How well-built is the case for Dollarization on Curacao?
The Business Perspective
Graduation Thesis International Business in International Financial Management
Student: Vanessa E.M. Overman Student Number: 1823868 Name Institution: The University of Groningen Name Faculty: Faculty of Social Science and Economics Name Major: International Business in International Financial Management Name Supervisor: Dr. W. Westerman Groningen July 2013
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Acknowledgements
“It does not matter if you finish last just as long as you never stop and finish what you started”.
-Unknown Author-
Praise the LORD I finished it. Through the ups and downs He has been my light and my source of knowledge. Without him I would not be able to present this thesis. I would like to express my utmost gratitude to Dr. Westerman who had the patience and understanding to help me with this investigation.
I am forever thankful. Furthermore I want to express my gratitude to my family and friends whose support was incredible during this particular journey. Last but not least, I want to take this opportunity to thank the respondents, who without their input this thesis was not possible.
Groningen July 2013 Vanessa Overman
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Table of Contents
Acknowledgements ... 2
Abstract ... 5
1. Introduction ... 6
1.1 Research question ... 7
1.2 Importance study ... 8
1.3 Methodology ... 8
1.3.1 The target group ... 9
1.3.2 Limitations ... 9
1.4 Structure thesis ... 10
2. Literature Review ... 10
2.1 Exchange rate regimes ... 10
2.1.1 Fixed exchange rate ... 10
2.1.2 Flexible exchange rate ... 11
2.1.3 Dollarization ... 12
2.2 The benefits and costs of dollarization ... 13
2.3 Advantages of dollarization ... 14
2.3.1 Elimination transactions costs ... 14
2.3.2 Elimination currency risk ... 15
2.3.3 Economic and financial integration ... 15
2.4 Costs of Dollarization ... 16
2.4.1 Loss of Monetary Independence ... 16
2.4.2 Loss of seigniorage revenue ... 16
2.4.3 The lender of last resort ... 17
2.3 Influencing factors of the exchange rate regime choice... 18
2.3.1 Choice of factors ... 18
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3. Monetary review of Curaçao ... 21
3.1 Monetary background of Curaçao ... 21
3.2 The current monetary situation of Curaçao ... 22
3.3 The process of dollarization in Curaçao ... 23
3.4 Issues regarding implementation ... 27
3.5 Assessment of Exchange rate regime-choice factors for Curaçao ... 28
3.5.1 Economic factors ... 28
3.5.2 Monetary factors ... 30
3.5.3 Political factors ... 31
4. Data analysis ... 32
4.1 Analysis of the factors ... 32
4.1.1 The analysis of the economic factors ... 32
4.1.2 The analysis of the Monetary Factors ... 34
4.1.3 The analysis of the political factors ... 35
4.1.4 The analysis of the firm specific questions ... 36
5. Conclusions and Recommendations ... 37
5.1 Recommendation for future studies ... 39
Bibliography ... 41
Appendix ... 46
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Abstract
Dollarization has been discussed for a long period of time in the academic literature. This exchange rate regime has the capacity among other purposes, to promote trade between the adopting country and the adopter country. As of October 2010 the existence of the Netherlands Antilles ceased. The island of Curacao and St. Maarten became autonomous within the Kingdom of the Netherlands and they both chose to form a monetary union with one central bank and a common currency. However there have been discussions on the island whether it is a good time to change their exchange rate regime and adopt the U.S. dollar as their official currency. This paper investigates the perception of small and medium sized companies about a possible exchange rate change from a fixed regime to dollarization. The investigation has been conducted by performing informal interviews and the distribution of
questionnaire among a sample group in Curaçao. The outcome of the investigation indicates that the preference of the small and medium sized companies in Curaçao goes for official dollarization.
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1. Introduction
Tthe world economy is experiencing its greatest slowdown since the Second World War. A financial crisis which began in the USA has reached the world as well as the shores of the island of Curaçao. Being a small island such crisis had undoubtedly affects on the economy in its total. In particular if that island is going through constitutional changes. Becoming autonomous in the Kingdom of the Netherlands gave the island of Curaçao the distinctive opportunity to address certain aspects of its investment climate that can be beneficial. An aspect that was and is still addressed is the chance to make a change in its exchange rate regime. As of October 2010 the Netherlands Antilles ceased to exist. The island of Curacao and St. Maarten opted to become autonomous within the Kingdom of the Netherland. The island chose to form a monetary union with one central bank and a common currency. Bonaire, Saba and St. Eustatius became special municipality of the Netherlands and chose the US dollar as their legal tender since January 1st, 2011. Unofficial dollarization has been going on for the last past decades on the financial markets of the island of Curaçao. It would be interesting to study what the perception is of the business community on this particular topic since they can be hugely impacted by this transition. It can be said that over the last decades dollarization has become a hot topic. Dollarization is not new it can be said that it derives from a phenomenon that was outdated. There was little interest by policymakers for dollarization however last decade it has been recommended by economists as an instrument of
economic policy. In time these notions change as more countries took on other currencies such as the Euro or the U.S. dollar as their new national currencies. This sparked new discussions on this topic with regards to the consequences and determinants on dollarization. According to authors such as Encinas- Ferrer (2000) theory lacks a general term to describe the phenomenon of dollarization adequately. The argument for this is that there are many articles and works on this particular topic where the new currency replacing the national currency is not necessarily the dollar (Minda, 2005). As said before, for the past decade unofficial dollarization has been noted on the island of Curaçao. Due to increasing inflation rates the island of Curaçao as other island in the Caribbean has increased their usage of foreign currency. According to the president of Central Bank of Curaçao and St. Maarten, Dr. Emsley Tromp full dollarization of Curaçao is a good approach since the former Netherlands Antilles islands: Bonaire St.
