13 Round Table: Policy Options and Strategies for Dollarized Economies

Adrián Armas, Eduardo Levy Yeyati, and Alain Ize
Published Date:
July 2006
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Agustín Carstens (Chair)

After glancing through all the material that has been presented, I am fully satisfied that the situation has been very well diagnosed; and that the origins and manifestations of dollarization, the problems in dealing with it and what to do with it in the future have been discussed thoroughly. However, I have the impression that the need for fiscal discipline has not been stressed enough, and I believe that a very important problem in Latin America is that – perhaps with the sole exception of Chile – we have not been able to truly establish a believable fiscal policy for the medium term. Furthermore, the subject of fiscal dominance over monetary policy weighs heavily in many of the region’s countries, including dollarized ones. Another aspect that may have been mentioned, but perhaps not as emphatically as it should have been, is that over the past 30 years Latin America has been engaged in a very profound intellectual and practical debate over the relationship between the exchange rate and competitiveness. Some of the papers do refer to it, such as Chapter 2 by Alain Ize, but I believe it is also very important at the end of the day to emphasize how to gain competitiveness without relying on the exchange rate. These structural reforms are very important and we should not lose sight of them.

For that reason I would like to ask the panelists if they could please address the following question: what can be done about de-dollarization, without setting aside the two problems I have mentioned, which are the lack of true fiscal consolidation and the lack of good competitive structural reforms?

Leonardo Leiderman

The process of de-dollarization in Latin America is already in place: dollarization is declining as an endogenous response to a more disciplined fiscal and monetary policy. The indicators for different countries that were presented at this conference clearly show the existence of this trend, with Peru providing a leading example.

We have seen in recent years that even highly dollarized countries have been able to bring inflation down to international levels, and some have even established inflation-targeting regimes. Peru’s case illustrates how an effective monetary policy can be implemented within an inflation-targeting scheme in this kind of environment. In this case, monetary policy basically uses two main instruments: the policy interest rate and foreign exchange market intervention. Since a dollarized economy can be highly vulnerable to large exchange rate shifts, both these instruments are typically set having the inflation target as a primary objective, but attempting to do that while smoothing the exchange rate path.

One area in which I believe the consensus is strongest is prudential regulation. While the papers presented at this conference clearly reveal that much remains to be done in this area, once again Peru offers a good example of the measures that could be adopted in other countries with similar experiences and also of those measures that remain to be adopted. In that sense, it would be useful to know more about the type of measures that the International Monetary Fund and other international organizations can propose to address the issue of prudential regulation in dollarized economies.

Monetary policy efficacy has been questioned under dollarization. One way to proceed in this regard is to enhance policy effectiveness by helping deepen the market for local currency-denominated assets, with maturity horizons as long as possible. Obviously, this task would not have been feasible under the previous conditions of high inflation and weak policy credibility. A question that has come up in this context is whether such a nominalization has to be accompanied by the development of a local CPI-indexed bond market.

Our discussion of the experiences of several countries at the last session showed that while introducing a market in indexed bonds can be useful to build up credibility, at the same time it may lead to a loss of some monetary policy flexibility. In particular, the experience of Chile and Israel with indexation suggests that it was very useful especially at times of high and variable inflation. Yet its mere existence, attenuating the negative effects of inflation on agents’ portfolios, may have given weaker incentives to the monetary authorities to effect a disinflation.

Interestingly, we have seen in recent years advanced countries that promoted indexed bond markets. A quick glance at what is happening on Wall Street reveals that many investment banks are opening trade divisions to focus on these new instruments. Overall, I conclude that while developing a domestic market in indexed bonds can enrich the asset menu and can result in a decrease in the degree of financial dollarization, the ultimate key step for enhancing monetary policy effectiveness is to develop markets in domestic nominal assets.

Another key topic that came up in this conference is the use of foreign exchange intervention as an additional policy instrument to achieve the inflation target in a dollarized economy. Evidence was provided that Peru implements an inflation-targeting regime that takes into account the risks of dollarization and thus partially relies on foreign exchange market intervention to smooth out exchange rate fluctuations. While the experience of other countries with inflation targets, like Israel, Chile, the UK and New Zealand, suggests unsatisfactory results from foreign exchange market intervention, I believe that the latter cannot be ruled out under high dollarization. Accordingly, under these conditions a monetary authority faced with, say, a sudden stop in capital inflows that endangers achieving the inflation target could lead to a policy response consisting of a mix of an interest rate hike and sales of foreign exchange out of international reserves. Clearly there is need for an analytical framework that considers all these issues within an inflation-targeting framework.

To conclude, I would say that I view the de-dollarization that is taking place in countries such as Peru as a gradual endogenous process, in which agents learn more and more about the new low inflation and more stable conditions. Even so, however, I feel there is room for promoting this process. That is, it can be somewhat risky to wait for the process to occur spontaneously. Considering that de-dollarization is under way, we have mentioned above that encouraging the development of local debt markets is a way to speed up this process. This is happening in Peru today, where seven-year nominal (local currency) debt instruments are being issued – something unheard of only three, four or five years ago. It is also important to encourage the development of a market for derivatives and to contribute to a transition towards a more flexible exchange rate.

Markus Rodlauer

I think we have made a great deal of progress on understanding dollarization, its causes and possible remedies. Let me speak briefly about where I see the main lessons from past experience, and then go on to where we find ourselves today and the main challenges ahead.

Generally speaking, this conference has revealed a consensus on several aspects. Institutional aspects are key for understanding the causes of dollarization and, thus, also for its remedies. And we must investigate carefully why monetary policy suffers from a lack of credibility – fiscal problems were revealed during the debate as being one of the main reasons for such lack of credibility. Fear of floating is another subject that must be given more careful study.

Regarding the imperfections of the financial sector, it was interesting to hear that just eliminating the regulatory bias against the peso may not be enough to level the playing field. As I understood it, the authors see a basic problem of coordination in achieving de-dollarization. Striving for good policies may not be enough to produce de-dollarization because there is an endogenous vicious circle involved: bad policy produces dollarization, which in turn produces bad policy. Coordination is needed in order to break through towards a new equilibrium without dollarization. This has led some countries to resort to fairly drastic administrative measures in order to de-dollarize. Looking at the experience of these cases, it is still too early to judge whether the desired results have been attained through good policies or whether indeed more aggressive action was needed. I guess the key question is how to achieve and maintain sound monetary policy, and thereby gain monetary credibility. While administrative measures to contain dollarization may help, the crux remains the underlying macro situation and the main institutions that support it.

