by Paul Smith
There is more to it than just saying the U.S. dollar is Panama’s currency and this is the justification for investing there. Yes, there is no inconvertibility risk in Panama. Yes, the U.S. dollar is used as the national currency and remittances abroad of capital and earnings are unrestricted. So are incoming payments. But what else is there?
Panama’s banking and monetary system are defined by two essential elements that produce financial integration with international markets: its own monetary system that uses the U.S. dollar as the national currency and the participation of international banks. The results are a performance equal to the optimum monetary policy, but without any government intervention. Financial integration produces low interest rates and almost unlimited credit for all economic sectors. The system is stable with low inflation and without macroeconomic or banking crises. The system is attractive to foreign investors for direct investment and financial investment because of its stability, the absence of exchange or inconvertibility risk and financial crises. These factors attract more foreign investment and therefore tend to produce greater growth.
Market mechanisms alone resolve the macroeconomic and monetary issues without the complications, imbalances, problems, and crises common in the managed systems. Prices remain at their equilibrium level. The problems produced by over-borrowing become plainly visible to the government managers. Budget deficits cannot be financed by creating money, leaving only tax increases. The system introduces rationality in public expenditures, avoiding over-spending, large losses by the state agencies, or subsidies of products and production, all of which would generate large budget deficits.
In the mid 1980s after the 1982 debt crisis, many Latin American governments were faced with unmanageable budget deficits created in part by policies of subsidizing certain costs to the consumers. Some of these subsidies were applied to the price of petroleum and its derivatives like gasoline and cooking gas, and to electric power, telephone services, bus fares through the subsidy of gasoline, and others. When these economies were forced to make the structural adjustments required for survival, the prices of these goods and services were adjusted upward to reflect international prices accompanied by a forced devaluation. There were also effects on the availability of credit and on loan interest rates. The common reaction to these adjustments was widespread rioting, looting, and political instability in many countries. In other emerging economies price distortions give false signals creating perverse incentives that induce excessive external borrowing and high risk-taking. These are some of the factors behind sharp devaluations and macroeconomic crises.
Panama was not affected in this way because of the adjustment mechanisms available in our monetary system and the fact that the government had not subsidized prices to the consumers of the products and services mentioned. To the contrary, the military government had early on increased the prices of the public utility services as a source of general funding. It had passed on to the consumer the price increases caused by the 1973 and 1979 oil shocks, avoiding the social consequences of the costly structural adjustments experienced by other countries. The decision to pass on the petroleum prices was made necessary because the government did not have access to the resources to finance the budget deficit a subsidy would have caused. The Panamanian people saw that the price increases were not caused by any action of their government and therefore accepted the price increases and made their individual adjustments.
The Panamanian consumer tolerates shocks for three important reasons: because his experience has been that financial shocks do not affect the value of the local currency against the dollar so there cannot be a devaluation and therefore the level of his savings is not affected; shocks have not affected the availability of credit except momentarily; and interest rates have remained stable over the long term allowing him to borrow for housing. Evidence of the Panamanians’ confidence in their monetary system is, uniquely for Latin America, the great volume of home mortgage loans outstanding, collectively the best quality loan portfolio of the banking system.
The system has effective self-adjusting mechanisms for shocks. Financial integration with the international markets allows the use of external financial resources when required and it avoids that political crises turn into economic crises through the banking system. Also, the Panamanian system requires less international reserves than those required in an autonomous system. Panama’s system is less expensive to operate, it does not require a costly supervisory organization, nor does it bear the expense of maintaining a central bank.
It is important to recognize that it is not dollarization per se that has brought so much stability to Panama, but rather dollarization together with a financial center that allowed Panama’s monetary system to integrate with the world financial markets. As a result, the Panamanian financial system is characterized by a large number of international banks that are indifferent at the margin between lending their resources in the local market or placing them abroad. This gives rise to financial integration. In Panama, banks play an essential balancing role by continuously adjusting their local and external portfolios in response to market forces. Confronting an excess supply of funds, banks fund profitable projects (at acceptable levels of risk) and place excess liquidity abroad. As a result, the adjustment mechanism for the economy is brought about through changes in the banks’ net foreign placements and investments instead of by selective interest rate changes by a monetary authority to manage the demand for financial resources within Panama. Because money that cannot be lent prudently within the country flows back out, Panama avoids a build-up of net domestic credit that might otherwise cause inflationary pressure. Even large inflows or outflows of capital have not significantly altered the price level.
This contrasts sharply with developing economies where the government blocks financial integration and protects local banks from international competition. It also draws attention to the very bad advice that some policy makers have given in favor of capital controls. It is precisely full capital mobility that provides the safety valve for excess funds. As to a deficiency of funds, sudden outflows in anticipation of a devaluation are unheard of because of the fact that uncertainty about the value of the currency is not in play.
Panama’s macroeconomic stability is, in large part, the result of a money supply that is demand determined instead of supply determined by government policy; the case in most countries. Thus, the Federal Reserve does not run Panama’s monetary policy. Fed policy affects Panama only to the degree that it affects all countries by altering the global supply of dollars, the international reserve currency, or by affecting global interest rates. Panama’s financial integration creates market-determined prices in the real exchange rate, interest rates, asset prices, and arguably real wages. As a result, financial decisions such as borrowing or the quantity of money held are in equilibrium. The banking system takes funds from the local or international markets to meet loan demand. It does not store excess funds for the eventuality that there might be loan demand.
One myth about dollarizing is that it fosters instability in the banking system and creates the need for a lender of last resort or a large amount of reserves to support the system. The Panamanian case refutes this. In Panama, the government has no responsibility for stepping up to rescue banks, nor does it have the means to do it. There are no legal reserve requirements on deposits that serve as a liquidity reserve, nor is there deposit insurance. Despite this, there has never been a systemic bank crisis. Indeed, in several instances international banks have acted as the system’s lenders of last resort. Another concern is the loss of seigniorage to a government - what the central bank books as income on the difference between the cost of printing currency and its face value. Offsetting the loss of seigniorage for Panamanians is the fact that smaller foreign reserve balances are needed than if a national currency were in use.
Those countries that have created monetary boards and have continued to issue their own currency backed 100 percent by dollars are not really dollarized. Their citizens do not have absolute confidence that the government will not undo the monetary board and devalue despite all the promises made. The only way to dollarize is to dollarize the currency and all the legal apparatus that supports the dollar as a national currency. I call it burning the ships. Dollarization with integration contributes to price stability and robust capital inflows and promotes high growth. Any competitive economy needs a competitive microeconomic environment through the elimination of trade barriers, less regulation, lower taxes, free prices, a stable currency, and minimal government ownership.
The great capitals of South America look tired, run down, and unkempt because the investors in old real estate do not want to make the investment in repairs of buildings and sidewalks in the face of an inflationary climate. This fear of inflation prevents long range planning and investment in favor of day to day speculation for survival against devaluations. Visitors to Panama City admire a skyline that rival’s Rio’s, except that ours is much newer.
Paul Smith, is a past-President of PanamCham, and a Vice-President of the
Association of American Chambers of Commerce in Latin America
Article Courtesy of Business Panama
The American Chamber of Commerce (AMCHAM)
and Deal Inc.
