On the sustainability of euroisation/ dollarisation regimes: how important are fiscal transfers,...

INTRODUCTION

Euroisation/dollarisation has become a prominent issue in the debate on strengthening the international financial architecture, as it is seen as one of the few sustainable exchange rate regimes in a world of increasing capital mobility (Calvo, 1999, 2001; Fischer, 2001). Indeed,

While most of the recent cases of euroisation/dollarisation were motivated by short-term macroeconomic stabilisation benefits, integration among currency union (CU) members is seen as a key prerequisite for the long-term sustainability of a common currency. In Europe, the question whether integration was deep enough to cope with asymmetric shocks has even been at the core of the debate on pros and cons of monetary union (Bayoumi and Eichengreen, 1993). According to the endogeneity view on optimum currency areas (OCA), however, integration can be seen as a consequence rather prerequisite for a sustainable currency union, because due to lower transaction costs a common currency itself may endogenously lead to a large increase in trade among union members. This view received support from studies by Rose (2000) and co-authors, who found that trade among countries with a common currency far exceeds trade between countries using different currencies.

This paper takes a closer look at the set of countries and jurisdictions that have been members of a currency union, either in the form of unilateral euroisation/dollarisation or in the form of a multilateral currency union. In particular, the paper investigates whether they have followed additional policies fostering integration, thereby supporting the sustainability of their exchange rate regime. The findings suggest that in addition to possible trade effects of a single currency, three policies have been at work in most cases considered: (1) substantial fiscal transfers from the anchor country; (2) financial integration via the establishment of offshore financial centres; and (3) real integration via tourism. These policies largely relied on factors exogenous to the monetary regime--such as strong historical and political ties with the anchor country, size, geographical location and political stability. As these factors cannot be assumed to be given for many other countries, the paper concludes that some caution might indeed be warranted when using the experience of sustained cases of euroisation/dollarisation as an example supporting the endogeneity view of optimum currency areas.

The paper is structured as follows. The main issues of the current debate on euroisation/dollarisation are summarised. Then an overview of the sustained cases of euroisation/dollarisation is provided. Next the three specific features mentioned above are reviewed: financial dependence through official development assistance or outright subsidies; offshore financial centres; and tourism. The final section concludes the paper.

CURRENT DEBATE ON EUROISATION/DOLLARISATION

Officially adopting a foreign country's currency has become a repeated piece of advice for many emerging market economies as a result of the recent currency and financial crises. Similar to the arguments put forward by the 'new' view on OCA, developed in the 1980s and early 1990s (Mongelli, 2002), euroisation/dollarisation is seen as an appropriate exchange rate regime for countries with a low degree of credibility of domestic monetary policy. This is because under these circumstances the use of an independent domestic monetary policy as a stabilisation tool is either very costly (Barro and Gordon, 1983), crisis-prone (Fischer, 2001), or ineffective (Jeanne and Wyplosz, 2001; Hausmann et al., 1999). Adopting a foreign currency is seen as an instrument of stabilisation, providing credibility, allowing for lower interest rates, fostering financial development and supporting non-inflationary growth.

In the past, however, only a few countries have opted for euroisation/ dollarisation. This can be explained, inter alia, by the 'old' view on OCAs (Mongelli, 2002), arguing that only those countries that show a high degree of real and financial integration are suitable candidates for a currency union. (4) The reason is that only with a high level of integration can a country forego domestic monetary policy when other adjustment mechanisms, such as price and wage flexibility or fiscal transfers, are weak or non-existent. Since--with the exception of the EU--such a high level of integration is quite uncommon (IMF, 2002), the potential costs of adopting a foreign currency or of forming a currency union seem in many cases to exceed the potential benefits (Berg et al., 2002).

Recently, however, it has been argued that the level of integration between countries is endogenous, rather than exogenous, to the exchange rate arrangement (Frankel and Rose, 1998; Rose and Engel, 2000; Dallas and Tavlas, 2001). In particular, trade integration is likely to deepen owing to lower transaction costs and the elimination of exchange rate uncertainty. Hence, the 'endogeneity view' on OCAs suggests that the sustainability of a common currency is, at least partly, supported by the exchange rate arrangement itself.

