## _wp0682

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---

### I. INTRODUCTION
- Dollarization defined as a portfolio shift from domestic currency to foreign currency; can be total or partial and de jure or unofficial.
- Full (de jure) dollarization is the hardest peg; debate has focused on emerging markets, not systematically on postconflict economies.
- Postconflict context: loss of confidence in existing currency, weak institutional capacity, and temptation to use full dollarization as a quick solution to regain confidence.
- Paper focus: pros and cons for Liberia of adopting full (de jure) dollarization versus developing domestic monetary institutions; Liberia already “de facto” highly dollarized.
- Relevance beyond Liberia: discussions and analysis may apply to other postconflict economies rebuilding infrastructure and institutions under fragile governance.

### II. PROS OF DOLLARIZATION: ANALYTICAL CONSIDERATIONS AND EMPIRICAL EVIDENCE
- Theoretical trade-offs:
  - Gains: imposes an iron frame, ensures fiscal discipline, reduces exchange rate risk → lower interest rates, higher investment, exports, and growth.
  - Losses: costly liquidity provision (loss of seigniorage), higher output volatility from real shocks, increased liquidity risk for banks (no lender of last resort).
- Promoting growth (supporters’ view):
  - Dollarization as a precommitment to anchor inflation expectations and eliminate exchange rate risk associated with “soft” pegs.
  - Expected outcome: greater confidence of international lenders and investors, lower interest rates, higher foreign and domestic investment, higher GDP and exports.
  - Liability dollarization argument: full dollarization could avoid central-bank dilemmas in countries with dollar-denominated contracts.
- Empirical evidence (selected findings):
  - Ghosh, Gulde, and Wolf (2002), sample of 147 countries, 1970–99:
    - No evidence of a strong link between exchange rate regimes and economic growth once controlling for country-specific effects and simultaneity.
    - Rigid exchange rate regime has a positive effect on inflation (reflecting discipline and credibility effects).
    - Fixed regimes strongly correlated with output volatility (two volatility measures used).
  - Levy-Yeyati and Sturzenegger (2003b), de facto classification, sample of 183 countries, 1974–2000:
    - In developing countries, less flexible regimes strongly associated with slower growth and higher output volatility; industrial countries show no significant impact.
  - Rogoff and others (2004):
    - No significant relationship between economic growth and exchange rate regime across full sample.
    - Pegged/intermediate regimes tend to have lower inflation in developing countries.
    - No relationship between output volatility and exchange rate regimes for developing economies; for emerging markets, volatility increases with flexibility (largely due to volatility after collapse of rigid regimes).
    - Conclusion: for developing countries with low exposure to capital movements, fixed regimes may offer credibility without compromising growth if policies are consistent.
  - Case evidence: Panama and Belize (dollarized) had higher standard deviation of output in 1980–89 and 1990–96 (Panizza and others, 2003).
- Dollarization and fiscal discipline:
  - Fixed regimes expected to impose fiscal discipline, but deficits can be financed by arrears, domestic credit, and other means, postponing costs.
  - Empirical findings:
    - Vuletin (2003): fixed regimes do not provide greater discipline; flexible regimes generate greater discipline via immediate punishment.
    - Tornell and Velasco (1995): CFA franc zone countries were slow to undertake fiscal adjustment compared with other flexible-regime sub-Saharan African countries.
  - Cross-country regression test in paper (summary):
    - Sample: 121 emerging market and developing countries for three two-year periods during 1998–2003.
    - Dependent variables: overall deficit and primary deficit as percent of GDP.
    - Regressors: dummies for full dollarization, fixed regime, currency board, currency union; controls: changes in terms of trade, GDP per capita, inflation rate, level of external debt (in terms of exports), IMF program dummy.
    - Result: coefficient for full dollarization dummy not statistically significant at conventional levels (Appendix I).
    - Result robust across different macroeconomic vectors and for both overall and primary balances.
    - Currency union adoption associated with better fiscal performance.
    - Per capita income plays critical role for fiscal performance; successful IMF program coefficient significant when primary balance used.
    - Chow test: no uniformity across subperiods for overall fiscal balance model; full dollarization dummy not statistically significant in any subperiod during 1998–2003 (Appendix II).

