Dollarization and currency exchange

We use a dual currency money search model to study dollarization. Agents hold portfolios consisting of two currencies, one of which is risky. We use numerical methods to solve for the steady-state distributions of currency portfolios, transaction patterns, and value functions. As risk increases, agents increasingly use the safe currency as a medium of exchange—dollarization occurs. Furthermore, the safe currency trades for multiple units of the risky currency. This type of currency exchange, and the corresponding nominal exchange rate, are often observed in black market or unofficial currency exchange markets in developing countries. Due to decentralized trading, a distribution of exchange rates arises, whose mean and variance change in predictable ways when currency risk increases.     

Financial dollarization: Short-run determinants in transition economies

This paper examines the determinants of financial dollarization in transition economies from a short-run perspective. Using aggregate monthly data of deposit and loan dollarization we study the drivers of short-term fluctuations in dollarization and test their importance at different levels of dollarization. The results provide evidence that (a) the positive (negative) short-run effects of depreciation (monetary expansion) on deposit dollarization are exacerbated in high-dollarization countries; (b) short-run loan dollarization is mainly driven by banks matching of domestic loans and deposits, currency matching of assets and liabilities, international financial integration, and institutional quality; and (c) both types of short-run dollarization are affected by interest rate differentials and deviations from desired dollarization.     

Financial dollarization: The role of foreign-owned banks and interest rates

Why in many economies households and firms borrow and make deposits in foreign currency? Expanding on the existing literature, our framework addresses this question allowing for interest rate differentials and access to foreign funds to play a role in explaining this process of asset substitution or financial dollarization. Using a newly compiled data set on transition economies and employing a standard panel as well as a panel-VAR methodology we find that increasing access to foreign funds leads to higher credit dollarization, while it decreases deposit dollarization. Interest rate differentials matter for the dollarization of both loans and deposits.     

Dollarization persistence and individual heterogeneity

A salient feature of financial dollarization, arguably the one that causes most concern to policymakers, is its persistence: even after successful macroeconomic stabilizations, dollarization ratios often remain high. In this paper we argue that this persistence is connected to the fact that the participants in the dollar deposit market are fairly heterogenous, and so is the way they form their optimal currency portfolio. We develop a simple model when agents differ in their ability to process information, which turns out to be enough to generate persistence upon aggregation. We provide empirical evidence that is consistent with this claim.     

The Impact of Deposit Dollarization on Financial Deepening

Banks in highly dollarized economies face risks that significantly affect their ability to perform their financial intermediation role. In these economies, dollarization plays a dual role: on the one hand, it provides a hedging instrument protecting the value of savings; on the other hand, it generates a currency mismatch on banks' balance sheets and increases default risk. Through these effects deposit dollarization can affect credit extension. This paper investigates the role of deposit dollarization on the financial depth of forty-four emerging market economies. Findings suggest that deposit dollarization has a consistent and negative impact on financial deepening, except in high-inflation economies.     

The hysteresis of currency substitution: Currency risk vs. network externalities

It is widely documented that currency substitution (using foreign money in transactions) increases in periods of high inflation but does not decline once inflation is reduced. The paper uses survey data from Bulgaria, which experienced this phenomenon, to investigate the origins of this ratchet effect. We find that expected devaluation of the domestic currency, while relatively high, does not play a major role in sustaining the dollarization of transactions. Conversely, preferences for the use of foreign money are strongly influenced by people's perception that foreign money is already widely used in the economy.     

Dollarization in Emerging Markets: Evidence from Georgia

This paper studies dollarization using the implications of three versions of a money-in-utility function model. These versions accentuate the roles of the exchange rate, the interest rates on foreign and domestic currencies time deposits, and domestic and foreign inflation. Monthly Georgian data for the period 1996-2007 are employed in the analysis. Findings indicate that the U.S. dollar is a strong substitute for the domestic currency and has a significant share in domestic liquidity services. The historical dollarization is well explained by the exchange rate model.     

