Causes and Problems of Dollarization


Seminar Paper, 2020

20 Pages, Grade: 1,3


Excerpt

Contents

Tables and figures

Abbreviations

1 Introduction

2 Theoretical concepts and characteristics

3 Causes of dollarization

4 Benefits of full dollarization

5 Problems associated with dollarization

6 Discussion on how to evaluate the causes and problems

7 Conclusion

Appendix

References

Tables and figures

Table 1: Fully Dollarized Countries

Figure 1: Regional Average Deposit & Credit Dollarization

Figure 2: Deposit Dollarization in a Number of Countries

Abbreviations

AREAER Annual Report on Exchange Arrangements and Exchange Restrictions

AUD Australian Dollar

ER Exchange rate

EU European Union

EUR Euro

FD Full dollarization

GDP Gross domestic product

ID Informal dollarization

IMF International Monetary Fund

IR Interest rates

USD US Dollar

1 Introduction

“Dollarization has evolved as one of the noteworthy features of globalization during the last two decades.”1 Although Mr. Yilmaz, the then Governor of the Central Bank of the Republic of Turkey, said this sentence at a conference on dollarization in December 2006, it remains more relevant than ever. Due to the increasing integration of the international financial system, the lifting of restrictions on capital mobility and the growing volume of trade, the debate on dollarization met with a growing interest in the 1990s. Nonetheless, today's economic journals are still filled with new publications on dollarization.2

This paper discusses the causes and problems associated with dollarization. Based on the results, it addresses the questions of how high dollarization rates can be evaluated and, in particular, whether it is advisable to opt for full dollarization (FD) or to what extent policymakers should rather aim for de-dollarization. As an introduction to the discussion, Chapter 2 will give a short illustration of the theoretical concepts of dollarization. Chapter 3 will then explain the causes of dollarization. The subsequent description of the advantages of FD in Chapter 4, which can also be cited as a reason for high rates of dollarization,3 leads directly to the problems associated with dollarization in Chapter 5. These problems arise – unless otherwise stated – both from high dollarization rates and from FD. The research up to Chapter 5 concentrates on a more theoretical level. The discussion on how to evaluate the causes and problems in Chapter 6 tries to link theoretical concepts with more general empirical analyses. Chapter 7 provides a brief conclusion of the most important findings and concludes with recommendations for future research.

2 Theoretical concepts and characteristics

Dollarization describes a process where market actors of a country extensively use foreign currency4 alongside or instead of the domestic currency.5 Furthermore, FD refers to a situation where one country officially adopts the currency of another country for all – or almost all – transactions as a legal tender.6 And while Table 1 on the following page shows that there are only a few larger independent countries in the world which are fully dollarized,7 Figures 1 and 2 on the next page illustrate that most developing and transition countries, which merely adopt market mechanisms8 and integrate their financial markets and trade with the world, face an informal form of dollarization.9

The phenomenon can be subdivided into asset dollarization, the replacement of local currency by foreign currency in the functions of money,10 and liability dollarization, which describes the situation where the banking system or government has large foreign debt obligations.11 As there are different definitions and concepts of dollarization, different measurement methods can be identified.12

Table 1: Fully Dollarized Countries

(Excluding participants in currency unions; based on the IMF’s classification in the AREAER)1)

Abbildung in dieser Leseprobe nicht enthalten

1) Annual Report on Exchange Arrangements and Exchange Restrictions (2018). Not included are three non-IMF member states (Andorra, Monaco, and the Vatican), which are using the euro after a special agreement with the EU authorities although they are not members of the EU.
2) Excludes the issuance of coins for primarily numismatic purposes.
3) As of 2018.
4) The year of adoption corresponds to the countries’ independence date.
5) The Deutsche Mark was introduced as parallel legal tender to the Yugoslav dinar.
6) Panama maintains the Balboa as the national currency, but only balboa coins circulate.
7) San Marino uses the euro on the basis of a formal arrangement concluded in 2000 with the European Community, through a monetary agreement with Italy (on behalf of the European Community).

Source: International Monetary Fund, (2019), p.6; Lönnberg & Jácome (2010), p.5; World Bank Data: GDP current USD, 2018

Abbildung in dieser Leseprobe nicht enthalten

Figure 1: Regional Average Deposit & Credit Dollarization

Abbildung in dieser Leseprobe nicht enthalten

Figure 2: Deposit Dollarization in a Few Countries

1) The dataset contains annual data for a sample of 77 emerging market and developing countries. A full description of the data is provided in the Appendix, p. 12.

Source: Bannister, et al. (2018), p. 10f.

