Chapter

III Risks and Benefits of Dollarization

Author(s):
Adam Bennett, Eduardo Borensztein, and Tomás Baliño
Published Date:
March 1999
Share
  • ShareShare
Show Summary Details

In a fully liberalized and convertible financial system, savers would prefer to hold a portion of their portfolio in foreign-currency-denominated assets, simply in order to achieve a desired distribution of risk and returns. But such diversification may increase systemic risks when financial systems are still immature and subject to many distortions. Therefore, dollarization of financial systems in developing countries presents both advantages and risks. On the one hand, allowing FCD in the domestic financial system provides the opportunity to allow greater domestic intermediation. On the other hand, because of currency risk and potential balance of payments problems, the systemic risks are high, and dollarization could increase the potential for financial and banking crises. These considerations imply that the speed with which it would be advisable to advance toward a fully convertible financial system and the proper timing for the liberalization of FCD and loans will be determined by the conditions prevailing in specific cases.

Benefits

Allowing FCD in the domestic financial system enhances the opportunity for reintermediation in economies that have undergone periods of very high inflation and unstable macroeconomic conditions, during which agents may have become reluctant to hold deposits in the banking system. With a restoration of stability, it is likely that confidence will be rebuilt only gradually. The availability of FCD can speed up this process to the extent that agents may be more willing to return to domestic intermediaries if they can hold dollar-denominated assets.

Allowing FCD also promotes financial deepening. Domestic banks can expand their operations rapidly by competing for the FCD held by residents in cross-border accounts. In fact, the growth of domestic banks would be somewhat limited if they were not allowed to offer FCD, since residents are unlikely to reduce significantly the share of their savings held in the form of dollar financial assets for some time. In addition, the existence of dollar accounts in domestic banks could facilitate the integration of the domestic market into the rest of the world and lower the cost of international financial transactions. Also, in case of fear of devaluation, the availability of FCD may encourage depositors to shift at least part of their local currency deposits (LCD) into FCD rather than CBD.14

Allowing residents to hold FCD can increase credibility by raising the cost of monetary indiscipline, thus committing the government to stronger financial policies. Similar arguments have been made to support the introduction of indexed government debt. A similar type of commitment strategy is to issue dollar-denominated debt to domestic residents as a substitute for domestic currency debt. However, it is not always the case that “raising the stakes” in this form will guarantee sound policies or avoid crises, and the costs of a crisis would be higher if one did occur.15 Furthermore, when confidence is very weak, it would appear that a different type of monetary framework, such as a currency board, would be more effective, both to bolster financial discipline and to reinforce confidence. When even this is not sufficient to strengthen the government’s financial discipline sufficiently, full dollarization—abolition of the domestic currency altogether—could indeed be the only alternative to achieve price stability. This would entail certain losses for the country: forgoing seignorage, limitations to the lender of last resort function, and the loss of the exchange rate instrument. It is true, however, that the value of these resources and instruments is limited in economies that are overwhelmingly dollarized.16 Yet full dollarization, being difficult to reverse, effectively precludes the possibility of a recovery in the demand for domestic money.

Risks

On the negative side, a rapid development of dollar-denominated operations in the banking system increases the risk of crisis in financial and foreign exchange markets. Capital inflows intermediated by the banking system may expand gross official international reserves, with a parallel increase in domestic short-run liabilities in the form of the increase in banks’ required reserves with the monetary authorities. Unless the monetary authorities hold all the resultant increase in required reserves in foreign exchange reserves, there will be a deterioration in their net foreign-currency-denominated position. More-over, the rapid expansion in dollar deposits and loans that may result from a return of flight capital is likely to increase the riskiness of the loan portfolio of the domestic banks. Although this increase in risk would also develop in the domestic-currency loan portfolio, an important difference is that the expansion in loans and deposits under the fractional reserve banking system implies that the total volume of dollar-denominated assets and liabilities will greatly exceed the volume of net dollar assets held in the economy. This lessens the central bank’s ability to act effectively as lender of last resort and increases the vulnerability of the banking system to capital outflows.17 Maturity mismatches between bank assets and liabilities in foreign currency would increase banks’ vulnerability to volatile capital flows. For example, withdrawal of short-term, dollar credits from banks forced the Mexican authorities to provide substantial dollar loans to the banking system in early 1995.18 Further, in the case of a devaluation, loan defaults would increase, and the financial position of banks deteriorate, unless dollar lending is largely to debtors whose net financial position benefits from a devaluation, for example exporters. In fact, the central bank may attempt to avoid significant devaluations because of the likely negative effect on the quality of the banks’ loan portfolios, even if there were otherwise valid macroeconomic reasons to devalue.

Dollarization also implies the loss of seignorage revenues for the monetary authorities (see Fischer, 1982). Other things equal, the use of foreign currency reduces the demand for domestic money and implies a lower level of seignorage for the government. While the central bank may earn some seignorage from below-market remuneration of banks’ required reserves in foreign currency, it cannot avoid seignorage losses that result from foreign currency in circulation. The data on flows of U.S. dollar currency to various dollarized economies (see Table 2) suggest that the circulation of foreign currency, and thus the potential seignorage losses, is indeed substantial in some of the more dollarized economies. For example, if the ratio of U.S. dollar currency to GDP is 10 percent, and monetary aggregates grow at an average of 15 percent a year, seignorage losses would amount to 1.5 percent of GDP a year.19

    Other Resources Citing This Publication