### III. CONS OF DOLLARIZATION
A. Loss of Seigniorage
- Dollarized economy gives up seigniorage revenues to the issuer (United States for U.S. dollar).
- Two seigniorage losses (Berg and Borensztein, 2000):
  - Immediate cost of buying back local currency in public circulation.
  - Future seigniorage from ongoing increases in money demand.
- Seigniorage burden significant unless seigniorage-sharing arrangements are arranged (South Africa shares with Lesotho and Namibia; United States has no sharing agreements with U.S. dollar users).

B. Higher Vulnerability to Shocks / Loss of Policy Autonomy
- Loss of independent exchange rate and monetary policy increases vulnerability to external shocks.
- Under floating regimes, exchange rate can act as shock absorber; under dollarization, adjustments must occur through wages, taxes, or productivity.
- Fiscal mismanagement in a dollarized economy builds imbalances over time because no nominal exchange rate correction; excess demand pressures nontradables and appreciates the REER, worsening current account and reducing U.S. dollar supply (money supply).
- Dollarization can postpone adjustment; success of adjustment depends on nominal wage flexibility or realized productivity gains.
- Risk of perverse incentives: dollarization could encourage short-lived governments to run large deficits for immediate benefits, leaving costs to successors.

C. Larger Output Fluctuations
- Output fluctuations likely larger in dollarized economies because price and wage flexibility are essential to adjustment.
- If nominal downward flexibility or productivity gains insufficient, recession may be required to restore competitiveness.

D. Burden on the Banking System
- Dollarization alters bank risk profile:
  - Eliminates foreign exchange risk if assets/liabilities and corporate contracts denominated in U.S. dollars.
  - Increases exposure to output volatility-driven credit losses.
- No effective central bank lender of last resort → banks must internalize liquidity risk by:
  - Holding higher liquid assets, or
  - Holding higher equity.
- Consequence: higher costs to banks, likely higher lending rates.
- Empirical prudential indicators (Table 1) for Ecuador, El Salvador, and Panama show high capital and liquidity:
  - Basel total capital ratio: Ecuador 11.8 (2002), 12.2 (2003); El Salvador 12.1 (2002), 12.8 (2003); Panama 14.5 (2002), 19.0 (2003).
  - Tier 1 equity ratio: Ecuador 9.2 (2002), 10.1 (2003); El Salvador 9.7 (2002), 9.7 (2003); Panama 9.7 (2002), ...... (2003).
  - Liquid assets to total assets ratio: Ecuador 35.1 (2002), 38.9 (2003); El Salvador 30.0 (2002), 31.7 (2003); Panama 31.7 (2002), ...... (2003).
  - Liquid assets to deposits ratio: Ecuador 27.2 (2002), 28.5 (2003) [net of public bonds]; Panama 29.0 (2002), 24.4 (2003).
  - In Panama, banks’ capital ratio is 19 percent (2003), about 95 percent of which is primary capital (i.e., equity).
- Minimum recommended ratios by Basel Committee: 8 percent capital and 4 percent equity noted as benchmarks; observed ratios exceed these.

