Title Page

Financial Dollarization

The Policy Agenda

Edited by

Adrián Armas

Alain Ize

and

Eduardo Levy Yeyati

Copyright Page

© International Monetary Fund 2006

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First published 2006 by

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Library of Congress Cataloging-in-Publication Data

• Financial dollarization : the policy agenda / edited by Adrián Armas, Alain Ize, and Eduardo Levy Yeyati.

  • p. cm.

• Includes bibliographical references and index.

• ISBN 1-4039-8759-9 (cloth : alk. paper)

• 1. Monetary policy – Developing countries. 2. Currency question – Developing countries. 3. Developing countries – Economic policy. I. Armas, Adrián, 1965 – II. Ize, Alain. III. Levy Yeyati, Eduardo.

HG1496.F56 2006

332.4’ 564—dc22

2006041757

10 9 8 7 6 5 4 3 2 1

15 14 13 12 11 10 09 08 07 06

Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham and Eastbourne

Nothing contained in this book should be reported as representing the views of the IMF, its Executive Board, member governments, or any other entity mentioned herein. The views expressed in this book belong solely to the authors.

Contents

• List of Tables

• List of Figures

• List of Boxes

• List of Abbreviations

• Notes on the Contributors

• Acknowledgments

• Foreword by Óscar Dancourt and Stefan Ingves

• 1 Financial Dollarization: An Overview

  • Adrián Armas, Alain Ize and Eduardo Levy Yeyati

• Part I Financial Dollarization: Roots and Dynamics

• 2 Financial Dollarization Equilibria: A Framework for Policy Analysis

  • Alain Ize

  • Comments on Chapter 2

  • Olivier Jeanne

• 3 Financial De-dollarization: Is It for Real?

  • Alain Ize and Eduardo Levy Yeyati

  • Comments on Chapter 3

  • Roberto Chang

• 4 Financial Dollarization in Latin America

  • Robert Rennhack and Masahiro Nozaki

  • Comments on Chapter 4

  • Kevin Cowan

• Part II Monetary Policy

• 5 Inflation Targeting in Dollarized Economies

  • Leonardo Leiderman, Rodolfo Maino and Eric Parrado

• 6 Inflation Targeting in a Dollarized Economy: The Peruvian Experience

  • Adrián Armas and Francisco Grippa

  • Comments on Chapters 5 and 6

  • Klaus Schmidt-Hebbel

• Part III Prudential Policy

• 7 To Hell and Back – Crisis Management in a Dollarized Economy: The Case of Uruguay

  • Julio de Brun and Gerardo Licandro

• 8 Towards the Effective Supervision of Partially Dollarized Banking Systems

  • Jorge Cayazzo, Antonio Garcia Pascual, Eva Gutierrez, and Socorro Heysen

  • Comments on Chapter 8

  • Julio de Brun

• 9 Managing Systemic Liquidity Risk in Financially Dollarized Economies

  • Alain Ize, Miguel A. Kiguel and Eduardo Levy Yeyati

  • Comments on Part III

  • Philip Turner

• Part IV De-dollarization Policy

• 10 Can Indexed Debt Absolve Original Sin? The Role of Inflation-indexed Debt in Developing Local Currency Markets

  • Allison Holland and Christian Mulder

• 11 De-dollarizing the Hard Way

  • Daniel C. Hardy and Ceyla Pazarbasioglu

  • Comments on Part IV

  • Augusto de la Torre

  • Comments on Part IV

  • Luis O. Herrera

  • Comments on Part IV

  • Claudio Irigoyen

• Part V Looking Ahead

• 12 Currency Mismatches and Domestic Liability Dollarization

  • Philip Turner

• 13 Round Table: Policy Options and Strategies for Dollarized Economies

• Index

List of Tables

• 4.1 Dollarization by region, 1995 and 2001

• 4.2 Average inflation by region (in per cent per year)