This reasoning has received support from the work by Rose and co-authors (eg Rose, 2000, 2001; Rose and Engel, 2000; Glick and Rose, 2001). Using a gravity model of trade, they show that two countries sharing a common currency trade far more, perhaps over three times as much, than comparable countries with different currencies. The results are statistically significant and robust with regard to other variables potentially affecting trade flows (eg free trade area, common border, language, same former colonial relationship, size, landlocked countries, islands, etc) and sample size. Hence euroisation/dollarisation would be associated with enhanced economic integration, diminishing the need for domestic monetary policy as an adjustment mechanism. (5)

SUSTAINED CASES OF EUROISATION/DOLLARISATION

The Rose results had a large impact on the debate on pros and cons of euroisation/dollarisation. Hence, it is useful to take a closer look at the sample of so-called CU countries, from which the policy conclusions have been derived. The sample (6) includes

* cases of euroisation/dollarisation in a strict sense, that is, countries and jurisdictions that adopted the euro/US dollar (or a euro legacy currency) as legal tender.

* cases where other third currencies (eg, those of Australia, New Zealand, Denmark, India, South Africa, Switzerland, the United Kingdom or New Zealand) were adopted;

* countries and jurisdictions that form a regional currency union, like the CFA franc zone and the East Caribbean Currency Area (ECCA).

Looking at the full sample of all the three groups mentioned, one of the most striking characteristics is the small size of the countries concerned. The economies, except Panama and some CFA and ECCA countries, are mostly small, with many of them being microstates with a population of less than 100,000 (Table 1). Despite the many control variables used by Rose and coauthors, this feature of the sample has raised doubts on the general validity of the policy conclusion the results seem to imply (Quah, 2000; IMF, 2000b; Edwards and Magendzo, 2002). (7)

The small size of most CU members is of importance, as it is known that small states do indeed have economic characteristics that distinguish them from larger countries (Kose and Prasad, 2002; Easterly and Kraay, 2000). (8) For example, they are in general more open to trade than larger countries. Moreover, they tend to have highly specialised production and export structures and hence seem to be more vulnerable to external shocks. And, indeed, a high degree of openness and a high specialisation of trade characterise the sample of CU members (Rose and Engel, 2000). In addition, they are found to have sizeable trade and current account deficits.

From a traditional OCA perspective, these characteristics have a mixed bearing on the sustainability of a common currency. A high degree of openness is associated with a lesser need for having an independent domestic monetary policy available to adjust to asymmetric shocks, whereas a higher degree of specialisation is associated with a greater need. However, large trade and current account deficits are generally perceived as a serious risk for the sustainability of a common currency (De Grauwe, 2000).

In view of these characteristics, how have countries that euroised/ dollarised a long time ago been able to maintain the exchange rate regime? Were trade effects of the common currency the only mechanism supporting its sustainability or were other mechanisms used to support the common currency? A closer review of some features of the sample of currency unions suggests that fiscal transfers from the respective anchor countries, and policies aimed at fostering financial and real integration via the establishment of offshore centres and the development of a tourism-intensive economy have been important elements. (9)

SPECIAL FEATURES: FISCAL TRANSFERS, OFFSHORE ACTIVITIES OR TOURISM

Role of fiscal transfers

Aid dependency is a general characteristic of many small states (Kose and Prasad, 2002). Since most countries and jurisdictions sharing a common currency are small, it is not surprising to find that approximately one-half of the economies receive transfers either in terms of development aid or subsidies in such an amount that they can be considered as financially dependent countries (Table 2). (10)

In fact, a majority of countries dependent on official development assistance (ODA) are members of currency unions. (11) In most of the cases (31 out of 35) the major donor and provider of subsidies is the respective anchor country (eg, France in the case of the CFA Franc Zone countries). Moreover, the degree of dependency is extraordinary (see Table A1 in the Appendix). For example, the islands in the North Pacific, the Danish and French dependencies have received subsidies from their respective anchor countries, the United States, Denmark and France, to an extent that their relatively high per capita GDP depends to significant extent on this support. In the case of several countries of the CFA Franc zone, France has been providing about one-third of the sizeable official development assistance funds to the respective countries.