Eustatius and Saba are fully dollarized as of January 1st, 2011. Dr. Tromp argues that the reason he believes it is necessary for the island of Curaçao to go fully over to the dollar is “because of the deteriorating balance of payments of the Netherlands Antilles, and given that, if another crisis was to occur then it would hit the islands harder” (St. Maarten News, 2009). Consequently, a debate is going on whether Curaçao should fully dollarize. The choice for the U.S. dollar is based on the fact that the United
Page | 7 States is Curaçao’s main trading partner and the U.S. dollar is used extensively for international
transactions. Namely, 82 percent of the external cash flow is in U.S. dollars, and 75 percent of international transactions are made with the United States.
The process of dollarization imposes both benefits and constraints on the economy. One of the benefits is that it limits currency crisis. Curaçao has a deficit on its current account for almost fifteen years.
Between the year 2006 and 2009, the current account expanded rapidly and reached -22 percent of GDP in 2008 and improve back slightly in 2009. The improvement was the effect of a debt relief program.
Without those debt relief grants, the current account on balance of payments of Curaçao would have reached -20.2 percent of GDP in 2010 (The Central Bank of Curaçao and St. Maarten, 2011). By rejecting inflationary measurements through dollarization, the domestic country may strengthen their financial institutions and create positive acknowledgment towards investments. Furthermore, a more integrated economy creates low transaction costs and imposes stability on prices and lower interest rates. On the other hand, a fully dollarized economy provides its government with a loss of seigniorage revenues, and limiting the role of the central bank as the lender of last resort. The dismantling of the Netherlands Antilles has increased vulnerability to external shocks, because of diminishing economies of scale. The financial market in Curaçao became more vulnerable during 1990’s. As the economic performance of Curaçao worsened, banks became more suppressed by high interest rates. The inflation rate of Curaçao increases with time. Due to Curaçao’s history of high inflation, the government’s task is to promise citizens a more compelling monetary reform.
1.1 Research question
Even though that Curaçao has already agreed to introduce the Caribbean dollar as their new legal tender, the question still arises whether it should adopt a new exchange regime and make the U.S.
dollar the country’s new primary currency and whether change of exchange rate regime would be an effective way of improving the island’s economical development. Small and medium sized companies are considered major contributors when it comes to employment and growth of their country. Based on this statement the following research question has been developed and is going to be discussed
throughout this paper. The question reads as follows: “How is a change in the exchange rate regime of Curaçao perceived by the local small and medium sized companies?”
Sub-questions have been created in order to answer the main question. The sub-questions read as follows:
Page | 8 1. What is the current exchange rate regime of Curaçao?
2. What is the difference between fixed, floating and official dollarization exchange rate regime?
3. Which factors should be considered and how do these factors influence the choice of an exchange rate regime in Curaçao?
4. What are the recommendations from the sample group with concerns to the choice of an exchange rate regime in Curaçao?
1.2 Importance study
Like aforementioned, small and medium sized companies are major contributors to employment and growth around the world. This is no exception in Curacao where they play an essential role in the local economy as they are a significant contributor to employment and local GDP. Hence the necessary steps should be taken in order to create business environment that leads to the improvement of the island competitiveness and that will also lead to sound business opportunities. Since constitutional changes in Curaçao, the opportunity arose for the island to discuss several aspects of its investment climate. One of these aspects was and still is being addressed is the chance for the island to make a change in its
monetary system. The given the island vulnerabilities in the present economic order of the world, dollarization seems the way to go. By doing so it is believed that the island will reap more benefits than shortcoming. Local supporter(s) for dollarization argue that dollarization will result in an increase of business opportunities and also the likelihood of survival will be higher. Given this it will be interesting to study what the perception is of the small and medium sized companies on the island, since they play a vital role within the economy of the island.
1.3 Methodology
Because the topic of dollarization on Curacao is new, the best proposed way to investigate it through a questionnaire. The first three sub-questions were answered by making use of secondary data. For the purpose of this study, the collection of secondary data included: literature presented in academic articles, journals related to exchange rate regime and IMF reports. Furthermore, conference
proceedings and also press releases from companies, organizations and the local central bank related to the subject will be used. Also, a number of online resources will be used in order to construct a
literature review. Numerical data will be used in order to understand the outcomes and effects of dollarization. In order to answer the last sub-question primary data was used. The compilation of the
Page | 9 primary data for this study was done in two manners. First off primary data was compiled through the questionnaires that were distributed amongst the target groups. By this means their opinion, perception and preference about a possible change in exchange rate regime was obtained. The questionnaires were distributed amongst a group of people with the assumption that they possess background
knowledge of this topic. This was done in order to assure the dependability of the information collected.
Secondly, non-formal personal interviews were conducted with experts/semi- experts in order to obtain primary data. This group was asked questions which are based on the questions that can be found in the questionnaire. The questionnaire is presented in the appendix. The list of questions together with the questionnaire was emailed to the interviewees in advance. This was done in order to give the
interviewee the opportunity to prepare the answers beforehand. By doing so, if there were any misinterpretations, they had the opportunity to ask for clarifications before the appointment.
1.3.1 The target group
To get in direct contact with the business community of Curaçao, questionnaires were distributed through local contacts. The group consisted of people of the business community of Curaçao. The experts/semi –expert groups consists of (ex) politicians, economists and bankers. Due to their social and professional position in Curaçao they were considered knowledgeable about the topic and furthermore it was assumed that they would have been directly or indirectly confronted with this issue.
1.3.2 Limitations
The main problem that was encountered was the low response rate. According to literature sending high number of questionnaires can increase the low response rate; however I ran into time constraints waiting on the necessary amount of responses to come in. Because there is a geographical dispersion, it was anticipated that response will take longer. A second problem that arose was that some of the managers did not have the knowledge about the topic and thus their response was biased. Furthermore I was not present during the filling in of all the questionnaires, so unclear question(s) were not able to be explained properly and this created incomplete questionnaires resulting also into bias.
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1.4 Structure thesis
The structure of the thesis is divided into 5 chapters. Following the introduction, chapter 2 gives a review of the relevant literature. Chapter 3 presents the monetary review of Curaçao. In chapter 4 the results of the analyzed data will be presented. Last but not least chapter 4 will draw the main
conclusions and also present recommendation for future studies.
