Chapter

1 Financial Dollarization: An Overview

Author(s):
Adrián Armas, Eduardo Levy Yeyati, and Alain Ize
Published Date:
July 2006
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Author(s)
Adrián Armas, Alain Ize and Eduardo Levy Yeyati 

1.1 Introduction

This volume presents a collection of essays, comments and discussions on the roots, risks and policy implications of de facto financial dollarization. The book’s analysis and conclusions are founded in an extensive survey of the theoretical and empirical literature – as well as original contributions – on the causes and risks of financial dollarization. Based on these insights and a close review of some country case studies, the book draws lessons for policy management in highly dollarized environments.

The policy agenda is quite broad. It covers: (i) macro management, mainly monetary policy but also fiscal policy and public debt management; (ii) prudential management, particularly how to limit the financial sector’s vulnerability to currency-induced credit risk and liquidity risk; (iii) crisis management, including how to attenuate the cost and likelihood of a liquidity crisis; and (iv) de-dollarization policies, in particular whether market-friendly measures (such as price indexation) are sufficient to promote the use of the local currency, or whether more aggressive actions are needed to fully internalize dollarization risks and discourage the use of the foreign currency.

In this introductory chapter, we briefly review the main themes covered in the book. Following the book’s structure, our overview is organized into four sections. Section 1.2 provides a bird’s eye view of the theory and evidence on the roots of financial dollarization. Sections 1.3 and 1.4 survey the main issues faced by the monetary and prudential authorities in a dollarized economy. Section 1.5 sums up the discussion on the scope for de-dollarization and reviews alternative routes towards this end. Section 1.6 concludes by summing up the main steps and challenges looking forward.

1.2 What causes dollarization?

The roots of financial dollarization are extensively discussed in the general analytical framework presented by Ize in Chapter 2 and the broad survey of the literature by Ize and Levy Yeyati in Chapter 3. The main finding of these chapters is that financial dollarization is the result of a market equilibrium in which both the suppliers and the demanders of funds choose an optimal currency composition. In this process, three basic drivers emerge: (i) the maximization of return volatility (in the presence of risk aversion) favours the currency that is more stable and credible, particularly over the longer run; (ii) the minimization of credit risk favours the currency that minimizes the probability of default (in the case of a single creditor or perfect information) or the loss-given default (in the case of multiple creditors and imperfect information); and (iii) the maximization of the option value of hail-out or deposit guarantees promotes moral hazard-driven equilibria in which the preferred currency is that which maximizes expected costs to the insurer. Dollarization will therefore tend to prevail in environments where monetary policy is perceived to be weak (increasing the volatility of real returns on local currency assets), and geared towards limiting exchange rate fluctuations (reducing the risk of foreign currency lending relative to local currency lending); and where foreign currency depositors and borrowers expect the government to come to their rescue in the event that a large devaluation cannot be avoided.

Chapter 2 offers a number of key additional insights regarding how monetary policy interacts with different sources of dollarization. In particular, it breaks down the problems affecting monetary policy into three interrelated, yet conceptually distinct, components: (i) lack of credibility; (ii) exchange rate smoothing (fear of floating); and (iii) policy asymmetry and overvaluation (as a result of a not fully credible exchange rate smoothing, the nominal exchange rate is not allowed to appreciate in good times but is expected to depreciate in bad times). The chapter shows that lack of credibility, as reflected in the expected pass-through of exchange rate devaluations on prices, has a dual role. Under risk aversion-driven dollarization, the pass-through defines the currency mix that minimizes the volatility of real returns in investors’ portfolios, i.e., the minimum variance portfolio (MVP), while under credit risk-driven dollarization, it defines the debt mix that minimizes firms’ currency mismatches.

However, a sizable local currency premium (resulting from an overvalued domestic currency and an asymmetric monetary policy) may allow the dollar to dominate the MVP under the credit risk paradigm. Moreover, when fear of floating reflects concerns for the financial fragilities associated with a highly dollarized economy, monetary policy can fall hostage to dollarization and multiple equilibria become possible. High dollarization triggers high fear of floating, limiting the risk of foreign currency lending and validating the preference for the foreign currency. Instead, low dollarization enables the monetary authorities to follow a more flexible exchange rate policy, limiting the risk of local currency lending and triggering a preference for the local currency.

