Ten Years Later- The Impact of Dollarization in El Salvador

Some economists argue that pursuing a dollarization strategy helps developing countries grow their economies through the stabilization of inflation and increases in investment. Other economists discourage a dollarization strategy because it causes these economically small countries to relinquish control over their own monetary policy. This past January marked the tenth anniversary of El Salvador’s adoption of the US dollar as its currency, and its worth assessing the “dollarized” currency regime to determine how successful its been.

Colones, the Salvadoran currency that was replaced by the US dollar in 2001

Adopting the US dollar as a nation’s official currency can be successful, such as in Ecuador. In the case of El Salvador however, dollarization does not seem to have improved economic development.  El Salvador’s economic growth since adopting the dollar as the official currency in 2001 has not been any higher than it was during the years leading up to dollarization. In fact, El Salvador saw higher growth rates in the years prior to its adoption of the dollar. It is difficult to directly attribute the country’s failure to obtain a higher growth rate solely to dollarization, but it most likely did play a role.

As it did in Ecuador, dollarization has helped many economies stabilize their high rates of inflation. El Salvador, however never faced hyperinflation and therefore did not reap any of the stabilizing benefits. Another argument favoring dollarization is that it lowers interest rates and stimulates investment. In the case of El Salvador however, investments did not flow into the country as much as expected due to instability caused by high crime rates and violence. If investors believe their money and capital is not secure, they will go elsewhere where labor costs are low (not denominated in dollars) and where violence and crime is less of a threat.

Under the dollarization regime, El Salvador has no control over its own monetary policy. By adopting the US dollar as its official currency, El Salvador has ceded its authority over money supply and interest rates to the Federal Reserve. It is highly unlikely that the Fed will consider El Salvador’s needs when determining interest rates. Therefore, the Salvadorian government has to depend on taxes and spending to stimulate the economy since it no longer has control over money supply and interest rates. This has caused El Salvador to run higher deficits through the last decade since the government was forced to raise expenditures to stimulate the economy as opposed to decreasing interest rates to spur consumption and investment.

The poorest Salvadorians are the most affected by dollarization. When the dollar was adopted, all businesses needed to change their prices and translate them into dollars. This led to a phenomenon known as “rounding up”. Because the colon-dollar exchange rate was not an exact value, but a fraction, the shift to the dollar caused businesses to change from colon to dollar by rounding up to the nearest dime, quarter or dollar. This left the poorest Salvadorians worse off because while prices rose, wages did not, leaving everyone with a lower real income. However, since the poorest Salvadorans have very low incomes, a fraction of a dollar comprises a larger part of their income than the average Salvadoran.

The effects of dollarization on trade have been somewhat ambiguous. Whereas it was able to compete against other developing countries when it had the colon, El Salvador’s exports have slowed because countries like China are trading with their own undervalued currencies while El Salvador trades with the dollar. Thus, El Salvador’s exports are relatively more expensive than Chinese exports. Use of the dollar, however, has helped trade with some countries by reducing transaction costs. Since so many of its goods are traded with the US, trade in El Salvador has benefitted. Thus, whether the net effect on trade has been positive or negative remains unclear.

Dollarization has provided some benefits. For instance, El Salvador has not faced hyperinflation like some of its Latin American counterparts have. Keeping inflation low is important because it allows banks to lend more, putting more money into the economy.  Additionally, having the dollar as their official currency has limited the chance of any sort of speculative attacks, which means that El Salvador is much less likely to face a Balance of Payments Crisis like Mexico or Argentina did.

The most important and perhaps disappointing part is that some economists believe a shift away from the dollar is not possible. Economists cite Gresham’s Law as the reason for this. In this context, Gresham’s Law argues that re-introducing the colon or another currency into the system would not work because Salvadorians would not trust it. The way this scenario would play out is: the government would try to introduce a new Salvadoran currency and it would ask its citizens to keep their dollars and instead use this new currency for all transactions. The problem is, without trust, that new currency will have no value. Because the dollar is much more trusted as a stable currency, Salvadorans would resist this change in currency and continue to make their transactions in dollars.

