This section focuses on the macroeconomic consequences of banks’ performance. Specifically, it analyzes the extent to which the sustainability of a widely implemented type of stabilization program in Latin America, namely, an exchange-rate-based program, depends on the performance of the banking sector. This discussion complements those in previous sections, which used a sample of five countries to analyze how alternative policy environments in those countries affected the behavior and performance of banks, as well as the options available to the authorities to handle financial difficulties.
Recent literature on the sustainability of adjustment programs has focused on the destabilizing effects associated with the lack of credibility in the permanence of the announced policies (e.g., see Calvo, 1991; Obstfeld, 1986; Flood and Garber, 1984a; Calvo and Végh, 1990; and Rojas-Suárez, 1992). An often-cited example is that even when a long-run consistency exists between macroeconomic fundamentals and the announced exchange rate policy, a lack of confidence in the persistence of the announced policy may result in a speculative attack on the domestic currency. Because the attack itself changes the fundamentals—notably, by expanding domestic credit if the authorities accommodate the demands of speculators, or by raising domestic short-term interest rates if the authorities attempt to defend the exchange rate parity by in-creasing the cost of speculation—the government may find it too costly to defend the exchange rate on a sustained basis. In such cases, the authorities may validate the attack and abandon the announced exchange rate.
In the remainder of this section, it is argued that the degree to which a Latin American central bank may be able to withstand a speculative attack on its domestic currency—whether it involves a reversal of the capital inflows or not—depends crucially on two factors: (1) the extent of the commitment of the central bank to stabilize prices in the financial sector; and (2) the strength of the banking sector. While the first factor is a natural extension of the well-known literature on speculative attacks,79 the second has not received sufficient attention in the economic literature. In addition, this section addresses the issue of the appropriate holdings of foreign exchange reserves by central banks.
As discussed in Section II and reinforced in Section V, although banks are a dominant feature in the financial landscape of Latin America, there are also significant differences in the degree of importance of banks and in the structure and organization of financial markets among countries in the area. The analysis that follows, therefore, centers on two cases that may best represent the alternative financial structures of the region: (1) an economy where the financial sector is largely dominated by banks and where dollar-denominated deposits are an important component of the banks’ balance sheets (such as Argentina and Peru); and (2) a financial sector where some other long-term financial institutions, such as pension funds, are important players in absorbing financial flows and where dollar-denominated deposits are not an important fraction of total bank deposits (such as Chile).80 By considering the specific effects of dollarization, the analysis will also derive conclusions for bank-dominated systems in which banks’ deposits are largely denominated in the domestic currency.
In both cases, stock exchanges are assumed to be a small, albeit growing, component of the financial sector. In conformity with the current policy stance in most Latin American countries, it will be assumed that the government does not allow the nominal exchange rate to adjust freely to market conditions.81
Bank-Intermediated System Facing Significant Dollarization
In the financial system to be analyzed here, the regulatory framework and/or domestic economic conditions prevent banks from facing significant competition from other financial intermediaries. This system, which characterizes many Latin American countries, can persist, even when constraints on credit allocation or interest rate controls are removed. An explanation for this occurrence is that high volatility in the net revenues of domestic firms complicates their issuance of commercial paper and bonds or their placement of equity shares.82 As discussed in Sections II and V, commercial paper and corporate bonds are practically nonexistent in most Latin American countries (Chile being the exception for corporate bonds), whereas stock markets are booming, although the number of listed shares is very limited. As a result, bank credit remains the sole source of credit for the majority of firms.
Dollarization is defined here in its broadest form, namely, to indicate that the U.S. dollar is used not only as a store of value, but also as a unit of account and the medium of exchange.83
Assets issued by residents of a particular country are subject to two kinds of risk: (1) the risk of large losses in the real value of assets denominated in the domestic currency as a result of economic policies that lead to rapid inflation or to large exchange rate depreciations; and (2) the default risk associated with solvency problems in the issuing institutions or with the expropriation of domestic assets.84 If the banking sector is perceived as sound and bank profitability is viewed as having a high priority among the authorities’ goals—effectively ruling out the probability of expropriation of deposits because such an action would hamper banks’ stability—a lack of confidence in the stability of the exchange rate would trigger a switch into bank liabilities de-nominated in U.S. dollars. By comparison, a lack of confidence in the soundness of the banking system would induce depositors to move their deposits de-nominated in either the domestic currency or U.S. dollars outside the domestic financial market; that is, it would trigger what is commonly known as capital flight.85 Expectations of an exchange rate devaluation could also induce capital flight in a sound bank-dominated financial system where deposits de-nominated in a hard foreign currency—the U.S. dollar—are not allowed.