Under the moral hazard paradigm, fear of floating similarly induces a preference for the foreign currency because it allows banks (and borrowers) to benefit from cheap funding under the likely outcome in which the exchange rate is maintained, and to discount the unlikely outcome in which the exchange rate is devalued and banks lose their capital. Multiple equilibria, underpinned by a range of capital values for which a low and a high dollarization equilibrium exists, also become possible when monetary policy is endogenous to dollarization.

Chapter 3, in turn, stresses that dollarization may reflect policy or market failures. Policy failures occur when the monetary or prudential authorities cannot precommit to maintain stable prices, let the exchange rate float, or avoid bailouts in a crisis. In such cases, dollarization is an outcome of agents’ optimal response to a suboptimal economic environment. On the other hand, market failures occur when poor market information lead to coordination failures in which individual creditors have an incentive to deviate from the social optimum. Market asymmetries, such as deeper or more efficient dollar markets, or more effective offshore legal frameworks, can also promote the use of the dollar, a point which the recent Costa Rican experience illustrates, as explained by Francisco de Paula Gutierrez in Chapter 13. Indeed, such asymmetries, in part associated with network effects and increasing returns to scale, underlie much of the ‘original sin’ literature which, unlike the papers in this book, focuses nearly exclusively on financial equilibria between residents and non-residents in the context of international markets.

Empirical contributions on the sources of dollarization, summarized in Chapter 3, provide broad-based support for the MVP view. The estimates presented by Robert Rennhack and Masahiro Nozaki in Chapter 4 corroborate earlier results, with a 10 per cent increase in the MVP translating into a 5 per cent increase in deposit dollarization. Rennhack and Nozaki also find, as do other studies, that various indicators of institutional quality contribute to explaining deposit dollarization. However, they find that these variables are no longer significant when OECD countries are excluded, suggesting that significant gains in institutional quality are needed to bolster confidence in the currency.

Rennhack and Nozaki also test for credit risk-induced dollar dominance by using, as proxies for the local currency premium, two measures of monetary policy asymmetry. The results are mixed. A bias measure, that assigns a higher value to months of currency depreciation than to months of currency appreciation, is found to be significant. However, an alternative measure, based on the skewness of the distribution of currency depreciations (to reflect the fact that dollarized countries that have experienced bouts of high inflation and high depreciation should have more skewed distributions with longer upper tails) fails to produce significant results. An analysis along similar lines, albeit not econometrically backed, is presented by Hardy and Pazarbasioglu in Chapter 11 to illustrate and contrast the exchange rate history of countries with high and low dollarization.

However, as underlined by Roberto Chang in his comments on Chapter 3, further efforts are needed to fully identify the root causes and dynamics of dollarization. In particular, policy endogeneity adds a crucial layer of complication in identifying the proper direction of causality between monetary policy and dollarization, a healthy reminder of the limitations faced in testing some of the analytical results, and of the caution needed while extrapolating policy conclusions from theoretical paradigms. A similar note of caution can be drawn from Olivier Jeanne’s comments on Chapter 2, where he shows that in some instances fear of floating, by limiting the local currency premium, could promote the local currency rather than the foreign currency.

1.3 Monetary management in highly dollarized economies

Ize and Levy Yeyati in Chapter 3, and Rennhack and Nozaki in Chapter 4, stress that dollarization has not been an impediment towards price stability. Dollarized countries are doing as well, if not better, than non-dollarized countries in terms of inflation. However, as noted by Juan Antonio Morales in Chapter 13, this good performance has generally been based on an exchange rate anchor. Rennhack and Nozaki illustrate the point by showing that dollarized countries in Latin America exhibit much less exchange rate flexibility than non-dollarized countries.

This last point is elaborated on by Leonardo Leiderman, Rodolfo Maino and Eric Parrado in Chapter 5. They show that monetary reaction functions in some highly dollarized Latin American countries differ significantly from those of the non-dollarized countries used as benchmarks. While central banks in dollarized countries are also concerned about inflation, they target the nominal exchange rate much more closely. In some cases, they use the nominal exchange rate, instead of the interest rate, as the primary operational target. In addition, they intervene more heavily in the foreign exchange market and let international reserves (rather than the exchange rate) play a more active role as the main front-line buffer against shocks.