It is well known that the 'old' view on OCAs has stressed the importance of fiscal transfers among currency union members as a mechanism to substitute for domestic monetary policy as an adjustment mechanism in the case of asymmetric shocks. Hence, the fact that almost one-half of the sustained cases of euroisation/dollarisation are financially dependent countries seems to constitute an important element in explaining why these countries have been able to sustain the exchange rate regime. Moreover, as substantial transfers are associated with strong political and historical ties between the euroised/dollarised country or jurisdiction and the respective anchor country, it is unlikely that many countries considering euroisation/ dollarisation today would be able to draw on such support from the respective anchor countries.

Offshore financial activities

The second pertinent feature of euroised/dollarised countries and members of regional currency arrangements is the fact that many of them are offshore financial centres (OFCs). (12) The list of countries consists of most European microstates, ECCA countries and other dollarised islands in the Caribbean and the Pacific (Table 3).

Being an offshore centre implies a strong degree of financial integration, as total cross-border assets and liabilities of banks in all offshore centres are estimated at around USD 2.3 trillion (FSF, 2000), (13) accounting for roughly 25% of total cross border-assets (IMF, 2000a). Limited information available, for example for the Crown Dependencies (UK Home Office 1998), that is, Jersey, Guernsey and Isle of Man, and the European microstates, suggests that funds from residents of the respective anchor countries constitute the largest share of assets managed in euroised/dollarised OFCs. Hence, even although there is a tendency of internationalisation, the development of OFCs seems largely to depend on geographical proximity to major economies (IMF, 2000a), which are in most cases of euroised/dollarised OFCs the respective anchor countries.

The 'old' view on OCAs identified a strong degree of financial integration as another adjustment mechanism countries might draw on in the case of asymmetric shocks, e.g. through capital inflows that can be reverted when the shock is over (Mongelli, 2002). (14) This is why the establishment of an offshore centre, leading to a high degree of financial integration, can be interpreted as a mechanism that reduced the need for domestic monetary policy as an adjustment tool). (15)

However, not any country is in a position to establish a successful offshore financial sector. Rather, small size, location and political stability seem to be indispensable factors, indicating that countries and jurisdictions that were able to establish sizeable offshore activities are indeed very special. In particular, political stability seems to be a conditio sine qua non for financial integration in general (IMF, 2002), as tax and regulatory incentives provided by offshore centres would be of secondary importance if investors felt that their funds were at political risk. Finally, it should be noted that the policy of financial integration by establishing OFCs has recently come under much more scrutiny, as OFCs have been called to comply with internationally accepted standards (FSF, 2000).

ROLE OF TOURISM

A third widespread characteristic among many CU countries is the significance of tourism as a source of national income. Table 4 reports a list of 'highly touristic' countries and territories, defined as those countries in which annual overnight visitors exceed the population of the country. (16) Exactly one-half of the countries and territories with this characteristic are CU members. In fact, of the top 10 countries in terms of tourism activity, seven are part of currency unions.

Moreover, for several euroised/dollarised countries, that is, the European microstates and the Caribbean islands, tourism receipts account for a large share of national income, contributing for most of them between 15% of GDP and 65% of GDP.

From an OCA perspective this is an important finding, as tourism can be regarded as a special kind of real integration between currency union members. Indeed, available data suggest that a greater proportion of tourists to CU countries comes from the anchor country (see Table A2 in the Appendix). (17) For example, tourists from the United States account for roughly 40% of stay-over arrivals in ECCA countries. Moreover, foreign exchange earnings from tourism contribute to improve the balance of payments situation and therefore facilitate the surpluses required to import high-powered money. Finally, as tourism expenditures tend to be heavily dependent on the economic situation of OECD countries, this would explain the synchronisation of business cycles among CU members.

