May 6, 2010
Most people don’t realize how many countries out there are dollarized.
In some countries, like El Salvador, Panama, Palau, Ecuador, etc. the US dollar officially circulates in the economy. In others, like Cambodia and Zimbabwe, the US dollar is the de facto currency, which means that they officially have their own currency, but US dollars are commonly used and accepted for everyday purchases.
Moreover, in other countries like Uruguay and Argentina, high ticket items like real estate generally change hands in US dollars. And finally, in many countries like Venezuela, Ukraine, Saudi Arabia, Hong Kong, Cuba, etc., the local currency is pegged to the US dollar at a fixed rate.
To be clear, there are many advantages to being dollarized. For tourists, it is far more convenient to deal in a major currency. For investors, there is generally less stability risk if you don’t have to deal with a third world peso. For business owners and traders, it makes sense to use the world’s #1 reserve currency.
But just as there are a lot of benefits to using the US dollar in a foreign economy, there is one massive, critical risk: what happens to these economies when the greenback finally breaks? What if there’s a run on the dollar, similar to what’s happening with the euro right now? Are these countries insulated? Here’s my take:
The actual currency unit in circulation, whether official or unofficial, is not that important. What is far more important is determining a country’s level of exposure to the United States.
El Salvador, for example, is heavily dependent on trade with the United States; 48% of its exports and 35% of its imports depend on the US… so a substantial dollar crisis which erodes the purchasing power of the greenback and reduces real wealth in the United States will have a devastating impact on El Salvador.
Then again, consider Honduras, which is not dollarized. 62% of it exports and 50% of its imports are bound to/from the United States. Honduras has an even greater level of exposure to the US, so a dollar crisis would likely be even more severe in that country, even though it circulates its own currency.
In contrast, consider Saudi Arabia, whose riyal currency unit is pegged to the US dollar at 3.75/$. Naturally, the preponderance of the Saudi economy is based on its oil exports, which it has no problems unloading to any number of countries across the globe, including China.
If the US dollar started to plummet, the price of oil (in dollar terms) would increase accordingly, and the Saudis would still be generating the same level of inflation-adjusted oil revenue. Net impact to the Saudi economy would be marginal, especially compared to places like Honduras.
We can see a very clear illustration of what would happen to these countries in the future by taking a look at the countries that are affected by the euro’s decline right now.
Take Switzerland, for example, which has its own, independent, time-tested, fairly sound currency. The Swiss economy is heavily dependent on the European economy, however, so as the euro has declined, so has the Swiss franc. Same with the Polish zloty, same with the Hungarian forint.
Overall, regardless of the currency in circulation, the safest places to be (economically speaking) in the event of a dollar crisis will be countries that have an independent source of income and do not depend on the United States for the preponderance of their trade.
Panama is one such example; revenues from the Panama Canal, its perpetual cash cow, will generally be enough to offset the negative impacts of a US decline.
Ecuador, with its reasonably well-developed (albeit de facto nationalized) oil sector, should also limp along just fine, similar to Saudi Arabia.
Peru, Chile, and Brazil are also on excellent footing; each of the three is blessed with substantial natural resource reserves and hungry export markets that are already diversified across the world. Chile’s trading partners, for example, are almost evenly split between China, Japan, the US, the EU, and the rest of South America.
This is a complicated topic, but it’s an important one to understand for anyone looking to plant multiple flags. I’ll be devoting more time to this next week when I talk about the nature of a dollar crisis, what it will look like, and when it will come.