As for the progress made in these areas, I agree with Leonardo Leiderman and Klaus Schmidt-Hebbel. Klaus underscores the progress that has been made, and this is certainly one of the points we at the IMF have recognized and made public. Two areas of progress are particularly noteworthy: fiscal discipline and price stability. In the fiscal area, public sector balances, as a per cent of GDP, have improved notably over the past five to ten years in Latin America. Inflation has also been kept stable, reflecting growing consensus on the need for independent central banks and well-supervised financial sectors.

The outlook for Latin America is quite favourable, but we must not lose sight of the risks ahead, such as oil prices, world interest rates and global imbalances, which could affect the region’s short- and medium-term prospects. In this connection, the improved monetary policy frameworks – which have achieved broadly favourable results so far – will likely be tested more seriously during the coming period, and perhaps this will be the test that will establish its lasting credibility. I think the main point here is that we should focus our efforts on using today’s good times, when reforms are easier to implement, to prepare ourselves for the bad times. One priority that been mentioned repeatedly in this context is the need to further build up the central banks’ independent monetary policy functions and supervisory tasks. It is easier for a central bank to act independently, and entrench its institutional strengths, when there are no difficult and controversial policy decisions to take. And supervisors can develop their institutional strengths and establish their independence more easily when they do not have to go around closing down banks.

A couple of additional comments. I think it is good advice to move away from a fixed exchange rate, particularly as countries become more integrated into global financial markets. We at the IMF have supported such greater exchange rate flexibility and, indeed, Latin America has made impressive progress here from the situation just a few years ago. At the same time, we have also consistently taken the view that policy implementation needs to take into account specific country circumstances. For example, for countries with relatively low reserves, it makes sense to use opportunities to boost reserves during times of strong external positions. For example, it was reasonable for Peru to accumulate reserves, within the context of its inflation targeting regime, in the years following the crisis. However, in implementing this policy care must be taken to preserve adequate exchange rate flexibility and not to slide back into a position of undue rigidity – which in turn would risk creating adverse incentives and expectations (leading, for example, to build-up of currency mismatches) that add vulnerabilities and rigidity. One way of combining reserve accumulation with appropriate exchange rate flexibility is to predetermine, and possibly preannounce, target levels of reserve accumulation over a reasonable time horizon, and letting the exchange rate float around this path depending on the daily shocks and fluctuations in the market.

Juan Antonio Morales

The comments on dollarization that I am about to express, although they are not directly related to Bolivia’s case, obviously reflect the Bolivian experience. I would like to start by saying that it is important not to lose sight of the main reason for wanting to de-dollarize. If the reason is to make monetary policy more effective, then the answer to de-dollarizing should be ‘no’. Obviously, it is impossible to have an independent monetary policy in a dollarized economy or, more precisely, the area of manoeuvre for an independent monetary policy is extremely limited in this case, but this does not preclude effective inflation control. For years, countries have maintained exchange rate anchors (dollarization is an extreme case) that have been able to stabilize inflation and, more broadly, the macroeconomy. The true problem with dollarization lies in the vulnerability of financial systems, and the liquidity and solvency risks that may be created by strong exchange rate movements, particularly when a sharp devaluation or depreciation occurs. The question then is whether de-dollarizing is the only possible way to reduce these risks. The answer is once again ‘no’ – at least in theory. If our domestic markets were more complete, deeper, and if our economies were more integrated with the international market, it would probably not even be necessary to talk about de-dollarizing. On the contrary, in order to integrate better with international markets, dollarization should be promoted even further. But this is not a realistic alternative for many of our small economies, and for that reason I will return to the main issue, which is de-dollarization.

De-dollarization involves a series of measures:

• A truly flexible exchange rate is needed.

• Monetary policy credibility is absolutely essential: both inflation rates and expectations of inflation must be kept low permanently. In order for that to be possible, the credibility of fiscal policy is of paramount importance, for if agents expect a worsening of the fiscal situation and a monetization of the deficit in the future, they will lose confidence in the local currency now. An independent central bank enhances the credibility of low inflation but it is not enough: it has to be shouldered by fiscal policy.

•It is important to create a market with sufficient depth in local currency assets. It is up to the government, obviously, to promote the initiative by issuing local currency paper. In order for the initiative to be successful, a credible fiscal policy must be in place. Neither the public nor the financial markets must see any sign at any time that the government may be tempted to reduce the real value of its debt through inflation.

•It is also important to have a good level of international reserves, but it must be kept in mind that an excessive level will only fuel dollarization.

•Changes must be made in banking regulation, so that the banks and the public internalize the risks of dollarization without transferring them to the government, inasmuch as the problem of moral risk is always present. Banking regulation, which is apparently blind to the currencies involved, ends up favouring – at least that is what the public thinks – holders of dollar-denominated assets. For instance, if a bank is liquidated, people have the impression that their dollar deposits should be given priority over local currency deposits; and that, I think, is very important in understanding existing dollarization levels. However, while it is true that de-dollarization is highly important, it must not be achieved at the expense of the development of financial markets. Many countries have had to resort to dollarization in order to develop their financial markets, and if de-dollarization is going to reduce financial intermediation, then it is not worth pursuing.

In conclusion, I would like to mention one issue that I think we have gone over a little too rapidly. I believe that financial dollarization cannot be separated from payments dollarization and real dollarization. In fact, in my opinion, payments dollarization leads to the emergence of a parallel monetary system that obviously facilitates financial dollarization. In the case of real dollarization, there are some questions that require further explanation. How is it that wages, which can represent 40 or 50 per cent of a country’s national income, are not dollarized, but at the same time the prices of some low-value items are given in dollars? In Bolivia, wages (an important sector) are not dollarized, as a general rule, yet the price of some relatively cheap items, like the football team’s sweatshirts sold by my grandchildren’s school, are given in dollars (some are even domestically produced). Why? What explains this segmentation of markets by currency? We do not have answers as yet and only conjectures can be provided. One of them is related to the low price elasticity of the demand for some goods and services. Obviously, setting prices in dollars also contributes to financial dollarization. If I have to pay for some goods, my rent or mortgage in dollars, then I will necessarily have to save in dollars, which only fuels dollarization.