Two key questions therefore emerge: (i) does the rigidity of the exchange rate regime have significant costs in terms of monetary or prudential management? And (ii) how can dollarized countries migrate from exchange rate anchoring to inflation targeting?

As regards the first question, a more rigid exchange rate regime should in principle limit the countercyclical capacity of monetary policy. However, while there is some evidence of higher output volatility in dollarized countries, it is not overwhelming. Ize and Levy Yeyati argue in Chapter 3 that the main drawback of exchange rate rigidity is more indirect. By promoting dollarization, it makes the financial sector more fragile (through balance sheet effects) and limits the monetary authorities’ capacity to deal with large liquidity crises and real shocks. This conclusion is supported by the statistical work of Chapters 6 and 7 that demonstrates that the quality of loan portfolios in dollarized economies deteriorates rapidly under an exchange rate depreciation. The importance of currency mismatches in disrupting financial contracts is also emphasized in Chapter 12 by Philip Turner, who proposes a simple and operationally attractive measure of mismatch-induced vulnerability, based on the ratio of the currency denomination of debt to the share of tradables in GDP.

This being said, it is important to remember that financial dollarization is often (albeit not always) an optimal risk management response to the policy environment in which economic agents operate. Hence, as stressed by Ize in Chapter 2 and Kevin Cowan in his comments on Chapter 4, financially dollarized economies may be only vulnerable to the extent that they become exposed to large unexpected regime changes. It also follows that forced de-dollarization is unlikely to reduce risk unless it is accompanied by a concomitant change in the policy regime.

As regards the second question, Armas and Grippa in Chapter 6 make a quite compelling case, based on Peru’s recent experience, for the feasibility and benefits of adopting an inflation-targeting framework in a dollarized economy. They show that the regime has been highly successful in maintaining inflation close to target, strengthening the credibility of the sol (the Peruvian currency) and helping develop local currency markets. They also show that the switch from a monetary operational target (bank reserves) to a price target (the overnight interest rate) was instrumental in helping stabilize domestic currency interest rates, thereby improving the transmission capacity of monetary policy and helping develop a yield curve in local currency.

A somewhat related conclusion is reached in Chapter 5 by Leiderman, Maino and Parrado, who find that the switch to inflation targeting in Peru has lowered the pass-through of the exchange rate on prices (an outcome which seems to apply to all inflation targeters, as noted by Klaus Schmidt-Hebbel in his comments) while increasing the pass-through of the policy interest rate on banking rates. By inducing behavioural responses that accommodate policy changes, this intriguing result suggests that policy reform can be self-promoting.

Armas and Grippa also recognize, however, that high dollarization continues to affect the conduct of monetary policy. In particular, they underline that the monetary authorities remain concerned about the financial stress impact of large exchange rate fluctuations. These concerns are reflected in: (i) a broader use of exchange market interventions than would perhaps otherwise be the case; (ii) a high level of international reserves as a self-insurance mechanism against dollarization risks, as well as high reserve requirements on dollar liabilities of financial intermediaries; and (iii) the (transitory) recourse to changes in the interest rate to attenuate pressures on the exchange rate.

In this context, Leiderman, Maino and Parrado emphasize in Chapter 5 that further thinking is needed on how to adapt an inflation-targeting framework to incorporate more frequent interventions in the foreign exchange market and better explain to the public the policy constraints imposed by dollarization. Stronger reservations on the frequent use of exchange rate interventions in an inflation-targeting framework are expressed by Klaus Schmidt-Hebbel in his comments. In particular, Schmidt-Hebbel expresses concerns that such interventions may dilute the credibility of the inflation target and may be vulnerable to political pressures that would make them one-sided.