Although the stock of foreign exchange reserves in the central bank is important for assessing the effects of a possible reversal of the capital inflows on the exchange rate, its importance is associated with the degree of dollarization in the economy. In the extreme case of a fully dollarized economy, an attack on the domestic currency is meaningless because the domestic currency no longer plays any significant role in the system. However, agents holding U.S. dollar deposits in domestic banks may demand to convert them into liabilities issued by U.S. authorities that are held by the central bank.86 In contrast, in an economy that is less than 100 percent dollarized, the stock of foreign exchange reserves plays a role in maintaining an announced exchange rate regime: an attack on the foreign exchange reserves of the central bank would involve short-term bank liabilities denominated in domestic currency. As in the former example, agents may also demand to convert U.S. dollar-denominated deposits into U.S. dollar bills. As will be discussed below, however, a speculative attack on the central bank foreign exchange reserves involving bank liabilities denominated in U.S. dollars will occur only if the public fears that its dollardenominated deposits are no longer safe in the domestic banking system.
The decision of how large the stock of foreign exchange reserves should be is perhaps one of the key policy decisions of central bankers in Latin America. The discussion in Sections III and V made it clear that a large net foreign asset position held by a central bank carries with it two risks: first, it increases the temptation of governments to delay the correction of policy inconsistencies; second, it provides central banks facing an adverse shock in the domestic economy with the option of simply selling those foreign assets and expanding credit rapidly, with ad-verse consequences for the soundness of the banking system. This is particularly true when the central bank has a weak franchise value, as exemplified by the Peruvian experience during the mid–1980s. In other words, too many foreign exchange reserves in the hands of central banks may limit the amount of market discipline that authorities feel the need to exert in making policy decisions. Moreover, when domestic interest rates (adjusted for changes in the exchange rate) are higher than international rates for risk-free assets, holding foreign exchange reserves is costly for the authorities because the marginal cost of central bank debt is higher than the marginal revenue of holding foreign exchange.
The discussion above suggests that there is a clear trade-off associated with holding foreign exchange reserves: on the one hand, they provide the resources to defend an exchange rate parity; on the other hand, they give rise to some risks and costs for sound policymaking, including delaying reforms of the banking sector. Aware of this problem, authorities in many Latin American countries are taking a policy stance regarding their desired holdings of foreign exchange reserves in a way that, according to their perceptions, minimizes such a trade-off. Indeed, their position regarding sterilization practices is a reflection of these choices. In the following two sub-sections, these choices are addressed.
Monetary Base Fully Backed by Foreign Exchange Reserves
One of the central bank’s choices is to maintain a ratio of the stock of (gross) foreign exchange reserves to the monetary base equal to or greater than one. This decision was made explicit in Argentina’s convertibility law of March 1991, but it has been implicitly followed in many other Latin American countries during the early 1990s, including three of the countries analyzed in this paper.87 The question to be addressed is to what extent the solvency of a banking system is important for determining the stability of a preannounced exchange rate in a dollarized economy where the monetary base is fully backed by foreign exchange reserves.
To analyze the importance of a solvent banking system for the stability of a preannounced exchange rate, assume that an adverse shock—which will remain unspecified here—generates a lack of confidence in the sustainability of the announced policies. Two scenarios will be considered. First, the shock produces a generalized expectation of a de-valuation, but banks are perceived to be sound.88 Second, the lack of confidence in the exchange rate is accompanied by a lack of confidence in the banking system.
