On Saturday, Sept. 9, 2000, Ecuador officially adopted the dollar as its currency, joining Panama and a handful of small island countries that use the dollar. Ecuador's move is representative of the heightened interest in dollarization throughout Latin America. Last March, the Federal Reserve Bank of Dallas held a two-day conference on dollarization that was attended by leading economists and top government officials from Argentina, Mexico, Brazil and several other Latin nations. No one thinks that Mexico is going to dollarize anytime soon, but one of the points of agreement was that dollarization could happen quickly in many parts of Latin America, and if it does, it will catch most people by surprise. Another point raised in the conference was that there are costs to dollarization, including a very real possibility that it could exacerbate social and political problems.

This issue of the Cross-Border Economic Bulletin examines the issue of dollarization from the standpoint of the U.S.-Mexico border. The main points are:

• Baja California is far more dollarized than any other state in Mexico;

• The most likely explanation centers on the effects of having a large share of the population on the border;

• Dollarization would probably benefit border states like Baja California that have large maquila sectors and a significant amount of cross-border economic activity;

• Dollarization could potentially harm areas in the interior of Mexico, particularly areas that are not synchronized with the U.S. business cycle.

Dollarization: Definitions and Measurement

Dollarization refers to the use of the U.S. dollar outside the United States. Official dollarization, as in the case of Ecuador, makes the U.S. dollar legal tender. The country may keep its own currency in circulation — Panama and Cuba both use dollars but have also kept their own currencies — or it may adopt the dollar as the only currency. Countries do not need permission from the United States to do this.

Dollarization also happens unofficially, as in the case of Baja California. Unofficial dollarization happens when the dollar is widely used but is not formally recognized as legal tender. Unofficial dollarization is much more common than official, since citizens in many countries choose to hold dollars as both a hedge against inflation and protection against devaluation.

Finally, dollarization is sometimes semi-official. Argentina is a case where the country has retained its own currency, but requires the central bank to hold $1 for each new peso put into circulation.

The easiest way to measure dollarization is by the share of bank accounts that are denominated in dollars. This is done by taking the ratio of the value of dollars in bank accounts (converted to local currency) to the total value of all bank accounts. Because it leaves out dollars that are not deposited, it is not a good indicator of the absolute value of dollars in circulation, but it does give a good estimate of their relative importance. Figure 1 shows the share of total bank deposits that are denominated in a foreign currency, presumably dollars, for each of the six Mexican border states.

Why Is Baja California So Dollarized?

Dollarization in Baja California is about 2.5 times greater than in Chihuahua (39.5 percent of the value of bank accounts, versus 16.2 percent), the second most dollarized state. (I am assuming that foreign currency deposits are dollars, although INEGI does not specify.) There are probably several reasons for this, with most of the explanation stemming from the fact that Baja California has a much larger share of its population located on the border. Figure 2 illustrates this point, using preliminary data from the 2000 census.

Where Baja California's three border cities (Tijuana, Tecate and Mexicali) comprise almost 83 percent of the state's population, in the state of Chihuahua 41 percent of the population lives on the border, and in Tamaulipas 43 percent lives there. One of the consequences of such a large border population is that there are more people who work in the United States but maintain residences in Mexico. Table 1 illustrates this point with data from INEGI's Census of Urban Employment (Encuesta Nacional de Empleo Urbano) for the second quarter of 2000.

City	Percent	Estimated Number*
Tijuana, BC	8.0	28,818
Mexicali, BC	8.4	16,642
Juarez, Chihuahua	3.2	15,082
Nuevo Laredo, Tamaulipas	2.6	3,210
Matamoros, Tamaulipas	4.6	3,824

Not only does Baja California have more of its labor force working in the United States, it also has a higher percentage. The primary reason is that across the border in the United States, there are large sources of demand for Mexican labor. San Diego offers employment opportunities in tourism and other sectors, and the Imperial Valley has a very high demand for seasonal agricultural labor. In other words, one of the reasons that Baja California is so much more dollarized is that far more residents have the ability to earn dollars.

Other factors are important as well, however. For example, the well-documented binational social and family networks are perhaps more extensive in Baja California and California. This is partly history, but it is also supported by the presence of large metropolitan areas on both sides of the border, including Los Angeles. Extensive family and social networks increase the likelihood of dollar-denominated gifts, loans and remittances passing from the United States to Mexico.

In addition, the large maquila sector plays a role, since local suppliers tend to invoice in dollars. Furthermore, industrial, commercial and residential leasing in Baja California is usually in dollars, much of which is related to the maquiladora industry.

It seems unlikely that money laundering related to the drug trade is an important source of dollarization. First, it would imply that the drug traffickers are not very intelligent if they let their drug profits pile up in one place. Second, the overall value (pesos plus dollars) of Baja California bank deposits are about average, on a per capita basis.

Should Mexico Dollarize?

Analysis of the benefits and costs of official dollarization is a large technical subject, and space permits only a few observations. First, it is obvious that the extensive dollarization of Baja California is not coerced or officially planned. In this sense, it is the result of the free and independent actions of its citizens as they follow their self interest. Consequently, dollarization must be viewed in a positive light. Second, the Baja economy is much more coordinated with the United States economy than are other parts of Mexico. Data limitations make it difficult to establish this beyond the shadow of a doubt, but the recession of 1995 illustrates the point. While the rest of Mexico was in recession, Baja California added jobs to its economy due to expansion in the maquiladora sector.

The degree of synchronization between the Mexican economy — or parts of Mexico — and the United States is an important determinant of whether the benefits of dollarization outweigh its costs. If it dollarizes officially, Mexico gives up the ability to use changes in its money supply and its exchange rate as means of managing the economy. There would be no power for Mexico to independently create dollars, and there would be no exchange rate. Hence, if Mexico were hit by a crisis that originates outside the country — such as a collapse of oil prices or a worldwide loss of confidence in developing-country economies — there would be fewer tools available to manage the economy. In this case, adjustment to hard times would have to come through changes in the domestic economy. Depending on the source of the disturbances, this might entail falling wages or large job layoffs. Baja California would probably weather the storm since its economy is more responsive to conditions inside the United States, but what of other states, such as Chiapas or Oaxaca? No one can rule out the possibility that in times of crisis, dollarization might worsen the problems of poverty and inequality in regions outside the border.

The usual list of benefits to dollarization include a reduction in trade costs (there is no exchange rate risk), deeper and more extensive trade ties and greater credibility in international markets, leading to greater inflows of foreign investment. Mexico, however, has had little problem attracting foreign investment over the last few years, and deeper, more extensive trade ties would also mean more competition for small and medium-sized enterprises and require deeper economic adjustments in the short-to-medium runs.

These are only some of the considerations that need to be taken into account when thinking about dollarization. From the perspective of San Diego, it looks beneficial for Tijuana and Baja California. For Mexico outside the border, however, it is very uncertain if the benefits would outweigh the costs.

The Cross-Border Economic Bulletin is prepared monthly by Dr. Jim Gerber, professor of economics at San Diego State University. It is underwritten by Concert, a global venture of AT&T and BT.