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The COVID-19 Crisis Response in Panama’s Monetary System

            In 1904, Panama declared its independence from Colombia. The United States actively encouraged this step, hoping for the construction of a canal connecting the Atlantic and Pacific oceans.  Consequently, the United States held considerable power in newly independent Panama to intervene in domestic affairs, including, controversially, the right to guarantee Panamanian sovereignty and preserve order. As a result of this influence, the US dollar became the de facto official currency in Panama. Dollarization can be beneficial, but also introduces complications to responding to financial crises like that triggered by the ongoing COVID-19 pandemic.

Why Dollarize? The Potential Benefits to Dollarization

The benefits of a dollarized economy, where legal authorities adopt the US dollar as an official currency, include fighting inflation and reducing economic uncertainty. Dollarization eliminates both the risk of depreciation of the domestic currency, and expectations of future currency depreciations, both of which can function to accelerate inflation of the domestic currency. Domestic currency depreciation risk is eliminated because there is no domestic currency to depreciate; all domestic currency has been replaced by the US dollar, a historically stable currency. This in turn eliminates expectations of future currency depreciations. Historically, numerous Latin American countries have experienced episodes of large domestic currency depreciation accompanied by very high inflation, making dollarization a compelling solution to a painfully persistent problem. For example, Ecuador dollarized its economy in 2000, when it was facing stagnating economic growth, pressure on domestic oil exporters from falling oil prices, slowdowns of infrastructure and production caused by El Niño, and runaway inflation from an overly accommodative central bank.

The Dollarization Process in Panama

Unlike in Ecuador, dollarization in Panama was a result of their independence process, and was almost entirely exogenous: the United States and France negotiated much of Panama’s creation through Secretary of State John Hay and Phillippe Bunau-Varilla respectively.

The last country in Latin America to officially dollarize was El Salvador in 2001, a more complex case relative to Ecuador, given high volumes of exports to the United States and large numbers of remittances received from the United States in dollars. Like Panama, the motivation to dollarize was not a response to high inflation or some other economic crisis, making comparing the two cases useful in understanding Panama’s dollarization. Officially, the motivation to dollarize in El Salvador was a desire for lower interest rates, higher foreign direct investment, and lower transaction costs, all of which would contribute to economic growth. However, this was not the only motivating factor. El Salvador’s financial sector was most likely to benefit from a dollarized economy as there would no longer be a risk of currency devaluation to maintain El Salvador’s peg. A substantial portion of the membership of the National Republican Alliance (ARENA), the ruling political party at the time, was in the domestic financial sector and entrepreneurial class in El Salvador.

A key difference between Panama and El Salvador is the scale of international bank presence in the economy. Relatively lenient banking regulations in both countries have attracted international banks.  However, a recent IMF report found that of the 79 banks in Panama, 46 were considered “onshore,” with almost two thirds of onshore banks being foreign owned.  By contrast, El Salvador has just 14 banks (two are state-owned, and of the remaining private banks, one is domestically-owned, and eleven are international) for an economy just under half the size of Panama’s. International banks’ heavy presence in Panama should provide the Panamanian economy and financial sector with easy access to dollars. When there is a shortage of dollars in Panama, private banks can transfer dollars from subsidiaries anywhere in the world to meet the excess demand. If there is any excess supply of dollars, banks in Panama can shift that excess to subsidiaries in other countries.

This financial integration with the global economy means that private banks cannot be used for political purposes, unlike traditional central banks, which have been manipulated in this manner in Latin American countries. By extension, private banks in Panama are relatively insulated from domestic crises: any pressures that result in a Panamanian subsidiary from a domestic economic downturn are shared with the larger, international “parent” bank.

A Dollarized Panama and COVID-19 Relief

In theory, dollarization imposes fiscal discipline by preventing governments from printing additional domestic currency to pay for fiscal actions intended to boost economic growth. Dollarization also greatly restricts the domestic central bank’s monetary policy authority and role as the lender of last resort. Because dollarized economies cannot print US dollars, they cannot engage in monetary policy actions that influence the supply of money in their domestic economy, nor can they create money to operate emergency lending programs for banks facing liquidity pressures. While this constraint can result in a more risk-averse banking sector, during crises, when financial conditions tighten, this constraint impedes a government’s ability to support a contracting economy.