Lack of Confidence in the Exchange Rate Policy, but Banks Are Perceived as Solvent
In an economy where U.S. dollar bank accounts are allowed and the banking system is perceived to be sound, an exchange rate policy that lacks credibility does not need to generate flight from the domestic financial system; rather, the public will be induced to convert its domestic-currency-denominated deposits into deposits denominated in U.S. dollars. In addition, speculators taking positions against the domestic currency will increase their demand for loans denominated in domestic currency in the expectation that the devaluation will bring about a capital gain. However, if the central bank is committed to keeping the monetary base fully backed by foreign exchange reserves, the central bank will not validate the expansion of credit denominated in domestic currency (i.e., it will not provide banks with reserves to allow the expansion of credit);89 instead, domestic currency interest rates will increase.90
Although central bank policy will prevent the ex-tension of credit denominated in domestic currency, the public may be able, to a large extent, to convert its domestic-currency-denominated deposits into U.S. dollar deposits.91 In the extreme, the public may want to have all its deposits (and cash holdings) denominated in U.S. dollars.92 Assuming that reserve requirements on domestic-currency-denominated deposits equal those on foreign currency deposits, banks will need to convert the value of their cash assets (for reserve requirements purposes) de-nominated in domestic currency into U.S. dollars. As a result, the domestic monetary base will be extinguished, but the reduction in the stock of foreign exchange reserves held at the central bank will be limited to the initial stock of domestic currency in circulation (i.e., currency held by the public and outside the banking system).93 The monetary system, that is, currency and deposits held by the public, will become, at least temporarily, fully dollarized.
Even in an extreme case when people prefer to move out of the domestic currency altogether, full dollarization will not persist if (1) there are some preexisting private contracts requiring payments in domestic currency; or (2) the authorities demand that certain payments take place in domestic currency, such as taxes and trading involving government bonds denominated in domestic currency. Although the demand for domestic currency to make payments on preexisting domestic-currency-denominated contracts may be temporary (it may vanish as the contracts expire), the demand for domestic currency to comply with authorities’ regulations will be permanent. Therefore, if conditions (1) and/or (2) hold, the monetary base will not vanish (or may do so for a very brief period) following the sudden loss of credibility in the announced exchange rate policy; it will, however, be reduced significantly.
An example of the changes in the balance sheets of banks and the central bank that may follow immediately after a sudden loss of confidence in the exchange rate regime is shown in the appendix. Following the conversion of domestic currency deposits into U.S. dollar deposits, banks may find themselves with a mismatch in the currency denomination of their assets (domestic currency and dollars) and liabilities (only dollars in the example under consideration). However, the same factors that would make the dollarization a temporary process would also make the currency mismatch temporary: as preexisting stocks of loans denominated in domestic currency mature and as the need to undertake transactions that must be effected in domestic currency leads to the conversion of some U.S. dollar deposits into domestic currency, the currency mismatch would disappear. The correction of the currency mismatch is shown in the example presented in the appendix. That example also shows a plausible new equilibrium where, compared with the above example, the monetary base has fallen drastically and the dollarization process has strengthened significantly.
An interesting question remains, however: once the overhang of loans denominated in domestic currency matures, will borrowers engage in further borrowing denominated in domestic currency for business purposes? Although there is no definite answer to this question, the dynamics of expectations behavior sheds light on this issue. Clearly, if the authorities are able to convince the public at large of their commitment to the exchange rate, the initial de-crease in the demand for domestic-currency-denominated loans will reverse because the real interest rate will decline.
Alternatively, uncertainty regarding expectations may lead people who are convinced of the authorities’ commitment to believe that others remain un-convinced and that a further speculative attack may occur in the future (resulting in additional increases in the interest rate on domestic loans). These perceptions will affect the process of dollarization. The initial increase in the interest rate, following a speculative attack, hits not only speculators but also borrowers in domestic currency whose loans mature at the time of the attack. Borrowers convinced of the monetary authorities’ commitment may fear the possibility of unanticipated future speculative attacks, because the resulting increase in interest rates will affect their maturing loans. Those borrowers may find it beneficial to shift the currency composition of their liabilities to the banks into U.S. dollar loans. That is, in this plausible outcome, different perceptions regarding the credibility of the monetary authorities’ defense of the domestic currency will result in a strengthening of the dollarization process. In this example, the persistence of dollarization results from a lack of information regarding expectations. That is, dollarization can strengthen even if everybody individually believes in the authorities’ commitment while thinking that others are unlikely to believe in such a commitment. Although this situation cannot persist in the long run, it can lengthen the period during which borrowers prefer dollar-denominated loans.
