In forex trading, there are several different currencies. Some are dollarized, and some are not. This type of trading may be considered an advantage for emerging market economies. In addition, some emerging markets may find dollarization to be a very strong discipline device. However, it may also pose some risks to forex investors.
What is Dollarization?
Dollarization is a process in which the inhabitants of a country use foreign currency as their domestic currency. The currency is used as a store of value, unit of account, or medium of exchange. The process can occur with any foreign currency. One measure of dollarization is the share of foreign currency deposits in a country’s banking system held by its residents.
Some countries may opt for full currency substitution, i.e., they use foreign currency to replace their native money. Others may choose to circulate common cash, but use their native currency to conduct international trade. As of today, only Liberia and Panama have fully dollarized their economies. About two-thirds of the world’s dollar currency is held outside the United States.
Dollarization helps to prevent hyperinflation, which is when the purchasing power of a nation’s currency decreases rapidly. It’s often followed by a demand for foreign currency, including the U.S. dollar. This is especially true in developing countries with weak monetary authorities and unstable economic environments. In these countries, dollarization may be an official monetary policy to reduce the risk of ongoing hyperinflation.
Another possible impact of dollarization is that it can facilitate greater economic integration. For example, studies have shown that Canadian provinces are more integrated than their U.S. counterparts, and they trade more than twenty times more than their U.S. counterparts. Dollarization, in this context, may be beneficial because it promotes a common currency and reduces restrictions on trade.
Currency boards
Currency boards for dollarization in forex trading are not a new concept, and some countries have been using them successfully for many years. This practice signals a commitment to a stable, credible exchange rate and a willingness to pay the additional costs associated with adopting a fixed exchange rate regime. It is also possible for a country to adopt a currency board and move to a more flexible regime later without incurring too many additional costs.
A currency board is different than a central bank in several ways. First of all, it does not act as a lender of last resort to commercial banks. In addition, it does not regulate reserve requirements or attempt to set a discount rate. It also does not lend to the government and is not allowed to issue debt. Its primary role is to maintain a fixed exchange rate and limit currency volatility.
Another approach to currency boards is to impose capital controls on countries’ foreign currency markets. This prevents them from causing financial instability. It is possible that the authorities may extend capital controls, exchange controls, or bank deposit freezes to avoid a currency board. However, it would also effectively kill the most important components of currency boards.
Credibly fixed exchange rates.
A credibly fixed exchange rate in forex trading is a type of price that a central bank maintains on its currency. This rate is determined by a fixed relationship between the domestic currency and the SDR. The rates are typically set within a margin of +7.25 percent, +2.25 percent, or +11.5 percent. This type of price involves more than one currency market.