3 Causes of dollarization

Informal dollarization (ID) can be described as a rational response to hedge a variety of risks,13 whenever economic agents have low confidence in the domestic currency.14 Since payments across borders are predominantly carried out in internationally accepted currencies, foreign currency inflows leading to ID are an almost unavoidable result especially for small economies being largely open to trade or exports.15 And while parts of the holdings of foreign currency can constitute the convenience of having transactions balances in the currency of payments, it cannot explain ID on the observed scales.16

Main factors arise from macroeconomic instability resulting from domestic inflation or real exchange rate (ER) movements.17 In the context of inflation uncertainty ID is technically explained through higher volatility of inflation, relative to that of the real ER.18 The inability to predict large fluctuations of the ER induces lenders to provide loans in foreign currencies and therefore intensifies dollarization.19 Another main factor, a high and fragile public debt structure along with high budget deficits, often results in the phenomenon “original sin”20. The concept of “original sin” is based on time inconsistency of governments, which can ex-post always devalue their currency in order to reduce the real burden of the debt denominated in local currency.21 As a result, foreign investors move away from domestic currency debt and without a developed financial market the risk premium of debt denominated in domestic currency rises.22 The country hast to borrow in foreign currencies since borrowing in their national currencies at longer maturities is almost impossible.23 In the presence of this incompleteness financial fragility cannot be averted and domestic investments will have either currency or maturity mismatches.24

Other factors for dollarization result from market imperfections.25 Many countries become dollarized following periods of high inflation.26 Policies that stabilize inflation by controlling the ER when it stabilizes faster than inflation can stimulate dollarization as well.27 Furthermore, fixed ER offer free insurance to market participants borrowing in foreign currency.28 Borrowers have little incentive to hedge their foreign exposures and the fixed ER will be a source of moral hazard that distorts investment choices and encourages borrowing in foreign currency.29 The argument of implicit government guarantees is also important when lenders anticipate that countries which officially claim to have a flexible ER, unofficially do not allow their ER to fluctuate freely.30 When international reserves are insufficient and the economy is affected by large devaluations economic agents expect to be bailed out.31 When governments do not credibly state to not bail out private agents, if the domestic currency depreciates sharply, borrowers do not fully internalize the risks of foreign currency debt, benefit from stable and low interest rates (IR) in foreign currency and rely on the government’s free insurance.32 Simultaneously, low institutional quality and the lack of legal protection for domestic creditors provide incentives for dollarization.33 In the existence of poorly developed financial markets – including inefficient foreign exchange markets – market actors will try to attract finance in alternative currencies, exposing themselves to foreign exchange risks.34 A good hedging policy for importers, in the absence of well-developed hedging mechanisms, is to fix prices in foreign currencies.35 Another important cause may be “currency-blind financial regulations”36 like deposit insurances, which do not correct the additional risk of foreign currency lending and underprice currency risk or safety nets in foreign currency.37

Finally, it must be considered that once a “public memory of instability”38 has been established, dollarization is often difficult to eliminate, even in times of macroeconomic stability. This, for example, can lead to a persistent wedge between expected and observed volatilities,39 mainly due to low institutional quality that inhibits the government from credible pre-commitment.40

4 Benefits of full dollarization

In countries with a persistent history of macroeconomic instability and market imperfections, “taking the next step”41 from ID to FD can be one way to respond to the problems arising from ID, to restore macroeconomic stability42 and to accept the logic of the “inconsistent quartet”43 concept.

Opting for FD can foster macroeconomic stability when solving credibility problems of central banks resulting in unstable inflation rates.44 By adopting a credible foreign monetary policy, inflation and IR are assumed to converge towards the level of the issuing country.45 Fiscal discipline may also be enhanced by eliminating the possibility of printing money to avert fiscal deficits.46 High risk premiums, caused by the present danger of a reduction in the value of money, internally (inflation risk) and especially externally (devaluation risk), can be reduced.47 Currency mismatches – in the sense of public or private foreign currency borrowing without notable foreign currency revenues – may be eliminated.48 With a stable currency being a precondition for financial development, domestic financial sector development is expected.49 A very quantifiable process is the elimination of transaction costs of exchanging domestic currency into anchor currency.50 Finally, a stronger economic and financial integration should be facilitated, through improved access to the market of the anchor currency and to international markets.51

5 Problems associated with dollarization

Countries with high rates of dollarization are confronted with the loss of effective monetary policy.52 ID reduces the effectiveness of the IR channel, as changes in the IR have almost no impact on the IR of foreign currency loans and deposits.53 Influencing the money supply and IR in case of FD and ID may only function by directly influencing the money supply via foreign exchange reserves or the generation of foreign currency – by regulatory interventions in the "money creation" and IR setting of the banking system or by indirectly influencing private foreign exchange generation.54

Countries are also confronted with a loss of the lender of last resort function when authorities are unable to inject an unlimited amount of liquidity into the payment system to prevent a default on deposits.55 Banking sector vulnerabilities may increase due to foreign exchange inconsistencies that raise credit exposure in foreign currencies56 and due to devaluations in the presence of substantial dollar lending to nonhedged borrowers.57 This results in a high risk of a crisis in financial or ER markets.58 Sudden changes in investors' and depositors' perceptions of the state of the banking system leading to a deposit run entail enormous liquidity risks, as the amount available for the purchase of banking assets and recapitalization of distressed financial institutions is limited to the country's holdings of foreign reserves.59

The loss of seigniorage is the most quantifiable cost,60 as revenues from issuing a domestic currency shift from the domestic monetary authority to the monetary authority of the issuing country.61 Even if the central bank can obtain part of the seigniorage from below-market remuneration of the foreign exchange reserves required from the commercial banks, it cannot avoid the loss of the seigniorage.62 Depending on the degree of ID, the loss of revenue should be smaller than with FD, but it any case revenue will be eroded by the domestic currency replacement.63

[...]


