## _wp10106

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---

### I. Introduction — purpose and scope
- Purpose: identify key institutional and operational aspects that countries willing to officially dollarize must necessarily address.
- Target audience: policy makers and practitioners implementing a unilateral adoption of a foreign currency as legal tender.
- Paper focus: operational guidance rather than a position on the appropriateness of dollarization.
- Scope exclusions: does not cover bilateral dollarization, accession to the European Union, or how to introduce a monetary union.

### II. Rationale, costs, and benefits of official dollarization
- Main rationale:
  - Desire to import a tested monetary policy framework that facilitates preserving price stability and contributes to fostering economic growth.
  - Appeal to post-conflict countries and small open economies closely linked to a large-country currency via trade and capital flows.
- Conventionally identified costs:
  - Loss of seigniorage.
  - Limited or no ability to provide lender-of-last-resort (LOLR) assistance to troubled banks.
  - Lack of exchange rate as a shock absorber.
  - Inability to reduce value of domestic-currency financial commitments via large depreciation or fueling inflation.
- Conventionally identified benefits:
  - Convergence of domestic inflation towards world inflation.
  - Elimination of currency risk, reducing domestic interest rates.
  - Better environment for investment from stable inflation and lower interest rates.
  - Absence of “original sin,” reducing country risk by removing currency mismatches.
- Definitions preserved:
  - “Official dollarization”: unilateral decision of adopting a foreign currency as legal tender; includes euroization.
  - “Legal tender”: currency that by law may be offered in payment of a debt and that a creditor legally cannot refuse.
  - “Original sin”: inability to issue debt in own currency, forcing issuance in a major international currency.

### III. Current global status (as of end-2008)
- Aggregate facts:
  - As of end-2008, eleven countries had unilaterally dollarized worldwide.
  - Three of these countries are emerging markets, one is a high income country, and the rest are developing nations with very small economies—some considered micro states.
  - Seven countries substituted their domestic currency for the U.S. dollar.
  - Three countries dollarized in the current decade.
  - Only two countries, Ecuador and El Salvador, went through the complex endeavor of replacing their established national currencies with the U.S. dollar as legal tender.
  - Kosovo, Montenegro, and Timor-Leste shifted from one foreign currency to another prior to becoming independent states.

### IV. Table: Formally Dollarized Countries (excerpt)
- Extracted entries:
  - Ecuador
    - Year adopted: 2000
    - Currency adopted: U.S. dollar
    - Issue of national coins: Yes
    - GDP (in billion (of U.S. dollar)): 45.79
    - Previous own national currency: Yes
  - El Salvador
    - Year adopted: 2001
    - Currency adopted: U.S. dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 20.37
    - Previous own national currency: Yes
  - Kiribati
    - Year adopted: 1979
    - Currency adopted: Australian dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 0.067
    - Previous own national currency: No
  - Kosovo
    - Year adopted: 1999
    - Currency adopted: euro
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 4.688
    - Previous own national currency: No
  - Marshall Islands
    - Year adopted: 1986
    - Currency adopted: U.S. dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 0.163
    - Previous own national currency: No
  - Micronesia
    - Year adopted: 1986
    - Currency adopted: U.S. dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 0.232
    - Previous own national currency: No
  - Montenegro
    - Year adopted: 1999
    - Currency adopted: euro
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 3.49
    - Previous own national currency: No
  - Palau
    - Year adopted: 1994
    - Currency adopted: U.S. dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 0.164
    - Previous own national currency: No
  - Panama
    - Year adopted: 1904
    - Currency adopted: U.S. dollar
    - Issue of national coins: Special case
    - GDP (in billion (of U.S. dollar)): 19.74
    - Previous own national currency: Special case
  - San Marino
    - Year adopted: 1999
    - Currency adopted: Euro
    - Issue of national coins: Special case

### V. Literature and gaps
- Literature emphasis:
  - Pros and cons of dollarization: Berg and Borensztein (2000), Panizza and others (2003), Levy-Yeyati and Sturzenegger (2003).
  - Timing and country selection: Eichengreen (2002) and Calvo (2002).
  - Geographic focus on Latin America and Panama-specific studies.
  - Few studies on operational aspects; Gruben and others (2003) noted as exception.
- Identified gap:
  - Practical implementation issues of unilateral dollarization are understudied and motivate this paper.

### Zimbabwe (2009) — unique unilateral dollarization case
- Overview:
  - 2009: Zimbabwe authorized use of any traded foreign currency as legal tender without formally abolishing Zimbabwe dollar.
  - Most prominent currency used during 2009: U.S. dollar; South African rand used for small cash transactions; neighboring currencies used regionally.
- Hyperinflation metrics:
  - Hyperinflation reached in February 2007.
  - Mid-November 2008: monthly inflation rate estimated at 79,600,000,000 percent—equivalent to a daily rate of 98 percent.
- Outcome: Multiple re-denominations in 2006–09 failed; national currency went out of circulation during second half of 2008.

### Macroeconomic performance of dollarized and hard-peg groups (2004–2009)
- Inflation and growth:
  - Inflation in dollarized countries converged to and remained close to world inflation during 2004-2009, including Ecuador (inflation had reached 100 percent year-on-year in 2000).
  - Merging dollarized countries with other hard-peg regimes shows:
    - Average inflation was lower and volatility larger because of the high pass through to domestic inflation from the 2007-2008 supply shock.
    - Economic growth in hard-peg countries was less dynamic and more volatile than in the rest of the developing and emerging market countries.
  - Among dollarized countries (aggregate, 2004-2009):
    - Panama: 7.6 percent average growth.
    - El Salvador: 2.3 percent average growth.
- Fiscal stance and public finances:
  - Dollarized countries maintained fiscal positions in check and had a stronger fiscal stance than the rest of developing and emerging market countries.
- Country risk and financial market indicators:
  - EMBI spread for El Salvador and Panama was lower or close to the composite EMBI spread.
  - EMBI spreads and interest margins rose for El Salvador and Panama during the recent financial crisis due to capital outflows and fears of banking crises.
  - Ecuador exhibited elevated country risk and higher interest rates, reflecting idiosyncratic political economy factors that led to a debt default in 2008.

### Key pre-conditions and trade-offs for de jure dollarization
- Competing views:
  - One view: pre-conditions should exist before adopting de jure dollarization to yield more benefits.
  - Opposing view: dollarization puts pressure to immediately adopt similar policies, so pre-conditions may be less critical.
- Minimum recommended pre-conditions:
  - (i) A robust financial system and strong financial supervision to minimize likelihood of banking crises with no—or limited—LOLR facilities.
  - (ii) Solid public finances to assure sustainability of fiscal policy.
  - (iii) Flexible labor markets to facilitate macroeconomic adjustment to external shocks.
- Experience examples:
  - Ecuador dollarized amid systemic financial crisis with high inflation under a flexible exchange rate.
  - El Salvador dollarized in macroeconomic stability with a fixed exchange rate.
  - Presence/absence of pre-conditions affects transition smoothness and downside risks.

