Chapter

I Introduction

Author(s):
Anne Gulde, David Hoelscher, Alain Ize, Dewitt Marston, and Gianni De Nicolo
Published Date:
June 2004
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Dollarization, a common feature in many developing and transition countries, can have important implications for financial stability. In a bid to promote financial intermediation and deepening, many countries around the world have openly encouraged or accommodated the growth of financial dollarization—the use of a foreign currency, mainly the dollar, to denominate financial contracts. Neither the phenomenon itself nor the specific financial sector risks that may be associated with it, such as the limitations it poses on the central bank’s lender-of-last-resort functions or the added constraints it may impose on banks’ liquidity management, are new. However, the recent rapid growth in dollarization in many parts of the world (Box 1), the ongoing financial crises in several highly dollarized Latin American countries, and the attendant visible problems for some countries’ banking systems suggest that allowing financial dollarization to spread might involve important trade-offs between financial development and stability.

Box I.Dollarization Types and Trends

Dollarization can take multiple forms. Official (de jure) dollarization occurs when the U.S. dollar is adopted as the predominant or exclusive legal tender. Partial (de facto) dollarization occurs when the local currency remains the exclusive legal tender but financial and payments transactions are allowed to be denominated in dollars, effectively allowing a bicurrency system to take hold. It is useful, in turn, to distinguish between payments dollarization (the use of foreign currency for transaction purposes), financial dollarization (residents’ holding of financial assets or liabilities in foreign currency), and real dollarization (the indexing, formally or de facto, of local prices and wages to the dollar). Financial dollarization can also be classified as domestic (e.g., the use of the dollar in claims between residents) or external (e.g., the use of the dollar in claims between residents and nonresidents). While the U.S. dollar is by far the dominant currency used in bicurrency systems, other currencies can be (and are being) used as complements to the local currency. The term “dollarization” should thus be taken in a generic sense.

Partial dollarization affects a wide set of countries and has increased in recent years. The set of partially dollarized countries includes a large number of developing, emerging, and transition countries (see Table 1). The ratio of onshore foreign currency deposits to total onshore deposits increased substantially in Latin America (defined as South America, Mexico, and Central America) and the transition countries. It has also increased, albeit somewhat more moderately, in Africa, Asia, and the Middle East. It remained constant on average (and low) only in the Caribbean region and the industrial countries.

Table 1.Average Foreign Currency Deposits to Total Deposits(In percent)
RegionsNumber of Countries199619971998199920002001
South America845.846.149.453.25455.9
Transition economies2637.338.943.544.346.947.7
Middle East736.537.237.737.538.241.9
Africa1427.927.327.828.932.733.2
Asia1324.92826.828.828.728.2
Central America and Mexico720.620.82222.122.524.7
Caribbean106.37.66.86.76.16.2
Industrial countries147.47.57.56.776.6
Sources: National authorities; IMF, International Financial Statistics database; and IMF staff estimates.
Sources: National authorities; IMF, International Financial Statistics database; and IMF staff estimates.

The main purpose of this paper is to contribute to the emerging debate regarding an adequate prudential and crisis management framework for dollarized economies. From a current policy perspective, two issues deserve particular attention. Do the additional financial sector risks in dollarized countries require adaptations to the commonly recommended prudential framework, particularly when viewed from a systemic perspective? Equally important, in the case where a country does face a financial sector crisis, is the recommended response different for dollarized countries? The associated issues in the area of prudential oversight have not yet been fully resolved among economists and supervisors, and no clear guidelines from relevant standard-setting bodies, such as the Basel Committee on Banking Supervision (BCBS), have yet been worked out. Against this background, our preliminary conclusions are intended to be first steps that may need to be revisited in the context of further analysis of country experiences and more in-depth discussions with supervisory and standard-setting bodies.

Dollarization is both a reflection of and has key implications for macroeconomic policies, especially monetary policy. While this paper recognizes these two-way linkages, it addresses macroeconomic issues only inasmuch as they have a direct bearing on financial sector stability. Moreover, although this paper takes a stance on the macroeconomic policies that need to accompany an effort to limit the financial vulnerabilities deriving from dollarization, its main focus is on how to limit these vulnerabilities given the macroeconomic environment.