The discussion above assumes that the authorities are able to use the interest rate defense as a tool to respond to speculative attacks. Some empirical examples suggest, however, that in some cases the authorities perceived the costs associated with such increases in the real interest rates as exceeding the perceived benefits from defending the exchange rate parity, and, as a result, a devaluation followed.94
In general, the costs to the authorities of increasing interest rates on domestic currency assets are well known: the government’s and businesses’ financing costs increase, which may lead to a decline in output and employment. In addition, the increase in interest rates exerts a downward pressure on the price of nonbank assets, including the equity market. In the case under consideration, to the extent that some transactions need to be carried out using domestic currency, there could be a short-term decline in real activity following the temporary rise in real interest rates. Moreover, the default risk faced by banks may increase following the speculative attack as the increase in domestic currency real interest rates may adversely affect some borrowers’ ability to pay. If, as assumed, banks are sound, they will be well capitalized and will be able to withstand the temporary increase in the default rate without the support of the monetary authorities.
The exchange rate parity can be preserved only if the authorities stand ready to accept the possible effects on the real economy of an increase in domestic real interest rates and avoid the temptation to expand credit in domestic currency, thereby abandoning the full backing of the monetary base with international reserves. Dollarization can, however, help minimize the well-known trade-off between real activity and exchange rate stability. The faster firms can adjust the currency composition of their liabilities—that is, the faster they can borrow in U.S. dollars rather than in domestic currency—the more limited the effect on the real sector.95 Dollarization would be particularly important for those firms whose access to financial markets is limited to the domestic banking system. In the absence of dollarization, these firms would have to face the higher domestic real interest rates: the higher the financing costs, the more contractionary the effect of using the interest rate to de-fend the exchange rate parity.96
The discussion in this section has made it apparent that in a bank-dominated system where liquid assets are largely bank liabilities, the authorities may be able to successfully defend its parity against a speculative attack if the banking system is sound and is perceived to be sound and if the monetary base is fully backed by foreign exchange reserves. In this process, a plausible outcome is that dollarization is strengthened either if the authorities fail to convince the public of their commitment to the announced exchange rate policy or if some economic agents believe that further speculative attacks could occur in the future.97 Allowing U.S. dollar-denominated ac-counts in the banking system is crucial for these results: by providing a source of financial investment denominated in foreign currency, dollarization prevents capital flight following a sudden loss of confidence in the exchange rate. Also, by providing a source of domestic credit denominated in foreign currency, dollarization minimizes the adverse impact of an increase in domestic currency interest rates on the financing costs of firms and, therefore, minimizes the pressure on the authorities to expand credit in domestic currency.
Lack of Confidence in the Exchange Rate Policy and in the Soundness of the Banking System
In this case, an adverse shock generates a lack of confidence not only in the exchange rate system, but also in the stability and soundness of the banking system. Now, the public has an incentive to shift all of its deposits—in domestic and foreign currency—out of the domestic banking system. Because, in the case considered here, there are no domestic alternatives in which the public can keep its financial savings, there is an incentive to transfer the funds outside the country—that is, an incentive for capital flight.
If perceptions are right and the banking system is not sound, the authorities can do little to prevent a sustained flight from the banking system (with the exception of freezing deposits). If banks are not sol-vent, they will not be able to use their assets to satisfy the public demand to cash in its deposits—non-performing loans cannot be liquidated to match the closing of deposit accounts. In this circumstance, the central bank would face strong pressure to bail out banks by extending credit to them. If the central bank were to expand the monetary base to extend credit to banks, however, the central bank would de facto be abandoning its commitment to fully back the monetary base with international reserves; this, in turn, would significantly hamper the central bank’s ability to satisfy the demand for foreign exchange reserves at the announced exchange rate.
In contrast, a solvent banking system has a better chance of withstanding a “lack of confidence crisis.” First, loans in good standing can be sold to pay bank depositors if there is a secondary market for bank loans, or used as collateral to obtain credit from foreign institutions, or, if there is room for monetary expansion without violating the assumption that the monetary base is fully backed by foreign exchange reserves, used to obtain credit from the central bank. When the system is solvent, the degree of maturity matching between assets and liabilities as well as banks’ access to additional sources of liquidity are important to the success of the banks faced with a run.98 Second, if banks are able to match the outflow of deposits with bank assets, and if the central bank does not expand domestic credit further, the maximum amount of demand for central bank foreign exchange reserves would equal the monetary base plus dollar-denominated reserve requirements.99 Because the monetary base is fully backed by foreign exchange reserves, the central bank will be able to satisfy the demand for foreign currency at the established exchange rate.100 As the discussion so far indicates, bank soundness complements exchange rate stability.
