II Trends and Explanations

Adam Bennett, Eduardo Borensztein, and Tomás Baliño
Published Date:
March 1999
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In general terms, dollarization is a response to economic instability and high inflation, and to the desire of domestic residents to diversify their asset portfolios. In conditions of hyperinflation, dollarization is typically quite widespread because the public seeks protection from the cost of holding assets denominated in domestic currency. But, remarkably, the increase in dollarization in some Latin American and Asian countries has continued and even accelerated in recent years following successful stabilization. Some authors have pointed to ratchet effects in currency substitution to explain this development. But there is suggestive data indicating that the increase in local holdings of dollar assets in the 1990s also resulted from the reversal of capital flight and remonetization.

Currency Substitution Versus Asset Substitution

To understand these developments, it is useful to distinguish between two motives for the demand for foreign currency assets: currency substitution and asset substitution.5 Currency substitution occurs when foreign-currency-denominated assets are used as a means of payment, while asset substitution occurs when foreign-currency-denominated assets serve as financial assets (store of value) but not as a means of payment or unit of account. Currency substitution typically arises under conditions of high inflation or hyperinflation when the high cost of using domestic currency for transactions prompts the public to look for alternatives. Asset substitution results from the public’s allocation decisions in view of the risk and return characteristics of domestic and foreign assets. Historically, foreign-currency-denominated assets have provided the opportunity of insuring against major macroeconomic risks in many developing countries. Where indexed monetary assets have been available, as in Chile and Brazil, dollarization has been much less widespread, suggesting that indexation may be an alternative to dollarization in the face of macroeconomic instability. Even in countries that currently enjoy stability, foreign-currency-denominated assets may still provide insurance against the probability, small though it may be, of a return to inflation and devaluation, and they may also contribute to a reduction in overall risk in a balanced portfolio.6

Because of their close connection with monetary developments, this section focuses on three types of dollar-denominated financial assets: FCD in the domestic banking system, dollar currency in circulation within the domestic economy (DCC), and cross-border deposits held at banks abroad (CBD). The last of these may not be considered representative of dollarization because it is located abroad, but it is highly relevant because of its close substitutability with FCD. Because reliable information is available only for FCD, most studies are based on this measure only.7 But even the incomplete information available on the other assets can shed some light on recent developments.8

Foreign Currency Deposits

FCD constitute a significant share of broad money in several developing countries and transition economies that have made use of IMF resources in recent years, reaching over 50 percent in Azerbaijan, Bolivia, Cambodia, Croatia, Nicaragua, Peru, and Uruguay in 1995 (see Table 1). An FCD ratio of around 15–20 percent appears common in countries where residents are allowed to maintain foreign currency accounts. On account of their large size, persistence, and volatility over time, FCD developments in two regions—Latin America and the transition economies of Eastern Europe and the former Soviet Union—are particularly worth highlighting. Figure 1 displays the ratio of FCD to broad money (inclusive of FCD) for a selected group of countries in these two regions.9

Figure 1.Dollarization and Stabilization1

(Ratio of foreign currency deposits, FCD, to broad money, M3; in percent)
(Ratio of foreign currency deposits, FCD, to broad money, M3; in percent)

Sources: National authorities; and IMF staff estimates.

1 Vertical line denotes end of period of high inflation. For Uruguay, the gradual nature of the stabilization process does not permit one to identify a precise timing for stabilization.

With the advent of market reforms in the transition economies during the early 1990s, restrictions on FCD were generally eased (Sahay and Végh, 1996). As a result, the FCD ratio rose rapidly, reaching peak levels of 30–60 percent in most transition economies during the 1990–95 period (see Table 1). High inflation rates, negative real interest rates on domestic-currency-denominated assets, and sharp devaluations that increased the domestic currency value of dollar deposits contributed to the rise in the FCD ratio. Following price stabilization, the FCD ratio declined sharply in countries such as Armenia, Estonia, Poland, and Mongolia. The valuation effect of substantial real appreciation also contributed to this decline, since it more than offset the rise in the dollar volume of FCD in several cases.

Abstracting from the periods when the convertibility of FCD was suspended, the ratio of FCD to broad money (inclusive of FCD) increased steadily in several Latin American countries during the 1970s and the 1980s, in a period of high inflation and a gradual easing of restrictions on FCD (Savastano, 1996). The 1990s witnessed a further easing of FCD restrictions in most countries, and FCD ratios continued to rise despite a sharp deceleration in in flation rates, reaching 80 percent in Bolivia and Uruguay, over 60 percent in Peru, and nearly 50 percent in Argentina by 1995–96 (see Figure 1).

Although the history of high inflation and financial instability is closely linked to the prevalence of dollarization in several Latin American countries, it is remarkable that the FCD ratio increased sharply after countries successfully battled inflation in the late 1980s and early 1990s. (The approximate time of stabilization is shown by the vertical line in Figure 1.) One possible explanation is “hysteresis” or some form of nonreversibility in the process of dollarization (see Guidotti and Rodríguez, 1992). This could emerge, for example, because changing uses and practices regarding the settlement of transactions is a slow process that involves (informal) institutional changes and takes place only when there are significant benefits to be gained by switching currencies. For the same reasons, a reversal of dollarization after stabilization would also be slow, especially if there are no significant benefits to be gained from switching back to the domestic currency as a means of payment.10 It is also possible that financial innovation and liberalization have permanently reduced the cost of holding assets denominated in dollars.

