to absorb the shock in the face especially of exporters who gained through artificial competitive advantage derived by currency depreciation.
So I think this argument about flexibility completely begs the question.
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I am worried about placing all the burden of economic policy on monetary policy, or actually importing monetary policy from abroad. Dollarization, as Dr. Calvo has already testified, is not a panacea. In Sebastian Edwards' words, it is not the cure for the common cold. It needs to be complemented with banking reform, with labor market reform, property rights reform, but it is an integral part and a credible part of an entire package of radical structural reform.
A recent and controversial paper published by the World Bank by David Dollar and Art Crane finds that the most positive antipoverty measure is the dramatic reduction of inflation. More than social spending, more than any other policies you can think of, even fiscal healing, is the stabilization of the price level.
I think that is the way that dollarization should be approached in Mexico and in Latin America as a means of reestablishing the integrity of the monetary contract.
Chairman BACHUS. Thank you. One thing you mentioned, Mr. Salinas, that I would call attention to the panel is these are all Doctors. We do not have Doctor by all their names, but all of them are Ph.D.s
I may have addressed one or two of you as ''Mister,'' but there are all those degrees.
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STATEMENT OF JUAN LUIS MORENO-VILLALAZ, Ph.D., ECONOMIC ADVISOR, MINISTRY OF ECONOMICS AND FINANCE, PANAMA
Mr. MORENO-VILLALAZ. Thank you.
Mr. Chairman and distinguished Members of the subcommittee:
My name is Juan Luis Moreno-Villalaz. I am an adviser of the Minister of Economics and Finance and I have extensively studied Panama's experience with dollarization. I thank you for the invitation to testify about it today. Besides my spoken testimony, I have written remarks that I request you include in the record.
Panama has used the U.S. dollar as currency since 1904, shortly after becoming independent from Colombia. An important part of our success with dollarization is what I call ''financial integration'' into the world markets.
This results from the participation of a large number of international banks in our banking system; extensive competition between banks; and no government intervention in financial markets, especially no restrictions on buying or selling foreign currency or on capital mobility by banks.
The facts of Panama's experience with dollarization speaks for themselves. Inflation over the last three decades has averaged about 1.7 percent per year, which is less than the United States.
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Interest rates are low, and are set by international markets. Credit conditions are very favorable. Commercial lending rates are less than 10 percentjust 1-percent-and-a-half-something, less than 1 percent and a half over U.S. prime rate. Thirty-year mortgages are readily available at 9 percent, which is very unusual for a developing country.
Low interest rates in Panama are the result of the lack of exchange risk, low risk of financial crisis, low spreads charged by banks due to competition, ample flow of funds from abroad, and absence of legal reserve requirements on deposits.
The economy is very stable. Economic growth has been between 4 to 5 percent per year. The economy was largely insulated from the Asian currency crisis, and government and private bank bonds are classified Ba1 or better.
Panama has never had a systemic banking crisis, even though it has no deposit insurance or government guarantees to banks.
The stability of Panama's banks compares favorably with the experience of other Latin American countries where losses from bank failures have been as high as 40 percent of GDP, much of that borne by taxpayers. When needed, international banks have acted as a lender of last resort to Panama's banking system.
But besides that, Panama epitomizes the operation of a pure competitive-market monetary system. The system has three characteristics:
Page 47 PREV PAGE TOP OF DOC First, Panama's money supply is endogenous, demand-determined by the actions of economic agents and banks instead of being supply determined by government policy.
Second, financial prices such as interest rates and asset prices are the result of a competitive market working without government intervention.
Third, banks play an essential role in balancing the monetary system and making it more stable. They do so by continuously adjusting their local and foreign portfolios in response to market forces.
Full capital mobility permits them to get rid of any excess supply of fundsby placing them offshorewithout creating excess demand for goods or large changes in prices within Panama, the same as the United States banking system does across State borders.
Most Latin American countries liberalized their financial markets in the 1980's and 1990's, but to protect local banks they restricted the freedom of entry by international banks.
However, the infant industry argument did not work in the financial sector as it did not work in international trade where free trade is known to be better. Because in developing countries the financial system is in large extent dominated by banks, a competitive and open banking system is necessary for a stable, efficient banking operation.
A popular view holds that a developing country surrenders its ability to ''fine tune'' its economy by dollarization, but no one in Panama advocates such powers for our government.
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Also, it is not correct to say that the Federal Reserve ''runs'' Panama's monetary policy. In fact, the policies of the Federal Reserve affects Panama only inasmuch as it affects all countries by altering the global supply of dollars, the international reserve currency, and global interest rates.
Chairman BACHUS. Mr. Moreno, I have just been advised that Mr. Ryan is going to be called to the floor in a few minutes.
What I would like to do at this time, if you would consent, is allow him to ask some questions.
Mr. MORENO-VILLALAZ. OK. Yes.
Chairman BACHUS. And then we will come back and we will have two minutes left for your statement. Would that be
Mr. MORENO-VILLALAZ. My statement is less than two minutes more. OK?
Chairman BACHUS. And so I am going to go ahead and let him ask his questions because he needs to leave.
Mr. MORENO-VILLALAZ. OK. Perfect.
Page 49 PREV PAGE TOP OF DOC Chairman BACHUS. If that is OK. I know it is a little unusual, but
Mr. RYAN. Yes, I thank the Chair.
Mr. Moreno, I am sorry about that, but I have an amendment on the floor. If you do not show for your amendment, you do not get to consider your amendment and you lose your amendment. So I have to go to the floor to work on an amendment.
I have been very intrigued with what you have been saying, and with what all of the witness's testimonies. There seems to be a debate that we have up here. It is kind of a chicken-and-egg debate.
We have gone over this with the Secretary of the Treasury, and this chicken-and-egg debate, as I call it, is some people think that you have to have fiscal policy stability first before you have monetary policy stability.
What this debate usually rages on about is you cannot dollarize, you cannot have monetary stability until these countries in Latin America, South America, get fiscal houses put in order; then let's consider monetary stability.
I think that it is the opposite of the case. I tend to believe that monetary stability is the necessary precursor toward fiscal stability.
If we continue to allow the argument that fiscal instability must precede monetary stability, then it seems to me that we will never get this going. Then we will never act on the issue of monetary stability.