1.4 Prudential and crisis management

In their fascinating description of Uruguay’s recent ‘return from hell’, Julio de Brun and Gerardo Licandro discuss in Chapter 7 the pitfalls of dollarization. They document the persistent liquidity crisis to which Uruguay was exposed in the wake of the Argentinian currency and banking crisis. While the Uruguayan banking system initially benefited from incoming deposits by Argentinians, the situation reversed and rapidly deteriorated as contagion effects settled in, dollar reserves dwindled and early International Monetary Fund (IMF) assistance proved insufficient to restore confidence. The floating of the exchange rate further amplified financial stress by undermining the debt-servicing capacity of dollar borrowers with incomes in local currency. De Brun and Licandro also stress that the exchange rate devaluation greatly complicated fiscal and public debt management, as most of the public debt was dollarized and the banking system, a large part of which was public, benefited from implicit official guarantees. In turn, the worsening fiscal and public debt situation further contributed to undermine confidence. The crisis was only overcome when deposit convertibility was partially suspended. In particular, this implied that, when deposit liabilities could not be backed by the bank, the bank was liquidated, or, in the case of public banks, their non-transactional deposits were reprogrammed.

De Brun and Licandro draw a rich menu of lessons from the crisis, including the following: (i) exchange rate targeting and deposit guarantees promote dollarization by artificially limiting the risks of dollar financial instruments; (ii) by introducing a large variable and unpredictable component, the dollarization of public debt complicates both the measurement of the fiscal stance and the assessment of public debt sustainability; (iii) switching the exchange rate regime in the middle of a crisis can greatly complicate crisis management; and (iv) to make up for the limited lender of last resort capacity in dollars, dollar deposits should be subjected to high liquidity requirements.

In Chapter 8, Jorge Cayazzo, Antonio Garcia Pascual, Eva Gutierrez and Socorro Heysen conduct a comprehensive review of the prudential reforms that are needed to better internalize risks, limit the vulnerability of dollarized banking systems and open the way for a more flexible monetary policy. The authors base their conclusions on a review of Basel I and II guidelines, and a survey of current prudential practices in seventeen countries with wide-ranging levels of dollarization. They find that all countries have introduced regulations to deal with foreign exchange risk and most countries have implemented measures to reduce the vulnerabilities of financial systems to liquidity risk. However, only a small minority of countries has introduced specific regulations to deal with currency-induced credit risk and, among those which have, very few are highly dollarized. Moreover, these reforms are still for the most part very recent, have a limited scope, or have not yet been fully implemented. Thus, while the bad news is that there is still much to be done, the good news is that things are starting to move. Indeed, dollarized countries have become much more concerned about the perils of dollarization in the wake of the numerous recent banking crises in which dollarization played an important role.

Cayazzo, Garcia Pascual, Gutierrez and Heysen make a forceful case for a more proactive approach to internalizing dollarization risks. While the measures they propose are fully consistent with the spirit of Basel guidelines (particularly Basel II), they indicate that full implementation of Basel I standards would be insufficient to adequately address the specific vulnerabilities of highly dollarized economies. Thus, they propose that: (i) foreign exchange position limits be specifically adjusted to reflect the dollarization of banks’ balance sheets; (ii) the supervision of currency-induced credit risk be strengthened through better information and disclosure, and more systematic stress testing based on parameters provided by the supervisor; (iii) the regulatory framework become currency specific, with higher provisioning or capital requirements on foreign currency-denominated loans to non-foreign currency earning borrowers; and (iv) the use of liquidity requirements be generalized to limit the banking system’s exposure to systemic liquidity risk.

In his comments. Turner further drives the point home that there is a critical need for prudential reform. He stresses that the Basel II framework should help in this endeavour. In particular, it should promote the development of a quantitative risk assessment culture that is fully grounded on statistical history. Turner also stresses the need for improving the market disclosure of dollarization-related risks. He also makes the interesting point that encouraging the entry of foreign banks into domestic markets should help limit dollarization and its risks by allowing foreign banks to lend internally in domestic currency rather than in foreign currencies from offshore.

Chapter 9, by Alain Ize, Miguel Kiguel and Eduardo Levy Yeyati, completes the discussion of prudential issues by discussing how to manage systemic liquidity crises of the type Argentina and Uruguay experienced. The authors make three basic points. First, while dollar liquidity buffers are expensive in countries where country risk premia are high (which is typically the case in highly dollarized countries), an external insurance that guarantees access to liquidity on an ‘as-needed’ basis is likely to be as expensive as self-insurance, once adjusted for effective risk coverage. Moreover, its availability in sufficient amounts is much less than certain. Indeed, the large insurance packages that have been put together recently for Mexico and Argentina turned out to be disappointing for the most part and not easily reproducible.