2. Literature Review
2.1 Exchange rate regimes
The highlight of this study is exchange rate regime. In ordinary words exchange rate is the rate at which a particular currency can be exchanged for another one. Authors such as (Flynn, 2008) say that exchange regime refers to specific institutional structures that are designed in order to produce specific exchange rate outcomes. The conceptual foundation of exchange rate regime was not of fixing but adjusting exchange rates in order to steer clear of the undue volatility thought to characterize floating exchange rates and of the prevention of depreciations, while permitting enough flexibility to adjust to
fundamental disequilibrium under international supervision. The exchange rate regime system knows of several classifications. Authors such as (Eiteman, Stonehill, & Moffett, 2007) discuss about the two types of exchange rate regimes. These authors suggest that if the government of a certain country would regulate the rates at which its currency is exchanged for another currency, the system or regime is classified as a fixed exchange rate regime. In contrast to this if the government does not interfere in the process of its currency valuation in anyway, the currency is than considered to be floating or to be flexible.
2.1.1 Fixed exchange rate
Fixed exchange rate can be defined as a system in which the value of a countries legal tender in relation to the value of other legal tenders is preserved at a fixed conversion rate by the means of government intervention. The central bank is the entity who’s responsible at all times to buy and sell its currency at a fixed price. Since a fixed exchange rate is fixed it is predictable and can be used in investment and other transactions to pinpoint the value of one currency to another. This provides a stable environment for international trade and investment. From the trade side point of view, both transaction costs and currency risk are reduced with a fixed exchange rate. Furthermore if reliable the fixed exchange rate can
Page | 11 in addition encourage long-term investments, since the investors can easily and with confidence predict their rate of return. The most important aspect of a fixed exchange rate is that is forces domestic monetary growth and therefore drive inflation rates down to the level of the country’s trading partners.
Since otherwise prices of import products would have been priced out of the foreign markets and furthermore imports would have flooded in. It has to be noted that having a fixed exchange rate regime can help local money borrowers because inflation rates and therefore interest rates are constrained by foreign levels. Furthermore the results due to fixed exchange rate on capital account are often positive and it helps with the reduction of capital flight. Automatic responses to shocks that are built into a flexible exchange rate are removed. On the other hand the ability to change exchange rates by the government must be sacrificed when choosing for a fixed exchange rate. However the loss will hurt national competitiveness, since the domestic currency will not be able to flow when third party countries devaluate their currency. Weak domestic financial sectors and vulnerability to volatile
international capital flows are two of the range of reasons that make it difficult for countries to defend a fixed exchange rate. Character trades of a country determine the benefits and the costs of fixed
exchange rate. Concerns about credibility and competitiveness should be generated when high levels of inflation exist. In order to bear the status of a credible country, that country with extremely high inflation in a desperate attempt to stabilize might be very likely to go over to a fixed exchange rate.
Nevertheless this would mean that a fixed exchange rate would require competitive pressures on tradable produces and pressures on the current account balance.
2.1.2 Flexible exchange rate
The flexible exchange rate is the system in which the value of a legal tender is determined by supply and demand without the intervention of the central bank. Thus, the currency exchange rate floats and its value changes on a constant base depending on like said before supply and demand and also on how much of the currency is held in foreign reserves. Unlike fixed exchange rate, the flexible exchange rate enables for automatic adjustments of tradable sector to occur when economic conditions such as terms of trade changes. In small open economies, where the pass- through of tradables prices into non- tradables prices is faster and more complete as to larger more closed economies, automatic adjustment such as changes in wages and prices might not work if there is a major depreciation that might lead to inflation in that economy. In developing countries, economic conditions can change quickly, which mean that this change might result into uncertainty in a flexible exchange rate regime. Negative are the effects of this uncertainty on investments. A fact of the matter is that with a flexible exchange rate the
Page | 12 government is allowed a greater freedom to pursue monetary and fiscal policies that they think seem appropriate to their situation. In the currency markets, the majority of the countries with flexible exchange rate mediate on an extent level (Rönnholm G. , 2007)
2.1.3 Dollarization
2.1.3.1 Official dollarization
According to literature dollarization can be divided into three types: official dollarization or full dollarization, semi -official dollarization and unofficial dollarization. Simple said, dollarization can be seen as the adoption of a fixed exchange rate. In order to understand the term dollarization there are more than one definition to take into consideration. Dollarization has become such a frequently used name however it does not automatically mean that the foreign currency adopted is the U.S. dollar. This can create some misunderstandings because other currencies other than the U.S. dollar have been used as the object of monetary polarization. Official dollarization entails that a country entirely discards the use of domestic currency in order to adopt a foreign currency (Minda, 2005) (Castillo, 2006), meaning that the foreign currency will assume the functions of the domestic currency. These functions are (i) medium of exchange, (ii) unit of account and (iii) store value. Schaclarek Curutchet (2001)argues that the total acceptance of a foreign currency as your own is comparable to the adoption of a fixed exchange regime with as consequence the disappearance of the domestic currency. Countries very much discussed in the literature that opted for official dollarization are Panama and Ecuador.
2.1.3.2 Official semi-dollarization
Furthermore you have official semi-dollarization. In this type of dollarization the use of foreign currency is legalized, and both the local currency and the foreign currency are being used as legal tenders. The local currency continues to be used for paying out wages, taxes and the everyday expenses. Based on some other literature this would refer to dollar denominated deposits as well (Reinhart, Rogoff, &
Savastano, 2003). Furthermore in sync with what some authors like Piontkovsky (2003) and Quispe- Agnoli (2002) imply, the term dollarization refers to the situation when locals have part of their assets in the form of foreign currency and foreign currency denominated assets.
In the overall literature on both official dollarization and official semi-dollarization there is a consensus that they can help in achieving economic stability by combating hyperinflation. In a full dollarization regime the local currency is replaced by the foreign currency, resulting into authorities no longer being
Page | 13 able to finance the Government deficit by printing currency whilst this a main source of inflation. When it comes to the official semi-dollarization monetary authorities need to take the foreign currency reserves into consideration since these need to back up when there is an increase in the domestic currency supply. This means that the domestic monetary authorities are only able to increase the domestic money supply if they are able to generate more foreign currency by running a balance of payments surplus.