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I would like to ask just each panelist what your thoughts are on that argument. Does dollarization in monetary stability come before fiscal stability? Or perhaps with it? And does the fact that a country does not have necessarily their fiscal house in order preclude them from being able to decide dollarization, to go with dollarization?
If I could just go from left to right and ask you to answer that, I would appreciate that.
Mr. GAVIN. I would be reluctant to rely upon dollarization to generate fiscal discipline. In other words, it is not an automatic mechanism which forces all other elements of the policy mix, including fiscal policy, to fall into place automatically.
Having said that, I think that fiscal indiscipline is as costly, arguably more costly, under flexible exchange rates than under fixed exchange rates.
Under flexible exchange ratesthe case of Ecuador was raisedfiscal indiscipline led to a banking crisis, a fiscal crisis winding up in default to international and domestic creditors, and hyperinflation.
Now we no longer have flexible exchange rates. We have a continued banking crisis. We still have a condition of default. And what you have done is eliminate the hyperinflation.
Now the Ecuadoran case will show, as previous cases have shown, that combining dollarization or a currency board regime as part of a package to address other flaws in the policy framework, especially fiscal indiscipline, is a better approach than waiting until fiscal policy is in place before the exchange rate issue is addressed.
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Mr. MOLANO. I think that dollarization and fixed exchange rate regimes have been considered as a policy or an incentive to force governments to demonstrate fiscal stability or discipline.
I think in the beginning they actually do that. That was actually the case in Argentina, which started to demonstrate greater fiscal discipline.
However, there seems to be a natural disposition, once that oversight begins to decline, that these governments then start to practice fiscal indiscipline, but it is not really that apparent because what the governments begin to do is they begin to increase their amount of external debt.
And in a way, we on Wall Street help accommodate that behavior since we are the ones who are issuing the debt. The problem is that these governments will continue to accumulate debt until they reach a problem of solvency. And that has actually been the case in Argentina, which Argentina is now starting to bump up against sovereigncy-types of problems.
So I would argue that Latin American countries, before they really truly embark on a dollarization initiative, should have mechanisms in place to have fiscal discipline and to exercise fiscal discipline.
Because one of the problems with the political systems in Latin America is that the elected politicians do not have the same amount of accountability and checks and balances as we do here in the United States.
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Until you have those institutional types of changes, I think it would be almost irresponsible to allow these countries to dollarize.
Mr. CALVO. Well, this is truly one of those issues where you can have a two-handed economy. You will have lots of two-handed economies.
Let me try to move away from that pattern, because it is not very useful. If I had to take a position, I would say that dollarization could come first.
The view that you had to have your house in order in order to be able to dollarize is not very easy to defend. We have seen what happened to Ecuador because it did not dollarize a year ago. And what happened to any country that has serious problems.
Because, on top of your structural problems, now people start thinking, ''Well, if these guys have structural problems, if they do not have access to the capital market, how are they going to solve the fiscal and banking problems? How?''
Well there is only one way, which is, print money.
So, when they start thinking that, they say, ''Well, shall I stay in the country? What is the interest rate that will make me happy to stay here?'' Well normally, a high interest rate, because you are under a very heavy risk.
So, interest rates are high. And therefore the whole situation deteriorates even faster. And that is my understanding of what happened in Ecuador.
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I mean the inflation that you are seeing now in Ecuador that Walter Molano was complaining about was an inflation that was essentially generated before dollarization. I do not want to enter into technical details, but that view could be defended.
So I think dollarization could very well come first.
Now let me show, timidly, my second hand as I say what on the other hand. On the other hand, the point that Molano made I think is something to keep in mind. And in relation to Panama, I would be interested in hearing Mr. Molano's comment, because it may turn out that when you dollarize you make things too easy for the policymakers and they can actually have bigger debts and bigger fiscal deficits.
And fiscal deficits is not the problem that has disappeared in Panama. So I could very well see somebody raising this as an important issue, if you do not have really the system to guarantee that the fiscal system will be in place and not deteriorate at least, there is a risk that dollarization can make life too easy.
But I think that can be taken care of, and I do not want to spend your time on this, that can be easily taken care of, and several Latin Americas are doing it by complementing the systems with a fiscal responsibility act, for example, which is like a balanced budget.
Argentina has Soro, Balanced Budget Amendment. And Brazil also has something like that which is called Fiscal Responsibility something.
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So if you complement dollarization with that kind of legislation, I really show my first hand. you can dollarize and everything will be fine.
Mr. SALINAS-LEON. I will try and be as brief as possible in my remarks.
I think that the issue is very important, but again it does not go to the heart of the matter. The heart of the matter here is whether dollarization constitutes a means to reestablish the stability of the purchasing power of the unit of account.
I believe that in the case of Mexico, a large portion of public debt is denominated in pesos or pays interest rate obligations in pesos. So shifting that, or switching that to dollars would entail a significant public savings.
Therefore, if I did have opposition to take on the one hand or on the other, I would say that, despite many potential counter-examples available, that monetary stability tends to feed fiscal stability.
Just as a footnote, at least in the case of Mexico, the floating exchange rate has been used in an irresponsible fashion to mask certain acts of fiscal irresponsibility, because it generates the moral hazard of abusing the sudden depreciation that the currency can be brought about to bear as a shock absorber for some of the structural imbalances that remain.
So I think that this suggests indeed that a structural reform to address fiscal discipline has to be thought of in terms not of whether dollarization or monetary stabilization precedes it or comes after, but rather in terms of something similar to a Fiscal Responsibility Act.
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Mr. MORENO-VILLALAZ. Do you want me to answer, or should I finish and then answer?
Chairman BACHUS. You can go ahead and finish and then, if you would like.
Mr. MORENO-VILLALAZ. I will just finish and then answer a couple of questions.
Chairman BACHUS. That would be fine.
Mr. MORENO-VILLALAZ. I was mentioning that, you know, that the Federal Reserve does not run Panama's monetary policy, and it will not do so for any country that dollarizes, because the market will establish the money supply.
In many countries, in developing countries, price distortion in financial markets give false price signals creating perverse incentives that induce excessive external borrowing and high risk.
These were factors behind macro-economic crises in several places, including Mexico and Asia. In Panama on the other hand the absence of distortions in financial prices leads to ''correct'' financial decisions. This is an experience which supports a systemic or market solution to macro-economic problems.