DOLLARIZATION FOR ARGENTINA

In January 1999, President Carlos Menem suggested replacing the Argentine peso with the U.S. dollar. President Menem's announcement has sparked a debate throughout Latin America and Eastern Europe about what has been termed "dollarization." That debate prompted U.S. Treasury Secretary Robert Rubin to deliver a major policy speech on alternative exchange-rate regimes on April 21, 1999 and the U.S. Senate Banking Committee to hold dollarization hearings the following day featuring Fed Chairman Alan Greenspan and Deputy Secretary of the Treasury Lawrence Summers.
This article presents a case for officially dollarizing Argentina. Dollarization is not new. Unofficial dollarization is widespread in emerging market countries; in fact, as much as 70% of the stock of U.S. dollars now circulates abroad. Twenty-eight countries and dependent territories are officially dollarized. Although official dollarization would result in Argentina losing seigniorage of about 0.22 percent of GDP, the author estimates that this cost would be more than offset by a reduction in interest rates that would increase Argentina's trend rate of GDP growth by about two percent.
After debunking the most common criticisms of dollarization, the article closes by offering recommendations about the specific form of dollarization and presenting a detailed dollarization statute for Argentina. The author proposes a competitive currency regime for Argentina, one in which all foreign money would be legal tender.     

The relationship between investment and large exchange rate depreciations in dollarized economies

We use a simple financial friction in an economy with high degree of liability dollarization - and currency mismatch - to show that the negative balance-sheet effect of an exchange rate depreciation may be observable only if the magnitude of the depreciation is large enough. This result justifies the difficulty to find strong empirical evidence for balance-sheet effects and suggests the convenience of including a “large depreciation” term in empirical analyses. We review some of the related empirical literature and provide some new evidence of this large depreciation effect.     

Dollars, Debt, and International Financial Institutions: Dedollarizing Multilateral Lending

Financial dollarization is increasingly seen as a concern becauseof its tendency to contribute to financial crises and outputvolatility. As a result the debate on financial dollarizationhas shifted in favor of a more proactive stance on dedollarization.While often neglected, lending from international financialinstitutions is an important source of financial dollarizationin emerging economies and must be considered in any dedollarizationstrategy. This article revisits old and new arguments in favorof international financial institution lending in the localcurrency and argues that any such initiative should rely, atleast initially, on demand from residents seeking stable returnsin units of the local consumption basket but who are reluctantto take on sovereign risk. Superior enforcement capacity enablesinternational financial institutions to intermediate these savings,currently invested in dollarized foreign assets, back into thelocal economy. The international financial institutions canoffer investment-grade local currency bonds and use the proceedsto dedollarize their own lending to noninvestment-grade countries,thereby reducing financial dollarization and fostering the developmentof local currency markets.     

Dollarization of bank deposits: Causes and consequences

This paper assesses the benefits and risks associated with dollarization of bank deposits. We provide novel empirical evidence on the determinants of deposit dollarization, its role in promoting financial development, and on whether dollarization is associated with financial instability. We find that: (a) the credibility of macroeconomic policy and the quality of institutions are both key determinants of cross-country variations in dollarization; (b) dollarization is likely to promote financial deepening only in a high inflation environment; and (c) financial instability is likely higher in dollarized economies. The implications of these findings for financial sector and monetary policies are briefly discussed.     

Monetary policy in emerging markets: Can liability dollarization explain contractionary devaluations?

In emerging markets, external debt is denominated almost entirely in large, developed country currencies such as the U.S. dollar. This liability dollarization offers a channel through which exchange rate variation can lead to business cycle instability. When firms' assets are denominated in domestic currency and liabilities are denominated in foreign currency, an exchange rate depreciation worsens firms' balance sheets, which leads to higher capital costs and contractions in capital spending. To illustrate this, I construct a quantitative, sticky price, small open economy model in which a monetary policy induced devaluation leads to a persistent contraction in output. In this model, fixed exchange rates offer greater stability than an interest rule that targets inflation.     

Monetary policy, ‘dollarization,’ and parallel market exchange rates: The case of the Dominican Republic

Excessive money creation may give rise to inflation tax revenues and to a depreciation of the domestic currency. this in turn leads to a shift away from the domestic currency into a foreign currency (e.g., the US dollar, hence the term ‘dollarization’). From the domestic monetary authority's point of view, ‘dollarization’ is an unwelcomed phenomenomn, thus the monetary authorities will attempt to arrest the ‘dollarization’ phenomenon while maintaining the excessive money growth. This paper develops and tests a model which analyzes the effects of monetary policy on dollarization and the ‘parallel’ market exchange rates.     