### Institutional issues and legal framework
- Political support and legal endorsement:
  - Strong political support and clear legal framework endorsed by society are critical.
  - Legislation typically requires changes to central bank law, financial sector legislation, accounting rules, and payment system regulations; sometimes constitutional amendments.
- Role and redefinition of the central bank:
  - Central banks commonly remain but with altered mandates: primary objective often to foster and maintain a stable financial system.
  - Typical tasks assigned: financial surveillance, prudential and supervisory regulation, cash handling, manage international reserves, centralized clearing, serve as fiscal and financial agent, undertake macroeconomic studies, and advise governments.
  - Prohibited/curtailed functions: printing new currency notes (but not necessarily minting national coins), conducting interest rate policy, and a drastically curtailed ability to serve as LOLR.
  - Examples:
    - Panama has no central bank.
    - Ecuador, El Salvador, and Montenegro preserved central banks with no commercial bank responsibilities.
    - Kosovo and Timor-Leste created central banking authorities after independence focusing on financial supervision.
  - Central bank governance and revenue model:
    - Reorganize governance and board expertise to reflect new mandate.
    - Seigniorage eliminated; central bank financing restricted; alternative income model needed (government budget and financial institutions’ contributions).
    - Legislation should establish government underwriting of central bank liabilities.
- International and issuing-country considerations:
  - Approach issuing-country authorities to explore cooperation (logistics, formal monetary association).
  - Euroization: EU authorities and the ECB are less complacent about unilateral adoption given EMU convergence procedures and Treaty reasoning.
  - Uncertainty for accession where a country had unilateral euroization (e.g., Montenegro, Kosovo).
- Timetable and communication:
  - Prepare and disseminate a timetable for dollarization; duration variable—could be less than six months (Ecuador example).
  - Timetable should specify conversion rate effective date; when new currency becomes legal tender; when central bank stops open market operations; start of replacing domestic currency; dual circulation period; dates for converting financial system balance sheets and accounting rules.
  - Comprehensive communication strategy essential: explain reasons, steps, conversion rate, transitory dual pricing, limit “currency rounding,” and provide procedures to financial system and public.

### Operational issues (conversion, backing, contracts)
- Conversion rate:
  - Choose a conversion rate close to the market rate and easy to use.
  - Ensure key central bank liabilities are covered by net international reserves when setting conversion rate.
- Backing rule and reserves:
  - Define a backing rule covering at minimum coins and banknotes; optimal coverage is base money plus interest-bearing central bank securities.
  - Failure to secure backing undermines credibility and sustainability.
  - If meaningful surplus of international reserves remains after backing, consider creating an emergency liquidity facility for financial distress.
  - For commodity-dependent dollarized countries, accumulating excess international reserves is warranted as a buffer.
  - New states may lack international reserves but can dollarize if they continue using the previous currency (e.g., Kosovo).
- Central bank balance sheet presentation:
  - Make explicit availability of international reserves backing domestic currency and central bank securities.
  - Show room for systemic liquidity management and likely limited LOLR support.
  - Quasi-fiscal liabilities should be absorbed by the government.
- Interest rate conversion and contract treatment:
  - Under stable macroeconomic conditions:
    - No need to change parameters of contracts maturing after dollarization; apply original terms at the conversion rate.
    - Converted dollar interest rates may still reflect previous expected devaluation and country risk premiums; voluntary renegotiations may be allowed (El Salvador allowed gradual conversion of colones interest rates over three months).
  - Under high inflation or hyperinflation:
    - Mechanical conversion can yield dollar rates much higher than prevailing post-dollarization rates and create distortions.
    - Government intervention to “dollarize interest rates” may be warranted but is disputed due to moral hazard and information problems.
    - Legislation may establish a new level of interest rates for pre-existing contracts (the desagio); Ecuador implemented a desagio rule by adjusting interest rates in sucres and dollar-denominated contracts.

### Monetary operations and lender-of-last-resort (LOLR) capacity
- Central bank role:
  - In a dollarized economy, the central bank loses ability to conduct monetary operations and generally should refrain, except to redistribute liquidity among financial institutions if it has international reserves to back such operations.
- Bank reserves and remuneration:
  - Bank reserves should support payment system operation and serve as liquidity cushion.
  - Ideally, bank reserves should be remunerated at a rate consistent with return central bank obtains from investing these funds (effectively part of international reserves).
- Country practices:
  - Ecuador: bank reserves used for payment systems purposes.
  - El Salvador: reserve requirements integral to financial safety net; bank reserves count in liquidity requirement calculations determined by Superintendency of Banks in absence of central bank LOLR.
  - Interest rate adjustment example at conversion: rates adjusted one time to 16.82 percent and to 9.35 percent for lending and deposit rates.
- Converting domestic interest rates to dollar rates:
  - Alternative: define reference rates for domestic currency and new legal tender and convert interest rates by measuring them in terms of the reference rates (Schuler (2002)).
  - Example conversion rule described in source.
- Compensating for lack of LOLR:
  - Central banks may provide liquidity support only if they hold surplus international reserves.
  - Alternatives:
    - Build a contingent liquidity fund with foreign loans (Ecuador created such a fund to accumulate resources up to one time the amount of the system’s regulatory capital).
    - Purchase private insurance from foreign private financial institutions (expensive and may not handle systemic crises).
  - Focus shifts to Ministries of Finance and international multilateral institutions for solvency support.
  - Example: El Salvador agreed with the Fund on an US$800 million Fund program to serve as a liquidity buffer in case of a liquidity event.

### Currency procurement, circulation, and conversion logistics
- Procurement of new currency:
  - Central bank should procure sufficient convertible currency for banknotes and coins in required denominations/subdenominations.
  - Responsibility for supplying dollar banknotes typically assigned to the central bank on behalf of government.
- “Dollarized” coins or national coins:
  - Reasons to mint national coins: preserve national symbol; U.S. coins may lack numerals; coin denomination issues; transport costs.
  - Ecuador and Timor-Leste use national coin series, fully convertible to U.S. dollars in their countries.
- Dual currency circulation:
  - Dual circulation causes extra costs and inefficiencies (retailers handling two sets of notes/coins; dual pricing; ATM and vendor reprogramming).
  - Conversion period normally as short as possible; El Salvador conversion period lasted six months after law approval.
- Managerial and organizational systems:
  - Conversion is multi-pronged; management can be by central bank or off-line project.
  - Exchange points: banks, money changers, post offices, temporary exchange points, mobile units for remote areas; equip with trained staff and security.
- Distribution and storage:
  - Prepare logistics plan and additional temporary storage (containers, secured vaults, strong boxes, safes).
- Invalidation and destruction of old banknotes:
  - Old banknotes must be invalidated at exchange to avoid fraud; techniques include mechanical shredding, ink/dye, manual/hydraulic punchers.
  - Destroy all national banknotes after invalidation and counting; best done centrally and integrated with currency reporting systems.

