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Appendix I: The Mechanics of a Speculative Attack in a Dollarized Sound Banking System where the Monetary Base is Fully Backed Up by Foreign Exchange Reserves: An Example

Assume that the authorities impose the following reserve requirements:

  • on domestic currency denominated deposits = k = 10 percent

  • on foreign currency-denominated deposits = j = 20 percent

Assume also that transactions required to take place in domestic currency (pay taxes, for example) are such that the public needs to hold a minimum of deposits denominated in domestic currency equal to $10. For simplicity, assume that the public hold no cash, so that their entire financial wealth takes the form of bank deposits. The exchange rate between U.S. dollars and domestic currency is assumed to equal 1.

An initial position can be characterized as follows (where bank capital has been netted out in the accounts):

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A lack of confidence in the announced exchange rate may lead to a shift away from the domestic currency. Hypothetically, if no other change occurs, the balance sheet may look as follows in the instant immediately after the shift away from domestic deposits. 117/

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As the monetary authorities will not accommodate an speculative attack on the domestic currency, the interest rate on domestic currency-denominated loans will increase. Such rise will prevent a currency restructuring of domestic currency loans.

In the above balance sheets, banks are not satisfying reserve requirements in U.S. dollars and, therefore, that position is a desiquilibrium one that could only exist for a very brief period of time. The position also shows a mismatch in the currency composition of banks’ assets and liabilities. As: (a) the existing stock of loans denominated in domestic currency expires and (b) the public need to hold a minimum of $10 in domestic currency-denominated deposits becomes binding, a possible outcome may be:

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In this outcome, the dollarization process has strengthened and will remain so, unless the public becomes convinced of the monetary authorities’ commitment to the exchange rate. Also, due to a reserve requirement on U.S. dollar deposits higher than that on domestic currency-denominated deposits, the new equilibrium involves a lower level of total loans to the economy. Notice that if k=j, total loans would have remained unchanged.

Table A1.

Argentina: Summary Accounts of the Financial System, 1982–92

(In percent of gross domestic product)

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Sources: Central Bank of Argentina; Ministry of Economy; International Monetary Fund, International Financial Statistics: and IMF staff estimates.

Preliminary data.

Foregien currency bonds (BONEX, BOTE, BOTESO, and BOCON). The item also enoomposes the adjustnent Ftor BONEX Included In the BCRA’s reserve assets.

Includes bonds and frozen deposits In the Central Bank.

The decomposition of Central Bank credit by financial Institutions is not available.

5/ On June 1,1983 the peso argentino, equal to 10,000 pesos was introduced. On June 14,1985 the austral, equal to 1,000 pesos argentino, was introduced. On January 1,1992 the peso argentino, equal to 10,000 australes, was introduced.
Table A2.

Mexico Summary Accounts of the Financial System. 1982-93

(In percent of gross domestic product)

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Sources: Bank of Mexico; International Monetary Fund, International Financial Statistics : and IMF staff estimates.

September 1993 data.

Net credit to federal government plus net credit to Other public sector.

Sum of medium- aid long-term liabilities plus money and quasi-money In foreign currency.

Liabilities to non bank financial pubic sector (which excludes liabilities to official trust funds of the Bank of Mexico); It also Includes dee capital and surplus for 1962-64.

For 1982, balance of payments support loan from Bank for international Settlements (BIS) was Included as a foreign reserve liability of the monetary authorities and only a portion appears as credit to the Federal Government.

The sum of the folowhg categories: Net credit to official trust lands of Bank of Mexico, net claims on FIOORCA. net credit to commercial banks, and net credit to government development banks.

Sum of net credit to commercial banks plus net credit to government development banks.

Data for 1985-92 are significantly revised in late-1980s, and hence tie 1981-83 data are notstrlctfy consistent with tie 1985-92 data.

Medium - and long-term liabilities item Included In this category also includes net disbursement) under Commodity Credit Corporation (CCC)oan h 1983,1984. and 1965.

Liabilities to onnbnak including public sector (which excludes liabilities to olliclal trust funds ol tie Bank ol Mexico) for 1985-92; It also Includes liabilities to rest of banking system tor 1963 and 1964 and capital and surpbs for 1982.

Excludes public sector deposit Incorrectly classified as private sector deposits

Table A3.

Peru: Summary Accounts of the Financial System, 1982–92

(In percent of gross domestic product)

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Source: Central Reserve Bank of Peru; International Monetary Fund, International Financial Statistics; and IMF staff estimates.

June 1992 data.

Table A4.