As in the first scenario, the central bank’s commitment to back the monetary base with international reserves would imply an increase in the domestic currency real interest rate following the increased demand by speculators for liabilities denominated in domestic currency. Also, as in the first scenario, the increase in real interest rates may increase the de-fault rate faced by banks. If banks are initially well capitalized, they can absorb the losses; otherwise, banks that were solvent before the run would be-come insolvent, inducing a further run out of the domestic banking system. The key, therefore, is appropriate bank capitalization such that a sound bank would remain sound following an unexpected increase in the default rate.
There is an additional similarity with the first scenario: if banks are indeed solvent, the authorities will be able to maintain the exchange rate parity only if they can resist the temptation to expand the monetary base to avoid the costs associated with the increase in the interest rates (even when the increase is temporary). There is, however, an important difference with the first scenario. Because the disintermediation from the domestic banking sector would include both domestic and foreign deposits, firms that depend completely on domestic banks would not be able to redenominate the currency of their loans because liquidity in both currencies would have dried up following the speculative attack; those firms would then have to pay the increased financing costs in full. If the process is understood to be temporary, these firms would have a greater incentive than before to delay production plans to avoid the increased financing costs. The temporary effects on output would, there-fore, be greater than in the first scenario. Likewise, government domestic financing costs would be greater. Notwithstanding these increased costs, if banks proved to be sound, the process of bank disintermediation would tend to reverse itself.
Would the results be affected by the inflow of large amounts of foreign capital before the crisis? If the banks were sound and stayed solvent and profitable during the inflows of capital—that is, if they did not increase the risk of their loan portfolio—there should be no significant difference with the results discussed above. The size of the banks’ balance sheets would be larger, as would the size of the temporary reversal of flows, but the analysis would remain unchanged.
If banks were not sound (or had a weak franchise value, to use the terminology of the previous sections), the previous capital inflow would make a difference: bankers who were not prepared to price risk correctly might have used the inflows of capital to extend risky loans that, in the presence of an adverse shock, would turn into nonperforming loans. If a bank run were to occur, the authorities would have to face the additional pressure of bailing out failing banks; the amount of central bank credit necessary to do so would increase in proportion to the size of the capital inflows used to extend bad loans. At this point, it is useful to recall the discussion on sterilization contained in Section V. As noted there, sterilization seems unnecessary if the banking system is sol-vent because the size of the capital inflows should make no significant difference. However, a sterilization policy seems to deserve strong consideration if banks are not yet strong enough to make sound credit decisions and the authorities fear a bank run before bank restructuring is completed. In this case, as discussed in Section V, curtailing the expansion of banks’ balance sheets through sterilization seems appropriate. Although the costs of sterilizing are well known,101 they may be outweighed by the costs of a bank run in the context of bad credit decisions. Sterilization could then be used as a temporary measure to allow enough time for banks to consolidate their operations. It is important to stress, however, that sterilization will yield the desired results only if the monetary authorities are in a better position than the banking sector to allocate financial resources.102
Monetary Base Partially Backed by Foreign Exchange Reserves
The discussion above suggests that a stock of foreign exchange reserves smaller than the monetary base may weaken the central bank’s ability to defend the exchange rate if a lack of credibility crisis emerges. This is the typical case analyzed in the traditional literature of speculative attacks (see Flood and Garber, 1984a; and Krugman, 1979) and does not need an extended discussion. Two main conclusions are appropriate to the example analyzed here.
First, even if there is no lack of confidence in the solvency of the banking system—such that the public would want only to change the currency denomi-nation of its deposits—a speculative attack on the domestic currency may force the monetary authorities to abandon the exchange rate because, in a massive attack on the currency, the central bank may not have enough foreign exchange reserves to satisfy demands from the public to convert domestic currency holdings into U.S. dollars. The higher the stock of domestic currency assets held by the public (including cash and bank deposits), the greater the pressure on the central bank’s foreign exchange reserves.103
Defending the exchange rate would, therefore, most likely involve a greater increase in the domestic currency real interest rate than if the monetary base were fully backed by foreign exchange reserves. As discussed above, this would increase the costs of defending the parity and might increase the authorities’ temptation to abandon such efforts.104
Second, if there were to be a loss of confidence in the domestic banking system, the pressures for a de-valuation would probably be greater if the stock of foreign exchange reserves were smaller than the monetary base, even if the banks were solvent and could use their assets to cash out the closing of deposits.105
A More Diversified Financial System
The limitations on the diversification of the financial system in Latin America were discussed in Section II. Indeed, as mentioned above, in countries where banks’ relative importance in the financial system has declined, the only significant competition in absorbing savings comes from pension funds. On the lending side, banks remain the most important source of credit; with the exception of Chile, very few firms in other countries issue bonds in the domestic markets. Moreover, the stock exchanges in Latin America, although showing rapid increases in share prices, have a limited number of listed companies.106
It is nonetheless important to recognize that the quick expansion of equity markets may create pressures on the government to protect the real value of share prices, especially if the development of more sophisticated and diversified capital markets becomes a government priority. Indeed, a current policy discussion among policy regulators in Latin America concerns the extent of government involvement in developing capital markets. To keep the analysis relevant for Latin America, this example will assume that banks remain the most important source of liquidity in the system but that long-term assets, such as bonds and equity, compete with bank loans as sources of credit. Also, bonds are assumed to be denominated in domestic currency.