Dollarization is not for all countries. For this policy to be truly successful, hyperinflation must be a real concern and investment must be contingent on interest rates and not other factors such as violence. El Salvador has benefitted in some ways by dollarization, however in the long run, there seems to have been more costs than benefits.

18 thoughts on “Ten Years Later- The Impact of Dollarization in El Salvador

  1. Pingback: El Salvador: The Impact of Dollarization, 10 Years Later · Global Voices

  2. This is an issue I have wondered about. Most left-sympathetic sources will tell you, and most “average Salvadorans” seem to believe, that dollarization has been bad, bad, bad. However, increases in the cost of living and the cost of goods are almost inevitable, and there have been other forces at work (for example the huge influx of money from the U.S., which has perhaps had the greatest impact on the cost of housing). And there would seem to be a benefits in the fact that, if your brother sends $500 from the U.S., it is much easier to tell if you received the full transfer than if you have multiply in a (constantly-changing?) exchange rate. As well, if we are promoting tourism, and possibly the majority of tourists come from the U.S., it would seem to be much easier for them to contribute to our economy if they don’t have to exchange currency and if they can judge prices without doing math. (A hotel room for $65? What a bargain! A hotel room for 829 colones? Sounds expensive!

    Thank you for a more balanced treatment of the issue.

  3. El Salvador’s economy has worsen because of many other factors such as the world economic crisis, an unstable economy in the US, violence in el salvador, etcc… The dollarization has its own effects but it is a marginal effect.

  4. Pingback: Salvadoran VP Sanchez Cerén Greeted by Protesters in Freeport, NY « Voices from El Salvador

  5. One thing you forgot to mention is that Ecuador and Panama have excess dollars. El Salvador has shortages. BIG difference. If you look at current account, it is getting worse. Only way to sustain it is by increasing remittances. To put it differently: the more salvadorans leave (or get the hell out of their country) the better. We will soon find out who is the last one to leave the poor country.

  6. Pingback: Dollarization: “A Sack of Unfulfilled Promises” « Voices from El Salvador

  7. Only the government and the already wealthy were the ones who pushed for the colon to be replaced by the dollar. This is a fairly small, but thieving and money hungry group. It is the most of the country who suffers consequences later and specially the poor because all things are rounded up except for their wages.

  8. El Salvador needs to get rid of it’s gang problem to help the local economy. I lived in El Salvador as teenager in the early 90’s and it was lovely. I had a recent trip and it has drastically changed for the worse. It feels very unsafe there.

  9. i truly believe that if the country is to proper, El Salvador needs to make sure that everyone gets paid by the hour; not by the day………by doing this, the common person will have more buying power, instead you have families making less than nothing to feed their families…..i believe the minimum wage is $220 a month, that comes out to $7 dollars a day based on a 31 day calendar.
    when you go to Mc donalds the meal is the same price as any state in the US… how can this be?

    • Melvin I definitely agree with you. How is it possible for a person to work an entire hard labor day for only $7 if lucky $8 a day! When a gallon of milk there is nearly $4-$5! When here in US we can get a gallon on sale for $1.99! The same with EVERYTHING else! It is very upsetting and tragic that Salvadorian people have to suffer and live in total poverty, just because the government or who ever decides what type if currency a country gets.
      Not good at ALL! This NEEDS to change! I will be praying for Salvadorian people get their currency back!

  10. Pingback: Here are all the countries that don’t have a currency of their own | PremiumCash.co.uk

  11. I from El Salvador I remember when they change the colon to dollar. I was in first grade. It defenetly was the worst decision ever made specially with the stupid corrupt president we had. Probabily only a really small part of the population benefit from this transition. Even when send back money to your family is not the same anymore because 100$ are still $100z everything is more expensive and people do not have good jobs. I hope that with the new goverment they can introduce a new currency. I think most salvadoreans agree to change the dollar. We are not even part of the US and we freaking used the US dollar.