Renzo Rossini

Financial dollarization in Peru has declined 16 percentage points over the past four years to 54 per cent – the dollarization level of twenty years ago (see Figure 13.1).

Figure 13.1Peru: financial dollarization ratio*

* Broad money.

However, payments dollarization, as Figure 13.2 shows, is relatively low: most registered transactions in cash and by cheque, debit, credit and ATM cards in the payments system are made mainly in local currency.

Figure 13.2Peru: dollarization ratios in the payments system

This fact reveals that dollarization in Peru is basically an asset dollarization. Drawing on this data, I would like to describe this situation and discuss what policy responses may be needed to address it.

In the first place, when the financial system started to remonetize following the hyperinflation that ended in 1990, the liquidity risk was what worried us the most, as remonetization was in dollars and we realized that the major risk was obviously being unable to act as the dollar lender of last resort. In this regard, a high dollar reserve requirement of 50 per cent was set at the beginning – and has been gradually reduced to its current level of 30 per cent. We have always been attentive to dollarization because of the danger of having to take over or support a bank faced by massive withdrawals of deposits in dollars.

It should be added that a policy was adopted to remunerate the required legal reserve at rates below the market. By way of example, the remuneration rate today is LIBOR minus 3/4, to penalize dollar intermediation. The intention was actually to penalize the deposit rate of interest and raise the lending rate as the required reserve and its remuneration created a margin over the interest rates. In addition, a liquidity requirement over all short-term dollar liabilities was applied to banks by the banking supervisor. An aspect of basic importance is if there are contingency plans to cover an eventual run – and it is not yet clear whether they are fully developed. The fact that banks have sufficient liquidity is not enough to prevent a crisis, since they may cling to that liquidity as their most prized possession and, despite having enough, become panic-stricken and cut off the payments chain. We experienced this sort of scenario in Peru in the second quarter of 1998.

As for the quality of balance sheets and the conditions for preventing them from being affected, Peru has a prudent international reserve policy and is introducing a new credit risk provisioning scheme – a 1 per cent provision can be established if a bank is unable to prove that it has implemented appropriate prudential measures. This can still be insufficient since, for example, mortgage loans with state guarantee have been exempted from this requirement. As 99 per cent of mortgage loans in Peru are in dollars, it would be better, in my opinion, to apply provisions also to government-supported mortgage loans.

As for the local capital market, what we are seeking through de-dollarization measures is to facilitate long-term financing protected from exchange risks. Peru’s experience with Treasury bonds, as Leonardo Leiderman mentioned, has been quite successful in this connection, and I think the reason for this is also because it was carried out simultaneously with the adoption of an inflation-targeting regime. This regime reduced the variability of interest rates to a minimum, and the Treasury expanded its placement of bonds with nominal interest rates to seven years and of indexed bonds to up to 30 years. I believe this is a significant improvement that has allowed companies to follow in the Treasury’s footsteps.

Another field of action is to reduce the legal incentives to use dollars in the payments system. Hysteresis can still be found, since the public continues to defend itself against the risk of inflation despite a rate below 2.5 per cent. For example, a recent law has established that prices have to be set in local currency, as part of the consumer defence policy. People decide to save in dollars because they buy durable goods with prices set in dollars. When this policy was implemented, prices began to gradually be set in soles. It will take some time for people to start to think in terms of soles for both the prices of durables and their savings. Another area of possible action is the elimination of regulations that entitle service companies to request payments with dollar bills instead of domestic currency.

I would like to conclude by stating that, in my opinion, an inflation-targeting regime can be applied in a dollarized economy. I believe the central bank’s decision to determine its policy stance on the basis of projected inflation – a decision the private sector seconds – is a major step forward. Exchange rate intervention is not at odds at any time with monetary policy because, first, it does not alter the interest rates on which the central bank acts and, second, neither the private sector nor any analyst considers it as being indicative of the monetary policy stance. In short, exchange rate intervention does not confuse people, does not confuse the market and does not indicate a shift in monetary policy.

Francisco de Paula Gutierrez

Conferences of this kind, which offer a good mix of academia, policy options and experiences, give one a huge number of issues to reflect on. I arrived here far more at peace than I leave, in terms of the challenges to be faced as a country.

Allow me to share some thoughts about our case and the policy options we are analyzing. Let me first give you a thumbnail sketch of Costa Rica’s economic outlook today. The economy is extremely open, with exports plus imports representing about 100 per cent of GDP; it is an economy with a capital account that has no restrictions whatsoever, with a private banking sector that started out as ‘offshore banking’ but has gradually become ‘onshore’, and now constitutes 50 per cent of the total banking sector; an economy that is partially dollarized – 50 per cent of the private sector’s financial wealth is dollar-denominated. The state-owned banking system is responsible for a large percentage of the local currency loans and deposits, while the privately owned banking system concentrates more on foreign currency.

This characteristic of the banking sector brings up an issue that we have not discussed here – and I don’t know whether it is unique to us or not – which is that the segmentation of banking markets could be a factor that prompts dollarization. The fact that the colones-denominated financial instruments market is concentrated in the state-owned banks – in part because there is a 100 per cent deposit guarantee – whereas the dollar denominated market has a strong participation of privately owned banks and also of foreign financial institutions, causes dollar-denominated financial intermediation margins to be much smaller than those in local currency. This market segmentation could induce a somewhat adverse risk selection. In other words, good loans seek the dollar market because they can obtain much lower rates than risky loans. Banks are then forced to try to recover part of their positions by raising the intermediation margin even more on local currency loans. This is a process worth studying.

Costa Rica is an economy with a persistent fiscal imbalance and with central bank quasi-fiscal losses. In this sense, and using Leonardo Leiderman’s comment, we have a monetary problem, given our fiscal situation. Last year, the consolidated fiscal deficit reached 3.5 per cent of GDP and the central bank deficit 1.4 per cent of GDP. The bank has a negative net worth, which means that we must somehow finance the bank’s losses through inflationary inorganic money emission. Inflation has held steady at around 10 per cent over the past five years, with a standard deviation of 1.4 per cent over that period – a rather steady, but high, inflation produced by the need to finance the Central Bank’s losses and also, in part, as a result of the twenty-year use of the crawling peg system. By keeping the real exchange rate highly stable over time and giving economic sectors certain, or many, guarantees, this system has been highly successful in avoiding financial crises. But, basically speaking, the cost of this credibility is reflected in our dollarization and in the limited space available for economic policy manoeuvre.