### IV. CHOICES OF CURRENCY REGIMES IN POSTCONFLICT COUNTRIES
- Postconflict constraints: destroyed physical/economic structures, weakened policy implementation capacity, humanitarian and social challenges.
- Many postconflict economies are de facto highly dollarized; lack technical capacity and data for independent monetary policy.
- Dollarization often seen as quick way to restore confidence with minimal technical needs.
- Historical choices and examples:
  - With exception of Timor Leste and Bosnia and Herzegovina, most recent postconflict countries favored their own currency, primarily because adoption of a foreign currency entails high costs (e.g., cost of replacing existing local currency in Afghanistan).
  - Timor Leste adopted full dollarization in January 2000 to eliminate distortions from multiple currencies after collapse of the financial system; factors included stable value, wide international use, convertibility, and most trade denominated in U.S. dollars.
  - Bosnia and Herzegovina experienced de facto adoption of the deutsche mark (later Euro) due to loss of confidence in local currency and hyperinflation; UNMIK legitimized deutsche mark use.
- Table 2 (summary in text) shows exchange rate regimes before and after conflict for several countries; examples include:
  - Sierra Leone (1999): Local currency (floating) before conflict and end of conflict.
  - Timor Leste (1999): Local currency (floating) before conflict → Full dollarization after conflict.
  - Kosovo (1999): de facto dollarization with DM noted in table context.
  - Note: Kosovo listed as a province under temporary UN administration in table notes.

### V. IS LIBERIA A CANDIDATE FOR FULL, DE JURE DOLLARIZATION? (SUMMARY)
- Context: August 2003 peace agreement ended Liberia’s civil war; major reconstruction tasks remain (poverty, living standards, corruption, governance).
- Liberia status (end-2005):
  - Partially dollarized but developing monetary instruments and enhancing Liberian dollar attractiveness.
  - 80 percent of all bank deposits are denominated in U.S. dollars.
  - Demand for local currency has rebounded with economic recovery.
  - Monetary instruments currently: reserve requirements on all bank deposits and foreign exchange auctions.
  - Central Bank of Liberia (CBL) developing a monetary policy framework and planning to establish a liquidity forecasting system and a credit facility for banks to cushion short-term liquidity shortfalls.
- Policy debate: some authorities and donors proposed adopting the U.S. dollar as sole legal tender to strengthen fiscal discipline and boost growth.
- Opening assessment: Liberia did not achieve fiscal discipline under the previous dollarization regime.

### VI. APPENDIX II — LIBERIA: HISTORICAL EXPERIENCE, SEIGNIORAGE, BANKING, AND FISCAL DATA
A. Historical experience with dollarization
- Liberia adopted a fully dollarized regime in 1946 and maintained it through favorable export and foreign direct investment conditions until the early 1970s.
- Between 1950-62, real domestic product increased "at least two and a half times," exports doubled, and government revenues increased "more than ten fold."
- Following the oil crises and global recession of the 1970–80s, Liberia’s terms of trade deteriorated, exports declined, and private capital left the country. Dollarization did not attract the capital inflows needed to reverse the balance of payments deterioration.
- Dollarization was ultimately abandoned and a local currency (Liberian dollar) was introduced in 1988; currency reforms occurred in 1988, 1992, and 1999, with the current Liberian dollar gradually replacing earlier issues during 1998-2000.

B. Macroeconomic consequences of dollarization in Liberia
- Dollarization amplified the macroeconomic consequences of external shocks by preventing exchange rate adjustment:
  - Balance of payments deficits led to a drying up of reserves while fiscal deficits and debts became unsustainable.
  - The exchange rate could not adjust to smooth the consequences of shocks; the government abandoned dollarization "in a chaotic way in 1988."
- Liberia’s experience in the 1970s and 1980s confirms potential disadvantages of full dollarization:
  - Higher output volatility due to loss of monetary and exchange rate policy.
  - Additional burden on the banking sector from stronger capitalization and liquidity requirements.
  - Loss of seigniorage revenue.
- Liberia did not face declining confidence in its currency as of end-2003: "While the exchange rate had been volatile during and right after the conflict, it has been maintained at a stable level since the end-2003."