2.1.3.2 Unofficial dollarization
The last type of dollarization discussed in this in this paper is unofficial dollarization. In this regime the domestic currency is the only legal tender however it ceases to accomplish its function as store value.
The foreign currency is used by the locals as a means of protecting their financial wealth by holding these in foreign assets. Although Minda (2005) suggests that the cause of unofficial dollarization is not exact since it differs from country to country and case to case, authors such as (De Nicolo, Honohan, &
Ize, 2005)defines three generic types of unofficial dollarization which is based on the three functions of money. First of all, you have transaction dollarization or currency substitution, being the use of foreign currency for transactions purposes. Moreover you have financial dollarization or asset substitution. This consists of locals’ holdings of financial assets or liabilities in foreign currency. The last type of unofficial dollarization is real dollarization. This type entails indexing the domestic prices and wages to the foreign currency.
2.2 The benefits and costs of dollarization
As stated before full dollarization is comparable to a fixed exchange rate regime. Those in favor for dollarization argue that countries that give up their own currency are not able to engage in monetary and macroeconomic mismanagement. It is believed that because of this the public finances of that country will stay in balance, macroeconomic policy will be trustworthy, and shocks provided by external factors will move within reasonable bounds (Edwards & Magendzo, 2003). Based on this view,
dollarization will have two major positive effects on the economic performance. First point of this view is argued by authors such as Alesina and Barro (2001). Their argument is that the inflation will be lowered in dollarized country in comparison to a non-dollarized country. This elimination of the inflation bias problem of discretionary monetary policy is achieved through the adoption of another nation’s currency. The second view suggests that growth has a tendency to be faster in dollarized countries.
Page | 14 However there are some authors that do not believe in the alleged positive effects of dollarization on growth and overall macroeconomic performance. The evidence on the relationship between monetary regimes and growth investigated by Eichengreen (2001) has been inconclusive and it does not support the claim that dollarization-for that matter, any other exchange rate regime-is a determinant of growth.
Dollarization has overall two important benefits which are the low transaction costs and the low interest rates. However cost of such a regime is the loss of monetary autonomy, seignorage revenue and the position of the central bank as a lender of last resort. It has to be said that the costs and benefits of dollarization differs between countries. These rely on the extent of the countries characteristics and the relationship with the main trading partner. Dollarization is dependent on primarily 3 characteristics: (1) lowering of transaction will be high when exchange rate volatility is high, (2) lowering of transaction costs is high while the conversion cost is high, (3) high foreign direct investment when there is a financial integration between the domestic dollarized country and the foreign currency is high (Schclareck
Curutchet, 2001). Based on those 3 characteristics the author argues that if there is a low commercial and financial integration due to trade and investment barriers, trade flows and investment flows will not increase no matter how much the transaction costs are lowered.
2.3 Advantages of dollarization
2.3.1 Elimination transactions costs
A fixed exchange rate regime conveys the reduction of exchange rate risks and the volatility of the exchange rate. According to Fischer (Fischer, 1982) and De Grouwe (2000) this is the most noticeable benefit. Still there will always be some certain degree of exchange risk. The reduction of transaction cost on exchange rate risk is between trading countries with differing currencies. This means that when the locals and the local business community engage in foreign exchange, they will avoid transaction costs and the need to hedge exchange rate risk. In terms of business the transaction costs of both exchange rate and currency conversion can be of benefit for bilateral/international trade and the flow of
investment(Berg & Borensztein, 2000). However, like mentioned before, theory suggests that this may not be possible if there is a low commercial and financial integration between the dollarized country and the foreign country (Schclareck Curutchet, 2001).
Page | 15 2.3.2 Elimination currency risk
Another benefit that can be achieved is with dollarization is the elimination of currency risk and a balance of payment crisis. Yet, it has to be noted that by adopting a fixed exchange rate regime it does not necessarily mean that credibility in the local government is achieved or maintained.
The two conditions in the fulfillment of benefits for a fixed exchange regime with the reduction in government’s ability to use exchange rate are presented in a discretionary way. The first condition emphasizes that the commitment of fixing exchange rate must be a credible measure. The second condition argues that the chosen foreign currency must be a strong currency, with the reason of a trustworthy reputation in relation to its monetary policy management (Stein, Talvi, Panizza, & Marquez, 1999). According to Stein et al (1999), anchoring the domestic currency with a foreign currency has additional benefits. These additional benefits are presented by the reduction of inflation rate and inflation volatility. Dollarization implies that the country will adopt monetary policy of the foreign country and will therefore achieve lower inflation rate, but also lower real interest rate. Lower interest rate encourages investments in foreign assets. It will also reduce the devaluation risk and uncertainty in the economy. Volatility of real exchange rate will also be reduced. In the short run, real exchange rate volatility will be lower under fixed exchange regimes. Furthermore, countries with weak currency will deepen their financial systems by reducing their financial fragility as a consequence of reducing real interest rate and real exchange rate volatility.
2.3.3 Economic and financial integration
Dollarization encourages capital mobility. According to the literature countries that adopt the dollar as their legal tender, will encounter close integration to the global and anchor economies. This would result from lower transaction costs, assured stability of prices in dollar terms and the possibility of lower interest rate (Frankel & Rose, 2002); (Dallas & Tavlas, 2001).The flow of capital helps in promoting financial integration, competition, and efficiency among financial institutions. Furthermore it will facilitate the inflow of foreign capital that eventually will lead to the stimulation of growth in a dollarized economy. Furthermore, depending on the level of economic integration it might lead to real
convergence in terms of GDP levels and convergence of business cycles with the issuing country (Frankel
& Rose, 2002) (Dallas & Tavlas, 2001). As an outcome of dollarization, the dollarized country and the anchor country’s shocks may become more symmetric. Besides, due to dollarization, business cycles are to become more in tuned, which leads to the further promotion of integration. Moreover the reduction of the needs for foreign exchange and trade controls are reduced by the elimination of foreign exchange
Page | 16 crises. Printing of money in order to finance fiscal deficits is eliminated due to dollarization which
provides constraints of the fiscal policy of a country.