• 4.3 Selected Latin American countries: deposit and loan dollarization

• 4.4 Indicators of macroeconomic stability, 1980–2003

• 4.5 Summary of free-fall events, 1980–2003

• 4.6 Deposit dollarization: results of cross-country regressions

• 4.7 Deposit dollarization: results of panel data regressions

• 4.8 Latin America: indicators of exchange rate policy

• 4.9 Risk management arrangements in selected highly dollarized economies, 2004

• 4.10 Corporate sector dollar-denominated liabilities, 2001

• 4.11 Latin America: indicators of currency mismatch, 2000–4

• 4.12 Deposit dollarization: effect of exchange rate policy

• 5.1 Alternative monetary frameworks

• 5.2 Volatility of selected variables

• 5.3 Peru, Granger causality: BCRP rate vs. banking interest rates

• 5.4 Reaction functions (based on GMM), 1993–2005

• 6.1 Inflation targets in some inflation-targeting countries

• 6.2 Peru: average annual inflation rates, 1900–2004

• 6.3 Peru: interbank interest rate

• 6.4 Slope of the IS curve, various countries

• 6.5 Peru: financial dollarization indicators

• 6.6 Peru: treasury bond interest rates in the local capital market

• 6.7 Peru: securities balances and average bond terms

• 6.8 Composition of fixed-income securities issued by the private sector

• 6.9 Peru: international liquidity indicators

• 6.10 Peru: exchange rate variability

• 6.11 Peru: interest rate variability

• 6C.1 Estimations of Taylor rules for Brazil, Chile and Mexico

• 8A1.1 Foreign exchange risk practices for selected countries

• 8A1.2 Credit risk regulations for selected countries

• 8A1.3 Credit management and stress-testing practices

• 8A1.4 Liquidity risk management practices

• 8A2.1 Estimates of annual NPL growth rates in selected banking systems

• 8A2.2 Peru: estimates of annual provision to loan growth rates

• 8A2.3 Effect of an exchange rate shock (ERS) on NPLs’ and provisions’ annual growth rate

• 9.1 International reserves, various countries

• 10.1 Market value of inflation-linked bonds

• 10.2 Bid-ask spreads

• 10.3 Latin American inflation experience, 1999–2004

• 10A1.1 Proportion of index-linked issuance

• 10A1.2 Sterling inflation-linked issuance

• 10A2.1 Summary of key characteristics

List of Figures

• 2.1 Interest rates without credit risk

• 2.2 Interest rates with credit risk

• 2.3 The dollarization risk map with an exogenous monetary policy

• 2.4 The dollarization risk map with an endogenous monetary policy

• 4.1 Yield curve for deposit interest rates, 2004

• 4.2 Sectoral composition of commercial bank loans, various countries

• 4.3 Deposit dollarization: out-of-sample forecast

• 4C.1 Mismatch in bank lending in Latin America and the Caribbean

• 4C.2 Liability dollarization in the tradable and non-tradable sectors

• 5.1 Peru: interbank rate, 2002-5

• 5.2 Peru: exchange rate and BCRP intervention, 2002–5

• 5.3 Bolivia: exchange rate crawl, inflation and real effective exchange rate, 1996–2005

• 5.4 Bolivia and Peru: financial dollarization

• 5.5a Chile: response of inflation to one SD nominal exchange rate innovation, 1993:01–2005:07

• 5.5b Peru: response of inflation to one SD nominal exchange rate innovation, 1993:01–2005:07

• 5.6a Peru: response to one SD innovation ±2 SE, 1993:01–1998:12

• 5.6b Peru: response to one SD innovation ±2 SE, 1999:01–2005:07

• 5.7a Chile: real effective exchange rate (year on year) and NPLs, 1993–2004

• 5.7b Peru: real effective exchange rate (year on year) and NPLs, 1993–2004

• 5.8a Chile: response of NPLs to one SD REER innovation

• 5.8b Peru: response of NPLs to one SD REER innovation

• 6.1 Evolution of the operational target interest rate

• 6.2 Interest rate pass-through by loan type, 1999–2004

• 6.3 Interbank, benchmark (ceiling) and overnight deposits (floor) interest rates (percentage points)

• 6.4 Quarterly projection model: headline inflation path after a 1 per cent transitory domestic currency depreciation shock

• 6.5 Peru: consumer price index

• 6.6 Monetary policy framework in Peru

• 6.7 Peru: inflation target and expectations, 1995-2005

• 6.8 Peru: interest rates for domestic currency Treasury bonds

• 6C.1 Ratio of exchange rate and international reserve volatilities in six countries