Page 56 PREV PAGE TOP OF DOC For Latin American countries to achieve financial integration with global markets, I believe most will need dollarization. Without dollarization there will not be sufficient confidence to attract capital flows or international banks.
As an exchange rate regime, dollarization has many advantages for the stability and efficiency of the capital markets. When you add the advantages of financial integration to the advantage of dollarization as Panama has done, you help preclude distortions in financial markets and thereby contribute to a stable financial order.
The discussion about improving the ''international financial architecture'' has emphasized strengthening international institutions to provide better response to crises. However, improving the performance of private capital markets in emerging economies reduces the likelihood of recurrent financial crises and should be an important complement to a better international financial system.
Now I will add now a couple of comments.
First, this idea that dollarization and the fiscal deficit can be seen as the problem of flows and stock, in fact Panama has fiscal deficit, and sometimes very high, and we have tended to have, in the past we had 80 percent of the GDP of debt, international debt, but the question is, as long as you can finance that in international markets, then there is no real problem. And when you reach a point at which the debt is too high, automatically the government will cut expenditures.
I have been there many times in which we say, the question in the government is we have no money. We cannot make expenditures without the dollars. We don't print dollars.
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At the point at which we cannot finance it, we have to cut expenditures. When I was in Ecuador I was telling the person who worries about the deficit that they should put a law that the deficit should not be more than 2 percent. Why should you worry? If somebody is financing it, what is the problem?
And when you cannot finance it, what is the problem? You just start cutting because you have no money. There is no way you can spend it without having the dollars. Therefore, it does have a very strong mechanism to force the government when it reaches a point at which it is difficult to get financing, to first go and adjust its deficit.
Also, it is true that better policies are not a panacea. You need a better policy and a market economy in many sense, but at the same time what happened in Panama is that even without good policies we do not create financial crisis.
And we are forced many times to do policies that the politician likes without imposing a deficit in the government or without creating financial crises.
As an example, we have subsidies, but not direct subsidies. We do not say the price of this will be lower and the government will pay, like almost every country in Latin America.
What we have in all cases is cross-subsidy. You want poor people to pay less for gas? Then the rich people pay more for gas. You want poor people to pay less for electricity? Then the rich people will pay more for electricity. Therefore, all policies, even subsidy policies, are made in such a way that do not create financial problems for the government.
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That has been a long story in Panama about that.
And second, what it means if we do not have the best policy? It means that we will have lower growth. And that we will have had in many years. But also that happened in a country without dollarization.
There isn't a mechanism of adjustment that we have in Panama without crisis. That is what it means. At the end, you pay for the wrong policies. OK? But in the other countries, they pay for the wrong policies and also have financial crises.
Thank you very much.
Chairman BACHUS. Thank you.
At this time I will turn to the gentleman from California, Mr. Sherman.
Mr. SHERMAN. Thank you.
Mr. Gavin, I have been looking over your paper a bit, the fact that you admit to neuroses in the first paragraph made it perhaps more psychologically interesting than the papers of your fellow panelists.
What is also interesting toward the end of your paper is the idea that the United States would one way or another pay Latin American nations for dollarizing.
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There is a term here that I will not even try to pronounce that starts with an ''S''. I wonder if you could pronounce it for me?
Mr. GAVIN. Seigniorage.
Mr. SHERMAN. Seigniorage?
Mr. GAVIN. Seigniorage.
Mr. SHERMAN. You put forward the idea that the United States could swap a few tens of billions of dollars for a few tens of billions of dollars worth of the currency that is being withdrawn, and you put forward the idea that of course there is some risk, but a few years down the road the country de-dollarizes and prints its own currency.
Do you know of any private insurance that would be available to the U.S. taxpayer that would insure us against that risk?
Mr. GAVIN. Certainly there are no existing policies that would cover that since there is
Mr. SHERMAN. I would tend to doubt that any syndicate would charge less than the seigniorage in question. In your paper you put that forward as a relatively small risk. I think that there would be a 20, 50, 80 percent chance in each and every country that within 5, or 10, or 20 years, whenever it hit the first bump in the road, or big bump in the road, or the second big bump in the road, that the opportunity to de-dollarize and save a government by doing so would be irresistible.
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I gather that many of these countries have dollarized to a significant degree without any U.S. payment.
Mr. GAVIN. Did you want a response to that?
Mr. SHERMAN. Yes.
Mr. GAVIN. I actually do not agree with the statement that countries would be inclined to de-dollarize in the event of a crisis.
First, experience has been that governments are afraid to raise the issue of de-dollarizing or unwinding, for example, a currency board arrangement, because they know that if they did that they would take a small- or medium-sized problem and turn it into a catastrophic problem.
The second point is that the dollarization does not just imply a transaction with the government; it implies an important transaction with the private sector.
Mr. SHERMAN. If I can interrupt, I do not even care whether it is a 1 percent risk or a 100 percent risk. I do not think it should be done unless the taxpayer is fully insured and let the private market decide whether it is a 1 percent risk or a 100 percent risk.
We could reducecertainly the country that is benefiting from the swap could pay in advance for the first 20 or 30 years of insurance.
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You see, I sit on the board of directors of the company that takes the risk, and unless we get total insurance I think it would be absurd for us to engage in the transaction.
Mr. GAVIN. The comment I would make to that is that there is a list of other nonfinancial benefits not related to this particular transaction that the United States should consider as benefits that would compensate it for that, in my view, small risk that the country would unwind the dollarization process.
Mr. SHERMAN. Whatever those benefits, I cannot imagine anybody here swapping $10 billion for 10 billion pesos without an insurance policy, and being told that some difficult-to-explain benefit justifies this difficult-to-calculate risk, unless we did it explicitly as a foreign aid with a foreign aid objective, in which case we should be having these hearings at the IR Committee where we consider voluntary transfers of wealth between our country and other countries.
Mr. GAVIN. In which case you would prefer the alternative mode of seigniorage sharing, which does not involve that risk, the mode that is in Congressman Ryan's bill.
Mr. SHERMAN. And that mode is that we send the check?
Mr. GAVIN. The so-called ''flow approach.''
