Ten years of greenbacks in El Salvador

In January 2001, El Salvador began using the US dollar as its official currency. The former national currency, the Colón, was gradually replaced with the US dollar as the money of the land. The administration of president Francisco Flores promoted the change to the greenback as a way to keep interest rates low, to control inflation, and to encourage foreign investment.

It would be fair to say that the move to the dollar has never been popular among the ordinary people of El Salvador. The symbolism of giving up a country's national currency was obvious. And many felt that stores used the change as a pretext to increase prices and cheat the little person.

You can read several reviews which have been written about the impact of dollarization on El Salvador. The evidence is decidedly mixed. For example, a 2003 report from Latin America finance experts at a large US law firm reported generally favorable results. Business Week pointed out in 2005 that El Salvador had now ceded control to, and exposed itself to the impacts of, the policies of the US Federal Reserve Bank. A 2007 article in LA Times described the mixed results of dollarization.

An article titled The Socioeconomic Implications of Dollarization in El Salvador, published in Latin American Politics and Society, Fall 2004, had this to say:

From a political standpoint the policy appears to be reflection of El Salvador's polarized political and socioeconomic system, the power of the financial sector of the ARENA party, and the very limited influence of the opposition represented by the FMLN.

Dollarization means lack of control over monetary policy, which, in turn, means that when the government has a budget deficit, it has no choice but to cut spending. It no longer can use its control over the exchange rate to promote exports. In times of crisis, monetary policy cannot be used as a shock absorber. If remittances decline and a liquidity crisis follows, the government will not be able to bail out banks or insert currency into the economy. The dollars removed from the national reserve and put into circulation, furthermore, cost $330 million, and the government will continue to lose money in the future because of lost interest on that reserve.

Dollarization may contribute to small increases in economic growth through lowered interest rates. The proponents of the neoliberal model promise that economic growth will eventually raise the living standards of all the people. As shown in this paper, however, dollarization in El Salvador has not yet increased economic growth.

For the poor, the policy has uniquely negative effects, including inflation from rounding up prices, as well as a sense of confusion and vulnerability. To the extent that the poor have no access to formal loans, they have not yet benefited from the decline in interest rates, the most positive effect of the policy. The financial elite, on the other hand, does benefit from the lower interest rates and from the elimination or reduction of transaction costs.

While it is clear that the adoption of the dollar has produced a negative effect on the poor, there is one ray of hope in the medium and long term. If followed by gains in productivity, dollarization should attract foreign investment and thereby generate jobs and increased earnings. It will be essential then for the Salvadoran government to pursue policies geared to improving productivity, especially by investing in education and job training.

It will also be important for the government to pursue policies geared to expanding access to credit in order to expand the positive effects of the policy to the lower-income groups. Ideally, the government should guide at least a part of the new foreign investment into job producing activities and away from strategic alliances with the Salvadoran financial sector. If capital goes only to the financial sector and is used mainly for speculative purposes, the policy will not only fail to generate any positive effects on the poor; it will reinforce the existing distribution of income and power.

In an opinion poll in late 2008, 30.7% of respondents said dollarization was the prinicipal reason that the cost of living was increasing in El Salvador.

Still, we are unlikely to see a change from the use of the dollar in the near future. President Mauricio Funes has indicated that El Salvador will not "de-dollarize" during his administration. There seems to be a grudging consensus among those in power that changing currencies again would just cause more damage than it's worth.