Pacific Magazine > Magazine > September 1, 2002

Business

Viewpoint

Dollarisation: A Remedy or Hara-kiri?

By Dr. T.K. Jayaraman

The Solomon Islands is in a deep economic crisis. More than two years of ethnic conflict combined with fiscal indiscipline, have landed its budget in the red.

With still six months to go, the July figures show that deficit has mounted to S$43.8 million due to overspending on the civil service at SI$28 million and non-materialisation of estimated revenue receipts.

Some radical reforms now before government include an across-the-board payroll reduction of 40% and a three-day week for public sector operations. Another remedy floated is to abdicate monetary sovereignty and adopt the Australian dollar as the domestic currency. Government plans to discuss dollarisation with a visiting International Monetary Fund (IMF) mission scheduled to visit the islands.

Gains of dollarisation

The touted gains are: Since money supply is determined by the country's stock of Australian dollars, additions to money supply are possible only by incremental export earnings or external borrowings.

If the Solomon Islands dollar is replaced by the Aussie dollar, there will be no recourse to the printing press for monetisation of fiscal deficits. So, government budgets have to be balanced. Further, there will be no central bank and no independent monetary policy. That will be the headache of the Reserve Bank of Australia (RBA). Since RBA targets inflation, the Solomons would have low inflation and the interest rate would be that of Australia. So dollarisation would bring about the much-needed macroeconomic stability the country needs and increase investment.

Costs of dollarisation

Dollarisation will result in loss of revenue associated with sovereign right of printing national currency, known as seigniorage.

The Solomons will lose it unless Australia is willing to share some of its seigniorage revenue. When Argentina negotiated with the United States Treasury in 1999 to adopt the United States dollar, the reply was a flat "no".

So Argentina had to be content with currency board arrangements (CBA) under which its money supply was to be fully backed with equivalent United States dollar reserves. Nothing prevents Australia from saying a firm no as well. Since the country's exchange rate would be the same as that of Australia, the Solomons has to sink or swim with Australia. If the Australian dollar appreciates, its exports of palm oil and logs would become unattractive to the rest of the world. There will be no exchange rate adjustment route to promote exports. The recent Argentine experience of its peso being tied to United States dollar through CBA is a case in point. Brazil could devalue its currency and fight recession, while Argentina could not do it. If Australia wants to fight inflation with a higher interest rate, the Solomons will have to fall in line, even in the absence of domestic inflation. In 1992, Britain, going through a recession, was under such a dilemma.

It was part of the European Monetary System (EMS), a precursor of the euro. Germany was fighting inflation with a tight monetary policy and under EMS, the exchange rate mechanism (ERM) required Britain and others belonging to EMS to follow Germany's contractionary policy. Which way to go? As domestic jobs were more important, Britain chose to exit ERM. Once bitten, twice shy! Britain's unwillingness to join the Euro is traced to this lack of convergence.

At least, the Argentines had their own peso and the British their pound. They could easily exit. Once the Aussie dollar is adopted, the Solomon Islands would find such exiting not easy. Reverting to discontinued currency would be expensive with the revival of the already closed central bank and all paraphernalia! Recent studies have shown that there has been no convergence in the past between Australian and Pacific islands growth rates. It means dollarisation is nothing but a monetary "harakiri"!

What are net gains ornet losses?
The Solomon Islands trade with Australia is small, only 25% of its national income. Further, the island country is not fully integrated with Australia, since investment and other capital flows are low. Therefore, savings in transaction costs in terms of lowered conversion costs due to dollarisation would be smaller than the loss of seigniorage revenue. So SI will be the loser.

How about low inflation and macroeconomic stability?
A study by J. R. Rosales of IMF shows that performance in regard to inflation in Kiribati which used the Aussie dollar and the Marshalls which uses the United States dollar respectively, was no different from that in other island countries with their own currencies. In fact, Fiji and Vanuatu performed better than Kiribati and the Marshalls. There is nothing to commend about dollarisation as their experiences are mixed.

Macroeconomic stability primarily depends upon the country's own discipline regardless of the exchange rate regime. Experiences in Latin America and elsewhere have shown that CBA arrangements or dollarisations are not sufficient. Ecuador, which bid farewell to its 150-year old sucre and adopted the United States dollar from January 1, 2001 is worried about its current fiscal deficit. Since it is not part of the United States, no federal fiscal transfers are possible to accommodate Ecuador's temporary needs.

Will the Solomon Islands be eligible for fiscal transfers from Australia?

It is not certain. So dollarisation is not the solution.

Credible fiscal policies without surrendering monetary sovereignty and loss of seigniorage revenue are possible under a common currency arrangement with fiscally more disciplined nations in the region such as Fiji and Samoa. Their growth rates are relatively more convergent in recent years with Solomon Islands. For similar reasons, DeLisle Worrell, a former Deputy Governor of Central Bank of Barbados, now with IMF, rejected the idea of 15 Caribbean nations adopting the United States dollar, but favoured a currency union with a common currency. One more reason: He was against the United States hegemony as adoption of its currency would give it enormous political power. Is Australia nurturing any such ambition?