C. Seigniorage cost estimates and projections (selected figures and series)
- Initial cost of replacing Liberian dollars in circulation (present reference) would be "about 2 billion Liberian dollars (equivalent to US$34 million, or 7 percent of GDP), accounting for almost one-half of fiscal revenue."
- Flow cost of dollarization is estimated at "US$5–6 million, or about 1 percent of GDP."
- Projected stock and creation of Liberian dollar base money (2004–09; Act./Proj.):
  - Stock of Liberian dollar base money (2004–09): 343 945 5054 59
  - (In percent of nominal GDP): 7.0 7.3 7.9 8.1 8.4 8.7
  - (In percent of total fiscal revenues): 49.5 41.4 40.1 40.0 37.2 35.1
  - Creation of Liberian dollar base money (2004–09): 6 5 5 5 5 5
  - (In percent of nominal GDP): 1.2 1.0 0.9 0.8 0.7 0.7
  - (In percent of total fiscal revenues): 8.4 5.4 4.7 4.0 3.3 2.7
- Note: "Liberian dollar base money are converted into US dollar, using the exchange rate as of end-2004." Projections and underlying assumptions are based on the medium-term projections in the IMF staff report on Liberia’s 2005 Article IV consultation.

D. Banking sector and growth channel
- Full dollarization would affect growth via the banking channel:
  - Liberian banks, after wartime losses, are being restructured and recapitalized.
  - Full dollarization would impose more stringent solvency conditions and raise the need to hold higher liquid assets, increasing lending rates and making financial intermediation more costly.
- Given Liberia’s fiscal situation, the initial and flow seigniorage costs "may be unable to afford a cost of this magnitude."

E. Fiscal experience during the 1980s (selected series, in millions of Liberian dollars)
- Overall fiscal deficit rose to "more than 10 percent of GDP during the 1980s."
- Total revenues (including grants) for 1981/82–1986/87: 279.3, 257.4, 260.1, 217.0, 205.6, 234.6
- Total expenditures for 1981/82–1986/87: 370.6, 390.4, 344.1, 382.6, 310.5, 366.3
- Overall balance for 1981/82–1986/87: -91.3, -133.0, -84.0, -165.6, -104.9, -131.7
- Financing for 1981/82–1986/87: 91.3, 133.0, 84.0, 165.6, 104.9, 131.7
- Changes in arrears for 1981/82–1986/87: -6.0, 8.0, 3.3, 68.7, 41.1, 78.0
- Borrowing from NBL for 1981/82–1986/87: 50.7, 81.6, 53.0, 57.3, 42.1, 29.7
- Other financing for 1981/82–1986/87: 46.6, 43.4, 27.7, 39.6, 21.7, 24.0

### VII. POLICY IMPLICATIONS AND RECOMMENDATIONS (AS PRESENTED)
- Full dollarization is not necessarily a solution for Liberia’s reconstruction challenges:
  - The potential advantages—fiscal discipline and stimulus for growth—are not guaranteed.
  - The potential disadvantages—higher output volatility, additional bank-sector burden, and loss of seigniorage—would likely materialize.
- Maintaining the current exchange rate regime has allowed policymakers to further develop monetary instruments:
  - Development of monetary instruments would give policymakers tools to smooth output fluctuations, helping minimize economic and social disruption, support sustainable growth, and preserve peace.
- Liberia’s social and economic fragility requires a policy framework that allows adjustment while minimizing adverse effects on output and the social fabric; strong capitalization demands in fully dollarized economies cannot currently be met by Liberian banks.
- Historical experience indicates full dollarization is not a panacea for lack of fiscal discipline: "the fact that Liberia was able to run fiscal deficits under full dollarization suggests that full dollarization is not a panacea to the lack of fiscal discipline."

*Source: _wp0682 - References (IMF PDF excerpt).*

### References..............................................................................................................

### _wp0682 - References..............................................................................................................