2.4 Costs of Dollarization
2.4.1 Loss of Monetary Independence
The loss of monetary independence is an outcome of the cost of dollarization. Both internal and external shocks cannot be eliminated or moderated with an expansionary monetary policy or currency
devaluation during a period of recession when a country is dollarized since it does not have a domestic currency. The literature describes 3 benefits for an economy with an independent monetary policy. The first benefit is the isolation of the domestic interest rate from the foreign interest rates. The dollarized countries is faced with some monetary and exchange rate policies from the U.S. in other words if and when there is a shift in the interest rate this will have an effect on the economy of the dollarized country. For example if the interest rates should increase and the U.S. dollar appreciate, this will aggravate a recession in the dollarized country. The second benefit would be that the monetary
policymakers are able to make use of the monetary policy as an instrument of anti-cyclical management of aggregate demand. However it is needless to say that for the dollarizing country the real expense of giving up a monetary system relatively small is, since it would require real economic adjustments in order to resist real economic shocks for which exchange rate change can only lessen the burden instead of eliminating it. And finally, to dodge massive deflationary adjustments, independent monetary policy can be used as well (Schclareck Curutchet, 2001). This meaning that it will always be possible for the central bank to influence the inflation rate by increasing money supply. It should be noted that in the particular case of Curaçao, the scope limited it to proceed with an independent monetary policy since it is small and open economies such as the one of Curaçao on the fiscal policies and structural measures rely in order to promote investment and growth (Boyd & Smith, 2006).
2.4.2 Loss of seigniorage revenue
The net revenue that is derived from issuing domestic currency is seigniorage. When dollarizing, the dollarized country will sacrifice its seigniorage rights, which entails giving up future revenues when issuing domestic currency for the cost of replacing it with a foreign currency. According to Rönnhom (2007), the net revenue represents the annual loss of the dollarized country and the annual gain of the currency issuing country. The increase is a result between the difference between the face value of a
Page | 17 coin or bank note and the cost of producing, distributing, and eventually retiring it from circulation (A.Berg & E.Borensztein, 2000). When relating this disadvantage to Curaçao, the central bank of Curaçao and St. Maarten estimated a loss of Naf. 89.9 million when it comes to government income. It can be said that although the estimated loss of governmental income is extremely high, the central bank is able to sustain such a loss of seigorage since their source of income is more from licensing fees than from seigniorage. This means that the central banks portion of profit mainly consists out of license fees from which profits will continue to be generated in a dollarized economy. Furthermore, the reserves of foreign currency exceeds the reserves of domestic currency on issue meaning that the central bank is more than likely to be earning income from those investment in the future. Since Curaçao does no longer maintain a fixed peg to the U.S dollar the central bank is no longer obliged to maintain reserves, it is free to invest its capital and reserves (including gold) at a higher return and by doing so protecting the profitability of the central bank.
2.4.3 The lender of last resort
The function of lender of last resort can be defined as the ability of the central bank to fully guarantee payment systems of bank deposits. If and when a country dollarize its central bank loses this function of lender of last resort in order to provide liquidity support to the local banks and/or a number of financial institutions that might be going through financial distress. Instead its task will be the maintainer of the soundness and efficiency in the local financial system. Just to be clear: there is no particular reason for a dollarized country not to put aside liquid funds necessary in order to lend to local banks in crisis and/or facilitating lines of credit with foreign banks in order for these banks to provide credit to local banks in need of financial assistance. Dollarization cannot be seen as a magic pill that solves problems (Rosaria, 2013). It is unable to resolve serious economic issues that a country might be facing such as
unsustainable budget deficit or debt burden that may lead to an economic and financial crisis. Such economic problems are not be impeded by dollarizing a country. When it comes to the central bank of Curaçao and St.Maarten, the costs of losing an independent monetary policy and its ability to assume the function of lender of last resort may not be of importance, because of the healthy levels of foreign reserves. Besides, the level of liquidity that can be provided to the banking system when a crisis occurs would be limited by the level of foreign reserves. In order to achieve this support the foreign reserves are to be invested in liquid instruments so its returns can be made available at all times in particular when it comes to financial deficit.
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2.3 Influencing factors of the exchange rate regime choice
Since exchange rate regimes has been extensively reviewed, an explanation should be given about the several influencing factors a country is faced with when it comes to the type of exchange rate regime it should consider when faced the choice of introducing a new exchange rate regime. These factors have been divided within three categories and are being explained in the upcoming section of the paper.
2.3.1 Choice of factors
The factors chosen for this study are derived from the factors used in the investigations of both Beverly Mathilda (2010) and Luizeduardo Sowma (2013). Both are former students of the University of
Groningen, who performed a qualitative research study on the preferences of exchange rate regimes in Curaçao and in Suriname. The reason for doing this is that their investigation acted as a basis on which the perspectives of a specific sample group can be targeted with a guideline. The factors that are being focused on are the economic factors, the monetary factors and the political factors. Each main factor has been sub-divided into aspects of the particular factor for this investigation. The economic factor consists of the country’s GDP, rate of inflation, competitive position, degree of openness of the country and the balance of trade of the country. The monetary factor consisted of constraints imposed by the different exchange rate regimes, the duration of the exchange rate regime, the level of reserves in the central bank and the country’s operating exposure. The political factor consisted of the government’s temptation to inflate and the political stability of the country (Mathilda, 2010; Sowma, 2013).
