The rise of Cryptocurrency has been a highly debated topic ever since this day with the DEFI community seeing it as a much more efficient method of payment while the traditional worlds see it as a threat to the current systems. We recently stumbled upon an article by COINDESK titled “Indian Central Bank Says Cryptos Could Lead To ‘Dollarization’ of Economy” and examine what the term “Dollarization” actually means in our economy? And Can Crypto lead to “Dollarization”?
What is Dollarization?
Cryptocurrency and fiat currency such as the Dollar were always meant to coexist. Seeing as Cryptocurrency would help facilitate the transition of our payment system in the digital era but somehow that is not always the case. The Dollar has always been the preferred method of exchange for international trade for over 50 years now and to understand the term Dollarization better we need to rewind our history of money to the Bretton Woods System.
The first US Dollar was issued shortly after the Federal Reserve act in 1913 which also led to the creation of the Federal Reserve and the current monetary system we know today. This system was obviously created to replace the traditional system where every bank issued its currency. This was also the time when the US economy grew to be the largest in the world, surpassing Russia and U.K although Europe was still the major destination for commerce.
This balance of power further shifted to the US and its Dollar when World War 1 broke out as most developed countries had to suspend their use of the gold standard to print more paper money and fund the war expenses. While the United Kingdom held to the gold standard, who maintained its position as the world’s leading currency had to find itself borrowing money for the first time during the third year of the war. The United States became the lender of choice for the United Kingdom and other countries in need of US Dollar bonds, unfortunately, the United Kingdom had to abandon the gold standard in 1931.
Although the USA entered after the combat began, they were the Allies’ main supplier for ammunition and machinery. As other currencies began to devalue because of excessive printing, the US started getting paid in Gold and therefore shifting the world’s gold reserves towards the United States. This is when the Bretton Woods System was created where delegates from 44 countries agreed to back their currencies with the US Dollar while the US Dollar itself would be backed by its gold reserves. This provided a much more streamlined foreign exchange system but it also gave rise to the US Dollar as the International Currency.
Of course, as we know the Bretton Woods system didn’t last long, as in 1971, President Richard Nixon took the dollar of its gold backing and gave rise to the free-floating currencies. Now, why is this a problem you may ask? This is a significant issue because even though the US Dollar no longer has its Gold Backing but it is still used as currency for Global Trade.
From what we know in economics, the value of anything comes from the relation of demand and supply so this is the same case with our currency. Because our currency does not have a real intrinsic value anymore, which in the case is gold, its value is determined by the demand and supply from the economy and other countries. Too much of a currency supply compares to the demand from the economy and the current will depreciate, this also applies otherwise where there is much more demand than its supply which will result in the currency appreciating. Now, what does all this have to do with Dollarization? Dollarization is the term for when the U.S. dollar is used in addition to or instead of the domestic currency of another country.
Since the US Dollar is more in demand than the domestic currency of a country, means that the US Dollar will appreciate because of higher demand while the domestic currency depreciates. This is how the relation of the US Dollar affects other currencies as in a foreign exchange market when a currency appreciates, the other depreciates.
Is this good? Dollarization is good in a certain way that it keeps the Dollar and the domestic currency at an affordable rate as it continuously depreciates and appreciates. It also encourages foreign investment and therefore also helps in lowering inflation rates. But dollarization taken to the extreme can also be a recipe for disaster as the domestic currency could be in threat of having no value compared to the dollar. Take the Crisis in Sri Lanka for example where the Sri Lankan Rupee has lost more than 44% of its value to the US Dollar.
With this in mind, Dollarization has its benefits and flaws but how does this concept relate to the crypto space? And is the crypto space a factor in dollarization?
How does it relate to crypto?
The Crypto Space has built itself to be a decentralized world that is free from the traditional economy but the link will always be there as we are still not living in the metaverse yet. Most of our day-to-day activities are done using fiat currency and the US Dollar is one of those currencies used frequently as our payment method.
Now in the crypto space, there are a couple of ways in which you can acquire a cryptocurrency, and it’s either a Centralized Exchange, Decentralized Exchange, or other platforms such as Mining and Staking. It is clear that most cryptocurrencies or NFTs are acquired through Centralized Platforms and these platforms will require you to deposit fiat money in your cold wallet. So there is a massive link between the DeFi world and fiat money.
Now looking at the perspective that most of our cryptocurrency on Listing sites or International Exchanges are denominated in US Dollars, it is fair to see why the crypto space could lead to dollarization. As National Banks may have found it hard to measure the number of US Dollars concerning the domestic currency circulating in the country which will make it difficult to determine a proper monetary system.
This is also true when we see it from the perspective that US Dollar based Stable coins are among the top-ranking coins and are frequently used in the market due to their stability. But it also has to be seen that domestic currency is still used onboard new users on domestic exchanges and also international exchanges like Binance have enabled the use of domestic currency in selected countries.
The growing regulations that are established on exchanges, also open the possibility of receiving the data of domestic currency circulating around from exchanges and for CBDCs to be used in onboarding new users’ deposits. So, while it is a factor that could lead to Dollarization due to foreign exchanges, it also is a platform that establishes a new world for any domestic innovator who wants to take a stride. The question is who will take the opportunity?
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