Second, providing dollar systemic liquidity through centralized reserves held at the central bank discourages banks from holding their own liquidity, subsidizes dollar intermediation and favours the more risky banks at the expense of the more conservative ones. Instead, it is optimal to impose liquid asset requirements (LARs) on dollar deposits.

Third, the adverse legal and fiscal implications from improvised attempts to stop systemic runs on deposits through forced deposit restructurings can be largely avoided with pre-wired circuit breakers (CBRs) that automatically suspend the convertibility of time deposits while ensuring continued access to sight deposits without breaking legal contracts. The authors conclude that CBRs, if presented in a non-threatening way and accompanied by adequate prudential policies (including LARs and an efficient bank resolution framework), can both narrow the scope for destabilizing runs on the banking system and limit the cost of bank runs once they occur.

1.5 The road to de-dollarization

Chapters 2 and 3 provide ample theoretical reasons why one may expect dollarization to be subject to considerable inertia and prone to hysteresis in already highly dollarized economies. Thus, reducing dollarization could be difficult, even if seemingly ‘good’ policies are being followed and price stability has been reached.

A first line of reasoning originates from the portfolio approach to dollarization. Under a constrained monetary regime, such as a pegged exchange rate, dollarization is a function of expected monetary management in the event of a collapse of the peg, no matter how improbable. Thus, depositors who expect inflation to erode local currency assets if the exchange rate is allowed to float will prefer to hold dollars. In turn, inflationary expectations are likely to translate into a high pass-through, feeding the monetary authorities’ reluctance to let go of the exchange rate and preventing them from gaining credibility. Hence, while the authorities may have been able to make progress towards price stability, they cannot capitalize on it and dollarization remains high.

The credit risk and moral hazard paradigms provide similarly striking examples of dollarization hysteresis. In particular, when the economy is in the ‘bad equilibrium’ where the dollar dominates the MVP, improvements in monetary credibility will have no impact on currency choice as long as they do not translate into an effective flexibilization of the exchange rate regime.

The high dollarization inertia is corroborated in Chapter 4 by Rennhack and Nozaki, who, based on panel data and dynamic estimates, find considerable dollarization persistence. Thus, a 10 per cent improvement in the MVP leads to only a 0.3 per cent reduction in dollarization after one year. They find that persistence is particularly high in the Latin American region. The silver lining in their results, however, is that changes in relative volatilities, towards more stable prices and more volatile exchange rates, will eventually pay off. Indeed, they find that their model has significant out-of-sample predictive power.

The ‘optimistic’ view that dollarization should respond to good policies is shared by Cowan in his comments, where he stresses that dollarization has stabilized or declined in all but two countries in the Latin American region in the current decade. He also suggests that, due to identification problems, the response to credible radical policy changes may be much faster than appears to be implied in Rennhack and Nozaki’s estimates.

That good monetary management pays off in terms of de-dollarization and local currency market development is indeed one of the key messages in the description of the Peruvian experience by Armas and Grippa in Chapter 6 and Renzo Rossini in Chapter 13. Dollarization in Peru has declined significantly over the last few years and local currency markets, including for medium-term nominal bonds markets, have grown quite rapidly under the current inflation-targeting regime.

Additional supporting evidence in favour of good policies is given in Chapter 11 by Hardy and Pazarbasioglu who cite the successful gradual de-dollarization experiences of Israel, Mexico and Poland, all of which have substantially de-dollarized (although their dollarization levels never reached those of Peru or Bolivia) after (or in the context of) adopting inflation-targeting frameworks. They also make an important related point that financial liberalization can help de-dollarize those countries where local currency markets have been repressed. The cases of Egypt and Pakistan provide telling illustrations.

The fact that good policies appear to work but may require a long time to make a real difference raises key strategic questions. Should all dollarized countries follow the same route and benefit from de-dollarization as a side effect of a shift to inflation targeting or should they follow alternative routes?