The primary focus of this paper is on economies that have a local currency but where a high proportion of domestic financial transactions involving residents is denominated in dollars. Based on the analysis, such highly dollarized economies pose the most serious risks and constraints. This paper refers to marginally or fully dollarized economies only to the extent that they provide a benchmark and does not directly address stability issues associated with large, dollarized, offshore financial centers, where transactions with residents account for only a small fraction of banks’ balance sheets and where prudential concerns are of a different nature. In addition, this paper mostly focuses on the domestic component of financial dollarization (e.g., transactions between residents) and refers to external dollarization (e.g., transactions between residents and nonresidents) only when it has a direct bearing on the stability of the domestic financial system.

While examples are drawn more heavily from the Latin American region, the issues addressed are equally relevant to dollarized countries in other regions of the world. The greater number of examples in Latin America reflects that banking crises or near-crises have been more frequent or more directly related to dollarization in this region. While the reasons underlying the relatively lower frequency of financial crises, or the lesser role played by dollarization in aggravating the crises, in other parts of the world with equally dollarized financial systems are complex, the lower level of financial intermediation and less open capital accounts are probably important explanatory factors (Box 2 and Table 2). If so, highly dollarized non—Latin American countries could become more vulnerable to such crises as their financial systems deepen and they become more integrated with the international financial system. Hence, the experiences of the highly dollarized Latin American countries provide useful lessons for other regions.

Table 2.Indicators of Domestic Financial Intermediation in Foreign Currency, 2001(In percent)
RegionsForeign

Currency

Deposits to

GDP
Foreign Assets

to Foreign

Currency

Deposits
Cross-Border

Deposits to

Foreign

Currency

Deposits
Latin America121.153.7124.0
Transition economies28.8104.1130.9
Low income37.8260.7472.1
Sources: National authorities; Bank for International Settlements (BIS), International Financial Statistics; IMF, International Financial Statistics database; and IMF staff estimates.

Includes 15 South and Central American countries.

Includes 23 transition economies.

Includes 13 African and 12 Asian countries.

Sources: National authorities; Bank for International Settlements (BIS), International Financial Statistics; IMF, International Financial Statistics database; and IMF staff estimates.

Includes 15 South and Central American countries.

Includes 23 transition economies.

Includes 13 African and 12 Asian countries.

Box 2.Dollarization Levels Versus Dollarization Risks

While high financial dollarization characterizes Latin American countries as well as transition economies and some (non-Latin American) low-income countries, the levels and nature of financial intermediation differ substantially among these three groups. Dollar intermediation in Latin American countries, as measured by the ratio of foreign currency deposits to GDP, is substantially higher than in transition economies and (non-Latin American) low-income countries (see Table 2). The more limited scope for financial intermediation in transition economies and (non-Latin American) low-income countries is reflected in higher ratios of foreign assets held by banks to foreign currency deposits (e.g., local foreign currency funding is primarily held abroad rather than loaned out locally) and higher ratios of cross-border deposits to foreign currency deposits (e.g., the public holds a large proportion of its foreign currency assets abroad rather than in the local banking system). While data limitations restrict the scope for similar cross-country comparisons of dollar cash holdings, there are indications that these are particularly important in many of the transition economies (see Havrylyshyn and Beddies, 2002).

These differences, which are likely to have important differential implications for financial stability, could erode over time as dollar financial intermediation deepens in the transition economies and the (non-Latin American) low-income countries. Liquidity risk is likely to be less of an issue in countries where local dollar deposits are small in magnitude and are not held as substitutes for funds abroad or under the mattress. In addition, both liquidity risk and solvency risk are clearly more limited when a large fraction of foreign currency deposits is held by local banks in the form of liquid assets abroad rather than loaned out locally.

The remainder of this paper is organized as follows: Section II examines the specific risks for financial soundness associated with dollarization; Section III discusses approaches to stopping bank runs and stabilizing liquidity conditions in the wake of a banking crisis in a dollarized economy; Section IV proposes measures to limit the risk of banking crises in dollarization-prone economies; and Section V concludes.

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