• 6C.2 Monetary policy response to the exchange rate in Brazil, Chile and Mexico

• 7.1 Uruguay: fiscal balance, 1991–2002

• 7.2 Uruguay: currency mismatch across sectors

• 7.3 Uruguay country risk, 1994–2003

• 7.4 Banco de Galicia: total deposits, 2000–2

• 7.5 Uruguay: country risk and bank deposits, August-November 2002

• 7.6 Uruguay: rate of change of bank deposits, August-November 2002

• 7.7 Uruguay: spread between LIBOR and the deposit rate, 2002–4

• 7.8 Uruguay: share of sight deposits in the banking system, 2002–5

• 7.9 Uruguay: exchange rate and inflation, 2002–4

• 7.10 Uruguay: short-term peso interest rate, 2002–5

• 7.11 Uruguay: maturity profile of the domestic and external public securities

• 8A1.1 Financial dollarization (FD) and capital requirements (CAR) for selected countries, 2004

• 8A1.2 Financial dollarization (FD) and international reserves (minus gold) for selected countries, 2004

• 8A2.1 Peru: effect of currency-induced credit risk on the solvency of the banking system

• 9.1 Liquidity premium

• 10.1 Peru: break-even inflation (for the seven-year bond)

• 10.2 Inflation experience of selected Latin American countries, 1995–2004

• 10A1.1 Proportion of inflation-linked bonds in portfolio

• 10A1.2a Five-year UK break-even inflation rate

• 10A1.2b Ten-year UK break-even inflation rate

• 11.1 Bolivia and Peru: share of foreign currency deposits, 1975–2004

• 11.2 Pakistan: stock of FCDs

• 11.3 Pakistan: contributions to broad money growth

• 11.4 Pakistan: balance of payments and international reserves

• 11.5 Pakistan: cumulative returns on local and foreign currency assets

• 11.6 Argentina: share of foreign currency loans and deposits, 1994–2004

• 11.7 Argentina: total banking system deposits, 2001–5

• 11.8 Argentina: total bank deposits

• 11.9 Argentina: bank deposits, 1994–2005

• 11.10 Argentina: financial intermediation and financial deepening

• 12.1 Currency mismatches and reserves coverage ratio

• 13.1 Peru: financial dollarization ratio

• 13.2 Peru: dollarization ratios in the payments system

List of Boxes

• 8.1 How does a devaluation affect the capital adequacy ratio (CAR) of a bank, depending on its foreign exchange position and asset dollarization?

• 8.2 Quantitative assessment of currency-induced credit risk and its application to off-site supervision: the case of Peru

• 8.3 Costs and benefits of prudential requirements to control liquidity risk: the case of Peru

• 9.1 The Argentinian contingent credit line

• 9.2 The Mexican contingent credit line

• 9.3 CBRs and suspension of convertibility in the free banking era

• 9.4 A more recent example of pre-programmed CBR: the Chilean ‘narrow bank’ safety net

• 9.5 The Argentinian ‘corralito’

• 10.1 Selected Latin American experience

• 10.2 The liquidity of inflation-linked bonds

• 10.3 Possible issuance strategy for inflation-indexed bonds

• 11.1 Instances of gradual de-dollarization

• 11.2 Exchange rate changes and incentives for dollarization

List of Abbreviations

Notes on the Contributors

Adrián Armas is Head of the Economic Studies Department at the Central Reserve Bank of Peru.

Agustín Carstens is Deputy Managing Director at the International Monetary Fund.

Jorge Cayazzo is Senior Financial Sector Expert in the Monetary and Financial Systems Department, International Monetary Fund.

Roberto Chang is Professor of Economics at Rutgers University, New Brunswick, and Research Associate at the National Bureau of Economic Research.

Kevin Cowan is Senior Economist at the Central Bank of Chile. He was a Research Economist at the Inter-American Development Bank at the time of the April 2005 Lima conference.

Óscar Dancourt is Acting Governor at the Central Reserve Bank of Peru.

Julio de Brun is Director of the Centre for Banking and Financial Studies, ORT University, Uruguay, and Executive Director of the Private Banks Association, Uruguay. He was formerly the Governor of the Central Bank of Uruguay.

Augusto de la Torre is Senior Regional Financial Sector Advisor of the Latin American and Caribbean Regional Office of the World Bank.