Lack of Confidence in Exchange Rate Policy
Assume, as before, that banks are sound and are perceived to be sound, but that an adverse shock results in a speculative attack on the domestic currency. What difference does the introduction of financial assets competing with bank loans make to the analysis? The key difference is that it imposes additional constraints on the monetary authorities and may therefore weaken their capacity to defend the exchange rate.
The public would want to shift from domestic-currency-denominated assets to foreign-currency-denominated assets. In addition to bank deposits, the public now has a more diversified portfolio of assets that it may want to convert into foreign-currency-denominated assets. Pension fund managers, as well as the general public, would then have an incentive to transform bonds and, probably, equity into foreign currency assets (cash or foreign currency deposits).107
The outcome of this attack on the domestic currency depends once more on the monetary policy followed by the central bank. If the monetary base is required to be fully backed by foreign exchange reserves at all times, the public as a whole will not be able to convert its bonds and equity holdings into U.S. dollar-denominated bank deposits. To under-stand this result, it is necessary to realize that for an economic agent to sell a bond or equity denominated in domestic currency, some other agent must give up a bank deposit denominated in foreign currency. This scenario is not possible in the aggregate because it contradicts the fact that, in the aggregate, the public wants to reduce its holdings of domestic currency assets. Two outcomes are then possible: (1) the monetary base will not expand, and bond prices, and perhaps equity prices, will fall, or (2) the monetary base will expand to prevent a decline in asset prices. The latter would imply a de facto abandonment of the full backing of the monetary base and would validate the attack on the exchange rate; this, in turn, would significantly weaken the central bank’s ability to defend the parity.
The outcome described in (1) would increase the probability that the monetary authorities could maintain their exchange rate policy. The downside of this outcome, however, is that the decline in asset prices, by reducing the real wealth of their holders, could increase the probability of default faced by banks if asset holders were also banks’ debtors.108 If the authorities perceived that the decline in asset prices could lead to problems in the banking system, they could have an incentive to abandon the exchange rate policy. That is, a more developed financial system imposes greater obstacles to the defense of an exchange rate even if the banking system is sound and if the monetary base is fully backed by foreign exchange reserves.109 This can be interpreted either as an argument against fixed exchange rates, or as one to keep most financial transactions under the roof of banks, at least during the transition period to-ward macroeconomic stabilization—when loss of confidence crises are likely to occur.
Lack of Confidence in Both Exchange Rate Policy and Soundness of Banking System
Can the availability of assets competing with banks’ liabilities help prevent capital flight during a bank run? Only if the alternative assets are denominated in foreign currency. This is just an extension of the discussion above and needs no further comment.110 However, even if asset alternatives to bank deposits were denominated in foreign currency and capital flight was avoided, the stability of the exchange rate would still depend on the strength of the banking system. Just as in the case where banks were the only financial institutions, the decline in the demand for assets denominated in domestic currency—cash and bank deposits—would imply a reduction in the stock of foreign exchange reserves held at the central bank and, therefore, would put pressure on the announced parity. In other words, the pressure on the exchange rate does not depend on whether the foreign currency stays in the economy or leaves it through capital flight; rather, it depends on whether international reserves leave the central bank.