Page 62 PREV PAGE TOP OF DOC Mr. SHERMAN. I think that would be relatively hard to get passed as well, but at least there we know what the cost is. We are writing a check each year in return for difficult-to-explain benefits.
Mr. GAVIN. Do you understand that this is not a net cost to the U.S. Government?
Mr. SHERMAN. I understand that you can make that argument, and I think you make it cogently in your paper, but the fact is that there are tremendous benefits and costs to the United States of the fact that billions of U.S. dollars are in circulation in other countries.
And I am not sure it is a net benefit to us even knowing that the seigniorage benefit is available. I am not aware that we have printed currency for the purpose of allowing it to be in circulation in other countries. We print a certain amount of currency. Printing currency is, you know, we take paper, we turn it into money. You know, that is a very profitable transaction.
I guess that if all of the dollars ever printed were in circulation in the United States, that could be inflationary.
Do you have an estimate as to how much currency we have printed and how much of it is in circulation outside the United States?
Mr. GAVIN. It is estimated at something over 50 percent of the currency of the paper that is printed is abroad. I believe that is a Federal Reserve Board guess.
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Chairman BACHUS. And in my opening statement I said that of $100 bills somewhere between 55 and 70 percent of the $100 bills circulate overseas.
Chairman BACHUS. Or outside the United States, not necessarily
Mr. SHERMAN. And when people in my District think of a suitcase filled with $100 bills, they think of that as a drug transaction. I am sure there are many legitimate transactions, as well, but how much currency do we have in circulation? Does anybody here know?
Mr. GAVIN. That is a good question.
Chairman BACHUS. $535 billion in circulation.
Mr. SHERMAN. And so half
Chairman BACHUS. Of that, $350 billion is abroad.
Mr. SHERMAN. So that is certainly odd. I do not knowit is odd for a country to print currency and to see so much of it taken offshore, and yes indeed, it would be inflationary if all of it came back on the same day.
Chairman BACHUS. I think the CBO and the Office of Management and Budget estimate that it is about a $35 billion profit.
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Mr. SHERMAN. Well that would assume a 10 percent return, which my
Chairman BACHUS. You might comment on that.
Mr. GAVIN. Yes, that would be a bitthat would be above my estimate of the benefits. But I would challenge the idea that if this money came back that it would be inflationary, because the Federal Reserve Board would have the option of reducing the monetary base through Open Market operations which would offset
Mr. SHERMAN. Yes. It would be inflationary unless you took deflationary action.
Mr. GAVIN. No, no, no. It would not be deflationary. In the course of keeping interest rates constant, it would be an automatic Open Market operation, which would have no effects on the economy except for the loss of the seigniorage that we currently earn.
Mr. SHERMAN. Is the seigniorage growing? I guess there is almost a limit with already almost half of our currency offshore. Is the Federal Reserve planning to print more to meet the circulation needs of Latin America and elsewhere?
Mr. GAVIN. Well the Federal Reserve Board does not print money in order to meet the needs of Latin America. It makes no provision for them. In fact, it only has rough estimates of how much money is actually going abroad.
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Again, in the course of conducting an interest rate policy which implies an accommodation of variations in the demand for United States currency, they would, if the demand for U.S. currency were to rise, automatically satisfy that demand. That would be a mechanism of insulating the U.S. economy against variations in the demand for money that might be generated by, among other things, changes in foreign demand.
Mr. SHERMAN. And that seigniorage accrues to thedoes that go to the General Fund, or a Fund maintained by the Federal Reserve?
Mr. GAVIN. It would go to the Federal Reserve and then be returned to the Treasury after that, because the counterpart of this money is assets that are on the Federal Reserve Bank's balance sheet.
Mr. SHERMAN. Has any Latin American country offered to dollarize if the seigniorage was paid for one way or another?
Mr. GAVIN. As an explicit quid pro quo, I am not aware of any. No. It has been raised as an objection within the context of a debate over dollarization in Argentina. No loss of seigniorage.
Mr. SHERMAN. One thing that concerns me is the national pride of nations in Latin America. Would we be seen as bribing them to abandon their currency? This could create the same kind of emotional reaction as if we were trying to buy an island or two.
Page 66 PREV PAGE TOP OF DOC Chairman BACHUS. And you might want to address that to Mr. Calvo or Mr. Salinas or Mr. Moreno, although Panama already does that.
Mr. SHERMAN. Panama has already dollarized without
Chairman BACHUS. So I would say Mr. Calvo or Mr. Salinas.
Mr. SALINAS-LEON. The north of Mexico is de facto already dollarized, and maritime ports have de facto already dollarized. In the short future, four out of every five transactions are going to be dollarized economic transactions.
I would also say
Mr. SHERMAN. That is in Mexico, right?
Mr. SALINAS-LEON. That is in Mexico, yes.
Mr. SHERMAN. Has that caused the Mexican Government to have to withdraw paper currency and lose seigniorage?
Mr. SALINAS-LEON. To an extent it has, but that has not been a significant issue. When it has printed a great deal of money, in the abuse of the inflationary tax it has earned a great deal of seigniorage, up to 3 percentage points of GDP. But that has fallen to under 1 percent.
Page 67 PREV PAGE TOP OF DOC Mr. SHERMAN. Because inflation has fallen?
Mr. SALINAS-LEON. Because inflation has moderately stabilized. Our inflation rate this year is projected to be 9.7 percent.
Chairman BACHUS. And I think Mr. Galvin has pointed out in his testimony that there has been a tremendousand Mr. Salinas has also mentionedthat northern Mexico has, there has been an infusion of capital as a result of
Mr. SALINAS-LEON. We even have a shortage of labor because of the capital expansion and economic expansion that has been observed.
Chairman BACHUS. So it has been a tremendous benefit, I would say, to capital hungry businesses in that area.
Mr. SALINAS-LEON. Well there remains some certain structural problems, particularly the cost of capital, but it is a far more financially integrated region than other regions in Mexico.
And frankly, in the broader terms of the dollarization debate, I think the issue of seigniorage would take a secondary place.
My feeling is that seigniorage, if we relinquish all seigniorage, we still in the cost/benefit equation, Mexicans relinquish all seigniorage and it is all a gain to the U.S., in the cost/benefit equation that would still come out positive in the case of Mexico because of increased output, lower cost of capital, greater transparency, and that really is a source of national pride, not a worthless currency.