### Key complementary structural reforms to strengthen dollarization
- General: package of fiscal, financial, trade, and labor reforms should be prepared, discussed, and approved to strengthen credibility and sustainability; ideally before dollarization.
A. Fiscal Reform
- With central bank unable to provide credit to government, fiscal rules are desirable to preserve sound public finances.
- Build stable tax base consistent with sustainable fiscal deficit.
- For commodity-dependent revenues, build stabilization funds to enable counter-cyclical fiscal policy (example: Ecuador’s fiscal responsibility law in 2002 and subsequent changes).
- Need adequate and timely monitoring of expenditure commitments to avoid cash-based budget arrears.
- Better bankruptcy and debt resolution frameworks may be required.
- Maintain public debt at sustainable levels and develop public debt capacity for treasury management.
B. Financial Reform
- Banking crises can threaten a dollarized regime; impose more stringent solvency and liquidity requirements.
- Example: El Salvador increased required risk-weighted capital-asset ratio to 12 percent and introduced a special liquidity buffer equivalent to 9 percent of deposits.
- Strengthen financial surveillance with risk-based supervision.
- Strengthen financial safety net: prompt corrective actions, deposit insurance, effective bank resolution instruments with clear exit rules.
  - Example: El Salvador increased deposit insurance coverage; Panama and Ecuador do not have deposit insurance.
- Capacity building for well-trained financial regulators critical.
- Presence of foreign-owned institutions can reduce vulnerabilities but support from parent banks is not guaranteed.
C. Trade Reform
- Reduce trade tariffs and distortions to expand export base and ensure availability of foreign currency adopted as legal tender.
- Encourage capital mobility and foreign direct investment, with caution about excessive FDI into non-tradable sector.
- Lowering tariffs aids convergence of domestic to world inflation in short run; diversify trade partners and exports in long run.
D. Labor Reform
- Minimize nominal rigidities, especially in labor market, to allow adjustment to external shocks.
- Promote labor market flexibility, job creation, and labor mobility.
- Phase out indexation clauses; de-indexation should be included in legislation establishing official dollarization and, if possible, introduced before dollarization.

### Case study: Ecuador
- Background:
  - Dollarized "from one day to another" amid a full-fledged financial crisis.
  - De facto dollarization had climbed to more than 50 percent of total bank deposits (38 percent a year before).
  - Government announced adoption of the U.S. dollar as legal tender on January 2000.
- Legislation and chronology:
  - March 13, 2000: Congress approved Economic Transformation Law (LTE); conversion rate established at 25,000 sucres per dollar (same rate announced on January 10, 2000).
  - LTE provisions: BCE must not issue domestic currency; BCE must exchange all sucres for dollars; all agents must convert accounting to dollars.
  - Key regulatory dates from Jan. 10, 2000 through Jan. 11, 2001 include reserve requirement establishment at 4 percent for all bank deposits.
- Operational design:
  - Conversion rate established to fully back monetary base with central bank international reserves.
  - BCE changed balance sheet presentation into four systems (“Exchange system”, “Financial reserve system”, “Operations system”, “System of other operations”).
  - Central bank operations narrowed to short-term liquidity management and payments system functioning; allowed to issue exclusively short-term securities to mop-up liquidity surpluses.
  - Reserve requirements reduced gradually from 11 to 4 percent for all bank deposits; liquidity assistance to banks legally proscribed.
  - Currency conversion tasks:
    - BCE procured national coins with same denominations as U.S. coins but own physical characteristics; local dollar coins began circulating by September 2000.
    - Currency conversion lasted one year.
    - Statistical data were revisited to express them in the new currency.

### Case study: El Salvador
- Background:
  - Since 1993, the colon was pegged to the dollar.
  - Fiscal and external disequilibrium moderate (on average about 1.5 percent of GDP during 1993–2000).
  - Financial dollarization was low.
  - Real interest rates were high and economic growth averaged about 3 percent during second half of 1990s.
  - Authorities officially dollarized at a conversion rate of 8.75 colones per U.S. dollar to reduce real interest rates and foster growth.
- Institutional arrangements (Monetary Integration Law, MIL):
  - Consultations conducted domestically and internationally; Federal Reserve cooperation for operational issues.
  - MIL provisions:
    - Prohibit BCR to extend credit to financial institutions and to print new currency notes beyond existing inventory.
    - Retain BCR powers to issue bonds and to purchase, sell, and exchange portfolio and securities.
    - Restructure LOLR framework, establishing a remunerated liquidity requirement.
    - Allow BCR to conduct repo operations with government resources in event of systemic liquidity shortfall.
  - MIL did not set a deadline for conversion of colones into dollar coins and banknotes; did not change BCR balance sheet presentation.
- Operational rules and liquidity:
  - Conversion lasted about two years and followed piecemeal approach via exchange points.
  - Federal Reserve was main provider of dollars directly to BCR.
  - MIL established a 90-day period for adjustment of interest rates in pre-existing colones credits, referencing reduction in financial costs and prevailing rates for new dollar credits.
  - Remunerated liquidity requirement conversion rules:
    - First 25 percent drawn free of interests.
    - Second 25 percent charged a market interest rate.
    - Remaining 50 percent use requires Superintendence of Banks authorization and a regularization plan with BCR.
- Chronology highlights:
  - November 22, 2000: President announced official dollarization.
  - November 30, 2000: Congress approved MIL.
  - January 1, 2001: Dollarization entered into effect with specified provisions (conversion rate, exchange rules, redenomination, 90-day interest rate adjustment, dual pricing for first 180 days).
  - June 2003: central bank introduced a 9 percent liquidity requirement on bank deposits.
  - January 2004: deposit insurance coverage increased from USD 6,250 to USD 7,060.
  - April 2006: central bank reduced liquidity requirement on bank deposits to 3 percent.

### Case study: Kosovo
- Background:
  - Dinar previously official; Deutsche Mark (DM) widely used due to prior hyperinflation and political issues.
  - September 1999 UN regulation: DM de facto legal tender; dinar subject to surcharge.
  - November 15, 1999: UNMIK established Banking and Payments Authority of Kosovo (BPK).
- Chronology highlights:
  - Jun. 10, 1999: Kosovo war ended.
  - Jul. 25, 1999: UNMIK took control.
  - Sep. 2, 1999: DM made de facto legal tender for payments rules.
  - Jan. 1, 2002: UNMIK made the euro de facto legal tender.
  - Feb. 17, 2008: Parliament declared Kosovo independent.
- Operational outcomes:
  - Successful introduction of DM welcomed by population.
  - Large imports of DM banknotes necessary; initial vault shortages led to improvised storage.
  - Euro conversion managed by BPK with IMF, USAID, and ECB assistance.
  - Logistics and staffing challenges due to destroyed bank offices and lack of surviving local banks; international experts and NATO troops supported implementation.

### Case study: Montenegro
- Background:
  - Longstanding use of foreign currencies due to weakness of Yugoslav currency and hyperinflation in 1992–93; remittances supported de facto use.
  - Excluded from sharing seigniorage with National Bank of Yugoslavia.
- Institutional stance:
  - Unilateral euroization initially tolerated due to political circumstances; Bundesbank did not support DM introduction.
  - EU/ECB later emphasized unilateral euroization is not compatible with treaties requiring structured convergence.
- Chronology highlights:
  - Nov. 2, 1999: dual currency with DM parallel to dinar.
  - Nov. 13, 2000: Montenegro left the dinar monetary area.
  - Jan. 1, 2001: DM declared sole legal tender.
  - Mar. 15, 2001: Central Bank of Montenegro started operating.
  - Jan. 1, 2002: DM replaced by euro, which became sole legal tender.
  - May 21, 2006: Montenegro voted for independence.
- Operational observations:
  - DM use widespread prior to formal adoption; decision politically divisive.
  - No serious proposals for special national coins; pfenning used initially, replaced by euro cents in 2002.
  - Commercial bank interest rates on loans and deposits varied considerably; treasury bill yields did not closely align with euro area trends.

