Could El Salvador, a country of 6 million people, be about to steal a march on its larger Latin American neighbours?
Since Brazil's devaluation in January, politicians and economists in the continent's larger economies have begun to fret about their own exchange-rate regimes. Argentina's president, Carlos Menem, was the first to suggest that it might be time for Latin American states to give up the pretence that they enjoy monetary sovereignty and adopt the dollar.
In Argentina's case, dollarization would not be such a big step. It operates a currency-board system: every peso in circulation is backed by a dollar in central-bank reserves.
Then Mexicans started to toy with the same idea. The country's economy is dominated by trade with the US and the two neighbours are already linked, with Canada, by the North American Free Trade Agreement. Why not follow the European example and go for monetary union too? The snag is that it might take a few years for Mexico to ditch its currency. Fear of US economic domination still runs strong there. Mexicans might have to wait for a bilateral treaty with the US before they can expect to use yankee dollars.
So step forward another candidate to be Latin America's monetary pioneer. El Salvador's outgoing president, Armando Calderón Sol, may be looking to leave his mark by making his country the first in Latin America to adopt the dollar since 1903, when Panama was spun off from Colombia in a hostile transaction leveraged by the US.
Calderón, who has presided over five years' economic reform and privatization, hasn't yet come out openly in favour of dollarization. But he has held meetings with representatives of the private sector to kick around ideas for a new monetary policy and to discuss how to implement an economic strategy for El Salvador drawn up by Chilean economist Sebastian Edwards. The Edwards plan recommends one of two approaches: float the currency, the colón, freely, or adopt a completely rigid exchange-rate policy. The plan rejects anything between these extremes, such as the crawling-peg system that failed in Brazil.
"Given El Salvador's positive experience of rigid exchange rates, both recently and earlier this century," says Edwards, "it might make more sense to go for rigidity." And this option either in the form of a currency board or outright dollarization seems to be the frontrunner among opinion-formers.
Claudio de Rosa, executive director of El Salvador's banking association, Abansa, points out that El Salvador already has sufficient foreign reserves to back every colón. Reserves equivalent to 108% of cash in circulation and bank reserves have risen from near zero in 1989 to $1.8 billion today, thanks to strong exports and money sent home by 2 million Salvadorans in the US.
And de Rosa believes the public would not object to the colón being anchored to the dollar. "This would be nothing new for El Salvador," he says. "In 1919 the country approved the dollar as legal tender and the following year we introduced a currency board. Since then currency stability has been tremendous. Things only started to go downhill after a monetary board was established in 1973. The public values currency stability and would probably accept a currency board with the dollar as parallel legal tender."
Steve Hanke, professor of applied economics at Johns Hopkins University, a leading advocate of dollarization and orthodox currency boards, is not surprised to hear that El Salvador is considering taking dramatic steps. "Back in 1995 when I saw them, the Salvadorans were tossing about the idea of a currency board or going for complete dollarization."
But Edwards, whose plan covers more than the exchange rate believes reforms are needed before El Salvador will be ready for dollarization. "There are weaknesses on the fiscal side," he says. "The procedures for getting budgets approved aren't adequate. The banking law needs to be approved to ensure banks are healthy and liquid enough to survive dollarization. They would need to put in place some safety net for the financial system in the absence of a lender of last resort. And they need to make efforts to introduce greater labour-market flexibility." Michael Peterson