### I. INTRODUCTION
- Dollarization defined as a portfolio shift from domestic currency to foreign currency; can be total or partial and de jure or unofficial.
- Full (de jure) dollarization is the hardest peg; debate has focused on emerging markets, not systematically on postconflict economies.
- Postconflict context: loss of confidence in existing currency, weak institutional capacity, and temptation to use full dollarization as a quick solution to regain confidence.
- Paper focus: pros and cons for Liberia of adopting full (de jure) dollarization versus developing domestic monetary institutions; Liberia already “de facto” highly dollarized.
- Relevance beyond Liberia: discussions and analysis may apply to other postconflict economies rebuilding infrastructure and institutions under fragile governance.

### II. PROS OF DOLLARIZATION: ANALYTICAL CONSIDERATIONS AND EMPIRICAL EVIDENCE
- Theoretical trade-offs:
  - Gains: imposes an iron frame, ensures fiscal discipline, reduces exchange rate risk → lower interest rates, higher investment, exports, and growth.
  - Losses: costly liquidity provision (loss of seigniorage), higher output volatility from real shocks, increased liquidity risk for banks (no lender of last resort).
- Promoting growth (supporters’ view):
  - Dollarization as a precommitment to anchor inflation expectations and eliminate exchange rate risk associated with “soft” pegs.
  - Expected outcome: greater confidence of international lenders and investors, lower interest rates, higher foreign and domestic investment, higher GDP and exports.
  - Liability dollarization argument: full dollarization could avoid central-bank dilemmas in countries with dollar-denominated contracts.
- Empirical evidence (mixed):
  - Ghosh, Gulde, and Wolf (2002), sample of 147 countries, 1970–99:
    - No evidence of a strong link between exchange rate regimes and economic growth once controlling for country-specific effects and simultaneity.
    - Rigid exchange rate regime has a positive effect on inflation (reflecting discipline and credibility effects).
    - Fixed regimes strongly correlated with output volatility (two volatility measures used).
  - Levy-Yeyati and Sturzenegger (2003b), de facto classification, sample of 183 countries, 1974–2000:
    - In developing countries, less flexible regimes strongly associated with slower growth and higher output volatility; industrial countries show no significant impact.
  - Rogoff and others (2004), similar sample/period as Ghosh:
    - No significant relationship between economic growth and exchange rate regime across full sample.
    - Pegged/intermediate regimes tend to have lower inflation in developing countries.
    - No relationship between output volatility and exchange rate regimes for developing economies; for emerging markets, volatility increases with flexibility (largely due to volatility after collapse of rigid regimes).
    - Conclusion: for developing countries with low exposure to capital movements, fixed regimes may offer credibility without compromising growth if policies are consistent.
  - Panizza and others (2003): Panama and Belize (dollarized) had higher standard deviation of output in periods 1980–89 and 1990–96.
  - Bordo (1993): real output volatility highest under the gold standard in long historical comparison.
- Dollarization and fiscal discipline:
  - Fixed regimes expected to impose fiscal discipline, but deficits can be financed by arrears, domestic credit, and other means, postponing costs.
  - Empirical findings:
    - Vuletin (2003): fixed regimes do not provide greater discipline; flexible regimes generate greater discipline via immediate punishment.
    - Tornell and Velasco (1995): CFA franc zone countries were slow to undertake fiscal adjustment compared with other flexible-regime sub-Saharan African countries.
  - Cross-country regression test in paper:
    - Sample: 121 emerging market and developing countries for three two-year periods during 1998–2003.
    - Dependent variables: overall deficit and primary deficit as percent of GDP.
    - Regressors include dummies (full dollarization, fixed regime, currency board, currency union) and controls: changes in terms of trade, GDP per capita, inflation rate, level of external debt (in terms of exports), IMF program dummy.
    - Result: coefficient for full dollarization dummy not statistically significant at conventional levels (Appendix I).
    - Result robust across different macroeconomic vectors and for both overall and primary balances.
    - Currency union adoption associated with better fiscal performance.
    - Per capita income plays critical role for fiscal performance; successful IMF program coefficient significant when primary balance used.
    - Chow test: no uniformity across subperiods for overall fiscal balance model; full dollarization dummy not statistically significant in any subperiod during 1998–2003 (Appendix II).