Of course, as in the case of offshore activities, the development of tourism facilities were not primarily motivated by considerations related to the sustainability of the exchange rate regime but were part of the development strategy of the respective countries. However, tourism can be regarded as an important factor in the analysis of sustained cases of euroisation/dollarisation as it represents a policy initiative aimed at fostering real integration between the euroised/dollarised economies and their respective anchor countries. (18)

Obviously, the development of a significant tourist industry, at least partly, depends on rather special factors exogenous to the exchange rate regime, like location, natural beauty and political stability. Hence, the fact that many of the existing cases of euroisation/dollarisation are tourism-intensive economies suggests that integration between euroised/dollarised countries and their respective anchor countries has not been driven by a purely 'endogenous' component related to the common currency.

SUMMARY AND CONCLUSION

Over the last few years, the pros and cons of euroisation/dollarisation have been intensively debated among academics and international policy-makers alike. In this regard, the papers by Rose and co-authors have been highly influential, as the results of their econometric analyses suggest that countries sharing a common currency tend to trade among themselves far more intensively than countries that use different currencies. This has been interpreted as evidence in favour of the endogeneity hypothesis, according to which countries may satisfy OCA properties ex post even if they do not exante. However, as the group of sustained euroised/dollarised countries and jurisdictions is mainly composed of very small states and jurisdictions, there is a controversial discussion on whether the results can be generalised and whether policy conclusions can be derived for other, larger countries.

This paper aimed at shedding some light on this issue by taking a closer look at the sustained cases. As already mentioned in the literature, CU members are small, politically stable and/or dependent as well as open economies. However, other characteristics have largely gone unnoticed so far, with three of them being substantial financial dependence on the respective anchor country, a high degree of financial integration via the establishment of offshore centres, and real integration by the development of a tourism-intensive economy. Out of the 75 cases for which the relevant data are available, 60 display at least one and 40 display at least two of these features.

These characteristics can be easily linked to OCA properties stressed by the 'old' view on optimum currency areas. According to this view, OCAs can be identified by certain properties exogenous to the exchange rate regime like fiscal transfers, real and financial integration. Hence, it is reasonable to assume that fiscal transfers from the respective anchor countries, the establishment of offshore centres and the development of tourism have been supportive to the sustainability of the exchange rate regime in the cases under study.

We think this evidence lends support to the view that some caution may be warranted in using the experience of sustained cases of euroisation/ dollarisation as a reference for other countries. First, in addition to the trade enhancing effect of a common currency, there seem to have been other adjustment and integration mechanisms at work that made the exchange rate regime sustainable. Hence, there has not been only an 'endogenous', but also an exogenous component of integration, based on supportive policies unrelated to the exchange rate regime. Second, fiscal transfers, offshore financial activities and tourism development seem to be rather special adjustment and integration mechanisms as they largely depend on (1) strong political and historical ties between anchor countries and euroised/dollarised countries and on (2) size, location, natural beauty and political stability.

This suggests that many countries considering euroisation/dollarisation today would not be able to employ the mechanisms the existing cases of euroisation/dollarisation have been using. Instead, they would have to use the more 'traditional' instruments that are usually considered when assessing the 'optimality' of a proposed currency union or a euroisation/dollarisation decision, like trade integration, factor mobility and price and wage flexibility. For many cases, in particular larger countries, these assessments come to the conclusion that a currency union or euroisation/dollarisation is most likely not advisable, explaining why in the past we have indeed observed this exchange rate regime mainly in small countries and jurisdictions.

APPENDIX

Table A1: Countries dependent on official development assistance

                     Dollarised/Euroised/CU countries (a)

                     ODA (b)    Share       Complementary qualitative
                      (as %   of largest          evidence (c)
                     of GNI)   donor in
                              total ODA

American Samoa         n/a       n/a      'Important financial
                                          support from the US'
Benin                  11%       20%

Bhutan                 12%       30%

Burkina Faso           14%       25%

Central Afr. Rep.      8%        40%

Chad                   10%       34%

Comoros                9%        37%

Cook Islands           n/a       n/a      '13.1 million (1995);
                                          New Zealand continues to
                                          furnish the greater part'

Faroe Islands          n/a       n/a      '135 million annual subsidy
                                          from Denmark (1999)'

French Guiana          n/a       n/a      'The economy is tied closely
                                          to that of France through
                                          subsidies'