A seemingly compelling case is made in Chapter 10 by Allison Holland and Christian Mulder for promoting price-indexed public debt instruments in order to limit the cost and risk of public debt, and encourage the growth of ‘dollar financial substitutes’. Holland and Mulder make the important point that price-indexed instruments should not be viewed as imperfect substitutes for fixed-price instruments, only to be used by those countries that are unable to make quick progress in enhancing the credibility of their currencies. Indeed, they show that price-indexed instruments have clearly become ‘mainstream’ in most industrial countries. While they recognize that the liquidity of price-indexed instruments is often more limited than that of fixed-price instruments where the two coexist at similar maturities, they stress that price indexation may be the only affordable way to rapidly extend the maturity of local currency instruments in highly dollarized countries. They also emphasize that, compared to fixed-price instruments, price-indexed instruments reduce the public debt cost of disinflation and limit the scope for inflating away the public debt. Thus, their introduction should enhance (rather than undermine) the credibility of monetary policy.

Ize makes a somewhat related point in Chapter 2. By limiting the vulnerability of the financial sector to exchange rate fluctuations, a shift from dollar instruments to price-indexed instruments can facilitate the flexibilization of the exchange rate regime, which, in turn, is a precondition to bolster demand for fixed-price local currency instruments. Price indexation can thus be viewed as a ‘bridge’ towards the development of local currency fixed-price markets, much as in the recent Chilean experience with the use of the ‘unidad de fomento (UF)’ as a bridge towards the local currency.

However, in his comments on Part IV, Augusto de la Torre stresses that the success of price indexation in financial contracts is likely to be ‘path dependent’. Thus, the fact that price indexation was successful to prevent dollarization in Chile offers little guarantee that it would also be useful in reversing dollarization in countries where dollarization is already entranched. When dollar markets are already blooming, price indexation may no longer be that attractive to market participants. Similar reservations are expressed in Luis Óscar Herrera’s comments, based on the Chilean experience. He stresses that the promotion of the UF in Chile was part of a comprehensive and very persistent strategy of ‘fully fledged indexation’, which may be hard to replicate. Herrera also warns about the potentially adverse impact of indexation on inflationary inertia (a concern echoed by Leonardo Leiderman in Chapter 13) and the difficulties indexation may bring at a later stage when the local and international financial markets need to be integrated (a somewhat related comment is made by Morales, who suggests that dollarization is the best route to integrate with international markets). Hence, Herrera’s view is that countries that have already achieved price stability should head straight to ‘nominalization’ (develop fixed-price local currency instruments).

While also expressing some reservations about the potential illiquidity of price-indexed instruments, Claudio Irigoyen, in his comments, takes a more middle-of-the-road view. He disagrees with the view that indexation, per se, fosters inflationary inertia. Instead, he justifies the need to issue price-indexed debt as part of a comprehensive, portfolio-based strategy that applies even to environments with full monetary policy credibility.

Chapter 11, by Hardy and Pazarbasioglu, presents the opposite extreme case of one-stop de-dollarizations through forced conversions. While they rightly emphasize that forced de-dollarizations might not be politically appealing during tranquil times, the case in their favour appears to be stronger than usually recognized, both on theoretical grounds and on empirical grounds. As underlined in Chapters 2 and 3 and by Jeanne in his comments, a forced conversion might provide the only effective way to ensure the necessary coordination for a successful and speedy exit from a high, bad dollarization equilibrium to a good, low dollarization equilibrium. Indeed, Hardy and Pazarbasioglu show that Pakistan’s forced conversion was seemingly successful and sustained. While caution is needed in the case of Argentina, where the jury is still out as regards the longer-term impact of the forced conversion, the experience thus far appears to be evolving rather positively.

The seemingly successful experiences in Pakistan and Argentina stand in sharp contrast with the unsuccessful experiences of Bolivia and Peru in the 1980s. Hardy and Pazarbasioglu justify the different outcomes mainly on the basis of radically different post-conversion macroeconomic policies. They also stress that policies that limit the dollarization of loan contracts, as was the case in Pakistan, are both likely to limit the scope for dollarization and facilitate a forced conversion if it becomes needed.