### Case study: Timor-Leste
- Institutional choices:
  - January 2000 UNTAET Regulation made U.S. dollar official currency and legal tender.
  - Federal Reserve contacted and had no objections.
  - Freedom of contract allowed voluntary denomination in any currency, but compulsory payments had to be in legal tender.
  - On transitory basis, compulsory payments to budget could be made in rupiah subject to 20 percent fee.
  - Banking and Payments Authority (BPA) set up by UN with IMF support to manage cash and supervision.
- Chronology highlights:
  - Aug. 30, 1999: UN-sponsored referendum; Nov. 27, 1999: UNTAET takes control.
  - Jan. 22, 2000: UNTAET Regulation No. 2000/7 establishing legal tender.
  - Jun. 8, 2001: Agreement with Bank Indonesia on repatriation of rupiah cash.
  - Jul. 20, 2001: UNTAET Regulation No. 2001/14 on official currency and legal tender.
  - May 20, 2002: Political independence achieved.
  - Nov. 10, 2003: Issue of new national centavo coins replacing U.S. coins.
- Operational experience:
  - Initial period: rupiah continued to dominate cash payments; U.S. dollar and other convertible currencies preferred as store of value.
  - Special dollarization program (mid-2001 to March 2002) focused on insisting on legal tender for transactions, requiring prices and payments be denominated in legal tender, and ensuring budgets and records maintained in legal tender.
  - Communication campaign targeted market vendors, teachers, civil servants, churches, transport operators, and businesses.
  - U.S. coins not readily accepted for low-denomination transactions; in 2003 new national centavo coins in five denominations issued with clear numerals and Timorese motifs; these quickly facilitated phasing out rupiah.

*Source: Excerpt from PDF chapter _wp10106.*

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

### _wp10106 - References .............................................................................................................

### I. Introduction — purpose and scope
- Purpose: identify key institutional and operational aspects that countries willing to officially dollarize must necessarily address.
- Target audience: policy makers and practitioners implementing a unilateral adoption of a foreign currency as legal tender.
- Paper focus: operational guidance rather than a position on the appropriateness of dollarization.
- Scope exclusions: does not cover bilateral dollarization, accession to the European Union, or how to introduce a monetary union.

### II. Rationale, costs, and benefits of official dollarization
- Main rationale:
  - Desire to import a tested monetary policy framework that facilitates preserving price stability and contributes to fostering economic growth.
  - Appeal to post-conflict countries and small open economies closely linked to a large-country currency via trade and capital flows.
- Conventionally identified costs of official dollarization:
  - Loss of seigniorage.
  - Limited or no ability to provide lender-of-last-resort (LOLR) assistance to troubled banks.
  - Lack of exchange rate to be used as a shock absorber.
  - Inability to reduce the value of financial commitments denominated in domestic currency via a large exchange rate depreciation or through fueling inflation.
- Conventionally identified benefits of official dollarization:
  - Convergence of domestic inflation towards world inflation.
  - Elimination of currency risk, which reduces domestic interest rates.
  - Better environment for investment as a result of stable inflation and lower interest rates.
  - Absence of the so-called “original sin,” reducing country risk as currency mismatches in the country’s balance sheet disappear.
- Definition notes:
  - “Official dollarization” defined as a country’s unilateral decision of adopting a foreign currency as a legal tender; includes euroization.
  - “Legal tender” defined as the currency used in a country that, by law, may be offered in payment of a debt and that a creditor legally cannot refuse.
  - “Original sin” defined as inability to issue debt in own currency, forcing issuance in a major international currency and increasing vulnerability to exchange rate depreciations.

### III. Current global status (as of end-2008)
- Aggregate facts:
  - As of end-2008, eleven countries had unilaterally dollarized worldwide.
  - Three of these countries are emerging markets, one is a high income country, and the rest are developing nations with very small economies—some considered micro states.
  - Seven countries substituted their domestic currency for the U.S. dollar.
  - Three countries dollarized in the current decade.
  - Only two countries, Ecuador and El Salvador, went through the complex endeavor of replacing their established national currencies with the U.S. dollar as legal tender.
  - Kosovo, Montenegro, and Timor-Leste shifted from one foreign currency to another prior to becoming independent states.

### IV. Table: Formally Dollarized Countries (excerpted entries visible in source)
- Table context: Excluding participants in currency unions; based on the IMF’s classification in the AREAER.
- Extracted country entries and table fields shown in source:
  - Ecuador
    - Year adopted: 2000
    - Currency adopted: U.S. dollar
    - Issue of national coins: Yes
    - GDP (in billion (of U.S. dollar)): 45.79
    - Previous own national currency: Yes
  - El Salvador
    - Year adopted: 2001
    - Currency adopted: U.S. dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 20.37
    - Previous own national currency: Yes
  - Kiribati
    - Year adopted: 1979
    - Currency adopted: Australian dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 0.067
    - Previous own national currency: No
  - Kosovo
    - Year adopted: 1999
    - Currency adopted: euro
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 4.688
    - Previous own national currency: No
  - Marshall Islands
    - Year adopted: 1986
    - Currency adopted: U.S. dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 0.163
    - Previous own national currency: No
  - Micronesia
    - Year adopted: 1986
    - Currency adopted: U.S. dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 0.232
    - Previous own national currency: No
  - Montenegro
    - Year adopted: 1999
    - Currency adopted: euro
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 3.49
    - Previous own national currency: No
  - Palau
    - Year adopted: 1994
    - Currency adopted: U.S. dollar
    - Issue of national coins: No
    - GDP (in billion (of U.S. dollar)): 0.164
    - Previous own national currency: No
  - Panama
    - Year adopted: 1904
    - Currency adopted: U.S. dollar
    - Issue of national coins: Special case
    - GDP (in billion (of U.S. dollar)): 19.74
    - Previous own national currency: Special case
  - San Marino
    - Year adopted: 1999
    - Currency adopted: Euro
    - Issue of national coins: Special case
    - (Table entries for San Marino continue beyond the excerpted source content)

### V. Literature and gaps
- Literature focus to date:
  - Primarily on pros and cons of dollarization: Berg and Borensztein (2000), Panizza and others (2003), Levy-Yeyati and Sturzenegger (2003).
  - Questions of timing or which countries should dollarize: Eichengreen (2002) and Calvo (2002).
  - Geographic emphasis on Latin America due to extensive de facto dollarization: Corbo (2001) and Salvatore (2001); country-level emphasis mainly on Panama (Moreno-Villalaz (1999) and Goldfajn and Olivares (2001)).
  - Few studies address operational aspects; Gruben and others (2003) is noted as an exception.
- Identified gap motivating this paper:
  - Practical implementation issues of unilateral dollarization have been less addressed in the literature compared with the benefits/risks debate.

*Source: Excerpt from PDF chapter titled "_wp10106 - References ............................................................................................................."*

### 1.7 No

### _wp10106 - 1.7 No

### Overview and context
- During 2009, Zimbabwe transited to a unique form of unilateral an officially dollarized economy by officially authorizing the use of any traded foreign currency as legal tender without formally abolishing the Zimbabwe dollar as legal tender.
- The most prominent currency used during 2009 was the U.S. dollar; the South African rand was used for small cash transactions; neighboring countries’ currencies are also used in some regions.
- Zimbabwe reached a hyperinflation in February 2007. In mid-November 2008, the monthly inflation rate was estimated at 79,600,000,000 percent—equivalent to a daily rate of 98 percent.
- Multiple re-denominations of the national currency in 2006–09 failed to restore confidence; the national currency gradually went out of circulation during the second half of 2008.