Because Panama’s central bank is unable to print more dollars, private banks are the main avenue through which dollars flow into Panama. During the COVID-19 crisis, international banks have sought to reduce risk, stocking up on relatively safe assets like US Treasuries, while reducing risky loans. As a consequence, credit conditions in Panama have tightened considerably. Because of Panama’s dollarized economy, the government could not ease financial conditions in the domestic economy through monetary policy actions, such as rate cuts, emergency lending, or large-scale asset purchases, to the same degree that a comparable country with a central bank able to conduct monetary policy could.  For example, Panama’s northern neighbor, Costa Rica, lowered interest rates from 2.25% to 1.25% on March 17th, with a subsequent decrease of fifty basis points in June of 2020, in addition to an arsenal of fiscal relief.

Because of the constraints resulting from dollarization, the crisis response in Panama has fallen solely to fiscal policy. Panama’s National Assembly has, for example, provided benefits to those who lost jobs and to the self-employed and informal workers; imposed loan repayment moratoriums on residential mortgages, credit card debt, and loans to Small and Medium-sized Enterprises (SME’s); eased tax burdens on businesses and households; created a fund for potential entrepreneurs; and increased the amount of food credits for workers by over 40%. The National Assembly has also taken steps to support the manufacturing sector to reactivate the economy and generate jobs by incentivizing multinational manufacturing companies to increase their presence and investment in Panama through benefits such as tax relief and easier visa processes.

From a public health perspective, Panama’s government has prioritized citizen health, declaring a state of national emergency on March 12th, freeing $50 million for state entities to acquire necessary goods to confront the pandemic and eliminating tariffs on the import of medical supplies, raw materials, and personal hygiene products. The government followed recommendations from the Pan American Health Organization, the World Health Organization’s specialized health agency for the Americas, by issuing a mandatory quarantine on March 23rd, and, when individuals were ignoring the quarantine, taking the controversial step of restricting those allowed in public based on gender, with women allowed to leave their homes on some days and men on others, easing enforceability.

The two other fully dollarized economies in Latin America, Ecuador and El Salvador, have responded similarly to Panama, with El Salvador instituting a strict lockdown only days after the first official case was detected. El Salvador’s government introduced a series of measures, including a cash transfer of $300 intended to support informal workers, suspending bills for basic services like water, electricity, and internet; as well as providing food baskets to those in need. Ecuador instituted programs to expand the social safety net to include a greater number of vulnerable populations, temporarily broadening unemployment insurance, and a cash transfer program, while also introducing price controls for basic food items and allowing citizens to delay payments on tuition, utilities, and health insurance.

How will Panama fund its response?

Government deficits occur when a government spends more than it takes in. Deficits are not always bad, as they can signal capital investment that will result in increased economic growth or tax revenues for government in the future that offset the amount of the current deficit. However, persistent deficits can be problematic as a greater share of government expenditures must be devoted to either paying off the accumulating debt or counterbalancing the deficit. In either scenario, government expenditures on programs that boost economic activity are reduced.

Monetary policy can reduce the strain to fiscal budgets directly by lowering interest rates on debt payments and indirectly by triggering economic activity as a result of the lower rates. Some evidence shows that unconventional monetary policy tools, such as large-scale asset purchases (LSAP) of longer-term securities, can further stimulate the economy even once interest rates have reached their effective lower bound. These LSAP programs can also lower longer-run debt-to-GDP ratios by lowering the interest rates on government bonds, making the servicing of those bonds less expensive than it would otherwise be. In addition, by stimulating the economy, monetary policy can make deficits easier to pay off by increasing tax revenues. However, the restrictions on monetary policy that dollarization imposes mean that not only is Panama’s government unable to trigger economic activity by lowering interest rates in the domestic economy, but pressures on fiscal policy that would have been eased by the lower interest rates remain.

