This report will focus on the issue of Mexico adopting the US dollar as its official currency. We will examine the feasibility behind the surrender of the Mexican peso, the replacement of the country’s physical currency with US dollars, and the effects that these actions will have on Mexico from an economic, political and social perspective. In examining these effects, we will determine whether the Mexican government should pursue official dollarization.
Some economists have argued that countries wishing to replace their central banking systems through dollarization must first fulfill certain preconditions, such as a high level of dollar reserves, a solvent banking system, sound government finances, and flexible wages (Joint Economic Committee). However, if these conditions already exist within a country, chances are their monetary policy would already be effective, which would negate the need for dollarization (Id.).
In Mexico’s case, there would be no preconditions to fulfill in order for the country to consider becoming a candidate for dollarization. However, there are a few important steps that the Mexican government must address once the decision to dollarize has been made. One of the main issues in dollarization is the exchange of all the Mexican peso currency into US dollar notes. This exchange will be handled by the current Mexican central bank.
The central bank will have to exchange all of its reserves for US dollars in order to be able to float the new currency within Mexico. In dealing with this exchange, the Mexican government must address the issue of foreign reserves within its central bank (Id. ). The central bank in Mexico will typically have almost no physical foreign notes, because the notes themselves do not pay any interest (Id. ). However, the bank will likely hold foreign currency deposits at foreign banks, in addition to foreign government bonds (Id. ).
Although reserves such as these are not suitable for dollarization (direct exchange for dollars), if the foreign assets are of substantial quality, they will likely be liquid enough to convert quickly once the government begins to dollarize (Id. ). Thus, the Mexican central bank must assess the assets that it holds, and determine whether the foreign reserves meet the liquidity requirements necessary in order to dollarize (Id. ). Next, the Mexican government must decide how much of the central bank’s liabilities will be dollarized.
In order to achieve the minimum requirement for official dollarization, the government must accept all peso notes and coins that the public wishes to convert into some form of US dollars (Id. ). However, other components of the monetary base such as domestic peso denominated bonds, and reserves of commercial banks, need not be dollarized at the outset (Id. ). Dollarizing domestic bonds may actually hurt the dollarization process, by putting pressure on the domestic bond market and thus hurting the balance sheets of some domestic commercial banks (Id.).
Furthermore, commercial banks that hold their reserves at the Mexican central bank need not convert all their assets into dollars (Id. ). Mexico can simply issue government bonds payable in US dollars, or simply give the commercial banks easily marketable securities, such as US Treasury bonds, in place of physical dollar notes (Id. ). Therefore, the government must first establish whether or not it has enough peso reserves to be able to convert all or part of the monetary base into dollars.
After the reserve and liability requirements have been established, the Mexican government must set an exchange rate, which will be used to convert pesos into dollars (Id. ). It is important not to try to overvalue or undervalue the peso against the dollar when setting the exchange rate, as this could have negative consequences on Mexico’s balance of trade. In overvaluing the peso against the dollar, Mexico’s exporters will be hurt because their products will become more expensive in world markets (Id. ).
Whereas, by undervaluing the peso relative to the dollar, Mexico would be hurting importers, and consequently hurting consumers within Mexico itself, by making imports more expensive to consume (Id. ). Thus, the Mexican government should allow the peso to float cleanly, without any intervention, for a period of no less than thirty days, in order to establish an appropriate, market determined exchange rate (Id. ). Once the floating period for the peso expires, the government should both declare an exchange rate for the peso relative to the US dollar, and declare the dollar as legal tender (Id.).
The central bank will then be required to exchange all peso denominated liabilities, such as the peso notes and coins in circulation, in addition to the amount of the monetary base that the government has determined will be dollarized (Id. ). This is the step where the central bank may begin physically exchanging the circulating peso currency for dollars. Depending on the speed with which the Mexican government wishes to implement dollarization, the entire currency could theoretically be replaced within a matter of weeks (Id. ).
Furthermore, the Mexican government could benefit from a rapid dollarization by reinforcing their commitment towards the new policy of dollarization (Id. ). Next, the central bank should announce that, effective immediately, all peso assets and liabilities are dollar assets and liabilities as per the new exchange rate (Id. ). It is important for the government to establish a transition period, preferably one that would last 90 days, in order to allow the smooth replacement of quotations of wages and prices in pesos with quotations in dollars (Id. ).
The 90 day transition period allows merchants and financial institutions ample time in order to update their systems and records to handle transacting business in dollars. All commercial bank assets and liabilities (bank loans and deposits); will become denominated in dollars during this period (Id. ). Furthermore, the central bank must ensure that commercial banks do not charge a commission, or conversion fee for converting pesos to dollars once the dollarization process begins (Id. ). Subsequently, the government must make a decision about coins in the new monetary base.
Depending on the exchange rate, US dollar coins may not convert easily into a whole number relationship with the dollar. Hence, the government may either choose to devalue or revalue coins, and only coins, to a nearby whole number equivalent that matches the new dollar rate (Id. ). Otherwise, Mexico may simply choose to follow in the footsteps of Panama, and issue its own coin currency, which may float alongside the dollar (Id. ). Since coins are a relatively tiny part of a country’s monetary base, the overall economic effects of choosing either revaluing or issueing coins will be insignificant.
Following the successful completion of the above steps, the government may then choose to redefine the role of the central bank. Once dollarization has been completed, the central bank will cease to be a monetary authority within Mexico (Id. ). Thus, the central bank’s role should be redefined towards the monitoring and regulation of financial institutions within Mexico (Id. ). Thus, Mexico would be able to leverage the expertise and organization that exists within the current central bank.