French Polynesia       9%        99%

Greenland              n/a       n/a      'Substantial support from
                                          Denmark'

Guadeloupe             n/a       n/a      'Depends on France for
                                          large subsidies'

Guam                   n/a       n/a      'Large transfer payments
                                          from the US'

Guinea-Bissau          38%       20%

Kiribati               22%       34%

Marshall Islands       57%       n/a      'Approx. 65 m annually
                                          from the US'

Martinique             n/a       n/a      'Substantial annual
                                          aid from France

Mayotte                n/a       n/a      'Extensive French
                                          financial assistance'

Micronesia, Federal    40%       n/a      'US provided' 1.3 billion in
States                                    grant aid during the period
                                          1986-2001'

Montserrat             n/a       n/a      'UK committed to a 3-year
                                          125 million aid program
                                          in 1999'

New Caledonia          10%       99%

Niger                  11%       29%

Niue                   n/a       n/a      'Critically needed
                                          grants from N. Zealand'

N. Mariana Islands     n/a       n/a      'Substantial financial
                                          assistance from US'

Palau                  21%       n/a

Reunion                n/a       n/a      'Depends heavily on continued
                                          financial assistance from
                                          France'.

Saint Helena           n/a       n/a      'The economy depends largely
                                          on financial assistance from
                                          the UK'

St Pierre and          n/a       n/a      'The islands are heavily
Miquelon                                  subsidised by France'

Senegal                10%       38%

Togo                   6%        34%

Tokelau                n/a       n/a      'Aid from New Zealand
                                          is greater than GDP'

Tonga                  12%       29%

Tuvalu                 n/a       n/a      'Substantial income is
                                          received annually from
                                          an international trust
                                          fund established in 1987
                                          by Australia, NZ, and the UK'

Wallis and Futuna      n/a       n/a      'Revenues come from French
                                          Government subsidies, etc'.

Sources: OECD, CIA Notes: (a) as defined in Table 1 above;
(b) 2000 or latest available OECD data; (c) CIA World Factbook

Table A2: Highly touristic countries

                       Dollarised/Euroised/CU   Share of visitors from
                       countries (a) Overnight   country with highest
                        visitors (b) (as % of   no. of visitors (c) (%)
                             population)

Andorra                         4361                     n/a
Anguilla                         363                      57
Antigua and Barbuda              346                      31
Bahamas                          536                      82
Barbados                         198                      42
Bermuda                          517                      77
British Virgin Is.              1350                      60
Cook Islands                     354                      30
Grenada                          145                      25
Guadeloupe                       144                      66
Guam                             817                      81
Liechtenstein                    191                      38
Martinique                       126                      80
Monaco                           942                      24
Montserrat                       132                      22
N. Mariana Is.                   693                      71
Palau                            304                      38
Saint Kitts and Nevis            178                      41
Saint Lucia                      171                      36
Turks and Caicos Is.             839                      74
Virgin Islands                   497                      82

Sources: World Tourism Organization (2002)

Notes: (a) as defined above; (b) latest year for which data
are available; (c) country with highest number of visitors
coincides with anchor country in all but the following cases:
Guam, Northern Mariana Islands and Palau which are anchored
to the US dollar but attract mostly Japanese tourists possibly
due to their geographical location and Liechtenstein (anchored
to the Swiss Franc, but receiving most visitors from Germany)

Table 1: Euroisation/dollarisation regimes

   Euroised countries                        Population

 1 Kosova                                     1,900,000
 2 Reunion                                      732,570
 3 Montenegro                                   680,158
 4 Guade loupe                                  431,170
 5 Martinique                                   418,454
 6 French Polynesia                             253,506
 7 New Caledonia                                204,863
 8 French Guiana                                177,562
 9 Mayotte                                      163,366
10 Andorra                                       67,627
11 Monaco                                        31,842
12 San Marino                                    27,336
13 Wallis and Futuna                             15,435
14 St. Pierre and Miquelon                        6,928
15 Vatican City                                     890