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Chairman BACHUS. And I think what you said is that we try to determine the benefits of dollarization, and then we can weigh those benefits against any cost of seigniorage.
Mr. SALINAS-LEON. Or other costs.
Chairman BACHUS. OK. Thank you.
At this time I am going to yield to Mr. Paul, and then we will come back for a second.
Mr. PAUL. Thank you, Mr. Chairman.
I have just a couple of questions for Dr. Salinas. It has to do with just the basic concept of inflation. When I refer to inflation, I generally refer to the expansion of money and credit as defined by the free market economists, rather than just rising prices.
I am concerned about the inflation both externally and internally. I think it would be agreed that countries that have abused their monetary standard. If they accepted dollarization, it generally eliminates their power to inflate their currency and would be a tremendous benefit to them.
I even see some benefit to us in that we are given some license to print more money and create credit, and it is exported. And they hold this currency. I think it does in some way relieve the price pressures here in this country.
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These dollars that they are talking about overseas, I think they are very significant. But it does not need much law changes in order to encourage this. You say that northern Mexico is already dollarized, and that means they have just removed the prohibition from using these dollars.
Cuba now in currency has been dollarized because they have removed it.
So, I get very suspicious when we start talking about legislation and transferring some benefits to foreign countries from my viewpoint.
But, what do you think could beI am thinking now more as a Member of Congress rather than thinking about, or worrying about what is happening in Mexico.
What do you think the long-term implications could be for America by allowing us, or encouraging this further exportation of dollars?
Could it be that at the initial stages that there would be a benefit? But on the long term we could be contributing to a financial ballooning up of the financial assets and getting some benefits that may seem very good on the short run?
And also externally, if a country has dollarized can they inflate through the fraction reserve banking system? They do not have a central bank that can create credit, but is it not true that they could still inflate depending on reserve requirements?
Page 70 PREV PAGE TOP OF DOC Would you make some comments on that?
Mr. SALINAS-LEON. Well those are fundamental comments and get to the heart of many debates. Arguably it has been stated in Mexico that the private sector credit bubble, after the bank reprivatization, was largely responsible for the peso collapse of 1994. That, plus some very irresponsible monetary policy. We will not get into the details.
In Mexico right now we effectively still have exchange controls. We have not eliminated the last part of exchange controls. In other words, de facto one way of inviting spontaneous unilateral dollarization would be by allowing the peso to compete with all other currencies and the denomination of transactions and contracts in paying wages and paying your taxes.
This is the proposal known as cohabitation that at least one extremely important former central banker, Francisco Gil-Diaz is currently proposing these days. In other words, let the dollar compete as any other merchandise would compete.
And then in that sense, both in the short term or in the long term, you would let the market determine the amount of dollars that it needs in order to carry out its productive activities.
Naturally you are surrendering monetary policy responsibility to the Federal Reserve, or actually trying to import a product of far superior quality than the peso, or less inferior if you would like to put it in those terms.
Page 71 PREV PAGE TOP OF DOC But I believe that in this regard the long-term implications, especially in the context of open trade and of commercial integration, Dr. Calvo already alluded to them citing a paper, I forget the name of the author, but a comparison of models that were done with stable parities in the region versus a one-unit-of-account.
We find that if we use in the region only one unit of accountif Canada, Mexico, and the United States only used one unit of account, the increase in commerce between those three countries would rise six-fold.
I think this is a fundamental finding that goes to the heart of the matter concerning investment opportunities. I am not sure that that answers all your questions. I do think that areas in the banking system, as long as you leave fractional reserve banking, you run the risk of these sudden credit bubbles. And that is not something dollarization is going to solve.
Mr. PAUL. That is right. Now one other short question that was briefly touched on about the dollars coming here and what type of insurance do we have about what do we do with the pesos, but what is your opinion?
Let's say Mexico dollarized and they bought dollars with pesos.
What do we do with the pesos?
Let's assume they quit printing pesos and they never go back to issuing their local currency.
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What do we do with them?
What happens to those pesos?
Why would they have value?
Mr. SALINAS-LEON. You mean with the pesos that you would be purchasing for the dollars?
Mr. PAUL. Yes, if Mexico gives me pesos and I give you Treasury bills or dollar bills, what do I do with the pesos?
Mr. SALINAS-LEON. Well you could send them back to the Bank of Mexico, which would arguably be turned into a museum and we could post them up there.
Mr. PAUL. So it would be risky?
Mr. SALINAS-LEON. Or recycle them for a different use, but certainly not for monetary use.
As far as the seigniorage, I think it is much ado about very little. It is not really the heart of the monetary contract
Mr. PAUL. It is not the issue.
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Mr. SALINAS-LEON. And if you want insurance, hey, we will give you all the seigniorage benefits in terms of growth and of lower interest rates and lower cost of capital and greater commerce far outweigh even the fact that we would surrender all sharing of seigniorage.
Mr. PAUL. Do nations that dollarize not expose themselves to some problems because we can abuse our standard? We had a serious abuse of our standard in 1979 and 1980, but doesn't that mean that no matter how well you do you may suffer some consequences that you might not want?
Mr. SALINAS-LEON. Yes, Dr. Paul, unless you have cohabitation which would allow you to choose another currency. I think Dr. Calvo can amply tell you about the deflationary problems that they have had in Argentina and how U.S. policythe objection in Mexico was why the dollar? Which seems like a silly objection until you actually explored the contents of it.
What happens if in the future you go back to an irresponsible monetary policy or something that breeds inflation? Then wouldn't we be importing a very bad product?
Well, yes, that risk remains. But in the cost/benefit equation I would rather take that risk than to continue trading in such a worthless and decimated currency.
Mr. CALVO. If I may add a small comment to that, the fact that you do not dollarize in Latin America does not mean that you are not exposed to the Fed's policy.
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And actually there is a paper showing that those countries that float their currencies against the U.S. suffer more from increases in the rate of interest in the U.S.
Mr. PAUL. Right. And I think the assumption is, and when you compare it to other currencies, whether they are South Asian currencies, or Central America, or South America, the dollar looks pretty good.
But I as an individual who feels responsible for protecting the dollar, I never work on the assumption that we have done a really great job. Because if you measure it say to the cost of a gallon of gasoline or a barrel of oil, maybe we are not doing so well right now.
