Dollarization and Lenders of Last Resort

Lessons from dollarized countries in Latin America.

In the last couple of weeks, the issue of dollarization once again became a topic of discussion with those in favor and against contrasting their points on social media and news outlets. Several concerns about dollarization have been put forward by a number of analysts. One concern is that by dollarizing the economy, Argentina loses its central banks as a lender of last resort (LOLR). A LOLR is an important player in the financial market because it can provide liquidity in case of an emergency such as a bank run.

This statement is problematic at face value. Recall that during the Great Depression bank fails by thousands under the watch of the Federal Reserve, while no single bank failed in Canada despite having no central bank. Besides the historical record, I find the argument that dollarizing an emerging economy (like Argentina) means giving up its LOLR problematic on two accounts.

The first issue is that this line of argument assumes that only a domestic central bank can function, efficiently at least, as a LOLR. Yet, we know from other dollarized countries that this must not be the case. Consider three dollarized countries in Latin America: Ecuador, El Salvador, and Panama.¹ How do they deal with having a LOLR while being dollarized? Some of their arrangements which, in turn, can be complemented one with each other:

• Through a deep financial integration, domestic banks have access to credit lines with international banks. International banks operating on domestic soil have their headquarters as their LOLRs. In short, banks have access to the worldwide financial market as a LOLR.

• Create an emergency liquidity fund. This facility can be managed by a government regulatory office or by a consortium of private banks. It can also benefit from a credit line in case of emergency with international banks and/or the IMF.

• Banks manage their own emergency reserves. This emergency fund can be held as a deposit in an international bank outside the scope of local politics.

There are two significant differences between these arrangements and a central bank serving as a LOLR. The first one is that a LOLR can offer unlimited funds. This is relevant in the case that the limited funds of the alternative arrangements are binding. This does not seem to be the case for dollarized countries in Latin America that never had the need to use their emergency funds, not even during the 2008 crisis. The second one is that a central bank is more prone to produce moral hazard behavior than the above-mentioned alternatives. By limiting risk-taking, a low moral hazard LOLR arrangement also limits the need to use emergency funds. It is possible that we overstate the need for a central bank as a LOLR precisely because of the moral hazard behavior it incentivizes.

The second issue with the LOLR argument against dollarization is that it is not possible to lose what you don’t have in the first place. Let me explain. For a LOLR to operate as such, it must be able to issue the currency that the public demands. If the public wants pesos but is concerned about the financial situation of the banks, the public will “run” against the banks, withdraw the pesos, and hold them. A LOLR can provide liquidity to the financial sector and put an end to the bank run.

However, if like in Argentina, the public does not demand pesos, then the central bank cannot operate as a LOLR. The public runs against the peso, not the banks. Pesos happen to be in the banks. When the public withdraws their deposits, the peso is used to purchase goods and services (inflation) or to purchase a hard currency such as the US dollar (currency crisis). A LOLR that “prints” pesos to provide liquidity fuels a spike in inflation, a currency crisis, and, in an extreme case, can trigger hyperinflation (if you are from Argentine… all this sounds remarkably familiar). Argentina has a central bank that fails to work as a LOLR because the market wants US dollars, not pesos. In practice, Argentina’s LOLR is the IMF, to whom Argentina turns for help anytime there is a currency or banking crisis. More important than having access to an issuer is having access to the currency the public demands.

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Figuring out alternatives to a central bank as a LOLR does not require much. All that is needed is to look at how this issue is managed in other dollarized countries. Giving up a central bank as a LOLR is not the strongest argument against dollarization.

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1. I won’t discuss them here, but there are also lessons to be drawn from old successful free banking regimes such as those in Scotland, Canada, and Australia, among others.