1.6 What lies ahead?

The main message in this volume is that it is time to take a more proactive approach towards dealing with financial dollarization and its risks. While not perfect, our understanding of the dollarization phenomenon has improved greatly. Moreover, early experiences in policy reform are sufficiently encouraging to warrant the formulation of a comprehensive policy agenda.

As noted by Agustín Carstens, Juan Antonio Morales, Francisco de Paula Gutierrez and Markus Rodlauer in Chapter 13, fiscal consolidation is a clear prerequisite for any realistic de-dollarization strategy. Without it, there is little hope for a strong and independent monetary policy. However, once the fiscal foundation is in place, a regime shift towards exchange rate flexibility and inflation targeting is feasible even in highly dollarized countries and should provide, albeit with some lag, the first incentives to de-dollarize. Foreign exchange market intervention cannot be ruled out at this stage, and should be disclosed and explained in a way that the market can understand and predict (as stressed by Leiderman and Rossini in Chapter 13), although interventions may ultimately need to be phased out (Schmidt-Hebbel).

This does not necessarily mean, however, that all countries should immediately adopt a fully fledged inflation target. As emphasized by Ize and Levy Yeyati in Chapter 3, some countries may not meet the necessary structural or institutional requirements to support such a radical policy switch, and the choice of an exchange rate regime may respond to other objectives than de-dollarization. Nor does this mean that countries should be constrained to choose between exchange rate flexibility and low inflation, on the one hand, and full dollarization, on the other. Indeed, it may be preferable to maintain a dual currency system, even when financial dollarization is very high, if this enhances the flexibility of the real exchange rate (as Leiderman, Maino and Parrado argue is the case in Bolivia).

As regards prudential policy, the key message is that more needs and should be done irrespective of the monetary authorities’ intentions and the reasons for dollarization. In particular, the liquidity and solvency risks to which highly dollarized banking systems are exposed need to be better internalized. Although this should help level the playing field for the local currency, the main rationale objective for prudential reform is not de-dollarization per se. Instead, it is to limit the vulnerability of banking systems in a way that is consistent with market efficiency and the prevailing monetary regime. In this sense, the currency exposure associated with dollarization should be treated as any other source of banking fragility, and addressed accordingly. As underlined in Chapter 8, however, prudential reform is likely to be a much tougher sell in already highly dollarized economies: tightening prudential norms on dollar contracts could induce some disintermediation – not a bad outcome in itself if it reflects a more accurate pricing of risk – or, as stressed by de la Torre, a shift into alternative but equally risky forms of intermediation.

In meeting these challenges head on, the supervisory authorities will require both the necessary skills and the political support (and, as Julio de Brun notes in his comments, autonomy from the monetary authority) to avoid mixing up the policy signals when setting the parameters to evaluate banks’ exposure to currency-induced credit risk.

Monetary and prudential reforms clearly need to be complemented by policies to help promote the development of local currency markets, the third main leg of the policy agenda. In particular, good public debt management and the development of a Treasury bond market in domestic currency make it possible to build a yield curve that can be used as a benchmark for private sector issuances. Whether this is based on consumer price index(CPI)-indexed or nominal bonds will depend on the credibility of the domestic currency, in particular the long-run inflation expectation premium. A combination of a nominal short end and an indexed long end is likely to be the preferable outcome in many cases. As emphasized by de la Torre and de Paula Gutierrez, investors’ interest for price-indexed instruments is more likely to materialize in the case of longer-term instruments, such as mortgages, that offer pension funds and annuity providers the hedge they need against their long-term CPI-indexed liabilities.

Finally, the linkages between payments dollarization, real dollarization (i.e., the dollarization of wage and price contracts) and financial dollarization are also important in devising a comprehensive strategy towards de-dollarization. As noted by Morales and Rossini in Chapter 13, throwing some ‘sand in the wheels’ and limiting, through legal or regulatory reform, the scope for using the dollar as a means of payment and a unit of account – that is, reversing the policies implemented in the past to facilitate dollarization in the belief that they promote financial deepening at little cost – should broaden the use of the local currency and ultimately also contribute to financial de-dollarization.

In sum, while good macroeconomic policies are a crucial prerequisite, recent experience shows us that they may not be sufficient. To undo widespread and entrenched dollarization, a comprehensive policy strategy that includes strong micro and market-oriented components is also likely to be needed.

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