It is quite clear to us that we must confront and correct these policies. Perhaps the first element to be considered is that, in order to reverse dollarization, or to move ahead with de-dollarization, we must first remove its causes. We are not willing to place restrictions on capital movements or on holdings of foreign currency accounts, but we must eliminate the elements that are causing the problem, one of the very first of which is fiscal. We think that unless we solve the fiscal problem, particularly the problem of the Central Bank’s losses, it will be very hard put to do away with the ‘crawl’. I listened with envy today to experiences in approving fiscal reforms in only fifteen days or in one month. After more or less three years of discussions, we are now in the final stage and hope to be able to resolve the matter of our fiscal reform within the next two months. This fiscal reform would allow us to increase revenues by about 2 percentage points of GDP, which, in accordance with our negotiations with the Finance Ministry, would be used mostly to capitalize the Central Bank.

This would allow us to announce, with credibility, that the Central Bank will no longer need to resort to inflationary money creation to finance our deficit. We could then proceed to the next step: to think about credible monetary and exchange rate policy alternatives. We have already held talks with the IMF to explore and advance in the design of a monetary policy oriented towards providing more exchange rate flexibility and achieving an inflation target regime, provided that we are able to capitalize the Central Bank.

This would be accompanied by microeconomic-type actions, such as, for example, promoting colon-indexed credit instruments, particularly for mortgages. The basic problem in the case of mortgages in colones is the shortening of the effective payment period, given the inflationary component on colones interest rates. In other words, with their cash flows people are able to buy far fewer square metres of ‘house’ with colones than with dollars. As a result, mortgages tend to be dollarized. This colon-indexed mortgage instrument has enabled us to make an interesting change and the demand for its use is heavy. State-owned banks have started to standardize mortgages so that pension funds can be used to purchase this type of financial asset.

We are studying different options in the case of liquidity reserves and discussing whether or not it is worth having differentiated reserve requirements according to the currency of deposits. However, given the openness of the capital account, we are extremely concerned with regard to the transfer abroad of accounts – the reinitiation of offshorization by the private financial system. For that reason, we have moved ahead very cautiously. At this time, we have the same legal reserve requirements for dollars as for colones.

I hope that over the next few years we will be able to lay much of the groundwork that some of the countries represented here today have in place in terms of stability. Hopefully, by the time the next conference takes place, we will be able to hold up Costa Rica as a successful experience in de-dollarization or as a country that has accomplished what it had to in the area of macroeconomic stabilization.


Africa 65, 66

aggregate demand 123-5

aggregate effective currency mismatch (AECM) 312

aggregate supply 122-3

aggressive banks 224, 234

Angola 68

Argentina 52, 66, 153, 154, 199-201, 226

  • Argentinians and banking in Uruguay 151-2

  • contingent credit line 219, 220

  • Convertibility Plan 148, 149

  • ‘corralito’ 228, 287

  • crisis 7, 133, 154, 216; spill-overs from the crash 154-5

  • crisis-induced de-dollarization 10, 285-91, 292

  • free-fall events 68

Asia 65, 66, 315-16

Asian crisis 153

asset dollarization 273

asset-liability management (ALM) 252

asset management company (AMC) 161

asymmetric exchange rate policy 2, 42, 77-8, 91-2

asymmetric monetary policy 2, 21, 42, 47

auctions 261-2

balance of payments 282

balance sheet effects 48-9

Banco Comercial 152, 154, 155, 156, 161-2

Banco de Crédito 152, 161-2

Banco de Galicia 152, 154, 155

Banco Hipotecario del Uruguay (BHU) 151

Banco de Montevideo 152, 157-8, 161-2

  • La Caja Obrera 152, 157-8, 161-2

bank lending

  • Argentina 288-90

  • Caribbean 92-3

  • discouragement of foreign currency lending 293

  • Latin America 78-80, 81, 92-4

  • loan classification rules 186-8

  • NPLs 107-10, 206-8

  • Peru 127-9

bank runs 216-17

  • CBRs and 229

  • Uruguay 155, 157, 159-60, 162-3, 164-5

banking crises 171-3, 238

  • Argentina 287-8

  • Uruguay 154-64

banking sector

  • Argentina 286, 287-8

  • currency-induced credit risk in selected banking systems 206-9

  • deposits see deposits

  • forced de-dollarization and capitalization of 294

  • market segmentation 325-6

  • model of LOLR and bank demand for dollar liquidity 223-4, 233-4; differentiated banks 224, 234

  • Pakistan 282-3, 284-5

  • regulation 37, 95-6, 322

  • removal of regulatory incentives for dollarization 293

  • Uruguay: Argentinians 151-2; financial fragility 150-1; link with public accounts 152-3

banking supervision 6-7, 11, 177-212, 213-15, 313

  • credit risk 180-1, 183-90, 197-203, 214-15, 238-9; in selected banking systems 206-9

  • current practice survey 179-81, 197-206, 213

  • foreign exchange risk 179-80, 182-3, 197, 198

  • implementation issues 194-6

  • liquidity risk 178-9, 180, 190-4, 203-6, 214-15

  • proactive approach 181

bankruptcy costs 76

Barclays Capital World Inflation-linked Bond Index 244-5

Basel Committee on Banking Supervision (BCBS)