On April 2, 2020, the National Assembly authorized the Ministry of Economy and Finance to increase the fiscal budget deficit to allow the government to pay for public health programs and help Panama recover from the economic crisis brought on by the pandemic. The revised deficit ceiling recommendations were presented on October 19th and passed on October 28th. The recommendations raised Panama’s deficit ceiling from just under 3% to between 9% and 10.5% of GDP for 2020, with deficit as a percent of GDP targets of 7-7.5% this year, 4% in 2022, and 3% in 2023.  Costa Rica ended 2020 with a comparable fiscal deficit of 8.3% of GDP.

Once COVID-19 has passed, Panama’s government will be unable to monetize a portion of the nation’s debt because of the lack of monetary policy tools associated with a dollarized economy. Monetization involves any effort by a government to finance itself by issuing non-interest-bearing liabilities such as currency or non-interest-bearing bank reserves. This inability to monetize leaves fewer options available to the Panamanian government to manage the government debts building up from supporting public health and economic stimulus programs during the pandemic. Developed economies that wish to reduce their debt, without the additional inflationary pressure of deficit monetization caused by printing more money, can pursue a mix of higher taxes and reduced government expenditures. But such policies will be painful for many in Panama given its high levels of inequality and relative lack of development.

Creating an independent central bank capable of conducting monetary policy would require Panama to leave dollarization and expand the use of the balboa, which is currently only used for coins.  However, this would be difficult to accomplish and has no certainty of success. As discussed, many of the typical motivations for dollarizing stem from a belief that a dollarized economy reduces inflation and economic uncertainty. Were Panama to leave dollarization in favor of the balboa, they would then have to reassure domestic consumers and the world that they are capable of controlling inflation, which, since their separation from Colombia a century ago, they have not needed to do. A further complication in any attempt to expand the use of the balboa is the costs associated with changing an entire economy built around the dollar to one independent of it. One option is to pursue policies that to some degree control the exchange rate between balboas and dollars, although other countries in the region have experienced mixed results with managed float policies. Ultimately, the optimal monetary regime depends on country-specific conditions and has no clear consensus in the literature. Floating regimes that allow for monetary policy may handle world production shocks like the economic crisis triggered by the worldwide COVID-19 pandemic, while extremely fixed regimes, such as dollarized economies, fare better than floating regimes in confronting confidence shocks, as dollars are insulated from the domestic crisis. Relying solely on fiscal policy to confront the economic strain triggered by the pandemic can present complications: slower government response times than would be the case with monetary policy, and the politicization of the full scope of coronavirus response. While an effective, independent central bank could allow for a more rapid, more decisive, and less politically charged response to the economic challenges posed by the COVID-19 crisis, it would by no means ensure one, and may introduce unintended consequences and hardship.

The benefits to a dollarized economy can be substantial given the context of many Latin American countries. However, Panama’s decision to dollarize, unlike Ecuador, was not motivated by a desire to realize the benefits of dollarization. Even so, Panama’s response to the economic crisis triggered by COVID-19 presents an opportunity to analyze the major differences between dollarized and floating currencies. The major benefits of dollarization, increased fiscal discipline and removing domestic political considerations from banking issues by relying on private banks for monetary policy, do not occur in international crises. Private banks’ behavior, such as large-scale purchases of relatively safe assets like US Treasuries, does not reflect the actions of a central bank, making crisis response fall solely to fiscal policy. This reliance on fiscal policy strains fiscal discipline by introducing uncertainty as to how governmental responses to crises will be funded, and it may even make repayment of sovereign debts accrued during the crisis more difficult in the future. However, the process necessary to abandon dollarization is complex and introduces uncertainty as well. Even governments with effective monetary policy have struggled to contain the virus and mitigate the economic consequences it has wrought. While there is no indication that such conversations are occurring in Panama, or anywhere else for that matter, policymakers considering substantive changes to exchange rate regimes should appreciate the importance of context-specific conditions in the success or failure of monetary regimes and should be aware of the full range of intended and unintended effects that wholesale changes like moving to or leaving dollarization can create.