Abstract

Dollarization can benefit the development and deepening of financial systems in small countries or those with weak currencies, but it also poses unique financial risks that need addressing. Experience shows that in bicurrency systems banks, investors and supervisors often do not sufficiently recognize or internalize the prudential risks associated with foreign currency operations. This problem is particularly acute in countries where the exchange rate has been tightly managed for a long time, partly out of concern for the potentially adverse consequences for the financial system of large exchange rate fluctuations.

Dollarization can benefit the development and deepening of financial systems in small countries or those with weak currencies, but it also poses unique financial risks that need addressing. Experience shows that in bicurrency systems banks, investors and supervisors often do not sufficiently recognize or internalize the prudential risks associated with foreign currency operations. This problem is particularly acute in countries where the exchange rate has been tightly managed for a long time, partly out of concern for the potentially adverse consequences for the financial system of large exchange rate fluctuations.

This paper proposes a regulatory tightening to help address some of the specific risks of partially dollarized economies. It outlines a set of prudential measures, including special reserves against dollar loans to local currency-earning borrowers and currency-specific liquidity requirements that could reduce banks’ risk exposure and increase the cushion available to cover such risks.

This paper also argues that there would be definite prudential advantages for dollarized countries from taking measures to promote the use of local currency. Such measures should be taken at the same time as the regulatory tightening is being implemented, because the regulatory measures alone might be an excessive burden on financial intermediation. In particular, steps should be taken to support the acceptance of the local currency as an intermediation medium, including through a more visible commitment to protect its purchasing power and through structural measures to promote the development of markets and instruments in local currency. Within this context, it is also worth stressing that the risk of banking crises in highly dollarized economies, as in other economies, can be limited by sound macroeconomic policies and good bank supervision.

The pace, nature, and extent of both prudential and market reforms are likely to be country specific and differ according to the degree of dollarization and its trend. This paper argues that, to limit adjustment costs and risks, more gradual and careful policy reforms are probably called for in countries that are already highly dollarized. Countries where dollarization is still marginal but rising rapidly should take more forceful and decisive actions.

Where crises do occur, dollarization may impose severe constraints on the possible responses. The absence of an unlimited lender of last resort, coupled with possibly more volatile deposits, will, in many cases, require more intense and, possibly more restrictive, answers to bank runs. Clearly defined, market-friendly solutions are more likely to limit the costs associated with the management of such crises and facilitate the recovery of financial intermediation.

This paper’s main recommendations are strictly preliminary at this stage. Further debate is needed on both the fundamental principles on which these recommendations are based and the details of their operational implementation, which can be rather complex. The relevant international groupings, most notably the Basel Committee, and supervisors in highly dollarized countries should be party to such debates. In view of the higher potential costs associated with measures taken by countries in isolation, it is important that a broad consensus view on best practices emerge soon. The IMF could play an important catalytic and advisory role in these discussions, both on a general conceptual level and on specific issues of implementation.

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