1 Yilmaz (2006), p. 1

2 See for example Coria (2019); Gete (2020); Ajide, et al. (2019); Samreth, et al. (2019)

3 Duma (2011), p. 5

4 Although the foreign currency is in the majority of cases the US dollar, in this paper a further definition is used, which also includes other internationally accepted currencies (Schuler, 2000).

5 Schuler (2000)

6 Berg & Borensztein (2001)

7 Table 1, p. 2

8 Berg & Borensztein (2001)

9 Figure 1 & 2, p. 3

10 The three functions of money are unit of account, means of exchange and store of value (Ponomarenko, et al. (2013), p. 8).

11 Ponomarenko, et al. (2013), p. 8

12 Ibid., p. 8ff.

13 De la Torre & Schmukler (2004), p. 1

14 Yilmaz (2006), p. 1

15 Ize & Yeyati (2005), p. 11f.

16 De Nicolo, et al. (2003), p. 11

17 Ize & Yeyati (2003), p. 334

18 Ibid.

19 Demidenko (2017)

20 Eichengreen & Hausmann (1999)

21 Yilmaz (2006), p. 2

22 Ibid.

23 Eichengreen & Hausmann (1999), p. 3

24 Projects that generate domestic currency will be financed in foreign currency. Long-term projects will be financed with short-term loans (McKinnon & Schnabl (2004), p. 182).

25 Yilmaz (2006), p. 2

26 Galindo & Leiderman (2005), p. 6

27 Demidenko (2017)

28 Eichengreen & Hausmann (1999), p. 334

29 Mishkin (1996), p. 8

30 Calvo & Reinhart (2000), p. 2, 27

31 Demidenko (2017)

32 De Nicolo, et al. (2003), p. 13

33 Ibid., p. 15

34 Yilmaz (2006), p. 2

35 Demidenko (2017)

36 Yeyati & Sturzenegger (2010), p. 4252

37 Ize & Yeyati (2005), p. 11

38 Duma (2011), p. 5

39 Ize & Parrado (2002), p. 22f., 25

40 Honig (2009), p. 21

41 Berg & Borensztein (2001)

42 Duma (2011), p. 5

43 The concept states that the combination of unrestricted capital flows, openness to trade, a fixed ER and monetary policy autonomy is incompatible (Trichet (2011)).

44 Lyzun, et al. (2019), p. 366

45 Goldfajn & Olivares (2000), p. 2

46 Fischer (1982), p. 295; Wolff (2003), p. 59

47 Berg & Borensztein (2001)

48 Winkler, et al. (2004), p. 8

49 Ibid.

50 Fischer (1982), p. 296

51 Borensztein & Berg (2000), p. 3

52 Baliño, et al. (1999), p. 13

53 Demidenko (2017)

54 Setting maximum IR or reserve ratios are examples for administratively regulating manners and influencing the cross-border flows of goods capital is one for influencing the private generation of foreign exchange (Wolff (2003), p. 75).

55 Quispe-Agnoli (2002), p. 8, 21

56 Demidenko (2017)

57 Duma (2011), p. 9f.

58 Baliño, et al. (1999), p. 13

59 Winkler, et al. (2004), p. 8

60 “Seigniorage is the difference between the value of currency/money and the cost of producing it” (The Economic Times). In principle, countries can agree to share seigniorage revenues, as in the case of the Common Monetary Area (Benn & Luijkx (2017), p. 14).

61 Winkler, et al. (2004), p. 8f.

62 Baliño, et al. (1999), p. 13

63 Quispe-Agnoli (2002), p. 19

Excerpt out of 20 pages

Details

Title
Causes and Problems of Dollarization
College
University of Leipzig  (Institute for Economic Policy)
Course
Financial Development and Innovation in Developing Countries and Emerging Markets
Grade
1,3
Author
Year
2020
Pages
20
Catalog Number
V703214
ISBN (eBook)
9783346187918
ISBN (Book)
9783346187925
Language
English
Tags
Dollarization Dollarisierung Dollarisation International Trade Politics
Quote paper
Fabio Botta (Author), 2020, Causes and Problems of Dollarization, Munich, GRIN Verlag, https://www.grin.com/document/703214

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