2.3.1.1 Economic factors
Size or GDP of a country is an influencing economic factor when it comes to choosing an exchange rate regime (Collins, 1996; Carmignani, Colombo, & Tirelli, 2008; Poirson, 2001). It is suggested by authors such as (Poirson, 2001) that countries with large economies are inclined in choosing more flexible exchange rates. The reasoning behind the before mentioned statement is that small countries with small economies might find it difficult than their opposite to manage a flexible exchange rate regime. This is the reasoning behind small country economies opting for fixing their exchange rate while at the other hand larger country economies choose to let it be flexible. Literature suggests that fixed exchange rates are more likely to be chosen by countries with moderate to high inflation rates. Collins (1996) suggests that these countries should anticipate a more rapid growth misalignment of their real exchange rates under fixed rates regime except if the fixed rate is adjusted on a frequent basis. This is why authors such as (Poirson, 2001)and (Carmignani, Colombo, & Tirelli, 2008) suggest that this leads to the second factor
Page | 19 which is the inflation rate. A study conducted by (Savvides, 1990) proposed that countries that
experience great levels of real exchange rate variability give preference to flexible exchange rate arrangements. The reasoning behind this preference is that on the long run, a flexible exchange rate policy might be more successful when stabilizing the real exchange rate. Because of this, the third economical factor which is considered when opting for a new exchange regime is the variability of the real exchange rate. Another factor which that is considered is the openness of the economy
(Carmignani, Colombo, & Tirelli, 2008; Collins, 1996). Some theory suggests that countries that are large and closed are less likely to go over to a fixed exchange rate (Carmignani, Colombo, & Tirelli, 2008).
Likewise (Barth, 1994) -who supports the before mentioned suggestion- claims that one of the most determinant issues with regards to the choice of an exchange rate regime is the relationship of national economies to the global system. The trade structure of a country is implicated as well with the
exchange rate regime. In a study concerning economic policy for external balance the author presented the characteristics of different types of the trade structure, in terms of specific values for demand or supply elasticity in the export and imports (Branson, 1983). From this study can be derived that trade structure of economies must at the same time be considered, when choosing an exchange rate regime.
2.3.1.2 Monetary factors
Monetary factors that ought to be considered when choosing an exchange rate regime are the
constraints that an exchange rate regime inflict on the monetary policy of a country (Wyplosz, 1999). In particular when there is a large degree of capital mobility, an exchange rate commitment, either explicit or implicit, should lead to market-based discipline that is imposed on the central bank. Duration of the exchange rate regime is another monetary factor that is of interest when considering a new exchange rate regime (Andreou, 2013). Durable arrangements tend to be related with peaceful exits. The resistance will be minor when an exchange rate regime needs to be changed after it has existed for an extensive period of time in comparison to an exchange rate regime that has been introduced on a short period of time. The level of exchange rate risk exposure increases the probability of fixing the exchange rate (Poirson, 2001).The argumentation behind this thought is that a reduced capability to hedge the exchange rate risk is inclined to reduce flexibility of the exchange rate regime. Based on this
argumentation, the literature suggests that exchange rate exposure is thus a monetary effect. An important monetary factor is the level of reserves that a country holds. Lower reserves tend to have a positive and significant effect on the exchange rate regime flexibility, according to the results of the study conducted by Poirson (2001).
Page | 20 2.3.1.3 Political factors
Theories on political economy show evidence that a country which lacks political stability has the incentive with all things being equal to let its exchange rate float since this country lacks the political aptitude and political support in order to take unpopular measures that might be required to defend a peg (Poirson, 2001). Based on this evidence it is imperative that political stability be considered as a political factor when choosing an exchange rate regime. It is suggested in literature that on average stabilization on exchange rate are presented before the elections, while the financial part of the stabilization is being implemented after the elections Aisen (2004, as cited in (Carmignani, Colombo, &
Tirelli, 2008). This is clear evidence that the electoral rounds of the current government of a country might have influence on the choice of exchange rate regime. Furthermore the literature on political business suggests that members of the sitting governing parties are able to manipulate macroeconomic policies before the elections in order to create an economic boom in order to win the next election (Hossian, 2009). The electoral system and legislative institutions have an influence on the choice of exchange rate regime, according to Bernhard and Leblang (1999 as cited in (Hossian, 2009)). This is the reason why the electoral system is of great importance to be considered when it comes to the choice of an exchange rate regime. It is argued by Edwards (1996, as cited in (Poirson, 2001) that if a government has an “ambitious” unemployment objective it tend to be attracted to inflate, and thus with everything else being the same, a high attraction to “tie its own hands” by pegging the exchange rate. So it is logical that the temptation to inflate to be considered a political factor as well. However from the results of the Mathilda (2010) investigation can be concluded that the electoral cycle and the electoral system have not been deemed relevant when it comes to the choice of an exchange rate regime in Curaçao. Based on this both those aspects will be left out of this investigation.
2.3.1.4 Firm specific questions
Literature suggest that the two most comprehensively investigated advantages of dollarization is that it has the ability to increase trade by eliminating currency risk and foreign exchange transaction costs and its ability to reduce inflation by importing monetary policy credibility. Furthermore, it is believed that dollarization is able to encourage the integration of a country into the international financial markets (Arallano & Heathcote, 2008). Authors such as Rose and van Wincoop (Rose & van Wincoop, 2000) and Frankel and Rose (2002) argue that dollarization has the ability to conduce to the increase international
Page | 21 trade. Product markets in some countries are under-developed and largely restricted to limited markets.
Hence, it is advisable for these countries to consider dollarization as a channel through which integration between developing countries product and financial markets and developed countries product and financial markets can be achieved in a short period of time with limited restrictions (Saamoi, 2011). According to theory, dollarization makes it possible for companies to enter the global world easier. Furthermore dollarization opens the door for companies to afford the needful investments required in order to create customer value. According to Uzun (2005), firm-specific factors are used to measured real dollarization. therefore some of firm-specific aspects have been asked in order to get a perception about what businesses think. It is the opinion of the author that these questions cover a wide array of a firm. In order to gain knowledge about factors that are of relevance for the small and medium sized companies on a firm level some firm specific questions were created. The questions were regarded the product positioning, business strategy, the corporate culture of the firm, profit
maximization and the supply/value chain.
3. Monetary review of Curaçao
3.1 Monetary background of Curaçao
At the beginning of the 19th century Curaçao and other Dutch territories like Bonaire and Aruba had no significance from an economic point of view making it an unprofitable discovery for The West Indian Company (Centrale Bank van Curaçao en Sint Maarten, 2010). The islands were completely dependent on imports except for product like salt and wood which could be found and produced locally.