  • Basel II framework 7, 177, 196, 239

  • guidelines 6, 177, 179, 181, 196; credit risk 184; foreign exchange risk 182; liquidity risk 180, 191

benchmark bonds 169

bi-currency system 53

bid-ask spread 249

Bolivia 66, 78, 102, 133, 323

  • deposit dollarization 81

  • failed forced de-dollarization 10, 52, 275-80

  • free-fall events 68

  • inflation 258

  • monetary performance 104-6

  • NPLs 207, 208

  • reaction functions 110-12

  • risk management arrangements 78, 79, 205-6

  • UFV 260-1

  • yield curve for deposit interest rates 70

bond average terms 131

bondholder participation 168-9, 170

Brazil 153, 199, 205, 207, 208

  • free-fall events 68

  • inflation-linked debt 246, 247, 250

  • Real Plan 148, 149, 153

  • Taylor rules 142

break-even inflation rate 250, 251

  • UK 266-7

Breedon, F. 257

buffers 181

  • credit risk 183, 186-90; size of the buffer 189-90

  • liquidity risk see liquidity requirements

Bulgaria 68

business cycles, demand-driven 252-3

Calomiris, C. 226

Calvo, G. 285-6

Calvo-Reinhart index of fear of floating 76-7

Campbell, J. 250

Canada 245-6, 267-8

capital adequacy ratio (CAR) 182, 183, 197, 198, 199, 200

  • exchange rate shocks and credit risk 209

  • foreign exchange risk and ‘risk-free’ position in foreign currency 213-14

capital asset pricing model (CAPM) 40, 62-3, 91

  • CCAPM 40-1,62

capitalization of banks 294

Caribbean 92-3

causes of dollarization 1-3

Central Bank of Uruguay 154, 157-8, 159, 160, 162, 164, 166-8

central banks

  • ability to act as LOLR 63

  • independent monetary policy functions and supervisory tasks 321

  • international reserves and liquidity risk 205-6

  • LOLR and liquidity requirements 233-4

Chadha,J. 257

Chang, R. 62, 63

Chile 95, 102, 117, 199, 205-6

  • financial indexation 304-5

  • gradual de-dollarization 274

  • inflation-indexed debt 246, 256, 257, 258; UF 9, 246, 299-300, 304

  • monetary policy transmission 106-10

  • ‘narrow bank’ safety net 225, 227

  • NPLs 207,208

  • reaction functions 110-12

  • Taylor rules 142

Chinese walls 230

circuit breakers (CBRs) 7, 217, 225-32, 240

  • activation of 231-2

  • methods of quarantining deposits 229-31

  • rationale for 226-9

  • collateral 239

  • recovery value of 185-6

collective action clauses (CACs) 169, 225-6

Colombia 102

  • inflation 258

  • inflation-indexed debt 246, 247

  • reaction functions 110-12

compulsory restructuring of time deposits 227, 228

conglomerates 196

conservative banks 224, 234

consumer price index (CPI) 260

consumption CAPM (CCAPM) 40-1, 62

contagion risk 224

contingency plans for adverse liquidity conditions 205

contingent credit lines 219-20, 221

convertibility, suspension of 226

coordination 320

corporate sector 80, 82

‘corralito’ 154, 155, 227, 229, 230

  • Argentina 228, 287

cost savings 248-51

Costa Rica 70, 71, 78, 325-7

  • bank lending 78, 80

  • deposit dollarization 81

  • risk management arrangements 79, 197-9

country size 44, 62

credibility 2, 40, 250, 279, 322

  • policy analysis framework 17, 28-9, 37; default equilibria and 25, 32-3

  • strengthening 28-9, 50

credit dollarization 291-2

credit registers 239

credit risk 116, 177-8

  • banking supervision and 183-90, 214-15, 238-9; capital vs provisions 190; expected losses 185, 186-8; size of the buffer 189-90; supervision of credit risk 184-6; unexpected losses 188-90

  • current supervisory practice 180-1, 197-203; prudential rules 199-201; supervisory assessment and preventive action 201-3; supervisory guidelines 201, 202

  • role in financial dollarization in Latin America 76-84

credit risk paradigm 2, 41-4, 46

  • imperfect information 43

  • moral hazard and prudential regulation 43-4

  • perfect information 41-2

  • policy analysis framework 18, 20-7;

    • default thresholds 21-4;

    • endogenous monetary policy 26-7;

    • exogenous monetary policy 24-6;

    • nature of the equilibrium 20; risk

    • premium 20-1

crisis-induced de-dollarization 285-91, 292

crisis management 5-7

  • Uruguay see Uruguay

currency-blind deposit insurance 92, 95-6

currency-blind prudential regulation 43-4

currency, deposit separation by 229, 230

currency-induced credit risk 195

  • selected banking systems 206-9

  • see also credit risk

currency mismatches 131-2

  • Caribbean 92-3

  • and domestic liability dollarization 311-17; domestic policy agenda 312-15; foreign interest in Latin American local currency bonds 315-16

  • Latin America 78-81, 82, 85, 92-4

  • Uruguay 151

currency substitution models 71-2

de facto (unofficial) dollarization 3, 38-60, 61-3

  • balance sheet effects 48-9

  • de-dollarization 49-53; bi-currency system 53; market-driven approach 49-52; radical approach 52-3

  • guidance from empirical evidence 45-8

  • monetary policy effectiveness 48

  • policy recommendations 54

  • theories of 39-45; credit risk paradigm 41-4, 46; financial environment 44-5; price risk portfolio paradigm 39-41, 46

de la Torre, A. 71

de Nicoló, G. 45-6

de Paula Gutierrez, F. 325-7

Deacon, M. 257

debt, public 171

  • and banking crises 172

  • floating rate debt 253

  • foreign currency-denominated 254

  • inflation-indexed see inflation-indexed debt

  • nominal fixed-rate debt 254-5, 264

  • optimal composition of debt portfolio 306-7

  • Uruguay 149-50, 152; recovery 170; restructuring 163, 165, 167, 168-9

de-dollarization 7-10, 49-53, 308, 321-3

  • bi-currency system as alternative 53

  • and efficacy of monetary policy 112-13

  • forced see forced de-dollarization

  • market-driven approach 49-52

  • Peru 127-31; failed forced dedollarization 275-80

  • policy analysis framework 28-30, 31

  • policy recommendations 54

  • radical approach 52-3

default equilibria 25, 27, 32-3

default probability 2, 36-7, 43, 185

default thresholds 21-4

demand, aggregate 123-5

demand-driven business cycles 252-3

deposit dollarization 291-2

deposit freezes 226-7, 228

deposit protection legislation 231-2

depositors 293


  • Argentina 288, 289

  • foreign currency see foreign currency deposits (FCDs)

