Why Does El Salvador Use the U.S. Dollar?

El Salvador was the first independent nation in Latin America to fully adopt the U.S. dollar as its official currency. This economic decision, implemented in 2001, reshaped the country’s financial landscape. Dollarization aimed to foster stability and growth by addressing long-standing economic challenges. This article examines the conditions that led to dollarization, its implementation, and the characteristics of a dollarized economy.

Economic Conditions Prior to Dollarization

Before dollarization, El Salvador faced persistent monetary instability, which eroded the purchasing power of its national currency, the colón. The country experienced high inflation rates, exceeding 20% annually during the 1980s and peaking at over 30% in 1986. This volatile environment made economic planning difficult for businesses and individuals, undermining confidence in the colón.

The depreciation of the colón against the U.S. dollar created challenges. Remittances from Salvadorans living abroad, primarily in the United States, played an important role in the national economy. Converting these U.S. dollar remittances into colones subjected families and the economy to exchange rate fluctuations and transaction costs. By 2001, remittances amounted to approximately 15% of El Salvador’s Gross Domestic Product.

The unstable currency led to high and unpredictable interest rates. For instance, in the mid-1990s, loan interest rates reached 24% even as inflation decreased. Such high borrowing costs hindered domestic investment and economic growth. The lack of a stable financial environment discouraged both local and foreign capital formation.

The Central Reserve Bank of El Salvador faced credibility challenges due to past economic crises and policy inconsistencies. Public trust in the national currency and the central bank’s ability to maintain its value diminished. This erosion of confidence contributed to a preference for holding assets in U.S. dollars, even before official dollarization.

El Salvador’s economic struggles were not unique within Latin America during the late 20th century. The region experienced economic instability, often called the “lost decade” of the 1980s, characterized by high inflation, debt crises, and slow growth. Many Latin American countries borrowed heavily from international creditors, and rising global interest rates in the late 1970s and early 1980s exacerbated their debt burdens. This regional context provided a backdrop for El Salvador’s consideration of a drastic monetary shift.

The Dollarization Implementation

El Salvador transitioned to the U.S. dollar via the Monetary Integration Law, approved by the Legislative Assembly in November 2000. The law set January 1, 2001, as the effective date for the U.S. dollar to become legal tender. It aimed to stabilize the economy, attract foreign investment, and reduce transaction costs, particularly those related to international trade and remittances.

The Monetary Integration Law established a fixed exchange rate. The colón was converted to the U.S. dollar at a rate of 8.75 colones to 1 U.S. dollar. This fixed rate eliminated exchange rate risk for transactions within El Salvador, providing a predictable financial environment for businesses and consumers.

Following the law’s enactment, both the U.S. dollar and the colón circulated simultaneously. The U.S. dollar gradually replaced the colón as the primary medium of exchange. The Central Reserve Bank of El Salvador stopped issuing new colón currency in 2001, and colón banknotes largely disappeared from circulation within months due to lack of demand.

With dollarization, the role of the Central Reserve Bank of El Salvador changed. It no longer possessed an independent monetary policy. Its primary functions shifted to maintaining financial system stability, managing international reserves, and serving as the financial agent of the state.

Efforts were made to inform the public about the transition, though initial adoption faced some public protest. The change required Salvadorans to adapt to new conversion values and understand the implications for their daily transactions. Despite initial resistance, the government facilitated a smooth changeover to the new currency regime.

Economic Characteristics of a Dollarized Economy

Dollarization in El Salvador contributed to lower and more stable inflation rates. Before 2001, inflation was often high; after dollarization, it remained closer to that of the United States. This stability helps preserve purchasing power and fosters a more predictable economic environment for businesses and consumers.

The reduction in currency risk associated with dollarization led to lower and more predictable interest rates. Commercial bank interest rates declined by an estimated 4 to 5 percentage points due to the elimination of devaluation risk. This reduction in borrowing costs can attract foreign investment and stimulate domestic lending, leading to increased economic activity.

A stable currency environment makes a country more attractive to foreign direct investment (FDI) and facilitates international trade. By eliminating exchange rate volatility, dollarization reduces uncertainty for foreign investors and traders, encouraging greater capital flows and commercial integration. El Salvador saw a notable increase in FDI as a percentage of Gross Fixed Capital Formation after dollarization.

A consequence of dollarization is the loss of monetary policy independence. El Salvador’s Central Reserve Bank can no longer print money, devalue the currency, or use interest rates to stimulate or cool the economy. This means the country cannot respond to economic shocks through traditional monetary policy, relying instead on fiscal policy or external support.

The inability to print money to finance government deficits enforces greater fiscal discipline. Governments in dollarized economies must rely on tax revenues or borrowing from financial markets, encouraging more prudent spending and debt management. This constraint leads to a more conservative fiscal approach, as inflationary financing is no longer an option.

Without an independent monetary policy, El Salvador’s economy becomes more susceptible to external shocks. Changes in U.S. interest rates or economic downturns in the United States can directly impact El Salvador without the buffer of a flexible exchange rate or independent monetary tools. The close synchronization of economic cycles with the U.S. has become more pronounced since dollarization.

The inability to devalue the currency impacts export competitiveness. In a dollarized economy, a country cannot intentionally make its exports cheaper by devaluing its currency. This makes Salvadoran goods relatively more expensive on the international market if other countries devalue their currencies.