Curaçao was the port where traders can meet in order to exchange raw materials destined for Europe which was coming from the Latin America and the Caribbean. Meanwhile traders from Europe traded their products with merchants from both Latin America and Curaçao in the open ports of Curaçao. Due to this trading various foreign currencies circulated on the islands. Spanish coins were widely used on Curaçao. The financial operation of Curaçao was based on coins such as the “piaste” or pillar dollar and for large payments the Portuguese golden Joe was used. Coins from France, Germany or Prussia also where used as payment units however they circulated as small change. Trade houses where used by traders as trade points for these foreign gold and silver coins. Despite the “excessive” trading between European traders and the traders of Latin America, at a certain point there was a shortage of money or
Page | 22 rather of coins on the island. This was due to the fact that the import was greater than the export. In order to increase the money circulation, the coins where cut into smaller segments for smaller values.
Due to shortage of coins merchants took advantage of this situation by speculating. They became producers and distributors of their own value notes. These notes came in the form of credit notes which they offered at high interest rates. A chaotic financial situation was the result of the use of the different coins and credit notes.
At the beginning of the 18th century the special issued Dutch coins circulated in the Netherlands Antilles.
These were issued especially for the Dutch holdings in the West Indies. The Spanish “reaal” was the currency that circulated on the islands between at the end of the 18th century and the beginning of the 19th century. King William 1st proposed in 1826 the establishment of a bank in the colony in order to organize its financial affairs. It was two years later that this proposal became a reality on February 6, 1828 when the Bank was established. The Bank was located in the same building as where the government administration was located in the Garrison Fort of the West Indian Company or better known as Fort Amsterdam. At that time the Bank had no official name and thus became part of the Financial Department. The Bank was established with the purpose to promote trade within the colony by providing credit notes to the merchants. Being the governments cashier was also a responsibility of the Bank. This task entailed making payments to the private sector on behalf of the government.
Furthermore, in 1828, now subdivided into 100 cents was introduced as the legal tender.
“Curaçao” was the currency name once they began issuing currency for use in the Netherlands Antilles.
The first Dutch denominated banknotes and coins were introduced in 1892 and 1900. The name Netherlands Antilles (Nederlandse Antillen) was introduced in 1952.
With the occupation of the Netherlands by the German during the Second World War, the link to the Dutch currency was stopped. This link was replaced with a peg to the U.S. dollar of 1.88585 guilders = 1 dollar. It was in 1971 that the peg was adjusted to 1.79 guilders = 1 dollar. Coins were introduced in 1974.
3.2 The current monetary situation of Curaçao
As a small island in the Caribbean, Curaçao has a population of 150 thousand as of January 1st 2012.
Curaçao is the largest and the most populated island of the Dutch Antilles. Together with St. Maarten,
Page | 23 Bonaire, St. Eustatius and Saba they constituted the Netherland Antilles up till the 10th of October of 2010. Netherlands Antilles also known as the Dutch Antilles is not a part of the European Union though it was an autonomous Caribbean country within the Kingdom of the Netherlands. The islands where listed as overseas countries and territories (OCT) of the Netherlands. The listed currency for the Netherlands Antilles was the Netherlands Antillean Guilder (NAf) which was pegged since 1971 to the U.S. Dollar by NAf. 1.79. Following the dissolution of the Netherlands Antilles the guilder is the legal tender for only Curaçao and Sint Maarten. In Curaçao the guilder and the U.S Dollar is the only two currencies accepted for payment transactions. A year after the dismantling of the Netherlands Antilles the islands that forms the BES-islands chose to replace the guilder and go over to the U.S Dollar as the legal tender. It was planned for 2013 that the Netherlands Antillean guilder would disappear for ever to be replaced by the newly created Caribbean guilder. However things didn’t proceed as planned and the launch date has been postponed till further notice. The island of Curaçao has a small open economy however compared to the rest of the Caribbean it has a well developed infrastructure and one of the highest standards of living. According to the figures as of January 1st 2012 Curaçao has a GDP per capita of 22 thousands of U.S. dollar. The economy is mainly based on financial services, tourism and
petroleum refining. Most of all consumer and capital goods are imported. The U.S., Brazil, Mexico and Venezuela are the major source of supply. Curaçao receives development aid from the Dutch
government. Moreover, the local government of Curaçao wants to create a diverse economy by attracting more foreign direct investment (FDI). Momentarily the Central Bank of Curaçao and Sint Maarten is responsible for the monetary policy of both islands. The primal goal of the policy management of the Central Bank of Curaçao and Sint Maarten is to safe guard the stability of the external stability of the Netherlands Antillean guilder (NAf.) and furthermore to promote the efficient functioning of the financial system on both islands (Centrale Bank van Curaçao en Sint Maarten, 2010).
In order to preserve confidence in the exchange rate, the Central Bank of Curaçao and Sint Maarten strives to maintain a level of official reserves (excluding gold) worth three months of merchandise imports.
3.3 The process of dollarization in Curaçao
One would believe that the topic of dollarization is a new one. However a report written by Kamps en De Boer (1986) indicates that since 1985 discussions about the possibility of dollarization have been going on. This discussion sparked in 1985 when in this time Aruba which was part of the Netherlands Antilles left the constellation and gained the “status aparte”. This was a huge shock for the remaining
Page | 24 islands leaving a gap in off-shore business sector (Rosaria, 2013). Furthermore it was around that time that Shell left the island and the Bolivar devaluated (Rosaria, 2011). According to Romero (Romero, 2007) the proposal of dollarization has been made as a possible solution for the problems the islands were having with competitive interest rates in the financial market, the difficulty with accessing the money and capital market fund, mounting fiscal problems and debt accumulation in the public sector.