Financial sector development and dollarization in emerging economies

This paper discusses important features of financial dollarization and its implications for the macro economy and financial sector deepening. Despite the need to slow down the rate of inflation and keep exchange rates under control, to achieve growth and economic development, monetary policies may permit increases in the base money to keep pace with real GDP growth. In heavily dollarized economies, during periods of sharp devaluations of the domestic currency, financial assets and liabilities shift toward foreign currency, exacerbating downward pressure on the exchange rate. When central banks face pressures to keep the exchange rate steady in nominal terms, interest rates in the domestic currency are set at levels substantially higher than those on dollar assets. In such states of the world, banks prefer to lend to the government sector at these higher rates than to the private sector. Although private firms may benefit from lower rates on dollar loans, they also face significant exchange rate or currency risk due to the currency mismatch emerging from their dollar debt while their receivables may tilt toward domestic currency denominated instruments. This weakens their balance sheet, which in turn increases the exposure of the banking sector to a variety of risks.     

Does Inflation Targeting Help Reduce Financial Dollarization?

We examine whether adopting an inflation‐targeting regime helps reduce financial dollarization as predicted by Ize and Levy Yeyati's ( 2003 ) portfolio model. To address the self‐selection problem of policy adoption, we apply a variety of propensity score matching methods to a large sample of 106 developing countries for the years 1985–2004. We find strong evidence that inflation targeting has large and significant treatment effects on lowering both actual financial dollarization and the model implied minimum variance portfolio dollarization. Our results are robust to alternative samples and model specifications and also to control for additional factors in postmatching regressions.     

Sudden stops and liability dollarization: Evidence from Asia's financial intermediaries

Before the currency crisis of 1997–1998, East Asian financial intermediaries borrowed heavily in international markets. During the crisis, the intermediaries' stock market value declined sharply, and a sizable fraction of the institutions were closed or nationalized. We investigate how the short-term and the foreign-currency nature of the intermediaries' international borrowing contributed to these outcomes. From the impact of long-term international debt on the stock returns of surviving intermediaries, we observe the negative effects of the foreign-currency nature of international debt (liability dollarization). From the impact of short-term international debt on the likelihood of firm failure and on the size of surviving intermediaries' assets and liabilities, we observe the negative effects of the short-term nature of international debt (sudden stops).     

The Impact of Central Bank FX Interventions on Currency Components

This article assesses the impact of official FOREX interventionsof the three major central banks in terms of the dynamics ofthe currency components of the major exchange rates over theperiod 1989–2003. We identify the currency componentsof the mean and volatility processes of exchange rates usingthe framework developed recently by Bos and Shephard (2006).Our results show that, in general, concerted interventions tendto affect the dynamics of both currency components of the exchangerate. In contrast, unilateral interventions are found to primarilyaffect the currency of the central bank present in the market.Our findings also emphasize a role for interventions conductedby these central banks on other related FOREX markets.     

Differences in beliefs and currency risk premiums

This paper studies the importance of heterogeneous beliefs for the dynamics of asset prices. We focus on currency markets, where the absence of short-selling constraints allows us to perform sharper tests of theoretical predictions. Using a unique data set with detailed information on foreign-exchange forecasts, we construct an empirical proxy for differences in beliefs. We show that this proxy has a strong effect on the implied volatility of currency options beyond the volatility of macroeconomic fundamentals. We document that differences in beliefs impact also on the shape of the implied volatility smile, on the volatility risk-premiums, and on future currency returns.     

Currency-Induced Credit Risk in a Dollarized Economy

We analyze the effects of exchange rate fluctuations on corporate credit default in a dollarized economy. The application, before an exogenous exchange rate shock, of a new regulation concerning currency-induced credit risk (CICR) in the Peruvian banking system created natural conditions for a comparison between exposed and unexposed corporate borrowers. We use firm-level data to find that CICR and debt dollarization have opposite effects on credit risk. While CICR increases default, debt dollarization reduces it. Our results suggest that banks transfer exchange risk as a hedging mechanism by lending to such borrowers in dollars only.     

Dollarization,Seigniorage, and Prices: The Case of North Korea

This study employs a general equilibrium monetary search model to examine the effects of the recent dollarization in North Korea on seigniorage and prices. Maximum seigniorage is generated at a high rate of money growth when dollarization is mild. However, under a high degree of dollarization seigniorage declines sharply when the money growth rate is high. Accordingly, seigniorage can be increased by de-dollarizing the economy through lowering the money growth rate. This finding implies that the post-2013 price stabilization may be a result of the restriction on printing of money with the aim of increasing seigniorage. This finding also recognizes that the North Korean authorities have little room for maneuver on monetary policy under the conditions of widespread dollarization.