Abstract

This section first reviews how monetary policy implementation and payments system arrangements have been adjusted in light of heavy dollarization and then discusses the implications of dollarization for prudential regulation and effective bank supervision, and the central bank’s role of lender of last resort.

This section first reviews how monetary policy implementation and payments system arrangements have been adjusted in light of heavy dollarization and then discusses the implications of dollarization for prudential regulation and effective bank supervision, and the central bank’s role of lender of last resort.

Implementation of Monetary Policy

Monetary operations can be conducted in either domestic or foreign currency instruments. Although conducting all monetary operations in local currency is simpler in principle and may be used to signal the central bank’s support for its own currency, the currency of denomination of monetary instruments should be consistent with the main money markets in the economy, as well as with the authorities’ monetary targets. Thus, at high levels of dollarization, where the local currency money market is thin, as in Bolivia, using dollar instruments is likely to be less costly and more effective in implementing monetary policy.27 In practice, however, there is considerable variation in the choice of single or multicurrency monetary operations in dollarized economies: the transition countries and Peru, for example, use a single currency (their own), whereas other countries, such as Argentina, Bolivia, and Uruguay, use both local and foreign currency. Further, the degree of substitutability between dollar-denominated government bonds and dollar assets available outside the home country affects the effectiveness of foreign exchange monetary intervention. The higher is the degree of substitutability, the lower is the effectiveness of this instrument.28

The design of reserve requirements in a dollarized economy is a complex issue. The authorities need to set several interlinked parameters: the level, the remuneration, and the currency of denomination. How these are set affects the cost for banks in funding themselves in domestic vis-à-vis foreign currency and also has prudential implications; insofar as dollarization reflects currency substitution, the level of the requirement will also have monetary implications. The weights to be given to these considerations will differ in different situations, and this will affect the policy advice to be given.29

In heavily dollarized economies, foreign currency reserve requirements on FCD can play a useful role as automatic liquidity stabilizers (as in Bolivia, Peru, and Uruguay). When denominated in foreign currency, averaging reserve requirements over the holding period allows banks to draw flexibly on their reserves, limiting the need for central bank intervention in the dollar money market.30 Reserve requirements on FCD can also be used to automatically sterilize or (when unremunerated) discourage capital inflows. However, as discussed below, heavy taxation of deposits puts a financial burden on banks and risks financial disintermediation. Moreover, frequent changes in reserve requirements are inadvisable because they complicate banks’ liquidity management.

Implications for the Payments System

A question also arises whether commercial banks should be allowed to effect interbank settlement in dollars on the books of the central bank, as in Bolivia, Lebanon, Nicaragua, Peru, and Uruguay, or whether that should be done on the books of a commercial bank (domiciled locally or overseas; see Table 3). Neither the central bank nor the commercial banks can create dollar reserves. Moreover, as illustrated by the experience of Bolivia, the choice of settlement bank may not have much impact on the pace of dollarization (Figure 3).31 However, private settlement arrangements may be subject to systemic risk, since in a crisis the clearing bank may be unwilling to extend emergency support, may withdraw its normal settlement credit lines, or may fail.32 Moreover, failure to settle dollar payments could trigger systemic failures that would affect both the domestic currency and dollar markets. In addition, the central bank loses seignorage if settlement balances are held with another bank. In heavily dollarized economies, those considerations argue in favor of settling interbank dollar balances on the books of the central bank, and in enabling the central bank to provide lender of last resort services in foreign currency, for which it would need an appropriate cushion of foreign reserves. Finally, the authorities should endeavor to ensure that payments services in domestic currency are able to compete in reliability and efficiency with those in foreign currency, so as not to provide an additional incentive for dollarization.33

Figure 3.
Figure 3.

Bolivia: Dollarization Trends

(In percent)

Source: Central Bank of Bolivia.
Table 3.

Payment and Regulatory Arrangements in Selected Dollarized Economies

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Sources: IMF, Exchange Arrangements and Exchange Restrictions Database; and IMF staff.

Prudential Supervision

The strategic risks that dollarization can impart to banks’ balance sheets were discussed in Section III. These risks relate primarily to the possibility of large capital outflows and exchange rate movements. The management of such risks is the broad responsibility of macroeconomic policy. In addition, however, prudential supervision and regulation need to take into account the risks of dollarization. The need to enhance banks’ capacity to sustain loan losses after a devaluation adds another argument for banks in developing countries to exceed the Basle guidelines for capital adequacy.34 Limits on foreign exchange positions—following international standards—should be strictly enforced to contain foreign exchange risk.35

As noted earlier, reserve requirements on FCD, if matched by foreign currency reserves, can limit systemic liquidity risk. Since that risk is likely to be higher for FCD than for LCD, from a prudential point of view a case can be made for the former to bear a higher reserve requirement than the latter, as is the case in Bolivia, Honduras, Nicaragua, and Peru (Table 4).36 Thus, the ratio of gross foreign assets of the central bank to M3 is substantially higher in Peru than in Bolivia, largely owing to Peru’s much higher reserve requirements on FCD. Liquidity requirements can also perform the role of limiting systemic risk—at a lower cost to the banks—as has been done in Argentina.37

Table 4.

Reserve Requirements on FCD for Selected Countries1

(In percent; end-December 1996 unless otherwise noted)

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Source: IMF, Monetary and Exchange Affairs Department, Information System on Monetary Instruments.

Unless otherwise specified, ratio on demand deposits.

L is local currency; F is foreign currency; LF commercial banks can deposit and hold reserves in local or foreign currency.

Liquidity requirements; reserves on both LCD and FCD may be held abroad.

Of which 12 percentage points must be held in vault cash and deposits in the central bank.

Weighted average ratio on LCD; reserves on FCD are held abroad.

As of end-March 1997; ratio on term deposits of more than 90 days.

Applied on new deposits since June 1994.

Some highly dollarized countries have imposed restrictions on FCL (foreign currency loans) to limit credit risks. In Lebanon, FCL are limited to 60 percent of FCD, forcing banks to hold the remainder in foreign currency assets abroad. In Vietnam, FCL may be given only for trade-related purposes. In Malaysia and the Philippines, dollar loans to the private sector can be made only to borrowers that generate an income in foreign currency. However, when FCD are high relative to LCD, strict restrictions on FCL may entail a severe limitation on the availability of credit for a given volume of total deposits.

Implications for the Central Bank

As lender of last resort, the central bank should ideally have foreign exchange reserves in sufficient quantity to forestall a run on FCD. The central bank (or the treasury) may also need reserves to support the market for dollar-denominated public securities.38 The central bank’s ability to secure its role as-lender of last resort, or to ensure orderly conditions in the market for (dollar-denominated) public sector debt, can be enhanced by access to emergency credit lines from other central banks or from commercial banks.39 In addition, allowing sound foreign banks, which can receive head office support in an emergency, to operate can also limit the need for central bank systemic support.

Supervisory authorities need to be particularly vigilant to ensure that financial institutions have the financial skills and the risk management arrangements to manage effectively the risks inherent in operating in a dual currency system. In particular, foreign currency exposures need to be monitored closely. These considerations apply also to banking systems that operate heavily in foreign currencies even if the economies in which they function are not dollarized. However, the problem is likely to be more widespread in dollarized economies, where banks are less likely to have a choice as regards the currency denomination of their operations.

Since a run on foreign currency bank deposits can destabilize a banking system (including the local currency segment), there is a case for including FCD in a country’s deposit insurance arrangements. Care should be taken, however, to price that insurance properly, in order to avoid cross-subsidization.

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