   Dollarised countries                      Population

 1 Ecuador                                   12,920,092
 2 El Salvador                                6,237,662
 3 Puerto Rico                                3,937,316
 4 Liberia                                    3,225,837
 5 Panama                                     2,845,647
 6 East Timor                                   890,000
 7 Bahamas                                      297,852
 8 Barbados                                     275,330
 9 Belize                                       256,062
10 Guam                                         157,557
11 Micronesia, Fed. States                      134,597
12 Virgin Islands (U.S)                         122,211
13 Northern Marina Islands                       74,612
14 Marshall Islands                              70,882
15 American Samoa                                67,084
16 Bermuda                                       63,503
17 British Virgin Islands                        20,812
18 Palau                                         19,092
19 Turks and Caicos Islands                      18,122

   Other cases of official                   Population
   foreign currency adoption

 1 Lesotho (ZAR)                              2,177,062
 2 Bhutan (INR)                               2,049,412
 3 Namibia (ZAR)                              1,797,677
 4 Swaziland                                  1,104,343
 5 Tonga (AUD) (a)                              104,227
 6 Kiribati (AUD)                                94,149
 1 Jersey (GBP)                                  89,361
 2 Isle of Man (GBP)                             73,489
 3 Guernsey (GBP)                                64,342
 4 Greenldnd (DKK)                               56,352
 5 The Faroes                                    45,661
 6 Lichtenstein (CHF)                            32,528
 7 Gibrdltar (GBP)                               27,649
 8 Cook Islands (NZD)                            20,611
 9 Nauru (AUD)                                   12,088
10 Tuvalu (AUD)                                  10,991
11 St. Helena (GBP)                               7,266
12 Falkland Island (GBP)                          2,895
13 Christmas Islands (AUD)                        2,771
14 Niue (NZD)                                     2,124
15 Norflok Island (AUD)                           1,879
16 Tokelau (NZD)                                  1,445
17 Cocos Islands (AUD)                              663
18 Pitcairn Island (NZD)                             47

   Regional currency areas                   Population

   CFA Franc
 1 Cote d Ivoire                             16,393,221
 2 Cameroon                                  15,803,220
 3 Burkina Faso                              12,272,289
 4 Mali                                      11,008,518
 5 Niger                                     10,355,156
 6 Senegal                                   10,284,929
 7 Chad                                       8,707,078
 8 Benin                                      6,590,782
 9 Togo                                       5,153,088
10 Central African Republic                   3,576,884
11 Congo, Republic                            2,894,336
12 Guinea-Bissau                              1,315,822
13 Gabon                                      1,221,175
14 Comoros                                      596,202
15 Equatorial Guinea                            486,060

   Eastern Caribbean Currency Union (ECCU)
 1 St. Lucia                                    158,178
 2 St. Vincent and Grenadines                   115,942
 3 Grenada                                       89,227
 4 Dominica                                      70,786
 5 Antigua and Barbuda                           66,970
 6 St. Kitts and Nevis                           38,756
 7 Anguilla                                      12,132
 8 Montserrat                                     7,574

Note: Countries in bold represent cases
of euroisation/dollarisation after 1998

Source: author's compilation

(a) Until 1974.

Table 2: Official development assistance/subsidies
and sustained cases of euroisation/dollarisation

Countries and jurisdictions dependent on ODA

Dollarised/euroised/          American Samoa
CU countries (35)             Benin
                              Bhutan
                              Burkina Faso
                              Central African Rep.
                              Chad
                              Comoros
                              Cook Islands
                              Faroe Islands
                              French Guyana
                              French Polynesia
                              Greenland
                              Guadeloupe
                              Guam
                              Guinea-Bissau
                              Kiribati
                              Marshall Islands
                              Martinique
                              Mayotte
                              Micronesia, Fed. St
                              Montserrat
                              New Caledonia
                              Niger
                              Niue
                              Northern Mariana Islands
                              Palau
                              Reunion
                              Saint Helena
                              Saint Pierre & Miquelon
                              Senegal
                              Togo
                              Tokelau
                              Tonga
                              Tuvalu
                              Wallis and Futuna

