El Salvador became a model for dollarization in Central America in January, 2001, when it followed Ecuador's decision a year earlier to abandon its own currency. The move was designed to keep inflation at bay and boost investors' confidence in the economy. Annual foreign direct investment has indeed climbed from $1.97 billion in 2000 to $2.6 billion in 2004. Today, the nation is one of seven independent nations that have officially adopted the dollar as their currency, including East Timor, Ecuador, the Marshall Islands, Micronesia, Palau, and Panama. Many other countries with their own legal tender are unofficially dollarized. And of the $460 billion in U.S. cash and coins circulating outside of the U.S., some $115 billion is estimated to be in Latin America.
What sets El Salvador apart from others is how it carefully paved the way for the dollar's introduction. Starting in 1992, it implemented a series of reforms that privatized big chunks of its tiny economy, reined in the fiscal deficit, and opened the country wide to foreign trade. That cushioned the transition and explains why dollarization has worked better there than in less-disciplined countries such as Ecuador. Argentina showed how not to do it when runaway deficits forced it to break a decade-long one-to-one currency peg to the dollar in 2001, with disastrous economic consequences.
Yet El Salvador may still be in for a dollar-induced shock. That's because the government has effectively forfeited control of its monetary supply to the U.S. Federal Reserve. While the Fed was busy cutting rates to stimulate growth after September 11, that proved to be a boon. But with U.S. rates rising, dollarized nations like El Salvador are at risk for a credit crunch. So far there's little evidence that liquidity has shrunk measurably in El Salvador. But some economists say that can't last long amid Fed tightening. "Washington handles our monetary policy," says Ra?l Moreno, an economics professor at the University of El Salvador. "If U.S. interest rates rise sharply, the impact on us will be all that much greater."NO MORE SAFETY LEVER?
Of course, higher rates will help counter inflation from rising energy costs. And a moderate rise in interest rates is unlikely to sink El Salvador's economy, since two-thirds of its trade is with the U.S. A potentially far greater threat is the loss of a safety lever in the form of currency devaluation. Since El Salvador uses the dollar, it can't devalue to export itself out of a slump -- or issue debt in its own currency. That could come to haunt the country by making its exports more expensive -- and imports cheaper -- when neighboring countries' currencies depreciate against the dollar.
Not being able to use money supply to stimulate growth is a problem, since the switch to dollars has done little to boost gross domestic product. GDP growth has averaged 1.9% over the past five years -- the most sluggish of any Central American country. What's more, dollarization hasn't improved the lot of the poor. Half of El Salvador's population still lives in poverty, leaving many exposed to hardship if the economy stalls. "For poor people like me, dollarization hasn't worked at all," says Samuel Renderos, a 70-year-old retired bus driver. "Basic necessities all got more expensive when we moved to the dollar."
Economists say El Salvador needs to gird its economy by improving education and worker training, and encouraging more private investment in basic infrastructure projects. "Dollarization was a vehicle to broaden their integration with the global economy, but additional reforms have to be deepened," says Mario Garza, the International Monetary Fund's chief of mission for El Salvador. Only then, he says, will dollarization make a difference for ordinary Salvadorans. By Geri Smith in Mexico City