### Macroeconomic performance of dollarized and hard-peg groups (2004–2009)
- Inflation in dollarized countries converged to and remained close to world inflation during 2004-2009, including Ecuador (inflation had reached 100 percent year-on-year in 2000).
- Merging dollarized countries with other hard-peg regimes shows:
  - Average inflation was lower and volatility larger because of the high pass through to domestic inflation from the 2007-2008 supply shock.
  - Economic growth in hard-peg countries was less dynamic and more volatile than in the rest of the developing and emerging market countries.
- Among dollarized countries (aggregate, 2004-2009):
  - Panama: 7.6 percent average growth.
  - El Salvador: 2.3 percent average growth.
- Fiscal stance and public finances:
  - Dollarized countries seem to have maintained their fiscal position in check and a stronger fiscal stance than the rest of the developing and emerging market countries.
- Country risk and financial market indicators (officially dollarized countries):
  - EMBI spread for El Salvador and Panama was lower or close to the composite EMBI spread, reflecting strong fiscal positions, capacity to repay debts, and absence of currency risk.
  - Interest rate margins over similar U.S. rates followed the same trend; both EMBI spreads and interest margins rose in the wake of the recent financial crisis in El Salvador and Panama due to capital outflows and fears of possible banking crises.
  - Ecuador exhibited elevated country risk and higher interest rates reflecting idiosyncratic political economy factors that ultimately led to a debt default in 2008.

### Key pre-conditions and trade-offs for de jure dollarization
- Two competing views:
  - One view: pre-conditions should exist before adopting de jure dollarization to yield more benefits.
  - Opposing view: dollarization puts pressure to immediately adopt similar policies, so pre-conditions may be less critical.
- Minimum recommended pre-conditions:
  - (i) A robust financial system and strong financial supervision to minimize likelihood of banking crises with no—or limited—lender of last resort (LOLR) facilities.
  - (ii) Solid public finances to assure sustainability of fiscal policy.
  - (iii) Flexible labor markets to facilitate macroeconomic adjustment to external shocks.
- Experience:
  - Ecuador dollarized amid a systemic financial crisis with high inflation under a flexible exchange rate; El Salvador dollarized in macroeconomic stability with a fixed exchange rate.
  - The presence or absence of pre-conditions affects transition smoothness and downside risks, including possible upward bias in country-risk indicators and domestic interest rates.

### Institutional issues and legal framework
- Political support and legal endorsement:
  - Strong political support and a clear legal framework endorsed by society at large are critical.
  - Legislation typically requires changes to central bank law, other financial sector legislation, accounting rules, and payment system regulations; sometimes constitutional amendments.
- Role and redefinition of the central bank:
  - New legislation should define an alternative role for the central bank; central banks commonly remain but with altered mandates.
  - Typical new primary objective: foster and maintain a stable financial system.
  - Common tasks assigned: financial surveillance, prudential and supervisory regulation, cash handling (banknotes and coins), manage international reserves, centralized clearing for payment systems, serve as fiscal and financial agent of the state, undertake macroeconomic studies, and advise governments.
  - Prohibited or curtailed functions: printing new currency notes (but not necessarily minting national coins), conducting interest rate policy, and a drastically curtailed ability to serve as LOLR.
  - Examples:
    - Panama has no central bank.
    - Ecuador, El Salvador, and Montenegro preserved central banks with no commercial bank responsibilities.
    - Kosovo and Timor-Leste have central banking authorities created after independence functioning prominently as financial sector supervisors.
  - Central bank governance and revenue model:
    - Reorganize governance to reflect new mandate; require relevant expertise on boards.
    - Seigniorage is eliminated; central bank financing is restricted; an alternative income model—partially or fully dependent on the government budget and financial institutions’ contributions—should be developed.
    - Legislation should establish that the government underwrites central bank liabilities.
- International and issuing-country considerations:
  - Approaching the authorities of the issuing country is warranted to explore cooperation (from logistical support for banknotes/coins to formal monetary association).
  - For euroization, EU authorities and the ECB are less complacent about unilateral adoption given EMU convergence procedures and Maastricht criteria; unilateral euroization may run counter to Treaty reasoning.
  - Uncertainty exists for cases of accession where a country had unilateral euroization (e.g., Montenegro, Kosovo) and how EU accession will treat such cases.
- Timetable and communication:
  - Government and central bank should prepare and disseminate a timetable for dollarization; no fixed duration—could be as short as less than six months (Ecuador).
  - Timetable should specify at least:
    - (i) when conversion rate enters into effect and, if relevant, when the new currency becomes legal tender;
    - (ii) when central bank stops conducting open market operations;
    - (iii) when the central bank starts replacing domestic currency with the new currency;
    - (iv) period in which both currencies circulate and date when domestic coins and banknotes are phased out;
    - (v) dates for converting financial system balance sheets into “dollars” and for new accounting rules for the corporate sector.
  - A comprehensive communication strategy is essential:
    - Explain why dollarization is adopted, implementation steps, and timetable.
    - Disseminate the conversion rate for re-denominating prices, assets, liabilities, contracts, and financial transactions.
    - Announce transitory period in which prices will be shown in both currencies and the date when local currency stops serving as means of transaction.
    - Campaign to limit “currency rounding,” which tends to delay price stability.
    - Provide specific procedures to financial system, private enterprises, and the public sector; use all media forms and informational materials.

### Operational issues
- Conversion rate:
  - Choose a conversion rate close to the market rate and easy for economic agents to use.
  - Ensure key central bank liabilities are covered by the stock of net international reserves when setting conversion rate.
- Backing rule and reserves:
  - Define a backing rule covering at minimum coins and banknotes; optimal coverage is base money plus interest-bearing central bank securities.
  - Failure to secure backing undermines credibility and sustainability.
  - If meaningful surplus of international reserves remains after backing, consider creating an emergency liquidity facility for financial distress in absence of LOLR facilities.
  - For commodity-dependent dollarized countries, accumulating excess international reserves is warranted as a buffer.
  - New states may lack international reserves but can still dollarize if they continue using the previous currency (e.g., Kosovo).
- Central bank balance sheet presentation:
  - Change presentation to make explicit availability of international reserves backing domestic currency and central bank securities.
  - Show any room for systemic liquidity management and the likely limited provision of LOLR support.
  - Quasi-fiscal liabilities should be absorbed by the government.
- Interest rate conversion and contract treatment:
  - Under stable macroeconomic conditions:
    - No need to change parameters of contracts maturing after dollarization; apply original terms at the conversion rate.
    - Converted dollar interest rates may still reflect previous expected devaluation and country risk premiums; voluntary renegotiations may be allowed (El Salvador allowed gradual conversion of colones interest rates over three months).
  - Under high inflation or hyperinflation:
    - Applying conversion mechanically can yield dollar rates much higher than prevailing post-dollarization rates and create distortions.
    - Government intervention to “dollarize interest rates” may be warranted but is disputed by Gruben and others (2003), who argue against intervention due to moral hazard and information problems.
    - Legislation may establish a new level of interest rates for pre-existing contracts (the desagio); Ecuador implemented a desagio rule by adjusting interest rates in sucres and dollar-denominated contracts.

