Front Matter

Front Matter

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

The Policy Agenda

Edited by

Adrián Armas

Alain Ize

and

Eduardo Levy Yeyati

© International Monetary Fund 2006

All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission.

No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP.

Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages.

The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988.

First published 2006 by

PALGRAVE MACMILLAN

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Companies and representatives throughout the world.

PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries.

ISBN-13:978-1-4039-8759-4

ISBN-10:1-4039-8759-9

This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources.

A catalogue record for this book is available from the British Library.

Library of Congress Cataloging-in-Publication Data

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

    • p. cm.

  • Includes bibliographical references and index.

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

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

HG1496.F56 2006

332.4’ 564—dc22

2006041757

10 9 8 7 6 5 4 3 2 1

15 14 13 12 11 10 09 08 07 06

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

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

Contents

List of Tables

List of Figures

List of Abbreviations

AECM

Aggregate effective currency mismatch

ALM

Asset-liability management

AMC

Asset management company

BCB

Central Bank of Bolivia

BCBS

Basel Committee on Banking Supervision

BCC

Central Bank of Chile

BCPR

Bank credit to private sector

BCRP

Central Reserve Bank of Peru

BHU

Banco Hipotecario del Uruguay

BIS

Bank for International Settlements

BOE

Bank of England

BROU

Banco de la República Oriental del Uruguay

CACs

Collective action clauses

CAPM

Capital asset pricing model

CAR

Capital adequacy ratio

CBRs

Circuit breakers

CCAPM

Consumption capital asset pricing model

CCL

Contingent credit line

CD

Certificate of deposit

CDRs

Exchange rate-indexed securities

CGFS

Committee on the Global Financial System

CND

Corporación Nacional para el Desarrollo

CPI

Consumer price index

DMO

Debt Management Office

DQAF

Data Quality Assessment Framework

EMBI

Emerging Market Bond Index

ER

Exchange rate

EU

European Union

FCDs

Foreign currency deposits

FD

Financial dollarization

FF

US Federal Fund rate

FFBS

Fund for Fortifying the Banking System

FFCT

Fear of floating competitiveness targeting

FFIT

Full-fledged inflation targeting

FLAR

Latin American Reserve Fund

FRNs

Floating rate notes

FSBS

Fund for Stability of the Banking System

FX

Foreign exchange

GDP

Gross domestic product

GMM

Generalized method of moments

HICP

Harmonized index of consumer prices

IADB

Inter-American Development Bank

IAS

International Accounting Standard

IFIs

International financial institutions

IFRS

International Financial Reporting Standards

IFS

International Financial Statistics

IG GEMMS

Index-linked Gilt edged market makers

IIT

Intermediate inflation targeting

IMF

International Monetary Fund

IS

Investment-savings

IT

Inflation targeting

LARs

Liquid asset requirements

LFT

Letras Financieras do Tesouro

LIBOR

London Inter Bank Offering Rate

LOLR

Lender of last resort

MFD

Monetary and Financial Systems Department

MVP

Minimum variance portfolio

NBC

New Banco Comercial

NER

Nominal exchange rate

NFCA

Net foreign currency assets

NIR

Net international reserves

NPLs

Non-performing loans

NTN

Notas do Tesouro Nacional

OAT

Obligations assimilables du Trésor

OECD

Organization for Economic Cooperation and Development

OLS

Ordinary least squares

OPP

Office for Planning and Budgeting

PR

Pakistani rupee

PRS

Political risk rating

QPM

Quarterly projection model

REER

Real effective exchange rate

SBP

State Bank of Pakistan

SDDS

Special Data Dissemination Standards

SDR

Special drawing right

TB

Treasury bills

TIIS

Treasury inflation-indexed debt

UF

Unidad de fomento

UFV

Unidad de fomento de la vivienda

UIRP

Uncovered interest rate parity

UR

Unidades reajustables

VAR

Vector autoregressive

VAT

Value added tax

WEO

World Economic Outlook

Notes on the Contributors

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Acknowledgments

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

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

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

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

Foreword

Óscar Dancourt and Stefan Ingves

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

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

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

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

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

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

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