In 2001, El Salvador abandoned its own currency for the US dollar. Business Week has a good article describing how turning over your monetary policy to the US Federal Reserve Board may not be such a good idea. Here is an excerpt:
Yet El Salvador may still be in for a dollar-induced shock. That's because the government has effectively forfeited control of its monetary supply to the U.S. Federal Reserve. While the Fed was busy cutting rates to stimulate growth after September 11, that proved to be a boon. But with U.S. rates rising, dollarized nations like El Salvador are at risk for a credit crunch....
Of course, higher rates will help counter inflation from rising energy costs. And a moderate rise in interest rates is unlikely to sink El Salvador's economy, since two-thirds of its trade is with the U.S. A potentially far greater threat is the loss of a safety lever in the form of currency devaluation. Since El Salvador uses the dollar, it can't devalue to export itself out of a slump -- or issue debt in its own currency. That could come to haunt the country by making its exports more expensive -- and imports cheaper -- when neighboring countries' currencies depreciate against the dollar.
Not being able to use money supply to stimulate growth is a problem, since the switch to dollars has done little to boost gross domestic product. GDP growth has averaged 1.9% over the past five years -- the most sluggish of any Central American country. What's more, dollarization hasn't improved the lot of the poor. Half of El Salvador's population still lives in poverty, leaving many exposed to hardship if the economy stalls. "For poor people like me, dollarization hasn't worked at all," says Samuel Renderos, a 70-year-old retired bus driver. "Basic necessities all got more expensive when we moved to the dollar."
Economists say El Salvador needs to gird its economy by improving education and worker training, and encouraging more private investment in basic infrastructure projects. "Dollarization was a vehicle to broaden their integration with the global economy, but additional reforms have to be deepened," says Mario Garza, the International Monetary Fund's chief of mission for El Salvador. Only then, he says, will dollarization make a difference for ordinary Salvadorans.
NOTE -- Click on the comments link for an extended discussion about dollarization and poverty.