  12. You guys surely haven’t been to Salvador or hardly done research when in past decade or more a family member send $500 it turn to 4000 colons n colon being there economical money things cost around that price 2 colon 1 colon 10 colon so money last longer and now that the dollar been introduced and the difference being pretty big the change made the price of things 8 to 9 times more expensive than it use to be costing people insane poverty especially when the pay for labor is around $8 a day and even less, resulting much more negatively in almost all aspect expect in property value and u could say marketing and a bit in medical profession and other things that are necessary for life but with little money people make or have to exchange doesn’t have no help but only tourist so most likely Salvador will borrow money to try take there self of this slump and hopefully it investments bear fruits I just hope they change the dollar back to colon but they also say in dark time the light is much more brighter… And talk to people over there and they prefer to bring the colon back then keeping the dollar….. Poor and some with degrees…
    P.S. Some people there are migrating to other places in central America and Mexico because life is better over there then Salvador and some people are migrating to Salvador cause the dollar is there so they could support there family so I hope dis bit information serves u well hope the best in life…

    • Have you ever heard of the saying GIVE YOUR FAMILY FISH AND FEED THEM FOR 1 DAY! TEACH THEM HOW TO GO FISHING OR HOW TO FISH AND FEED THEM FOR A LIFETIME. I have done both and I think teaching them how to fish is much better than giving them free fish…

      • Roxanna, You have no idea what you are talking about! You speak for yourself and wired family!! Not all Salvadorians take advantage of the money sent to them. You are weird!

  13. I’m from El Salvador born and raised until I moved to California at age 11, I was so sad and devastated I love love my country. Now I live in Switzerland I’m an entrepreneur and travel want to do invest there since I noticed many people from USA are doing in for example at Playa El Tunco, many of those hotels and restaurants are owned by non Salvadorians…. after much research I noticed the problem IS NOT THE DOLLAR!!! by all means, the dollar is the worlds currency, the problems I have seen is many people are full of fear because of the gangs but really I see so many others that are’t afraid open businesses and do VERY WELL… ALL THOSE WITH FEAR ARE JUST LAZY, like many of my cousins they are so used to receiving free money from family in US that work their but off and they don’t do anything all day because they’re afraid even though we have them in one of the safest communities in ES. my other 2 cousins on the other hand DON’T HAVE FEAR, they have graduated as news reporter and teachers, one works for Legislative branch and one at a school and they actually live in a more dangerous neighborhood. I DID A TEST TO PROVE MY THEORY! I WENT TO CHINA ON A INVESTMENT TRIP SO I DECIDED TO SEND MY 4 GIRL COUSINS CLOTHES A WHOLE LOT OF IT, I GAVE THEM A VERY LOW PRICE BUT NOT FREEEEEEEE off course the lazy ones have not even tried because they’re just lazy and the other two sold 150 dollars the first day the goods arrived… LONG STORY SHORT!!!! SALVADORIANS DON’T SEND MONEY TO MAKE YOUR FAMILY LAZY!!! SEND OPPORTUNITIES, IDEAS, HELP THEM IN OTHER WAYS NOT WITH MONEY!!! BUY A HOUSE AT A SAFER COMMUNITY AND SEND THEM THE RENT ONLY KNOWING AT THE END THAT WILL BE YOUR HOME UNDER YOUR NAME. BUT DON’T SELL THEM MONEY, FOOD IS EVERYWHERE, NO ONE IS DYING FROM HUNGER!!! THE’RE JUST LAZY, NOT ALL BUT MANY, AND THAT RAISES CRIME!! YES LAZINESS RAISES CRIME

    • I am born in USA and have to say you are the ignorant one! Saying your people are lazy. It might just run in your family! because all the Salvadorian people I know are very honest and very hard working people. So you get off your ego saying your successful, and stop putting your people down! You do not live there 24/7 to know exactly what they go through. My prayers for them.

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