The whole thing is because we are the political and economic powerhouse. We get a lot of benefits that are not quite discounted in the market yet.
I mean I think we may look like we have a dollar that is so much better than maybe the market might decide three, or four, or five years from now. Maybe the economy will change and maybe our revenues will go down, and maybe our stock market will go down. Maybe our dollar will go down, and it will change all the fundamentals. And maybe this dollarization debate may fade rather quickly.
Right now, you know it may be that the perceptions are such that it looks good, and it looks good for everybody, but those attitudes may well change.
It seems like discipline is something that does not come easily, whether it is the spending disciplines, or the monetary disciplines. There are some old-fashioned disciplines that are not easy to spell with that we sometimes have to face up to whether they are spending or creation of credit.
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I thank the gentleman.
Chairman BACHUS. Thank you.
I want to direct this to Mr. Molano and Mr. Gavin.
I have got figures that show in 1998 of all bonds issued in Latin America, 73 percent of them were denominated in U.S. dollars; 6 percent in euros; 21 percent was other.
Just to show you the speed of financial integration, so far this year 64 percent have been denominated in U.S. dollars; 34 percent in euros; and 2 percent in others. So it is obvious here that there is a trend toward euros in Latin America.
My question, and my overall question, Mr. Paul said would dollarization in Latin America be beneficial or harmful to the United States, and my question might also be if we do not have dollarization, but they turn to the euro, what implications would that have? Maybe not Mexico obviously, but let's say Argentina or Brazil or Chile.
If Latin America has more of an investment relationship with Europe than it does with the United States, would thisand you quoted a California study professor that said that you are six times, whether you have financial
Mr. GAVIN. Monetary integration is associated with six times more international trade than would be the case, other things being equal.
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Chairman BACHUS. I would ask youand then I will ask the gentleman from Latin Americabut is there any risk that if they do not dollarize they turn to the euro as a denominator? Particularly if the European countries offer to give up seigniorage or to share that with Latin American countries.
And I am not so much concerned about Mexico. I think that may be theat least initiallybut, I would ask that question. And what detriment would that have to the United States?
Mr. GAVIN. One, I do believe that greater monetary integration is in the cards for Latin America. If it is not dollarization, some other form of monetary integration.
For Mexico, Central America, as you say, dollarization is essentially the only model that makes sense and is likely to occur. But for the rest of the region, and particularly the southern cone, Brazil, Argentina, and Chile, other models are available.
The euro is a possibility, but it strikes me as the less likely of the two possibilities. I mean first, if the euro was adopted then that would lead to a much stronger trade relationship between Europe and the southern cone than we would see if dollarization were to come into play.
And the counterpart of that would be a comparative disadvantage that firms in the United States would feel investing and taking part in the development of the southern Latin American markets. Not dissimilar to the concerns that British firms now feel about being left out of the European economics base because of the decision not to take part so far in the European monetary integration. That would be a negative.
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A more likely scenario I think would be if Latin America decides against dollarization to see a rise within the context of a reasonably sustained period of monetary stability in Brazil a mercosur-oriented monetary integration in which Brazil takes the lead, something which they are very eager to do, which would give Brazil significantly more diplomatic, economic, and financial clout vis-a-vis the United States than they now enjoy, and may well set back the efforts to promote greater integration between North and South America, because Brazil's vision is, let's say, less multi-lateral and more regional than the United States I think would like to see.
Both of those have important negatives I think for U.S. business.
Mr. MOLANO. I do not really see a difference whether Latin America starts to adopt the euro or the U.S. from a U.S. perspective.
I think that the increase in euro issuance has been really due to an opportunistic type of stance by the governments in Latin America.
Monetary policy in Europe is such that Latin American governments can actually issue easier in Europe, finding a lot of buyers of their bonds, and they would issue in yen or dollars or euro depending on which are the best conditions from them. They look at it from that perspective.
Probably in the short term I think that the costs and benefits of dollarization or versus the Latin Americans adopting the euro depend on time horizons.
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I think in the short term there probably would be a lot of benefit to the United States in the form of trade integration and capital flows.
However, my biggest concernand I repeat it againis one of credit and the long-term viability. The problem is that if you have these Latin American countries that increase their debt levels repeatedly and then get themselves to a situation where they cannot service those debts, I disagree with Dr. Moreno in that they just adjust their spending.
They have one other option, and that is called default. In 1982, Latin America defaulted on its debt. It almost drug down the U.S. banking system. And in 1995, Mexico was on the verge of default and the U.S. Government had to intervene.
So there is one other policy implication of this, of dollarization. I think it is one that we have to keep in mind as all of these different Latin American countries start to buildup dollar liabilities, which are then matched off by dollar assets in U.S. financial institutions, insurance companies, and pension funds.
Mr. MORENO-VILLALAZ. I can only speak about Panama's experience. In 1992 we were the only one. We did not default. We paid. We paid with a lot of sacrifice. We caught the deficit and the government expended substantially.
Second, in 1988-89 when we have the crisis with the United States, look at what happened in Panama. We closed the banks. And after they were open, long-term accounts were not paid except for foreigners. We paid all foreign accounts.
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Therefore, the experience of Panama is contrary to what you think. We have been paying, and we have beenand not because the Panamanians are different. You know, I do not think we are different. Because we have a system in which we take care of it.
Mr. MOLANO. But it still defaulted.
Mr. MORENO-VILLALAZ. No. Onlyyes, you are right, we did that in 1989, but in very special conditions, you know. You cannot repeat that. There were tanks around, and the governmentyou know that is a very special consideration. That was not related to any economic situation.
Mr. MOLANO. That is true.
Mr. SALINAS-LEON. Mr. Chairman, if I may have a couple of minutes, the defaults that Mr. Molano alludes to of course were closely, intimately associated with massive currency devaluations.
In other words, with massive exchange rate risk, which is precisely what dollarization would attempt to eliminate or to tackle, whether in its weak form of a currency board where you still retain some of that risk, or its more ambitious forms as unilateral dollarization or cohabitation.
This may also be used to compare, or to measure the cost/benefit equation of why a $52 billion loan.
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Chairman BACHUS. They are telling me that the time is running out on the floor. Let me do this. This is of tremendous import for this Congress and for our country.