### III. CONS OF DOLLARIZATION
A. Loss of Seigniorage
- Dollarized economy gives up seigniorage revenues to the issuer (United States for U.S. dollar).
- Two seigniorage losses (Berg and Borensztein, 2000):
  - Immediate cost of buying back local currency in public circulation.
  - Future seigniorage from ongoing increases in money demand.
- Seigniorage burden significant unless seigniorage-sharing arrangements are arranged (South Africa shares with Lesotho and Namibia; United States has no sharing agreements with U.S. dollar users).

B. Higher Vulnerability to Shocks / Loss of Policy Autonomy
- Loss of independent exchange rate and monetary policy increases vulnerability to external shocks.
- Under floating regimes, exchange rate can act as shock absorber; under dollarization, adjustments must occur through wages, taxes, or productivity.
- Fiscal mismanagement in a dollarized economy builds imbalances over time because no nominal exchange rate correction; excess demand pressures nontradables and appreciates the REER, worsening current account and reducing U.S. dollar supply (money supply).
- Dollarization can postpone adjustment; success of adjustment depends on nominal wage flexibility or realized productivity gains.
- Risk of perverse incentives: dollarization could encourage short-lived governments to run large deficits for immediate benefits, leaving costs to successors.

C. Larger Output Fluctuations
- Output fluctuations likely larger in dollarized economies because price and wage flexibility are essential to adjustment.
- If nominal downward flexibility or productivity gains insufficient, recession may be required to restore competitiveness.

D. Burden on the Banking System
- Dollarization alters bank risk profile:
  - Eliminates foreign exchange risk if assets/liabilities and corporate contracts denominated in U.S. dollars.
  - Increases exposure to output volatility-driven credit losses.
- No effective central bank lender of last resort → banks must internalize liquidity risk by:
  - Holding higher liquid assets, or
  - Holding higher equity.
- Consequence: higher costs to banks, likely higher lending rates.
- Empirical prudential indicators (Table 1) for Ecuador, El Salvador, and Panama show high capital and liquidity:
  - Basel total capital ratio: Ecuador 11.8 (2002), 12.2 (2003); El Salvador 12.1 (2002), 12.8 (2003); Panama 14.5 (2002), 19.0 (2003).
  - Tier 1 equity ratio: Ecuador 9.2 (2002), 10.1 (2003); El Salvador 9.7 (2002), 9.7 (2003); Panama 9.7 (2002), ...... (2003).
  - Liquid assets to total assets ratio: Ecuador 35.1 (2002), 38.9 (2003); El Salvador 30.0 (2002), 31.7 (2003); Panama 31.7 (2002), ...... (2003).
  - Liquid assets to deposits ratio: Ecuador 27.2 (2002), 28.5 (2003) [net of public bonds]; Panama 29.0 (2002), 24.4 (2003).
  - In Panama, banks’ capital ratio is 19 percent (2003), about 95 percent of which is primary capital (i.e., equity).
- Minimum recommended ratios by Basel Committee: 8 percent capital and 4 percent equity noted as benchmarks; observed ratios exceed these.

### IV. CHOICES OF CURRENCY REGIMES IN POSTCONFLICT COUNTRIES
- Postconflict constraints: destroyed physical/economic structures, weakened policy implementation capacity, humanitarian and social challenges.
- Many postconflict economies are de facto highly dollarized; lack technical capacity and data for independent monetary policy.
- Dollarization often seen as quick way to restore confidence with minimal technical needs.
- Historical choices:
  - With exception of Timor Leste and Bosnia and Herzegovina, most recent postconflict countries favored their own currency, primarily because adoption of a foreign currency entails high costs (e.g., cost of replacing existing local currency in Afghanistan).
  - Timor Leste adopted full dollarization in January 2000 to eliminate distortions from multiple currencies after collapse of the financial system; factors included stable value, wide international use, convertibility, and most trade denominated in U.S. dollars.
  - Bosnia and Herzegovina experienced de facto adoption of the deutsche mark (later Euro) due to loss of confidence in local currency and hyperinflation; UNMIK legitimized deutsche mark use.
- Table 2 (summary in text) shows exchange rate regimes before and after conflict for several countries; examples include:
  - Sierra Leone (1999): Local currency (floating) before conflict and end of conflict.
  - Timor Leste (1999): Local currency (floating) before conflict → Full dollarization after conflict.
  - Kosovo (1999): de facto dollarization with DM noted in table context.
  - Note: Kosovo listed as a province under temporary UN administration in table notes.