Other currency regimes (25)   Albania
                              Armenia
                              Djibouti
                              Eritrea
                              Georgia
                              Guinea
                              Haiti
                              Honduras
                              Jordan
                              Laos
                              Madagascar
                              Malawi
                              Mauritania
                              Mongolia
                              Mozambique
                              Nepal
                              Nicaragua
                              Papua New Guinea
                              Samoa
                              Sao Tome and Principe
                              Sierra Leone
                              Solomon Islands
                              Suriname
                              Vanuatu
                              Zambia

Sources: OECD (2002), CIA World Factbook, own calculations

Table 3: Offshore centres and sustained
cases of euroisation/dollarisation

Offshore financial centres

Dollarised/euroised/          Andorra
CU countries (30)             Anguilla
                              Antigua and Barbuda
                              Bahamas
                              Barbados
                              Belize
                              Bermuda
                              British Virgin Islands
                              Cook Islands
                              Dominica
                              Gibraltar
                              Grenada
                              Guernsey
                              Jersey
                              Liberia
                              Liechtenstein
                              Isle of Man
                              Marshall Islands
                              Monaco
                              Montserrat
                              Nauru
                              Niue
                              Panama
                              San Marino
                              St Kitts and Nevis
                              St Lucia
                              St Vincent and Grenadines
                              Tonga
                              Turks and Caicos Islands
                              Virgin Islands

Other currency regimes (17)   Aruba
                              Bahrain
                              Cayman Islands
                              Costa Rica
                              Cyprus
                              Hong Kong
                              Lebanon
                              Luxembourg
                              Maldives
                              Malta
                              Mauritius
                              Netherlands Antilles
                              Samoa
                              Seychelles
                              Singapore
                              Switzerland
                              Vanuatu

Source: OECD, CIA World Factbook, Financial
Stability Forum, own calculations

Table 4: Tourism and sustained cases of euroisation/dollarisation

Highly touristic countries and jurisdictions

Dollarised/euroised/          Andorra
CU countries (21)             Anguilla
                              Antigua and Barbuda
                              Bahamas, The
                              Barbados
                              Bermuda
                              British Virgin Islands
                              Cook Islands
                              Grenada
                              Guadeloupe
                              Guam
                              Liechtenstein
                              Martinique
                              Monaco
                              Montserrat
                              Northern Mariana Islands
                              Palau
                              Saint Kitts and Nevis
                              Saint Lucia
                              Turks and Caicos Islands
                              Virgin Islands

Other currency regimes (21)   Aruba
                              Austria
                              Bahrain
                              Cayman Islands
                              Croatia
                              Cyprus
                              France
                              Greece
                              Iceland
                              Ireland
                              Luxembourg
                              Macau
                              Maldives
                              Malta
                              Netherlands Antilles
                              Portugal
                              Seychelles
                              Singapore
                              Spain
                              Switzerland
                              United Arab Emirates

Source: World Tourism Organization, CIA World Factbook, own calculations

(1) This is a revised version of the paper presented at the 8th Dubrovnik Conference in June 2002. The authors are grateful to Gunnar Jonsson, Arnaud Mehl, Jeff Miller, Paul Wachtel and an anonymous referee for helpful comments and to Oscar Calvo-Gonzales for excellent research assistance. Views expressed are those of the authors and not necessarily those of the European Central Bank.

(2) This paper focuses only on the official adoption of a foreign currency as a country's own and does not consider the unofficial or parallel use of a foreign currency. Moreover, while acknowledging significant differences between multilateral currency unions and unilateral euroisation/dollarisation (Angeloni, 2002), we use the terms currency union and euroisation/dollarisation as synonyms. This is in line with the literature inspired by Rose and co-authors (eg Glick and Rose, 2001), who define a currency union as a situation in which money is interchangeable between two countries at par for an extended period of time. This definition encompasses both euroised/dollarised countries and members of multilateral currency unions.

(3) See, for example, Berg et al. (2002), Gligorov (2001), Bratkowski and Rostowski (2001), Begg et al. (2001).

(4) Bayoumi and Mauro (2001) argue that in addition to real and financial integration countries forming a common currency area have to have a political willingness to accept a certain loss of sovereignty to achieve greater economic integration.