Cross-Border Deposits

While the hysteresis argument may explain the persistence of dollarization, it would still not account for the cases of steady increase in dollarization after stabilization. The surge in capital inflows to developing countries in the 1990s offers an additional, or perhaps alternative, explanation for the persistent growth in the FCD ratio in the poststabilization period in Latin American countries.11 It is quite suggestive that the increase in FCD (in dollar terms) coincided with the decrease in CBD in the 1990s for various Latin American countries, including the short-lived reversal in the cases of Mexico and Argentina at the time of the Mexican peso crisis (Figure 2). This suggests that the increase in FCD in part reflected a shift in residents’ portfolios from CBD to dollar deposits in the domestic banking system. In this sense, the increase in domestic dollarization would reflect an increase in confidence in the domestic economy (although not necessarily in the domestic currency), rather than a persistent lack of credibility.12 This could be part of the process of general remonetization of the economy, as well as an increase in dollar-denominated lending by domestic banks. Moreover, because the persistent increase in the FCD ratio seems to be related to shifts from CBD to FCD, it is possible that the increase in the volume of FCD does not represent an increased volume of overall dollar assets. If a more comprehensive measure were available, one inclusive of cash and cross-border deposits, the share of this broader set of foreign currency assets might even be seen to be declining.

Figure 2.FCD and Cross-Border Deposits (CBD)

(In millions of U.S. dollars unless otherwise noted)
(In millions of U.S. dollars unless otherwise noted)

Sources: Bank for International Settlements (BIS); national authorities; and IMF staff estimates.

Dollar Currency in Circulation

Although estimates of the amount of DCC in the home country do not exist, there is some suggestive data on flows of U.S. currency to other countries, collected from U.S. Customs forms called Currency and Monetary Instruments Reports (CMIR), which are completed when currency in amounts of $10,000 or higher is physically transported into or out of the United States.13 The data displayed in Table 2 show strikingly large flows of U.S. currency to several developing countries. The cumulation of net flows into these countries since 1989 reaches or exceeds 12 percent of GDP for Argentina (Box 1), Bolivia, Latvia, Russia, and Uruguay and exceeds DCC by a factor of two to three. One obvious shortcoming of these data is that much of the currency shipped to some countries ends up in third countries (or returns to the United States without being recorded) via capital outflows, tourism expenditures, and so on. In Russia, for example, “shuttle” trade (imports by individuals who cross borders to purchase goods in other countries) is conducted mainly in cash. In Argentina, significant outflows of dollar currency have also apparently taken place, including a large volume related to international tourism (Kamin and Ericsson, 1993).

Table 2.Cumulative Net Inflows of U.S. Dollar Currency, 1989–96
CountryIn Millions of

U.S. Dollars
In U.S. Dollars

per Capita
As Percent of

Local Currency

in Circulation
As Percent

of GDP
As Percent of

Foreign Currency

Sources: Data on cumulative net dollar currency flows from the United States from 1989 through 1996 from Financial Crimes Enforcement Network, U.S. Department of the Treasury, as recorded in the Customs Service Currency and Monetary Instruments Reports (CMIR) forms. See text for discussion. Other data from IMF, IFS, and from national authorities (central bank bulletins).
Sources: Data on cumulative net dollar currency flows from the United States from 1989 through 1996 from Financial Crimes Enforcement Network, U.S. Department of the Treasury, as recorded in the Customs Service Currency and Monetary Instruments Reports (CMIR) forms. See text for discussion. Other data from IMF, IFS, and from national authorities (central bank bulletins).

The experience of Latin American and transition economies suggests several stylized facts. First, as restrictions are lifted, the FCD ratio can be expected to increase as the public takes advantage of the opportunity to diversify its asset portfolio or to repatriate funds that were held in other countries. Where restrictions are suddenly removed, as in some transition economies, a distinct stock adjustment can be observed. Second, the existence of macroeconomic imbalances reflected in high inflation rates can lead to currency substitution, especially when other inflation-protected liquid financial assets are not available and more so in situations of hyperinflation. Third, currency substitution can persist even after countries have successfully brought down inflation rates, especially when they previously experienced long periods of inflation. Finally, even in the absence of currency substitution, dollarization in the form of asset substitution can be a permanent feature, especially as the process of financial deepening and globalization advances.

Box 1.Flows of U.S. Dollar Cash to Argentina

Despite shortcomings, the data from U.S. Customs Currency and Monetary Instruments Reports (CMIR) can be informative, as the depicted evolution of net dollar cash inflows to Argentina suggests. At times of financial insecurity there are sharp increases in the shipment of U.S. dollar currency into the country. This is noticeable in the two spikes in the first figure. The first spike took place at the time of the Mexican crisis (end-1994/early 1995), and the second one at the time of the resignation of Minister Cavallo in July 1996. The second figure shows that the increase in DCC (obtained from cumulative flows) parallels that of FCD, except for a movement in the opposite direction at the time of the Mexican crisis (1994–95), which presumably reflects a run on domestic dollar deposits. This evidence suggests that DCC may function partly as CBD (as suggested by the flight from FCD to CBD and DCC during the Mexican crisis) and partly as a complement to FCD (as suggested by the general growing trend in both aggregates). While this information does not permit one to construct firm estimates, it is suggestive of the magnitude and relevance of the stock of DCC in dollarized economies.

Argentina: Net Inflow of Dollar Cash per Quarter

(In billions of U.S. dollars)

Argentina: Stocks of Foreign Currency Deposits, Dollar Cash, and Cross-Border Deposits per Quarter

(In billions of U.S. dollars)

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