  • segregation of 229-31

depreciation 120, 122

Derry, A. 257

devaluation thresholds 17-18

disclosure requirements 186, 195-6

discretion 231

dollarization hysteresis/persistence 8, 40, 85, 95, 274

dollarization risk maps

  • endogenous monetary policy 26-7

  • exogenous monetary policy 24-6

domestic bonds, foreign interest in 315-16

domestic currency, promoting use of 196, 215, 280

domestic policy agenda 312-15

Dominican Republic 79, 81

Dwyer, G. 226

earnings, average 260

Ecuador 226, 230

Egypt 8, 274

Eichengreen, B. 311

Elasser, R. 249, 256, 257

eligible assets 193

endogenous monetary policy 26-7, 42, 47

equity across sectors 294

Europe 226

exchange rate 4, 318

  • Bolivia 104, 105

  • changes: and banking crises 172; and incentives for dollarization 277-9

  • flexibility 29-30, 321; two-way 295

  • floating 157, 158-9

  • interventions and inflation targeting 140

  • movements and indicators of credit risk 206-9

  • and NPLs in Chile and Peru 107-10

  • Peru 103, 104

  • shocks 107, 108; and credit risk 208-9; impact on value of banks’ portfolios 189; probability distribution of 189

  • Uruguay 164, 165-6, 167-8

  • volatility in Latin America 141-2

exchange rate equation 125

exchange rate-indexed securities (CDRs) 134

exchange rate pass-through 106-7, 123, 142

exchange rate policy 76-8, 84-5

  • measures of asymmetry 77-8, 91-2

exchange rate smoothing see fear of floating

exit consents 169

exogenous monetary policy 24-6

expectations of inflation 248-50

  • Peru 129-30

  • real yield curve 257

expected losses 185, 186-8

expected MVP 46

exports 80-1, 82

external insurance 218-19

fear of floating (exchange rate smoothing) 2, 22, 25, 41-2, 47

  • evidence of among inflation targeters in Latin America 141-3

  • Peru 134

fear of floating competitiveness targeting (FFCT) 101-2

financial contracts, voluntary de-dollarization of 299-303

financial environment 44-5

financial fragility 150-1, 153-9

financial indexation 304-5

fiscal consolidation 10

fiscal deficits

  • Costa Rica 326

  • Latin America 72, 72-6

  • Uruguay 149, 150

fiscal policy 318

  • Uruguay 149-50

Fischer, S. 258

fixed-rate debt 254-5

floating exchange rate 157, 158-9

floating rate debt 253

floating rate notes (FRNs) 247, 253, 264

forced de-dollarization 10, 273-98

  • Argentina 10, 285-91, 292

  • failed forced conversion experiences 275-80

  • lessons from and policy implications 291-5

  • Pakistan 280-5

foreign banks 313

foreign currency bearer certificates 283

foreign currency (FX)-denominated debt 254

foreign currency deposits (FCDs)

  • Argentina 286, 288, 289

  • Bolivia and Peru 275-7

  • de-dollarization and allowing 294

  • Latin America 66, 67

  • Pakistan 280-3; FCD freeze 283-5

foreign currency lending, discouragement of 293

foreign exchange exposure, limits on 197, 198

foreign exchange market intervention 319-20

foreign exchange reserves/short-term external debt ratio 314, 315

foreign exchange risk 177-8

  • banking supervision 182-3; current supervisory practice 179-81,197,198

  • determination of ‘risk-free’ position in foreign currency 213-14

forward cover scheme 283, 284


  • financial 150-1, 153-9

  • structural 148-53, 171

France 246, 261, 262, 268-9

free banking era 225, 226

free-fall events 68-9

full-fledged inflation targeting (FFIT) 101-2

fully fledged indexation 305

Fund for Fortifying the Banking System (FFBS) 157, 159, 160

Fund for Stability of the Banking System (FSBS) 159, 160, 161

Galindo, A. 274

GDP deflator 260

GDP-linked bonds 307

general provisions 188

Germany 269

Giavazzi, F. 253, 254

globalization 44, 45-6

Goldfajn, I. 252

Goldstein, M. 311, 312

Gorton, G. 226

gradual de-dollarization 273-4

Greece 246, 269

Guidotti, P. 71

Guide, A.-M. 133

Hasan, I. 226

Hausmann, R. 311

hedging 307-8

hedging instruments 201

Honduras 78, 79, 80, 81, 199

Honohan, P. 45-6

idiosyncratic liquidity risk 190, 224

see also liquidity risk

imperfect information 27, 43, 47

income smoothing 18

indexation lag 259-60

indexed savings products 256


  • break-even inflation rate 250, 251, 266-7

  • financial dollarization as a rational response to inflation uncertainty 69-76, 84

  • forecasting 122-5

inflation-indexed debt 9-10, 243-72, 304-5, 306-8

  • alternatives to 253-5

  • characteristics of major markets 267-9

  • country experiences 244-7

  • local market development 255-7, 259, 319, 320

  • operational issues 259-64; institutional prerequisites 262-3; instrument design 259-61; issuance mechanisms 261-2; market support mechanisms 262; strategic issues 263-4

  • portfolio benefits 248-53; limiting costs 248-51; limiting risks 251-3

  • spill-over effects 257-9

  • UK experience 245, 261, 262, 264-7, 268

  • Uruguay 166, 246-7

  • and voluntary de-dollarization of financial contracts 299-303

inflation targeting 4-5, 95, 99-114, 117, 139-44, 325

  • evidence of fear of floating among Latin American inflation targeters 141-3

  • impact of dollarization on monetary policy 100-2

  • monetary experiences of Peru and Bolivia 102-6

  • monetary policy transmission in Chile and Peru 106-9; financial stress 107-9; exchange rate pass-through 106-7; interest rate pass-through 107, 109

  • Peru see Peru

  • reaction functions 110-12

  • Uruguay 166

Inoue, H. 249


  • framework and liquidity risk 205-6

  • MVP-based explanation of dollarization 47

  • prerequisites and inflation-indexed debt 262-3

  • quality 71, 72-6

insurance 217, 218-21, 232

  • private 219-21

  • public 221

  • self-insurance vs external insurance 218-19

interest rate

  • interbank rate in Peru 103, 119-20, 122, 126

  • shocks 107, 108

  • target in Peru 116, 118-21

  • Uruguay 167; spread 163

interest rate pass-through 107, 109, 120, 121

intermediate inflation targeting (IIT) 101-2

internalization of risk 128, 131-2

International Accounting Standard (IAS) 39, 190

international bonds, in local currency 315

international financial institutions (IFIs) 221

  • see also International Monetary Fund (IMF)