Results
This section has used a simple balance sheet approach to analyze the role of a sound banking system in allowing the central bank to maintain the announced exchange rate policy following a speculative attack on the domestic currency. A summary of the results follows:
• Dollarization may be an ally for governments pursuing exchange-rate-based stabilization programs but only if the banking system is sound. Dollarization may prevent capital flight if a lack of confidence in the sustainability of the economic program leads agents to substitute away from bank deposits and other assets denominated in domestic currency into those denominated in foreign currency. Dollarization also minimizes the impact on output and employment resulting from a possible increase in the domestic currency interest rate that may follow the speculative attack, because domestic firms may find it advantageous to shift from bank loans denominated in domestic currency to bank loans de-nominated in U.S. dollars.111
• In sharp contrast, if a bank-dominated financial system is not sound but the public does not have information about banks’ financial difficulties, dollarization may be a problem for governments under-taking serious adjustment efforts. In this case, although a speculative attack on the domestic currency may not be followed by capital flight, the problem would not vanish as depositors would just shift the currency composition of their deposits within the same troubled banks.112 In the event of a run on the banking system, pressures to rescue problem banks would increase the government’s incentives to abandon the announced exchange rate policy.
• Sterilization may be a useful policy in bank-dominated financial systems facing a large inflow of foreign capital, but only as a temporary measure to give time to banks to strengthen their balance sheets. As discussed in Section V, if the banking system is sound, sterilization is not only unnecessary but it also increases the financing costs for firms and the authorities.
• Increasing the domestic real rate of interest to defend the exchange rate may weaken the banking system because it may lead to an increase in the de-fault rate faced by banks. If banks are well capitalized, however, the authorities may not face significant pressures to extend credit in order to rescue banks in trouble—that is, the better the banks’ capitalization, the greater the probability that the authorities will be successful in preserving the exchange rate parity.
• A more diversified financial system imposes additional constraints on a government defending the exchange rate after a speculative attack. For the exchange rate defense to be successful, asset prices would have to decline. If a fall in asset prices is viewed as having a serious impact on the real sector of the economy, the authorities may have a greater incentive to expand domestic credit and abandon their exchange rate policy.
See, for example, Flood and Garber, 1984b; and Krugman, 1979.
Although the analysis could incorporate the use of any foreign currency, U.S. dollars are, by far, the most commonly used currency in which bank deposits in foreign currency are denominated in those countries where foreign currency deposits are allowed.
This is true even in those Latin American countries with the lowest degree of government intervention in foreign exchange markets, such as Peru.
See Weisbrod and Lee (1993) for a detailed discussion of this issue.
The need to clarify the use of the concept is important because there is no agreement on the meaning of the term, and some authors (Calvo and Végh, 1992) would refer to this broad use of the foreign currency as “currency substitution.”
See Rojas-Suárez, 1991. Although the two types of risk are distinguished for analytical purposes, a situation may arise in which both risks become indistinguishable. For example, expectations of a devaluation—which increases the first kind of risk—may increase the expectation that the authorities, in an attempt to defend the domestic currency, would freeze dollar-denominated bank deposits—which increases the default risk.
Notice that funds need not flow outside the country; they may well remain in an informal financial market dealing in U.S. dollars.
Investors may also want to convert other assets denominated in U.S. dollars into U.S. dollar bills. They would be successful, however, only to the extent that the central bank guaranteed convertibility of those assets.
By the end of 1993, the ratio of gross foreign exchange reserves in Colombia, Mexico, and Peru was about 1.5. In contrast, Chile kept a smaller ratio of 0.8.
In the remainder of this subsection, it is assumed that the exchange rate equals one. This simplifies the exposition greatly without affecting the analysis.
In a fractional reserve requirement system, the monetary base includes reserve requirements on deposits denominated in domestic currency, other bank deposits in the central bank, and domestic currency in circulation.
Likewise, by not providing an expansion of domestic currency to satisfy an increase in banks’ reserve requirements, the monetary authorities would make it too expensive to reschedule existing loans denominated in U.S. dollars into loans denominated in domestic currency.
Converting domestic-currency-denominated time and saving deposits into U.S. dollar deposits usually carries a cost. It is assumed here either that those costs are negligible or that they are outweighed by the expectation of large losses in the real value of those deposits arising from a devaluation.
Although this is a highly unlikely case if interest rates are allowed to fluctuate freely, the example is used here to evaluate the capacity of the system to withstand flight from assets de-nominated in domestic currency. In a more realistic scenario, the people induced to shift into U.S. dollar assets would be those whose expectations of the size of the devaluation exceed that contained in the interest rate on domestic-currency-denominated deposits.