*Source: Annual Report on Exchange Arrangements and Exchange Restrictions, International Monetary Fund.*

### introduction of the currency board in 1991 is a case in point.

### _wp10106 - introduction of the currency board in 1991 is a case in point.

### Monetary operations and lender-of-last-resort (LOLR) capacity
- In a dollarized economy, the central bank loses its ability to conduct monetary operations and, given it cannot issue national money, it should refrain from conducting monetary operations; exceptionally it may redistribute liquidity among financial institutions during times of financial distress, provided it has international reserves to back these operations.
- Bank reserves uses and remuneration:
  - Bank reserves should be used primarily to support the operation of the payments system, but could also serve as an instrument for liquidity cushion.
  - Ideally, bank reserves should be remunerated; the interest rate paid on bank reserves should be consistent with the return the central bank obtains from investing these funds (which are effectively part of the international reserves).
- Examples and country practices:
  - Ecuador: bank reserves are used for payment systems purposes.
  - El Salvador: reserve requirements are an integral component of the financial safety net; bank reserves count in the calculations of liquidity requirements and are part of a prudential liquidity measure determined by the Superintendency of Banks in absence of a central bank LOLR facility.
  - Interest rate adjustment example at conversion: Interest rates were required to be adjusted for only one time, to 16.82 percent and to 9.35 percent for lending and deposit rates.
- Converting domestic interest rates to dollar rates:
  - One alternative is to define reference rates for both the domestic currency and the new legal tender and convert interest rates by measuring them in terms of the reference rates (Schuler (2002)).
  - For instance: government may set reference rates of 100 percent and 10 percent for domestic currency and dollar denominated interest rates; a 120 percent local currency interest rate would be converted into a 12 percent rate in dollars.
- Compensating for lack of LOLR:
  - Central banks in de jure dollarized countries may only provide liquidity support if they hold a surplus of international reserves.
  - Alternatives:
    - Build a contingent liquidity fund constituted, for example, with foreign loans (Ecuador followed this path; the recently created liquidity fund will accumulate resources up to one time the amount of the system’s regulatory capital).
    - Purchase a private insurance policy with foreign private financial institutions (may be very expensive and entail large fiscal costs; would hardly work to tackle a systemic financial crisis, as observed in 2002 in Argentina).
  - With limited central bank LOLR ability, the focus shifts to Ministries of Finance and international multilateral institutions; ability to deal with solvency problems depends on the strength and willingness of the fiscal authority to allocate fiscal resources.
  - Multilateral/regional institutions can play a crucial role (example: El Salvador agreed with the Fund on an US$800 million Fund program to serve as a liquidity buffer in case of a liquidity event).

### Currency procurement, circulation, and conversion logistics
- Procurement of new currency:
  - Central bank should have sufficient convertible currency available to procure the new banknotes (and coins) in sufficient quantities and appropriate denominations/subdenominations.
  - Responsibility for feeding the economy with dollar banknotes is typically assigned to the central bank on behalf of the government.
- “Dollarized” coins or national coins:
  - Reasons for national coins: preserve national symbol; U.S. coins may lack numerals and be difficult to understand; four U.S. coin denominations may be too few for low denominations (lack of a 50 cent coin problematic); transporting coins over long distances is expensive measured by value.
  - Ecuador and Timor-Leste use national coin series, fully convertible to U.S. dollars in their countries.
- Period of dual currency circulation:
  - Dual circulation leads to extra costs and inefficiencies: retailers handle two sets of banknotes/coins; prices must be announced in both currencies at the official conversion rate; ATMs and vendors need reprogramming.
  - Conversion period is normally set as short as possible to ensure an orderly exchange.
  - Example: In El Salvador, the conversion period lasted six months following approval of the law officially establishing dollarization.
- Managerial and organizational systems:
  - Currency conversion is multi-pronged and may be managed by the central bank or as an off-line project if central bank lacks skills.
  - Exchange points: use banks, money changers, post offices, temporary stationary exchange points, and mobile units for remote areas; equip with trained staff, security, counting machines, security detectors, invalidation tools, accounting and reporting systems.
- Distribution and storage:
  - Prepare a logistics plan with timetable; distribution and storage demands will vastly exceed normal year needs; additional temporary storage (containers, secured vaults, strong boxes, safes) often leased.
- Invalidation and destruction of old banknotes:
  - National banknotes must be invalidated at exchange to avoid fraud; techniques include mechanical shredding, ink/dye, manual/hydraulic punchers.
  - All national banknotes should eventually be destroyed after invalidation and counting; techniques include mechanical shredding and incineration; best done centrally and integrated with currency reporting systems.

### Key complementary structural reforms to strengthen credibility and sustainability of dollarization
- General: A package of fiscal, financial, trade, and labor reforms should be prepared, discussed, and approved to strengthen credibility and sustainability of dollarization; ideally approved before official dollarization but may be approved in short run if dollarization occurs amid crisis or hyperinflation.

A. Fiscal Reform
- With central bank unable to provide credit to government, a set of fiscal rules is desirable to preserve sound public finances.
- Build a tax base providing stable revenue flow consistent with a sustainable fiscal deficit.
- For commodity-dependent revenues, build stabilization funds to enable counter-cyclical fiscal policy (example: Ecuador approved a fiscal responsibility law in 2002 to maintain fiscal deficits in check, reduce public debt burden, and use extra oil revenues to establish a stabilization fund; overtime the law has been changed extensively, which eventually undermined the fiscal discipline initially envisaged).
- Need for adequate and timely monitoring of expenditure commitments to avoid cash-based budget arrears blocking payment system.
- Better bankruptcy and debt resolution frameworks may be required.
- Maintain public debt at sustainable levels and develop public debt capacity to facilitate treasury management.
- Central banks empowered to provide short-term credit (less than one year maturity) to cope with seasonal government revenue fluctuations in 60 out of a sample of 123 developing and emerging market countries (see Jácome and others, 2010).

B. Financial Reform
- Banking crises can threaten a dollarized regime; with limited/no LOLR facilities, impose more stringent solvency and liquidity requirements.
- Example: El Salvador increased required risk-weighted capital-asset ratio to 12 percent (well above the 8 percent required in Basel I) and introduced in 2003 a special liquidity buffer equivalent to 9 percent of deposits. This rate has changed over time as a prudential measure.
- Strengthen financial surveillance using a risk-based approach to bank supervision.
- Strengthen other elements of financial safety net: prompt corrective actions, deposit insurance mechanism, effective and efficient bank resolution instruments with clear exit rules.
  - Example: El Salvador increased deposit insurance coverage; Panama and Ecuador do not have any deposit insurance.
- Capacity building for well-trained financial regulators is critical.
- Presence of foreign-owned institutions:
  - Foreign banks can reduce vulnerabilities by providing higher standards of corporate governance and perceived greater ability to withstand stress; in practice, except Ecuador, other officially dollarized countries have large penetration of foreign-owned banks.
  - Support of parent banks cannot be taken for granted during contagion; close cooperation with home supervisors is needed.

C. Trade Reform
- Dollarizing countries should aim to reduce trade tariffs and distortions to expand export base and favor sustainability of the monetary regime.
- Functioning of dollarized regime hinges on availability of the foreign currency adopted as legal tender, resulting from export inflows and capital inflows.
- Approve far-reaching trade reforms and regulatory frameworks conducive to capital mobility and to encourage foreign direct investment.
  - Note: Excessive FDI into the non-tradable sector can have destabilizing effects.
- In short run, lowering tariffs benefits convergence of domestic to world inflation.
- In long run, engage in trade negotiations and diversify trade partners and export base to reduce dependence on single commodities and to lessen linkage of domestic cycle to that of the currency-issuing country.