International Monetary Fund (IMF) 171-2, 219

  • contingent credit line (CCL) initiative 221

  • public insurance 221

  • and Uruguay 156-7, 158, 168-9

international reserves 221, 222

  • liquidity risk 205-6

  • Peru 133

  • reaction functions 111, 112

  • Uruguay 164, 171

  • volatility in Latin America 141-2

investment grade 148, 155

IS curve 123-5

Israel 257

  • exchange rate fluctuations 278

  • free-fall events 69

  • gradual de-dollarization 8, 274

issuance mechanisms 261-2

Italy 246,268,269

Ize, A. 45-6, 71, 76

Japan 246, 268

lag, indexation 259-60

Lahura, E. 120

large borrowers 47

Latin America 4, 64-89, 90-6

  • credit risk 76-84; empirical results 81-4

  • estimation methodology 88

  • financial dollarization as a rational response to inflation uncertainty 69-76, 84; empirical results 72-6; theoretical overview 69-72

  • foreign interest in Latin American local currency bonds 315-16

  • inflation experience 243, 251, 252, 258

  • inflation-indexed debt 246-7

  • inflation targeting 116,139-40; evidence of fear of floating in inflation targeters 141-3

  • policy implications of financial dollarization 94-6

  • policy options and strategies 318-27

  • reversal of capital flows 285

  • trends in financial dollarization 65-9

  • variable description 86-7

  • see also under individual countries

Latvia 203-5

Lebanon 201, 202, 203-5, 205-6

legal imperfections 44-5

Leiderman, L. 274, 318-20

lender of last resort (LOLR) 172

  • model of LOLR and bank demand for dollar liquidity 223-4, 233-4; case of no LOLR 223, 233; case with LOLR 223, 233-4; differentiated banks 224, 234

  • systemic liquidity risk management 223; policy implications 224-5

Levy Yeyati, E. 45-6, 71

liability base 193

liability dollarization 273

liquid asset requirements (LARs) see liquidity requirements

liquidation funds 161-2


  • inflation-indexed bonds 249-50

  • trade-off with hedging 307-8

liquidity premium 228

liquidity requirements 7, 192-4, 203, 204, 232, 239, 315

  • CBRs and 229, 231-2

  • systemic liquidity risk management 217, 221-5; model of LOLR and bank demand for dollar liquidity 223-4, 233-4; policy implications 224-5

  • Uruguay 161

liquidity risk 47-8, 116, 238, 239-40

  • banking supervision 178-9,190-4, 214-15; buffer 192-4; supervision and management 191-2

  • current supervisory practice 180, 203-6; institutional framework and market conditions 205-6; prudential rules 180, 203, 204; supervisory assessment and preventive action 205; supervisory guidelines 203-5

  • systemic liquidity risk management see systemic liquidity risk management

loan classification rules 186-8

local currency bonds 315-16

local market development 11, 45

  • inflation-indexed debt and 255-7, 259, 319, 320

macroeconomic stability 66, 67

market awareness initiatives 256-7

market-driven de-dollarization policy 49-52

market failures 3, 43, 44-5, 61-2, 62-3

market segmentation 325-6

market support mechanisms 262

maturity extension 169

maturity mismatches 132

  • limits 203

Mercosur 148-9

Mexico 7

  • contingent credit line 220, 221

  • de-dollarization 8, 52, 274

  • inflation-indexed debt 246, 247, 255-6, 263

  • Taylor rules 142, 143

minimum variance portfolio (MVP) 2, 19-20, 21, 30-1, 40

  • computation of 87

  • equilibrium 26-7, 32

  • explanation of dollarization 45-7

  • financial dollarization in Latin America 71, 72-6, 83-4, 91

mismatch ratio 312, 314-15

Missale, A. 253, 254

monetary policy 4-5,10-11

  • asymmetric 2, 21, 42, 47

  • effectiveness 48; de-dollarization and 112-13

  • endogenous 26-7, 42, 47

  • exogenous 24-6

  • impact of dollarization on 100-2

  • implementation in Peru under financial dollarization 121-7

  • inflation targeting see inflation targeting

  • policy analysis framework 17-18

  • reaction functions 110-12

  • role in Uruguay crisis 165-8

  • shocks 107, 108

  • transmission 106-10; exchange rate pass-through 106-7, 108; financial stress 107-9; interest rate pass-through 107, 109

monetary targets 119

moral hazard paradigm 2, 18, 27-8, 43-4, 47-8

Morales, J.A. 321-3

mortgages 326-7

narrow bank schemes 229, 230-1

  • Chile 225, 227

New Banco Comercial (NBC) 161

Nicaragua 69, 70, 79, 81

nominal fixed-rate debt 254-5, 264

nominalization 9, 305

non-delivery forward contracts 164

non-performing loans (NPLs) 107-10, 206-8

non-tradable sector 92-4

observed MVP 46

offshorization 44-5, 230

operational target, Peru 116, 118-21

option clause 226

‘original sin’metaphor 311

Ouro Preto, Treaty of 148

output gap 123-5

overvaluation overhang 2, 22, 25

Pakistan 8, 10, 52, 274, 280-5, 292

  • FCD freeze and de-dollarization 283-5

  • policy-induced dollarization 280-3

Paraguay 66, 70, 78, 79, 81, 133

path dependence 9

payments dollarization 273, 323

  • Peru 323, 324, 324-5

perfect information 20-7, 41-2

Peru 8, 52, 63, 66, 80, 115-38, 315, 318

  • asset dollarization 323-5

  • banking supervision 187, 201, 202, 203, 205-6

  • controlling financial dollarization risks 127-34; de-dollarization policies 127-31; exchange rate smoothing 134; internalization of risk 131-2; international reserves 133; reserve requirement on dollar liabilities 133-4

dealing with inflationary pressures (2004) 126-7

deflationary pressures 126

deposit dollarization 80, 81

effect of credit risk on solvency of banking system 209

failed forced de-dollarization 10, 275-80

financial dollarization indicators 129

free-fall events 69

inflation experience 258

inflation forecasting system 122-5

inflation-indexed debt 246, 247, 250, 251, 255-6, 263-4

inflation targeting 4-5, 102, 116, 117-18, 140-1, 144; in practice 125-7

interest rate variability 131, 135

monetary policy: implementation under financial dollarization 121-7; performance 102-4, 105, 106; reaction functions 110-12; transmission 106-10