Francisco de Paula Gutierrez is Governor of the Central Bank of Costa Rica.

Antonio Garcia Pascual is Economist for the Monetary and Financial Systems Department of the International Monetary Fund.

Francisco Grippa is Senior Economist of the Monetary Division at the Central Reserve Bank of Peru.

Eva Gutierrez is Economist for the Policy Review Department of the International Monetary Fund.

Daniel C. Hardy is Deputy Division Chief of the Monetary and Financial Systems Department of the International Monetary Fund.

Luis Óscar Herrera is Director of the Financial Policy Department at the Central Bank of Chile.

Socorro Heysen is Deputy Division Chief of the Monetary and Financial Systems Department of the International Monetary Fund.

Allison Holland is Debt Management Advisor for the Monetary and Financial Systems Department of the International Monetary Fund.

Stefan Ingves is Governor of the Central Bank of Sweden. He was the Director of the Monetary and Financial Systems Department at the time of the April 2005 Lima conference.

Claudio Irigoyen is Chief Economist at the Central Reserve Bank of Argentina.

Alain Ize is Area Chief for the Monetary and Financial Systems Department of the International Monetary Fund.

Olivier Jeanne is Deputy Division Chief of the Research Department of the International Monetary Fund (currently on leave, visiting the Department of Economics of Princeton University).

Miguel A. Kiguel is Academic Advisor at the Financial Stability Centre, and Professor at the Torcuato Di Telia University.

Leonardo Leiderman is Professor at the Berglas School of Economics at Tel Aviv University, Israel.

Eduardo Levy Yeyati is Professor and Director of the Center for Financial Research at the Business School of the Torcuato Di Telia University and Research Associate at the Research Department of the Inter-American Development Bank.

Gerardo Licandro is Director of the Research Department of the Central Bank of Uruguay.

Rodolfo Maino is Senior Economist at the Monetary and Financial Systems Department of the International Monetary Fund.

Juan Antonio Morales is Governor of the Central Bank of Bolivia.

Christian Mulder is Deputy Division Chief of the Monetary and Financial Systems Department at the International Monetary Fund.

Masahiro Nozaki is Economist at the Western Hemisphere Department of the International Monetary Fund.

Eric Parrado is Advisor at the Financial Policy Division of the Central Bank of Chile.

Ceyla Pazarbasioglu is Division Chief of the International Capital Markets Department at the International Monetary Fund.

Robert Rennhack is Division Chief of the Western Hemisphere Department at the International Monetary Fund.

Markus Rodlauer is Senior Advisor at the Western Hemisphere Department of the International Monetary Fund.

Renzo Rossini is General Manager of the Central Reserve Bank of Peru.

Klaus Schmidt-Hebbel is Chief of Economic Research at the Central Bank of Chile and Professor at the Catholic University of Chile.

Philip Turner is Head of the Secretariat Group at the Monetary and Economic Department of the Bank for International Settlements.

Acknowledgments

The editors wish to thank all those who contributed to this volume and participated in the April 2005 Lima conference, (The Policy Implications of De Facto Dollarization), which was co-sponsored by the International Monetary Fund (IMF) and the Central Reserve Bank of Peru (BCRP). We wish to thank in particular Agustín Carstens, IMF Deputy Managing Director, for fitting the conference into his busy schedule.

We would also like to recognize the special efforts of all those at the IMF and BCRP who provided logistical and editorial support to the production of this volume and the preparation of the conference. We are most indebted to Magally Bernal for her untiring and excellent assistance in preparing the conference, putting together the volume and, more generally, making sure that all loose ends were taken care of. We also wish to thank Funke Fasalojo and Hortense N’Danou, who provided valuable back-up support to Magally, and to Graham Colin-Jones, the Monetary and Financial Systems Department (MFD) editor, for his excellent editorial work.

We are also grateful to Julia Vivanco and Jose Rocca at the BCRP for coordinating the on-site work for the conference and ensuring the success of the event. More generally, we wish to thank Óscar Dancourt, Renzo Rossini and the management of the BCRP for their warm hospitality during the conference.

Finally, the editors would like to acknowledge the advice and general editorial support received from Sean Culhane in the IMF’s External Relations Department, who coordinated the arrangements for publication. The patience and advice of Katie Button at Palgrave Macmillan are also very much appreciated.