D. Labor Reform
- Dollarized countries need to minimize nominal rigidities, particularly in the labor market, to allow adjustment to external shocks.
- Promote and maintain labor market flexibility; handle administrative wage increases with caution.
- Encourage job creation and enhance labor mobility.
- Phase out indexation clauses in the short run to facilitate rapid decline of inflation; de-indexation should be included in legislation establishing official dollarization and, if possible, introduced before dollarization to eliminate inertial inflation.

### Case study: Ecuador (Appendix I)
- Background:
  - Ecuador dollarized "from one day to another" amid a full-fledged financial crisis. De facto dollarization had climbed to more than 50 percent of total bank deposits (38 percent a year before). Government announced adoption of the U.S. dollar as legal tender on January 2000; announcement improved market sentiments and stopped run on bank deposits.
- Institutional issues:
  - Legislation to implement dollarization approved on March 13, 2000 (Economic Transformation Law, LTE) established conversion rate of 25,000 sucres per dollar (same rate announced on January 10, 2000).
  - LTE key provisions:
    - (i) Central Bank of Ecuador (BCE) must not issue domestic currency any more.
    - (ii) BCE must exchange all sucres for dollars at given exchange rate.
    - (iii) All economic agents must convert accounting to dollars.
  - BCE primary functions under LTE: (i) promoting macroeconomic stability; (ii) managing the free disposable international reserves; (iii) preserving functioning of payments system; (iv) being a fiscal agent. LTE did not assign a new mandate to BCE.
  - Communication: BCE designed a broad communication campaign entitled “knowing the dollar,” comprising three phases:
    - Starting April 2000: massive educational effort to acquaint population with new banknotes and coins; conferences and seminars for selective audiences.
    - September 2000: procedures to replace old currency with new legal tender, major efforts to rural areas.
    - February/March 2001: procedures to finalize currency exchange.
- Brief chronology of main events:
  - Jan. 10, 2000: Following government announcement, BCE issued regulation establishing fixed exchange rate at 25,000 sucres per U.S. dollar.
  - Mar. 13, 2000: Congress approved LTE. Key provisions directly linked to adoption of new legal tender include:
    - Authorizes BCE to exchange all sucres with U.S. dollars.
    - Defines concept of Free Available International Reserves.
    - Prohibits BCE to issue sucres banknotes and can only issue coins.
    - Requires BCE to modify presentation of its balance sheet.
    - Authorizes BCE to conduct repo operations at up 90 days maturity.
    - Establishes a 12 percent interest rate for all BCE and government paper after Jan. 11, 2000.
    - Forbids any form of indexation from Jan. 10, 2000 onward.
  - Mar. 21, 2000: Regulation of BCE’s participation in the interbank market via repos.
  - Apr. 11, 2000: Definition of dollar interest rates applicable to existing contracts in domestic currency and in foreign currencies.
  - May 16, 2000: Issue regulations for all previous exchange rate operations.
  - Aug. 23, 2000: Issue regulation for the definition of the maximum interest rate to be charged in any contract or financial transaction.
  - Jan. 11, 2001: Establish reserve requirements at 4 percent for all bank deposits.
- Operational issues:
  - Conversion rate established to fully back monetary base with central bank international reserves.
  - Conversion boosted exports; convergence of domestic to world inflation lasted more than four years.
  - BCE changed balance sheet presentation into four systems:
    - “Exchange system”: freely disposable international reserves (FDIR) appeared backing currency in circulation.
    - “Financial reserve system”: additional FDIR backed bank reserves and central bank securities (in domestic currency).
    - “Operations system”: incorporated public sector and financial sector liabilities, including other liabilities with international multilateral institutions and treasury operations, backed with remaining FDIR.
    - “System of other operations”: remaining assets and liabilities plus BCE’s equity and income statement’s balances.
  - Central bank operations narrowed to short-term liquidity management and securing payments system functioning; allowed to issue exclusively short-term securities to mop-up liquidity surpluses.
  - Reserve requirements reduced gradually from 11 to 4 percent for all bank deposits; providing liquidity assistance to banks was legally proscribed.
  - Currency conversion tasks:
    - BCE procured a family of coins with same denominations as U.S. coins but with own physical characteristics; local dollar coins began circulating by September 2000, exchanged at BCE branches in urban areas and at National Development Bank for rural areas.
    - Currency conversion lasted one year.
    - Statistical data were revisited to express them in the new currency.

*Italicized source: _wp10106 - introduction of the currency board in 1991 is a case in point.*

### 2000. Since 1993, the colon

### _wp10106 - 2000. Since 1993, the colon

### El Salvador — Background and motivations
- Since 1993, the colon was pegged to the dollar.
- Fiscal and external disequilibrium was moderate (on average about 1.5 percent of GDP during 1993–2000).
- Financial dollarization was low.
- Real interest rates were high and economic growth was on average about 3 percent during the second half of the 1990s.
- With the expectation of reducing real interest rates and fostering economic growth, the Salvadoran authorities officially dollarized at a conversion rate of 8.75 colones per U.S. dollar.

### El Salvador — Institutional arrangements and legislation (Monetary Integration Law, MIL)
- Consultations:
  - Domestic and international consultations were conducted before adopting dollarization.
  - Cooperation from the Federal Reserve was obtained exclusively for specific operational issues (provision of U.S. dollars bills and coins; training of BCR staff on security procedures to avoid counterfeiting).
- Communication:
  - A vast communication strategy was deployed to explain benefits and facilitate trade and financial transactions in the new currency.
  - Prices of goods and services were allowed to be expressed in both colones and U.S. dollars during the transition.
- Key MIL provisions and BCR powers included:
  - (i) Prohibit the BCR to extend credit to financial institutions and to print new currency notes beyond the existing inventory.
  - (ii) Retain BCR powers to issue bonds and to purchase, sell, and exchange portfolio and securities with financial institutions.
  - (iii) Restructure the LOLR framework, establishing a remunerated liquidity requirement.
  - (iv) Allowing the BCR to conduct repo operations with government resources in the event of a systemic liquidity shortfall.
  - The MIL did not establish a deadline for conversion of colones into dollar coins and banknotes.
  - No changes to the presentation of BCR’s balance sheet were adopted.
- Restrictions and retained capacities:
  - MIL preserved BCR capacity to issue its own securities denominated in U.S. dollars and to purchase and swap these securities in the secondary market.
  - BCR could swap assets with financial institutions under Directive Counsel guidelines.
  - MIL authorized the BCR to lend to the Deposit Guarantee Institute but prohibited lending to public and private financial institutions.

### El Salvador — Operational rules and liquidity framework
- Conversion process:
  - The conversion of colones into U.S. dollars lasted about two years and followed a piecemeal approach via exchange points (primarily commercial banks).
  - The Federal Reserve was the main provider of dollars (banknotes and coins) directly to the BCR and handled replacement of unfit banknotes.
- Interest-rate adjustment:
  - The MIL established a 90-day period for the adjustment of interest rates in pre-existing colones credits.
  - Financial institutions were required to refer to two criteria: (i) reduction in their financial costs; and (ii) prevailing interest rates for new dollar credits.
- Remunerated liquidity requirement (conversion of previous bank reserves):
  - Key rules for the use of these resources:
    - The first 25 percent is drawn free of interests.
    - The second 25 percent is charged a market interest rate.
    - The use of the remaining 50 percent requires authorization from the Superintendence of Banks and acceptance of a regularization plan designed together with the BCR.