  • NPLs 207, 208

  • operational target 116, 118-21

  • risk management arrangements 78, 79

  • yield curve for deposit interest rates 70

Phillips curve 122-3

physical location, and segregation of deposits 229, 230

Poland 205, 246, 269

  • banking supervision 201, 202

  • exchange rate fluctuations 278

  • free-fall events 69

  • gradual de-dollarization 8, 274

  • NPLs 207, 208

policy analysis framework 2, 15-34, 35-7

  • credit risk paradigm 18, 20-7

  • de-dollarization 28-30, 31

  • default equilibria and monetary credibility 32-3

  • imperfect information paradigm 27

  • model 16-19; economy 16-17; financial equilibrium 18-19; monetary policy 17-18

  • moral hazard paradigm 18, 27-8

  • volatility paradigm 18, 19-20

policy credibility see credibility

policy failures 3, 42

policy-induced dollarization 280-3

policy options and strategies 318-27

political security 283, 285

political stability 72-6

Powell, A. 76

prescriptive approach 188

preventive action

  • credit risk 201-3

  • liquidity risk 205

price discovery 261-2

price indexation 51-2, 92

  • see also inflation-indexed debt

price risk portfolio paradigm 39-41, 46

prices, listing in foreign currency 131

private insurance 219-21

private sector 256

privately issued indexed debt, markets for 307-8

provisions 183, 186-8

  • vs buffer 190

  • estimating credit risk 207-8

prudential guidelines 78, 79

prudential policy 5-7, 11

  • see also banking supervision; systemic liquidity risk management

prudential regulation 319

  • credit risk 199-201

  • foreign exchange risk 197, 198

  • liquidity risk 180, 203, 204

  • moral hazard and 43-4, 47-8

  • tightening 30, 50-1, 196

public accounts: link with banking sector 152-3

public debt see debt, public

public insurance 221

quantitative risk management culture 239

quarterly projection model (QPM) 122, 123, 123-4

radical de-dollarization 52-3

reaction functions 110-12, 140

real dollarization 273, 323

real yield curve 257

recovery value of collateral 185-6

regional bubble 148-9

regulatory arbitrage 196

regulatory incentives 169

  • removal of 293

Reinhart, C. 115, 274

remittances 281-2, 284

reserve accumulation 321

reserve requirements 203, 204

  • buffer for liquidity risk 193-4

  • Peru 133-4, 193-4

  • Uruguay 160

reserves coverage ratio 314, 315

risk premia 20-1, 218-19

  • inflation-indexed debt 248-51

risk sharing 61-2, 62-3

risk-tolerance level 189-90

Rodlauer, M. 320-1

Rodríguez, C.A. 71

Rogoff, K. 115, 274

Romania 201

Rossini, R. 323-5

Russian crisis 153-4

Sack, B. 249, 256, 257

safe haven effect 20, 26, 40-1, 47

Savastano, M. 115, 274

savings products, indexed 256

scenario analysis 191-2, 201, 202

Schmidt-Hebbel, K. 142, 143

Schmukler, S. 71

securities balances 131

securities, composition of 131, 132

self-insurance 218-19

Shah, P. 226

Shiller, R. 250

sight deposits

  • narrow bank system 227, 230-1

  • Uruguay 163-4

Singapore 201, 205

Slovakia 207, 208

Slovenia 201, 206

solvency risk 177

South Africa 269

special drawing right (SDR) 156, 157

specific provisions 188

spill-over effects

  • Argentinian and Russian crises 153-4

  • inflation-indexed debt 257-9

State Bank of Pakistan (SBP) 282-4

stochastic structure of the economy 306-7

strategy 263-4

stress tests 195, 215

  • credit risk 180, 185, 186, 187, 201, 202, 206-9

  • liquidity risk 191-2, 205

structural fragility 148-53, 171

supervisory assessments

  • credit risk 186, 201-3

  • foreign exchange risk 197, 198

  • liquidity risk 192, 205

supervisory guidelines

  • credit risk 201, 202

  • foreign exchange risk 197, 198

  • liquidity risk 203-5

supply, aggregate 122-3

suspension of convertibility 226

Sweden 205, 206

  • inflation-indexed debt 246, 262, 268

systemic liquidity risk management 7, 216-37

  • case for liquidity requirements 217, 221-5

  • circuit breakers 225-32

  • insurance 217, 218-21

  • model of LOLR and bank demand for dollar liquidity 223-4, 233-4

  • see also liquidity risk

Taylor rules 110-12, 142

Thatcher, M. 248

tradable sector 92-4

trade 148-9

  • exports 80-1, 82

transition economies 65, 66

transmission capacity 48

transparency 112

Treasury bills 166, 253

Treasury bonds 324

  • Peru 129-30

trends in financial dollarization 65-9

trigger for CBRs 231-2

Turner, P. 311, 312

turnover 249

Udibonos (Mexico) 246, 247

unexpected losses 188-90

  • capital vs provisions 190

unidad de fomento (UF) (Chile) 9, 246, 299-302, 304

Unidad de Fomento de la Vivienda (UFV) (Bolivia) 260-1

United Kingdom (UK) 245, 261, 262, 264-7, 268


  • inflation-linked bonds 246, 268

  • suspension of convertibility 226

Uribe, M. 71

Uruguay 66, 80, 133, 226

  • banking supervision 201, 202

  • crisis management 5-6, 147-76, 238; August plan 159-62; debt restructuring 168-9; early results of crisis resolution strategy 162-5; eve of the banking holiday 157-9; lessons from the crisis 171-3; recovery 147, 169-70; role of monetary policy 165-8; spill-overs from Argentinian and Russian crises 153-4

  • deposit dollarization 81

  • free-fall events 69

  • inflation-linked debt 166, 246-7

  • in the 1990s 148-53; banking for Argentinians 151-2; financial fragility of banking system 150-1; fiscal policy 149-50; link between public accounts and banking sector 152-3; trade, Mercosur and regional bubble 148-9

  • risk management arrangements 79

  • yield curve for deposit interest rates 70

Velasco, A. 62, 63

volatility 2, 249, 251

  • paradigm 39-41, 46; policy analysis framework 18, 19-20

voluntary de-dollarization 273-4

Walker, E. 246, 255

weak institutions 71

Werner, A. 142, 143

yield curves 69-71

Zambia 69

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