Foreword

Óscar Dancourt and Stefan Ingves

The materials in this book gather the proceedings of a conference held in Lima, Peru, during 21–22 April 2005 on The Policy Implications of De Facto Dollarization’. The conference was jointly organized by the Central Reserve Bank of Peru (BCRP) and the Monetary and Financial Systems Department (MFD) of the International Monetary Fund (IMF). It originated from a desire by the Peruvian authorities to share with other countries in the region their rather unique experience as inflation targeters in a highly dollarized environment and, more generally, compare notes on how to deal with dollarization and its risks. The conference brought together practitioners, policy-makers and academics who, through research or work in the field, have had a first-hand opportunity to think about the root causes of dollarization and its policy implications. It was attended by representatives from most (if not all) regional central banks, ministries of finance and supervisory institutions, as well as representatives from several multilateral institutions, including the World Bank, the Bank for International Settlements (BIS), the Inter-American Development Bank (IADB) and the Latin American Reserve Fund (FLAR), in addition to a sizable contingent from the IMF.

The time appears to be ripe for an in-depth review of the policy implications of financial dollarization. Notwithstanding declining, and often quite low, rates of inflation, de facto dollarization has continued to rise (or failed to decline) in most regions of the world, most particularly in Latin America. At the same time, following a number of recent crises episodes where dollarization played an important role, most notably in Asia and Latin America, the view of de facto dollarization as a mostly benign and, on the whole, beneficial phenomenon, has given way to more sobering thoughts. Indeed, the recent Argentinian crisis and its tidal waves throughout the region brought home the realization that dollarization can be a major source of financial fragilities. It can induce liquidity crises and undermine the solvency of banks and their borrowers in the event of large depreciations when most loans, even to those sectors that do not earn dollars, are in dollars. Concerns about the financial impact of exchange rate fluctuations can, in turn, hold monetary policy hostage and greatly complicate crisis management when crises occur.

The range of policy responses to dollarization and its underlying causes has been quite varied, increasingly proactive and, in many cases, seemingly successful. Comparing notes on such experiences and sharing lessons is indeed a key objective of this book. The experience of the few countries like Israel that have largely de-dollarized based on good and persistent monetary management provides, of course, a key point of reference. But good monetary management and a shift towards more exchange rate flexibility appear to have also paid off in countries that remain highly dollarized, such as Peru, Bolivia, Uruguay and Paraguay. Attempts to reign in dollarization through more aggressive methods, both in the region and outside the region, are also worth looking into. At the same time, many countries have innovated in terms of how to conduct monetary policy under a highly dollarized environment and limit the prudential risks of high dollarization. While the Peruvian experience of formal inflation targeting with an interest rate as an operative target is rather unique, several other countries, including Bolivia and Uruguay, also have interesting experiences to share in this respect. Several countries in the region have also recently reviewed (or are in the process of reviewing) their prudential framework to better assess and internalize the risks of intermediating in foreign currency.

Last but not least, there has been substantial progress in the academic literature on dollarization in recent years, both of a theoretical and empirical nature, that helps understand the root causes of dollarization and its linkages with monetary and prudential policies. Together with a greater awareness of the need for policy reform, fully grasping the intricacies of the phenomenon at hand is, of course, a key prerequisite for policy action.

While there are some good reasons for optimism, one needs to remain cautious about the perspectives for de-dollarization and mindful, when formulating a policy agenda, that one size may not fit all. In particular, de-dollarizing only becomes an option when the weak macroeconomic and institutional background that has led to dollarization has made a sufficient turnaround that it can now support a ‘good-quality’ local money that is well equipped to compete with imported ones. In some cases, the policy agenda may need to limit its focus to living with dollarization and containing its risks. In other cases, the preferable policy may be to promote dollar substitutes, such as price-indexed instruments, until the local currency is better able to compete head to head with the dollar. In all cases, good coordination between all policy-makers involved, including central banks, supervisory agencies and ministries of finance, is likely to be crucial in ensuring the successful design and implementation of the policy agenda.

The chapters in this volume do not pretend to have all the policy answers to an inherently complex and multifaceted phenomenon. The aim of the book is mainly to provide a solid reference piece to help guide the policy response to an issue which is likely to remain high on the agenda for years to come.