I would like to recess for 45 minutes. Some of you may have scheduled travel arrangements where you cannot come back, but as opposed to cutting this hearing off prematurely, I would like to come back in 45 minutes and reconvene the hearing.
I know that there are at least two other Members who would like to come back and ask some questions, too.
Can all of you come back in 45 minutes?
[Panel nods in the affirmative.]
Chairman BACHUS. Is that a problem? Could we do that? We will get into, again I want to stress, the benefits to both Latin Americans and to us, and also maybe to the possible detriments of dollarization.
So I have got about a minute-and-a-half to get to vote, so we will recess for about 45 or 50 minutes and be back here let's just say at 1:35.
Page 81 PREV PAGE TOP OF DOC Mr. RYAN. [presiding]. The hearing will come back to order.
Thank you, gentlemen. I just want to start off by thanking you for enduring the day here and coming here. This place gets kind of out of order often because of the intervening votes that we often have, and I had an amendment myself on the floor. I wish I could have been here for the entire earlier part of the hearing. But I would rather go on into some more questions.
We talked about, before I left, having monetary stability preceding fiscal stability, and in many ways monetary stability ushering a good foundation for fiscal stability.
I wanted to ask you about what do you gentlemen think are the largest and, in the ranking of importance, barriers toward dollarization in South America, and then what do you think are the largest barriers against dollarization from the United States' standpoint.
Everybody has their ideas. The cultural significance I know most of you mentioned that as a smaller problem, but it does exist.
I would be interested to know if you think the cultural problem is much stronger in one country versus another. And what are the biggest hurdles and barriers in the order of importance for both sides?
If I could just start with you, Michael, and then move from left to right.
Mr. GAVIN. Sure. Let me think for 15 seconds. That is a very good question. Let me just give 2 seconds worth of thought to it.
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I would say
Mr. RYAN. Take your time.
Mr. GAVIN. I would say, yes, I would say there are three major barriers.
The first is the risk that a dollarizing country runs that is created by the fact that its neighbors are not dollarizing and therefore free essentially to engage in competitive devaluations. So you think about the circumstances facing Argentina
Mr. RYAN. Do Brazil and Argentina leap to your mind?
Mr. GAVIN. Precisely, precisely. Which means that a move toward a more dollarized monetary regime ought to be thought of in terms of a big push. Right? There ought to be some kind of an impetus rather than simply waiting for an individual country to dollarize because of that risk.
The second and related to that is that U.S. monetary policy does create risks, as well. Again Argentina is a good example where the massive depreciation of the dollar against the euro has been an ill-timed deflationary shock for the country.
Mr. RYAN. That is a good one. Let me add a third aspect to my question, then.
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What do you think are good recipes for improving U.S. domestic monetary policy?
There is another bill I am interested in to amend the Humphrey-Hawkins statute to make sure that it purges it of the Phillips curve type of language that guides that statute and focuses on price stability solely.
Mr. GAVIN. Um-hmm.
Mr. RYAN. That is something I am interested in. I think inflation-targeting is something we ought to take a look at around here, as well.
Mr. GAVIN. Yes.
Mr. RYAN. So what are the pressures against dollarization in South America?
What are the pressures against dollarization in the United States of America?
What can the U.S. do to improve its domestic monetary policy to avoid those types of problems?
Mr. GAVIN. Yes. I think that within the context of an inflation-targeting framework, some attempt multilaterally to dampen unnecessary volatility in the major currency markets would be a major plus for this initiative, for many other reasons as well.
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So this benign neglect of the U.S. currencies world value is an inhibition to dollarization in Latin America.
Then let us come to the political issues. I do agree with Guillermo that knee-jerk nationalist rejection of the dollar simply because it comes from North America is probably to be discounted in most countries of the region. Certainly I think in Mexico where there is grassroots, much less opposition; certainly in Argentina.
There are countries, and I think Brazil is one of them, where adoption of a North American currency would rankle. However, there is another dimension of the political problem, which I think is very severe and could potentially be a show stopper, which is if the dollarization process is viewed as a unilateral one in which the U.S. gives really nothing very meaningful and imposes sanctions or conditions that are reminiscent of this highly disruptive drug certification process, that is a huge negative.
Mr. RYAN. So you are saying the seigniorage sharing we have in the bill, 85 percent to the country and 15 percent withheld, is good and necessary and important, but you think the drug certification language that the Treasury Department asked for is destabilizing?
Mr. GAVIN. Precisely. Precisely.
Mr. RYAN. That is very interesting.
Page 85 PREV PAGE TOP OF DOC Mr. GAVIN. No, I think it is hugely negative. There is a high, high, high sensitivity and not just in governmental circles, but across the board, deeply felt feelings in Latin America.
And then the third issue is, and by far the least important, I think is the issue of seigniorage. It is significant. It would be a welcome gesture. It would be important financially at the margin. But it is not the most important.
From the United States I think that the major issue is lack of comprehension and an element of distrust that needs to be overcome.
We had a question while you were on the floor from Congressman Sherman which really betrayed a strong sense of distrust in contract that might be reached, explicit or implicit, with the Latin American governments that we are talking about, as well as in many circles I think there is a feeling that we are giving something away by sharing seigniorage and I think that that is quite wrong.
There is also I think an exaggerated sense of the risks that dollarization poses for U.S. monetary policy, which in my view are quite, quite negligible.
Let me stop there and allow the others.
Mr. RYAN. Mr. Calvo, I will go to you. I know, Walter, you just came in so I will just go starting with you, Mr. Calvo.
Page 86 PREV PAGE TOP OF DOC Mr. CALVO. I share many of the views, the points that Michael made.
On the political side, I do not think that having the heroes in the peso bills is a big deal. But there are political problems somewhat.
For example, barriers in Argentina to the dollarization proposal came from Menem, the past president. The guy who is empowered now, the opposition. So it is really awkward for them to come forward with a project that was originated by Menem.
So unfortunately I do not think that is going to fly in the short run. However, I think they keep the proposal in the sleeve and they may think about it if there is a crisis.
Mr. RYAN. Yes, it is unfortunate that Walter just left the room, but I know that some of his concerns seem to stem around political problems. politicians, policymakers concerned of losing control of the monetary policy, which is a sense of losing political control and power to manipulate markets for political ends and political means, which is all too often a cause of our problems in monetary markets.