### El Salvador — Chronology of main events and subsequent regulatory changes
- November 22, 2000: The President of the Republic announced official dollarization.
- November 30, 2000: Congress approved the Monetary Integration Law.
- January 1, 2001: Dollarization officially entered into effect. Key provisions directly linked to the adoption of the U.S. dollar as legal tender included:
  - Definition of a conversion rate.
  - Provisions to exchange colones with dollars in banks without charging a fee (banks would, in turn, exchange colones at the central bank).
  - Payment of all liabilities—existing before this law entered into effect, including checks—either in colones or in U.S. dollars.
  - Redenomination in U.S. dollars of banks’ balance sheets and all financial transactions previously agreed in colones.
  - Government takeover of central bank obligations.
  - Financial institutions had 90 days to gradually adjust interest rates in pre-existing contracts—in line with new U.S. dollars interest rates.
  - Prices of goods and services should be expressed in the two currencies during the first 180 days.
  - The Superintendence of Financial Institutions should establish a liquidity reserve.
- June 2003: The central bank introduced a 9 percent liquidity requirement on bank deposits.
- January 2004: The coverage of the deposit insurance was increased from USD 6,250 to USD 7,060.
- April 2006: The central bank reduced to 3 percent the liquidity requirement on bank deposits.

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### Kosovo — Background and operational experience
- Prior currency environment:
  - Official currency used to be the dinar; DM were also widely used for years.
  - A Regulation passed by the local UN administration in late 1999 made the DM de facto legal tender in Kosovo with preferred status compared to the new dinar.
  - In Mitrovica (northern Kosovo), the Serbian currency remained primary legal tender; elsewhere DM recognition reflected prior hyperinflation and political issues with the dinar.
- Institutional steps:
  - September 1999: UN regulation stated all compulsory payments to the budget were to be paid in DM; compulsory payments in dinar were subject to a surcharge of 10 percent.
  - November 15, 1999: UNMIK established the Banking and Payments Authority of Kosovo (BPK).
  - IMF staff and advisory missions provided critical contributions; ECB supported later euro conversion.
- Chronology highlights:
  - Jun. 10, 1999: Kosovo war ended.
  - Jul. 25, 1999: UNMIK took control.
  - Sep. 2, 1999: DM made de facto legal tender through rules on payments; dinar continued with a fee.
  - 2000–01: Major importation of DM banknotes and coins.
  - Jan. 1, 2002: UNMIK made the euro de facto legal tender.
  - 2002: Massive replacement of DM with euro cash currency.
  - Feb. 17, 2008: Parliament declared Kosovo independent from Serbia.
- Operational outcomes and challenges:
  - Introduction of the DM was successful; population welcomed DM as stability.
  - Large imports of DM banknotes were necessary; initial vault shortages led to improvised storage (e.g., guarded tents).
  - Early management of the euro conversion was handled by the BPK with IMF and USAID technical assistance and ECB cooperation.
  - Legal/accounting handled by UN legal experts with IMF assistance; communications program using TV, radio, newspapers, and printed materials supported the transition.
  - Problems encountered: staffing and logistics due to destroyed bank offices and lack of surviving local banks; international experts and NATO troops had to implement practical aspects.

### Montenegro — Background, institutions, and outcomes
- Background:
  - Longstanding use of foreign convertible currencies due to weakness of Yugoslav currency and hyperinflation in 1992–93; significant remittances supported de facto use.
  - Montenegro was excluded from sharing seigniorage with the National Bank of Yugoslavia, which stopped delivering banknotes to Montenegro.
- Institutional stance:
  - Montenegro’s euroization was a unilateral action tolerated initially by EU institutions due to political circumstances.
  - Bundesbank did not support DM introduction in Montenegro, noting no obligation to support countries using the DM as legal tender.
  - EU/ECB later emphasized that unilateral euroization is not compatible with treaties, which require meeting stability criteria through structured convergence.
- Chronology highlights:
  - Nov. 2, 1999: Montenegro established a dual currency system with the DM as parallel legal tender to the dinar.
  - Nov. 13, 2000: Montenegro left the dinar monetary area, withdrawing remaining dinars.
  - 2000–01: Major importation of DM banknotes and coins.
  - Jan. 1, 2001: DM declared sole legal tender.
  - Mar. 15, 2001: The Central Bank of Montenegro started operating.
  - Jan. 1, 2002: DMs started to be replaced by euro, which soon became sole legal tender.
  - 2002: Massive replacement of DM with euro cash currency.
  - May 21, 2006: Montenegro voted for independence from Serbia in a referendum.
- Operational observations:
  - DM use was already widespread prior to formal adoption.
  - The decision was politically divisive; timing was driven by political, not economic, considerations.
  - No serious proposals for special national coins; pfenning used initially, replaced by euro cents in 2002.
  - Interest harmonization did not become prominent; commercial bank interest rates on loans and deposits varied considerably.
  - Yield dynamics on treasury bills did not align closely with euro area trends, reflecting differences in inflation rates.

### Timor-Leste — Institutional choice, implementation, and operational lessons
- Institutional decisions:
  - January 2000 UNTAET Regulation made the U.S. dollar official currency and legal tender for public and private transactions.
  - Federal Reserve had been contacted and had no objections.
  - Freedom of contract allowed parties to denominate voluntary transactions in any currency, but compulsory payments had to be in legal tender.
  - On a transitory basis, compulsory payments to the Timorese budget could be made in rupiah subject to an additional transaction fee of 20 percent.
  - Banking and Payments Authority (BPA) was set up by the UN with IMF support to manage cash currency matters and banking supervision in the absence of a central bank.
- Chronology highlights:
  - Aug. 30, 1999: UN-sponsored referendum; Nov. 27, 1999: UNTAET takes control.
  - Jan. 22, 2000: UNTAET Regulation No. 2000/7 on establishment of legal tender.
  - From 2000: U.S. banknotes and coins started being imported.
  - Jun. 8, 2001: Agreement with Bank Indonesia on repatriation of rupiah cash currency.
  - Jul. 20, 2001: UNTAET Regulation No. 2001/14 on the official currency and legal tender.
  - May 20, 2002: Political independence achieved.
  - During 2003: Importation of U.S. coins halted.
  - Nov. 10, 2003: Issue of new national centavo coins replacing U.S. coins.
- Operational experience and program:
  - Initial period (2000–mid-2001): Indonesian rupiah continued to dominate cash payments; U.S. dollar and other convertible currencies favored as store of value.
  - July 2001: After rupiah repatriation agreement, U.S. dollar made official currency and sole de jure legal tender.
  - A special dollarization program (mid-2001 to March 2002) focused on:
    - (i) insisting on the use of legal tender for all transactions;
    - (ii) demanding prices and payments for goods and services be denominated in legal tender;
    - (iii) ensuring budgets, financial records, and accounts be maintained in legal tender.
  - Communication/education campaign included seminars, press conferences, posters, electronic and printed media targeting market vendors, teachers, civil servants, churches, transport operators, and businesses to provide coins and assist price conversion.
- Operational challenges and adaptations:
  - Initial dollarization effort largely failed as the public preferred the rupiah and multiple currencies coexisted with nonmarket-oriented exchange rates causing confusion.
  - U.S. coins were not readily accepted for low-denomination transactions; in 2003 new national centavo coins in five denominations were issued.
  - The new coins had clear numerals and motives connected to Timorese culture or well-known products and quickly became a success, greatly facilitating phasing out of the rupiah.

*Italic: Content based only on the supplied source text.*

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