This is so because reserve requirements on domestic currency deposits held at the central bank will be converted into reserve requirements on foreign currency deposits also held at the central bank.
The exchange rate crisis of the European Monetary System during the fall of 1992 offers a good example of the costs associated with using the interest rate defense to protect the exchange rate parity. For a detailed analysis of this episode, see International Monetary Fund (1993).
This possiblity is of course related to the maturity structure of the existing stock of domestic-currency-denominated debt at the time of the speculative attack.
Likewise, the net fiscal effect of a temporary increase in interest rates on domestic assets will be minimized if the government is able and willing to shift the currency composition of its debt.
The authorities’ alternative is to increase the number of trans-actions that have to be carried out in domestic currency to the ex-tent that they force de-dollarization. As discussed above, however, this alternative would motivate capital flight even when the banking system is perceived as sound.
Obviously, banks would not keep a perfect currency and maturity match between bank assets and liabilities. Likewise, however, it would be extremely unlikely that the run would dry up bank liquidity 100 percent, especially in an economy fully dependent on banks for financial transactions.
Total net liabilities of the central bank can be approximated as the monetary base plus other net liabilities denominated in foreign currency, which, for the purpose of this discussion, is assumed to equal U.S. dollar-denominated reserve requirements (see the example in the appendix).
Forthistobetrue, foreign exchange reserves need to be accounted for net of U.S. dollar bank deposits in the central bank to satisfy reserve requirements because investors may convert the entire stock of domestic currency into dollars.
See Calvo(1991).
If the reserve requirement on U.S. dollar deposits is smaller than that on domestic currency deposits, banks may find them-selves with excess reserves following the conversion of domestic-currency-deposits into U.S. dollar deposits. Banks may, therefore, be willing to extend further credit in domestic currency, and the central bank may find that it is asked to convert these new domestic currency deposits into U.S. dollars. Further pressure on the exchange rate would then follow.
Notwithstanding these additional pressures, as in the case when the monetary base is fully backed by foreign exchange reserves, the possibility of substituting among the domestic and foreign currencies may minimize the impact of the increase in domestic currency real interest rates on the firms’ and government’s financing costs; this may, therefore, minimize the costs of defending the exchange rate.
As discussed above, if (1) the banks can liquidate assets to match the closing of deposits, and (2) the authorities do not expand domestic credit further, the maximum demand for foreign exchange reserves would equal the monetary base plus reserve requirements on U.S. dollar deposits. This demand would not be fulfilled if the monetary base exceeded the stock of foreign exchange reserves.
International placement of bonds and equity in the international capital markets by private Latin American companies is improving in terms of both the number of issues and the con-tracts. See International Monetary Fund (1992). Once again, however, these markets remain small and confined to a select number of large companies with international standards.
If there are bonds denominated in foreign currency, the public may be satisfied to change the currency composition of its assets and there may not be a shift toward bank deposits denominated in foreign currency. Because equity is a real asset, it is not clear that the demand for it would decline following adverse expectations about the exchange rate. The most affected issuing firms, however, would be those whose liabilities are mostly de-nominated in U.S. dollars but whose earnings are denominated in domestic currency (an example could be a firm producing a nontradable good using imported inputs).
Banks would also be directly affected if they were holding a significant proportion of the assets whose relative prices had declined.
The larger the stock of international reserves relative to the monetary base, the higher the probability of success for a central bank defending a parity in a speculative attack. In the extreme, if foreign exchange reserves equal the monetary base plus the value of bonds and equity, a speculative attack is unlikely to be successful. However, as discussed at the beginning of this section and in Sections III and V, keeping a high ratio of foreign exchange reserves to the monetary base, which could be achieved through high reserve requirements on U.S. dollar deposits or through sterilization, may entail high costs both for the real sector—through the effects of higher real interest rates—and for the banking system, as it may weaken the franchise value of banks.
The currency denomination of capital markets instruments may deter capital flight only to the extent that the lack of confidence includes only the banking system and not the entire financial system.
Or, to the extent that it is permissible by the legislators, from issuing bonds denominated in domestic currency to issuing bonds denominated in foreign currency.
The problem would compound if the reserve requirement on dollar-denominated deposits were lower than that on domestic currency deposits. In that case, the balance sheets of troubled institutions would expand further.