You are saying that you think that a big factor of the resistance is because of those political power concerns, as well?
Mr. CALVO. Political power concerns, which are kind of in a way very marginal for a country like Argentina because they have given up already the power by pegging the peso.
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Mr. RYAN. Yes. I really meant the other nations.
Mr. CALVO. They do not have any degrees of freedom. But the situation is different for Chile, Brazil, and Mexico. I think there, momentarily, the present system they see as successful.
So they do not see any much pressure to change in the short term. I do not know if you want to call it political. It is also an economic issue at present. But they are following what is called inflation targeting, and that seems to be working in the short run.
I think the other concern, even for those that are in favor of dollarization, is that you do not want the crisis right after you dollarize. Not because you think the dollarization will cause the crisis necessarily, but because people are going to think that way.
For example, Molano mentioned the case of Ecuador's inflation this year of 100 percent. Well that has nothing to do with dollarization. That has to do with the fact that when they dollarized they paid at the very, very high exchange rate that has been going much faster than prices.
So what you see now is a catching up of prices to the exchange rate.
Now people just see inflation. So they say, ''See, we dollarize and look what happened. We have huge inflation.'' That has nothing to do. So that is something that you do not want.
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Mr. RYAN. OK.
Mr. CALVO. And finally, on this issue of Senator Mack's proposal and the certification business, I have been talking to some people in Argentina recently who favor the legislation and who like the proposal, but are worried about this ELE
Mr. RYAN. Certification.
Mr. CALVO. Certification exercise that maybe loosening that, relaxing that a little bit.
Mr. RYAN. OK.
Mr. CALVO. For example, to do it every five years, or three years. That would improve a lot, because the problem with the certification is not only a political issue that is raised, but it is an economic issue.
If you know that you have a flow coming from the United States, you can go to the market and say ''let me discount it.''
Mr. RYAN. There is more certainty in the income stream.
Mr. CALVO. Exactly.
Page 89 PREV PAGE TOP OF DOC Mr. RYAN. Sure. OK, that is a good point.
I would like to keep moving on because that was the ten-minute bell. We will just adjourn after that.
Dr. Salinas-Leon, if you could answer that question, but also you basically said that Mexico is de facto dollarizing; that it is becoming a common currency within Mexico. That is a fascinating point, I think.
What do you think are the cultural concerns in it, and if those cultural concerns are quickly diminishing because of this de facto dollarization?
And what do you think are the chances of having a dollarization agreement with Mexico?
Mr. SALINAS-LEON. I think the chances are good because, rather than talk about monetary convergence in the North American area, some people are beginning to talk about monetary assimilation, because of the fact that such a large proportion of our economy is represented by the tradeable sector and such a large proportion of the tradeable sector constitutes exports and imports with the United States and Canada.
So it makes all the sense in the world to search for one unit of account that will reduce transaction costs and permit greater expansion of commerce.
In fact, my view is that the main obstacles toward some form of dollarization and radical monetary reform in Mexico is simply a matter of sorting out the technical details in the time process of maybe three, to five, to eight years.
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Mr. RYAN. Do you think this new election presents an opportunity to get that moving?
Mr. SALINAS-LEON. Well, theoretically it shouldn't, because we are supposed to have an independent central bank. But the central bank seems to be moving in the direction right now of adopting a regime of inflation targeting. They are going to announce it for next year.
Inflation is suppose to converge to U.S. levels, if everything else remains equal, which it never does in Mexico anyhow, but if everything else remains equal, at 3 percent by the year 2003, with the banking situation pretty, fairly much fixed up. With greater labor flexibility, we have three years in order to undertake labor reform, to set up all the conditions and with a very high stock of reserves that we could accumulate by then, if you set up all the conditions to begin a weak form of dollarization, a la Argentina, a currency board style arrangement with an eye toward moving to a negotiation that will establish a unit of account.
But I think that you have wonderful anecdotal evidence and plenty of statistical evidence to suggest that the cultural concern is mostly a fascination of academic nationalists in Mexico, and that those peoplewhen 1 million Mexicans illegally come into the United States every year, what they are doing is dollarizing themselves.
Mr. RYAN. Yes.
Mr. SALINAS-LEON. That is exactly what they are doing.
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Mr. RYAN. That is an interesting way of putting it.
I guess there is about five minutes left.
Mr. MORENO-VILLALAZ. No, don't worry
Mr. RYAN. This happened to you last time.
Mr. MORENO-VILLALAZ. I should talk about
Mr. RYAN. You already dollarized.
Mr. MORENO-VILLALAZ. We have dollared.
Mr. RYAN. What do you think about the arrangement we have with the 15 percent share?
Mr. MORENO-VILLALAZ. No, but I would talk about my experience going to different countries in talking about dollarization.
Dollarization right now seems to be a concern of small groups. You know, we are here talking about it. But in the countries, very few people know about it.
The economic community, neither in Latin America, except in Argentina, I suppose, but not in Chile or in the rest of Latin America, and not even in the United States have they taken that issue.
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I think that they should be more larger discussion, professional as well as for the public, to understand dollarization. It is not just a question of taking the decision for everybody else involved with something that came from the air. That will be my experience.
Mr. RYAN. That is a very good point, and it is a good one to close with, because we have a vote again and I do not want to make you guys keep hanging around here.
I have really enjoyed your testimony. I think that is a very good point. That is why we are having these hearings. I believe this is an issue which is growing. This is an issue that I personally am trying to work in educating other Members of Congress about.
Senator Mack is trying to do the same thing over in the Senate. I believe it is something that has great and tremendous merit and promise.
Robert Mondel is a person we often look to here for counsel on these things, and there is a convergence that is occurring in monetary policy. And it is a good convergence. Sound money is clearly something within the realm, within the future, within the future of our lifetimes.
I am excited about your testimony and I just thank you gentlemen for travelling the distances you did to come and testify today. We will be extending your testimony around to other Members of the Congress.
Page 93 PREV PAGE TOP OF DOC This is a great service, and this will help us promote this issue. Thank you, very much.
Members of Congress can introduce statements and remarks for the remaining five days, and if you want to introduce any more statements for the record that will be done without objection. This hearing is adjourned.
[Whereupon, at 2:00 p.m., the hearing was adjourned.]