VI Measures to Affect Dollarization
- Adam Bennett, Eduardo Borensztein, and Tomás Baliño
- Published Date:
- March 1999
The prerequisite to containing dollarization in an economy is always a sound macroeconomic policy. Also, institutional arrangements that bolster confidence in the maintenance of price stability—such as an independent central bank with a clear price stability mandate—can enhance confidence in the domestic currency and thereby reduce the degree of dollarization. As is argued above, however, it is possible for an economy to remain dollarized even after stabilization. This section discusses the various alternative measures available to limit dollarization and considers their effectiveness and drawbacks. It concludes that the most effective “dedollarization” measures are likely to be those that limit the need for dollar instruments. The least effective are those that directly restrict dollarization.
Alternative Financial Instruments
To limit dollarization, authorities may promote alternative financial instruments, such as stocks, mutual fund shares, corporate finance bonds, and asset-backed securities and also facilitate the use of specific indexed instruments or simple derivatives (swaps, futures, and options). These instruments, which are likely to be used mostly by enterprises and large investors, unbundle risk coverage from the transaction and store-of-value functions of currency. By limiting the replacement of local currency by foreign currency, including reserve money, those instruments in principle can enhance the scope for monetary policy. However, they are likely to be only partial substitutes for FCD and FCL—owing, for instance, to high transaction costs—and may be difficult to develop in unsophisticated markets. Furthermore, derivatives entail risks, to which the authorities should ensure that banks are not unduly exposed.
In several countries, dollar-indexed financial instruments provide an alternative to FCD. For example, in Bolivia and Nicaragua, dollar-indexed deposits coexist with dollar deposits.40 The supply of the former may be easier to influence because they are settled in domestic currency, which is under the control of the central bank. However, because of the uncertainty associated with the exchange rate at which dollar-indexed instruments can be effectively converted into dollars, particularly under systemic crisis conditions, these instruments are imperfect substitutes for FCD.41
Indexation with alternative indices, such as the price level or a short-term interest rate, can also reduce the risk associated with real returns on domestic currency deposits. In Brazil, while FCD have been strictly restricted, the relatively moderate capital flight suggests that indexation adequately met the public’s demand for inflation protection.42 In Chile, as has happened in some highly dollarized economies, price indexation is still widely used, despite the country’s success in bringing inflation under control.43 Although FCD are also available, they are small (Figure 4), which suggests that price indexation can be an effective substitute for dollarization. However, in considering indexation as an alternative to dollarization, the authorities need to evaluate carefully the benefits and risks. The latter include the danger of indexation being extended to the labor market and the difficulties this might create, including for bringing inflation down.
Figure 4.Chile: Indexation and Dollarization
Sources: IMF, International Financial Statistics(IFS); and national authorities.
Policies That Create an Interest Rate Wedge
To the extent that portfolio choices are sensitive to relative prices, the dollarization of deposits can, in principle, be reduced through policies that create a wedge in favor of local currency interest rates. However, when those policies take the form of a tax on foreign currency intermediation, they run the risk of driving deposits overseas and reducing domestic lending.44 Interest rate wedges will be the more effective in reversing dollarization to the extent that FCD are closer substitutes for LCD than for CBD, which can be the case in economies where confidence in the domestic economy has been restored.
Financial liberalization can permanently change the level of interest rates. Reflecting this, Egypt experienced a dramatic and lasting reversal in dollarization after liberalizing interest rates in 1991.45 FCD decreased as a percentage of total deposits from over 60 percent in 1991 to less than 30 percent in 1996 (figure 5). Monetary policy may also induce interest rate wedges, although these are likely to be temporary.46 Thus, in Hungary, the sharp increase in the interest rate spread during 1995–96 became ultimately unsustainable because it was associated with large capital inflows that could not be fully sterilized, and the wedge had only a small and transitory impact on dollarization (Figure 6).
Figure 5.Egypt: Asset Substitution and Real Deposit Rates1
Sources: Central Bank of Egypt; and IMF, IFS.
1 Real deposit rate is measured as the nominal term deposit rate adjusted by inflation in the previous 12 months.
Figure 6.Hungary: Interest Rate Differential and Asset Substitution1
Sources: IMF, IFS; and National Bank of Hungary.
1 Interest rate differential measured as domestic currency deposit rates as a percentage of Hungarian deposit rates adjusted for the previous 12-month depreciation rate. The use of the forward 12-month depreciation rate to calculate the interest differential does not yield a higher correlation coefficient (in absolute terms) between the interest rate differential and the ratio of FCD to total deposits.