### V. CONCLUSIONS: IS LIBERIA A CANDIDATE FOR FULL, DE JURE DOLLARIZATION?
- Context: August 2003 peace agreement ended Liberia’s civil war; major reconstruction tasks remain (poverty, living standards, corruption, governance).
- Liberia status (end-2005):
  - Partially dollarized but developing monetary instruments and enhancing Liberian dollar attractiveness.
  - 80 percent of all bank deposits are denominated in U.S. dollars.
  - Demand for local currency has rebounded with economic recovery.
  - Monetary instruments currently: reserve requirements on all bank deposits and foreign exchange auctions.
  - Central Bank of Liberia (CBL) developing a monetary policy framework and planning to establish a liquidity forecasting system and a credit facility for banks to cushion short-term liquidity shortfalls.
- Policy debate: some authorities and donors proposed adopting the U.S. dollar as sole legal tender to strengthen fiscal discipline and boost growth.
- Points for policymakers in considering full dollarization include:
  - Liberia did not achieve fiscal discipline under the previous dollarization regime (text begins this assessment; further points follow in source beyond provided excerpt).

*Source: _wp0682 - References (IMF PDF excerpt).*

### Appendix II). As Liberia’s experience in the 1980s proves, dollarization can coexist for

### Appendix II: Liberia — Dollarization Experience and Seigniorage

### Historical experience with dollarization
- Liberia adopted a fully dollarized regime in 1946 and maintained it through favorable export and foreign direct investment conditions until the early 1970s.
- Between 1950-62, real domestic product increased "at least two and a half times," exports doubled, and government revenues increased "more than ten fold."
- Following the oil crises and global recession of the 1970–80s, Liberia’s terms of trade deteriorated, exports declined, and private capital left the country. Dollarization did not attract the capital inflows needed to reverse the balance of payments deterioration.
- Dollarization was ultimately abandoned and a local currency (Liberian dollar) was introduced in 1988; currency reforms occurred in 1988, 1992, and 1999, with the current Liberian dollar gradually replacing earlier issues during 1998-2000.

### Macroeconomic consequences of dollarization in Liberia
- Dollarization amplified the macroeconomic consequences of external shocks by preventing exchange rate adjustment:
  - Balance of payments deficits led to a drying up of reserves while fiscal deficits and debts became unsustainable.
  - The exchange rate could not adjust to smooth the consequences of shocks; the government abandoned dollarization "in a chaotic way in 1988."
- Liberia’s experience in the 1970s and 1980s confirms potential disadvantages of full dollarization:
  - Higher output volatility due to loss of monetary and exchange rate policy.
  - Additional burden on the banking sector from stronger capitalization and liquidity requirements.
  - Loss of seigniorage revenue.
- Liberia did not face declining confidence in its currency as of end-2003: "While the exchange rate had been volatile during and right after the conflict, it has been maintained at a stable level since the end-2003."

