Academic journal article The Cato Journal

Financial Integration and Dollarization: The Case of Panama

Academic journal article The Cato Journal

Financial Integration and Dollarization: The Case of Panama

Article excerpt

Panama's unique macroeconomic and monetary arrangements embody, as no other country, freedom of choice in the capital markets. This article discusses and explains how Panama's macroeconomic system operates. Panama's system has a long-standing record of stability stemming from consistent market-based institutional arrangements. The study of Panama's experience will give a new perspective on how to deal with monetary disequilibrium and systemic risk.

Panama's Institutional Framework

Panama's macroeconomy is characterized by dollarization, full financial integration, and specialization in service exports. These features are at the core of a consistent free-market institutional system that has produced a stable economic order and an efficient macroeconomic adjustment mechanism. This experience contrasts with other emerging markets that typically rely on macro-management or policy action and have a record of macroeconomic instability.


The U.S. dollar has been Panama's legal tender for 100 years. Successive governments have chosen to maintain this "self-denying ordinance" because the dollar anchor has given the country a degree of monetary stability. The absence of a central bank ensures no monetary intervention, so Panama essentially has a private monetary system in which the stock of money is determined by the decisions of private agents and banks. The unified currency system eliminates foreign exchange risk, currency mismatches, and speculative attacks so common in other countries with central banks and "sovereign" money. The absence of "policy decisions" regarding monetary or exchange rate affairs reduces risk because less information is needed by outside investors.

Panama meets many of Robert Mundell's conditions for an optimal currency area with the United States. However, a point should be made about Panama's production structure. Panama is not a large producer of goods, as its industries are mainly intermediaries. Thus, a revaluation or devaluation of the dollar tends to shift demand from imported U.S. goods to imported Japanese goods (or vice versa)--without affecting the real effective exchange rate (REER). More industrialized nations, or countries more integrated with their neighbors or subject to significant terms of trade shocks, may require a more flexible exchange regime.

Full Financial Integration

A large number of major international banks operate in Panama and intermediate between the local and the international financial system, inducing a complete or full financial integration. Financial integration equalizes Panama's and world interest rates and implies that capital inflows and outflows arising from banks' portfolio adjustments are a crucial element in the macroeconomic adjustment process. The banking system is highly competitive with almost no government intervention, not even reserve requirements. There is freedom of entry for foreign investors, no restrictions on capital movements, and market-determined interest rates. The system is successful in the microeconomic sense, with large inflows of financial resources, low interest rates, and credit balances of more than 100 percent of gross domestic product. Efficient banking operations, due to competition, are evidenced by widespread loan securitization--both domestic and foreign, without any special law or institution--and commercial bank lending to small enterprises.

Specialization in Service Exports

Revenues from exports are more than 30 percent of GDP, and come mainly from services related to the Panama Canal, commercial intermediation from the Colon Free Zone (CFZ), tourism, and port container transshipment. Financial intermediation services and legal services, such as registrations of firms and ships, are particularly important. Many export activities take place in free markets with no government intervention or restrictions, and foreign ownership is large. …

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