Modifying the currency composition of domestic public debt or introducing differential reserve requirements can introduce a permanent wedge. Increasing the share of local currency domestic public debt at the expense of foreign currency domestic debt can increase interest rates in local currency and lower those in foreign currency. However, the higher interest rate on local currency loans reduces at the same time the demand for such loans and increases the share of FCL. In addition, the interest costs associated with such operations can quickly escalate.
Setting differential remuneration rates on reserve requirements on FCD introduces a wedge in banks’ intermediation spreads, thereby in principle affecting dollarization measured both in terms of deposits and loans.47 Thus, using such a technique Israel succeeded in the late 1980s in encouraging the substitution of dollar-indexed deposits (“Patzam”) for dollar deposits (“Patam”). However, the effectiveness of reserve requirements in Israel was enhanced by the close substitutability of the Patam and Patzam. Other efforts to lower dollarization through high remunerated reserve requirements on FCD have been mostly inconclusive. In Nicaragua, the share of FCD in total deposits has increased during the period in which such requirements have been in effect. Inversely, in an effort to stimulate dollarization, El Salvador sharply reduced reserve requirements on FCD in April 1995. This led to only a small increase in asset substitution, suggesting that changes in reserve requirements—even when accompanied by clear policy announcements—can have only a limited impact on dollarization when dollar assets are not close substitutes for local currency assets.48
Moreover, the scope for using reserve requirements to tax FCD is limited when such deposits can be substituted through off-balance-sheet transactions, informal intermediation, or derivatives. For instance, in Peru, where FCD are subject to a high reserve requirement (45 percent), banks have partially substituted offshore intermediation for domestic foreign currency intermediation.49 In addition, banks circumvented reserve requirements on FCD through the use of domestic currency operations linked to the future foreign exchange rate. However, the central bank curtailed these operations when in 1995 it imposed on them the same requirement as on FCD.50
Direct Restrictions on Foreign Currency Deposits
The liberalization of regulations on FCD has often been followed by a rapid expansion of asset substitution. However, in countries where FCD had been allowed, measures to reverse that authorization through forced conversions, as in Bolivia and Mexico in 1982 and in Peru in 1985, had severe adverse effects. While FCD were initially substituted by LCD, the gain was only temporary (Figure 7), and FCD were later reintroduced. Moreover, the forced conversions entailed a substantial loss of government credibility and increased the confiscation risk perceived by domestic residents.51
Figure 7.Bolivia, Mexico, and Peru: Share of Deposits
Sources: IMF, IFS; and national authorities.
1 Share of cross-border deposits (CBD), foreign currency deposits (FCD), and local currency deposits (LCD) over their total. Although in Mexico and Peru FCD were allowed once again in December 1985 and September 1988, respectively, exchange and capital controls were removed only in December 1987 in Mexico and in August 1990 in Peru.
Access to FCD can be limited, rather than prohibited. For example, in Mexico, only firms can hold FCD, and such holdings are limited as a proportion of banks’ total liabilities. While more effective than reserve requirements in limiting FCD, those measures are also likely to be more distortionary. By limiting access to both FCD and CBD, capital account restrictions can, in principle, also be used to limit dollarization. However, the effectiveness of such restrictions is likely to be transitory at best, since domestic residents find ways to circumvent them.52 Moreover, such restrictions place a heavy burden on a country’s administrative capacity.
Policies to Encourage the Use of Local Currency Cash
Countries can also implement legal and institutional measures to encourage the use of domestic cash over foreign cash. In addition to granting legal tender status only to the domestic currency, all public sector transactions, including tax payments, can be required to be effected in local currency. To assist in this regard, home currency cash should be readily available in all denominations.53 At the same time, commercial banks should be responsible for importing or exporting foreign cash, and foreign cash should not be eligible to comply with reserve requirements on FCD if banks can fulfill that obligation by holding a dollar deposit with the central bank locally.54 There may also be some scope for widening the central bank’s bid-ask spread.55 By raising the cost of roundtripping between local currency and foreign currency, a wider spread can discourage the use of foreign currency cash as a temporary store of value.
The authorities could consider a policy mix that seeks to discourage the use of foreign means of payment (cash and sight deposits) for domestic transactions, while allowing the use of foreign currency as a store of value. In particular, direct restrictions on demand deposits would be effective if, as regards such deposits, FCD are closer substitutes to LCD than to CBD. For instance, since 1980 Israel has limited the use of foreign exchange as a means of payment for domestic transactions by imposing a ban on direct transfers of FCD from one local resident to another.56 This measure was effective because it encouraged the substitution of sight LCD for sight FCD. However, Israel remains a moderately dollarized economy (excluding nonresident deposits). Other measures to discourage the use of foreign currency means of payment, including some forms of taxation (such as a transaction tax on foreign exchange checks and other foreign exchange payments), could discourage their use in a graduated and flexible way.57