(5) However, as Glick and Rose (2001) emphasise, the trade effect may take some time. Hence, the immediate effects of adopting a foreign currency on trade between the euroised/dollarised country and the anchor country could be rather small.

(6) European Monetary Union countries were excluded, as the history of EMU is too short to draw empirical conclusions.

(7) Moreover, Persson (2001) and Nitsch (2002) found that the trade integration effects might be considerably smaller than suggested by Rose, whereas Klein (2002) presents evidence for strictly dollarised countries, that is. countries that adopted the US dollar, showing that the Rose result is not robust if only bilateral United States trade is considered.

(8) Kose and Prasad (2002) define a 'small state' as a sovereign country with fewer than one and a half million people. Easterly and Kraay (2000) define a 'microstate' as a country having an average population over the period 1960-1995 of less than one million.

(9) As the common currencies of the CFA franc zone and the ECCA have been closely linked to the franc/euro and the US dollar, these currency unions essentially act as fixed exchange rate regimes (Bayoumi and Mauro, 2001). Hence, an analysis of the sustainability of these currency unions should focus on the relation between members of the respective currency unions and the respective anchor countries (France and the United States).

(10) The list of ODA-dependent countries is based on OECD (2002) and CIA World Factbook data. From the OECD, we take countries to be ODA-dependent if net receipts of ODA to Gross National Income in the last year for which data are available exceed 5% and simultaneously at least 20% of ODA received incomes from a single donor (32 countries, of which 13 are CU members). In order to capture countries for which no breakdown by donor is available, it also considered as aid dependent those countries for which ODA to GNI exceeds 20% regardless of the share of the largest donor (10 countries, of which four are CU members).The data from the OECD is complemented with those countries that the C1AWorld Factbook refer to as receiving "substantial transfers" or being "highly dependent on subsidies". This cross-referencing is necessary both because the OECD coverage is limited to 175 countries and also to capture more subtle cases through which countries may receive official transfers. More detailed information is available from the authors on request.

(11) That some euroised/dollarised countries have been highly dependent on official transfers from the anchor country or the international community has previously been noted by Edwards (2001) and Nitsch (2002).

(12) Countries are considered to be OFCs if they appear classified as tax havens by the OECD (2000) or were reported as such by the Financial Stability Forum (FSF, 2000). The list includes the six 'advance commitment jurisdictions' that were not named in the OECD report because they had made public a commitment to eliminate their harmful tax practices prior to the publication of the OECD report.

(13) This figure excludes USD 2.7 trillion that are held at International Financial Centres in New York, London and Tokyo (IMF, 2000a).

(14) As in the case of fiscal transfers, the empirical evidence on whether financial integration amplifies or smoothes shocks is mixed, however. Whereas deeper financial integration has been associated with lower output volatility in small developing countries (IMF, 2002), it has not reduced their aggregate consumption volatility (Kose and Prasad, 2002). Moreover, the experience of countries in the Western hemisphere suggests that financial integration has not led to a cushioning of temporary asymmetric shocks.

(15) This does not imply that offshore centres were founded with the view to support the exchange rate regime. Rather, small countries engaged in offshore activities with the primary reason of generating income (IMF, 2000; Levin, 2002; Suss et al., 2002), as part of a development strategy. However, income generated by offshore activities represents--ceteris paribus--a balance of payments surplus as offshore services are provided to non-residents only. Accordingly, for small countries offshore activities help mitigating the balance of payments constraint of euroisation/ dollarisation by providing a rather stable flow of hard currency earnings.

(16) Latest available data on overnight visitors for all countries reported in the World Tourism Organisation (WTO) Compendium of Tourism Statistics (2002 edition). Calculations are available from the authors on request.

(17) Detailed evidence is available from the authors on request.

(18) According to Edwards and Magendzo (2002), it is the performance of the highly touristic ECCA countries which lead to the econometric result that, with other things given, CU members grow at a faster rate than countries with a domestic currency.

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FRANCESCO MAZZAFERRO, CHRISTIAN THIMANN & ADALBERT WINKLER (1)

European Central Bank, Kaiserstrasse 29, 60311 Frankfurt, Germany. E-mail: christian.thimann@ecb.int