### Seigniorage cost estimates and projections
- Initial cost of replacing Liberian dollars in circulation (present reference) would be "about 2 billion Liberian dollars (equivalent to US$34 million, or 7 percent of GDP), accounting for almost one-half of fiscal revenue."
- Flow cost of dollarization is estimated at "US$5–6 million, or about 1 percent of GDP."
- Projected stock and creation of Liberian dollar base money (2004–09; Act./Proj.):
  - Stock of Liberian dollar base money (2004–09): 343 945 5054 59
  - (In percent of nominal GDP): 7.0 7.3 7.9 8.1 8.4 8.7
  - (In percent of total fiscal revenues): 49.5 41.4 40.1 40.0 37.2 35.1
  - Creation of Liberian dollar base money (2004–09): 6 5 5 5 5 5
  - (In percent of nominal GDP): 1.2 1.0 0.9 0.8 0.7 0.7
  - (In percent of total fiscal revenues): 8.4 5.4 4.7 4.0 3.3 2.7
- Note: "Liberian dollar base money are converted into US dollar, using the exchange rate as of end-2004." Projections and underlying assumptions are based on the medium-term projections in the IMF staff report on Liberia’s 2005 Article IV consultation.

### Banking sector and growth channel
- Full dollarization would affect growth via the banking channel:
  - Liberian banks, after wartime losses, are being restructured and recapitalized.
  - Full dollarization would impose more stringent solvency conditions and raise the need to hold higher liquid assets, increasing lending rates and making financial intermediation more costly.
- Given Liberia’s fiscal situation, the initial and flow seigniorage costs "may be unable to afford a cost of this magnitude."

### Fiscal experience during the 1980s
- Overall fiscal deficit rose to "more than 10 percent of GDP during the 1980s."
- Poor fiscal performance reflected a steady decline in revenues and a rise in expenditure; deficits were financed largely through:
  - Accumulation of arrears on external debt-service payments and domestic payment arrears (including wages and salaries arrears).
  - Emergence of various forms of government liabilities (including duty drawbacks and unpaid vouchers owed to suppliers).
  - Borrowing from the banking system (mainly through the central bank).
- Fiscal Balance in the 1980s (selected year series, in millions of Liberian dollars):
  - Total revenues (including grants) for 1981/82–1986/87: 279.3, 257.4, 260.1, 217.0, 205.6, 234.6
  - Total expenditures for 1981/82–1986/87: 370.6, 390.4, 344.1, 382.6, 310.5, 366.3
  - Overall balance for 1981/82–1986/87: -91.3, -133.0, -84.0, -165.6, -104.9, -131.7
  - Financing for 1981/82–1986/87: 91.3, 133.0, 84.0, 165.6, 104.9, 131.7
  - Changes in arrears for 1981/82–1986/87: -6.0, 8.0, 3.3, 68.7, 41.1, 78.0
  - Borrowing from NBL (National Bank of Liberia) for 1981/82–1986/87: 50.7, 81.6, 53.0, 57.3, 42.1, 29.7
  - Other financing for 1981/82–1986/87: 46.6, 43.4, 27.7, 39.6, 21.7, 24.0

### Policy implications and recommendations from the source
- Full dollarization is not necessarily a solution for Liberia’s reconstruction challenges:
  - The potential advantages—fiscal discipline and stimulus for growth—are not guaranteed.
  - The potential disadvantages—higher output volatility, additional bank-sector burden, and loss of seigniorage—would likely materialize.
- Maintaining the current exchange rate regime has allowed policymakers to further develop monetary instruments:
  - Development of monetary instruments would give policymakers tools to smooth output fluctuations, helping minimize economic and social disruption, support sustainable growth, and preserve peace.
- Liberia’s social and economic fragility requires a policy framework that allows adjustment while minimizing adverse effects on output and the social fabric; strong capitalization demands in fully dollarized economies cannot currently be met by Liberian banks.
- Historical experience indicates full dollarization is not a panacea for lack of fiscal discipline: "the fact that Liberia was able to run fiscal deficits under full dollarization suggests that full dollarization is not a panacea to the lack of fiscal discipline."

*Source: Appendix II (excerpt) from the supplied IMF content unit.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp0682.pdf_