Around 1997, fading effects of the measures on the revenues of the government and also high inflation rates, in the earlier years resulted into an increase of the inflation in Curaçao. In 1995, a peak was experienced in the international financial sectors, however, it declined in 1997. Furthermore due to changes into the tax arrangements with the Netherlands, the local government received less tax transfers during this period as well. With the introduction of the Captive Insurance Association of
Curaçao the competitive position of the Netherlands Antilles was affected. Money supply was expanded by growth of the international reserves. The tightening of the monetary policy in 1997 by the competent authorities reflected the introduction of intermediate targets for credit expansion to private sectors.
With activities in the international financial sector diminishing, by 1998, Curaçao reached its lowest level of inflation since 1995.
At the break of the new century the inflation rate of Curaçao raised to 5 percent for both domestic and foreign factors. Rising oil prices and the inflation rates of the main trading partners where the main contributors to the increasing inflation rate. In 2000, the monetary aggregate expanded. By the accounts of the private sector the credit market of in Curaçao experienced an expansion. It is remarkable the money supply growth of 2000 which was 2.2 percent compared to a growth of 7.1 percent in 1999.
Same conspicuity can be noted for foreign currency denominated deposits. In 1999 an expansion of 26.5 percent was recorded while a contraction of 12.5 percent was noted in 2000.
By 2003 there was growth in the economy of the Netherlands Antilles. Curaçao saw an increase in its GDP per capita which increased from 0.4 percent in 2002 to a 1.4 percent in 2003. Inflation also had a significant raise in 2003 by 1.9 percent in 2003 when compared to 2002 figures. Fast rising oil prices was the main inflation driver. Nevertheless, the international financial sectors were still experiencing a decline in activities. On a positive note during this period the current account of Curaçao experienced a small increase. This surplus is predominately due to higher earnings from bunker sales and tourism. In 2003 the monetary expansion was slowed by the local government.
Page | 25 Even though on a slow pace, the economy of the Netherlands Antilles grew by 2004. This economical development is due to activities primarily in it most important sectors, the wholesale and retail trade, tourism and the financial sector. The expansion noted in the financial sectors was due primarily to the good performance of the local banking system, save for the international financial sector which didn’t perform all that well due to the slow progress in the new tax treaties. Compensating disadvantages which resulted from the elimination of the distinction between onshore and offshore activities was the main purpose behind the new tax treaties.
With the increase of the GDP per capita by 1.5 percent in 2005 in comparison to the year before which was 1.1 percent growth of the economy of the Netherlands Antilles is what it resulted into.
Furthermore the economy expansion of 2005 similar to 2004 was attributed to domestic spending.
Higher oil prices and domestic demands snowballed into a shortage on the balance of payments that led to a decline in net foreign demand and is so the reason for the expansion. Private sector led the growth in domestic spending primarily. Several infrastructural expansion projects had as consequence that the private investment amplified. As for monetary aggregates they proceeded to extent in 2005.
Furthermore there was growth in government spending as well. All considered there was a constant growth in 2006 in comparison to 2005 when it came to the economy of the Netherlands Antilles. The expansion in real GDP in for both years was estimated at 1.5 percent.
Forceful was the growth in 2007 in the Antillean economy. Strengthening of the domestic economy was the outcome of an acceleration growth. The rapid increase in private investment went hand in hand with the amplification of leniencies programs towards lending standards. As consequence an
impairment of the non-performing loans resulted. A budgetary increase was observed in the balance of payments of 2007, which was a further reflection of the accumulation of net international reserves.
Furthermore, the shortage of the current account nearly doubled in 2007 when compared to the year before, this as consequence to widening of the trade deficit. The expansion of the trade shortage was an outcome of worldwide constant increase in oil prices, increase in tourism, and the further
appreciation of the euro vis-à-vis the Netherlands Antillean guilder. Direct investment and net borrowing from abroad is how the shortage on the current account was ultimately financed (Central Bank of Curaçao and Sint Maarten, 2011).
Page | 26 Great was the impact of the 2008 world financial crises imposed on the economic developments of Curaçao. A slow growth of 2 percent was noted for GDP per capita in comparison to a 3.7 percent in the year 2007. Noticeable declining in consumption was the conductor of continuous withdraws of private demand. External public debt was failed to be paid-off as consequence domestic triggers of the
declining GDP per capita in Curacao. These triggers were of weak fiscal management. On the other hand, strong performances of the local banking system helped maintain growth rate in the financial sector.
Banks where exercising great supervision on the non-performing loans and the growth of the credit extension remained strong. Moreover, the balance of payments continued to experience impairment in 2008 however this was on a slower pace. Compared to 2007, in 2008 the money supply grew more rapidly. The expansion was reached with help of the acceleration of net foreign assets which went hand in hand with a balance of payments overage and revaluation of gold stocks. Another reason of the economy of Curaçao’s poor performance was induced by the vulnerability towards petroleum. Drastic was the increase in oil prices over the previous years. In the course of the years, this instability in the international oil prices had its effects on the consumption level, investment level and the trade balance of Curaçao.
A shrinkage of 0.2 percent was registered for the economic activities in 2009, which was attributed in its entirely to lower domestic demand. The decline in the domestic demand went along with a decline in private demand. As a result of reduction in consumption spending by the consumers, the private demand declined as well. Moreover, in 2009 the shortage gap on the current account narrowed this as consequence of a raise in net current transfers from abroad and a fall in the trade deficit.
Compared to an economic shrinkage of 0.5 percent in 2009, in 2010, the Netherlands Antilles experienced an economic growth of solely 0.1 percent. Increase in government spending especially attributed to this almost economic expansion. An expansion of the goods and services related to the dismantling of the Netherlands Antilles provoked an increase on government spending. Furthermore, while the consumer spending increased, the private demand diminished as consequence of reduction in investments for 2010. Likewise Curaçao saw a decline in its net foreign demand a shortage on its balance of payments. As a result of high international oil and food prices, Curaçao experienced high inflation in 2010. Inflation rates in 2009 for the Netherlands Antilles was 1.6 percent, however it rose to 2.8 percent in 2010. The status of autonomous however within the Dutch Kingdom both Curaçao and Sint Maarten received as of the 10th of October 2010. The islands agreed that together they will form a