Chile: Summary Accounts of the Financial System, 1982–92

(In percent of gross domestic product)

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Sources: Central Bank of Chlie; and IMF staff estimates.

Preliminary data.

Excludes holdings of treasury notes on account of the 1983–86 capitalization of the Central Bank which are included in other net domestic assets.

Includes foreign liabilities on account of deposits placed by the corporate sector in the Central Bank In the context of the 1983–85 rescheduling agreements with foreign commercial banks.

Table A5.

Colombia: Summary Accounts of the Financial System, 1982–92

(In percent of gross domestic product)

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Sources: Banco de la Republica; and IMF staff estimates.

Banco de la Republica accounts were revised In December 1989 to Improve the account sectorization between private and public sector. Because of this revision the series of credit flows to the private and public sector, before and after these dates, are not strictly oomparable.

Central administration plus rest of public sector.

The category central administration excludes assumption of debt for Col$5,174 million (capitalization of Banco del Estado) and for Col$9,691 million (capitalization of National Electric Finance Company (FEN)) In 1982.

For commercial banks plus specialized banks.

Includes adjustment for exchange rate valuation account before end-1989 includes capital of Banco de la Republics and Special Exchange Acoount.

A new reporting system was Introduced for financial system accounts starting In December 1989 and was adjusted In December 1990. Thus, data for end-1989 and end-1990 are not comparable to earlier data.

Comprises development finance corporations, trade finance companies, savings and loan companies, cooperative Institutions, and development banks (BANCOLOEX, FINAGRO, FINDETER).

A new reporting system br financial system accounts was Introduced at end-1990. data for 1990 are therefore not strictly comparable with earlier data. Data for 1990 exclude PROEXPO.


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This paper was written when Steven Weisbrod was a consultant at the Capital Markets and Financial Division of the Research Department. The paper has greatly benefitted from lengthy discussions with David Folkerts-Landau. The authors are also grateful to Guillermo Calvo, Peter Garber, Andres Gluski, Leonardo Leiderman, Carmen Reinhart, Brian Stuart, and Michael Spencer for very valuable comments and to Patricia Brenner, Martine Guerguil, Salvador Valdes and Andres Velazco for helping us to improve our understanding of the Chilean case. The high-quality research assistance provided by Kellett Hannah and Subramanian Sriram is gratefully acknowledged. Any errors, of course, remain the responsibility of the authors.


For the discussion of the role of banks in transition economies, see Blommestein and Spencer (1994).


The exception is Argentina, where the category “commercial banks” includes the Caja Nacional de Ahorro y Seguros, the Banco Hipotecario Nacional and the Banco Nacional de Desarrollo (BANADE). BANADE was closed in May 1993. As reported in Morris (1990) in Argentina assets of developing financ\ial institutions accounted for about 20 percent of total assets of the financial sector by 1987.


Typically, development banks are recipients of public funds and enjoy special privileges from the government.


Although Venezuela showed a similar trend by 1992, the recent banking crisis has been followed by large injections of government funds into the commercial banks in early 1994.


Brazil is a noticeable exception of this trend. Market capitalization is defined as the market value of the equity of firms quoted on the stock exchanges.


For a discussion of the issues related to the rapid increase in market capitalization in a number of developing countries, see Feldman and Kumar (1994).


Data on market concentration taken from IFC (1993).


Limited data for Mexico is also reported in Singh and Hamid (1992). The data show that during the period 1984–88, the top 50 manufacturing corporations listed in the stock exchange used equity as their most important external source of finance. However, this result is derived using financing flows rather than stocks and should, therefore, be taken with care as it may lead to serious misinterpretations of the Mexican financial structure. During the period 1984–88, restrictive monetary policies in Mexico had a significant impact on the availability of bank loans. Moreover, during that period, corporations in Mexico achieved almost no real growth. Thus, as the authors themselves concluded: “ the peculiar circumstances of the Mexican economy in the mid-1980s, the Mexican corporations achieved relatively little growth; but of the growth that did occur, a large proportion of it was financed by equity” (p. 47). The point to be learned from this analysis is that in economies facing large variations in real economic activity and in the design of economic policies, conclusions regarding the corporate financial structure cannot be based on flows data which may be of a temporary nature. The particular advantage of using stock data is that, by its very nature, temporary fluctuations get diluted.


Corbo and others (1992) indicate their methodology may understate equity funding but the understatement is less severe than the overstatement that would arise if current market prices were used.


The recent increased access by a number of firms to international capital markets may be viewed as an additional source of competition to bank loans. This issue is discussed in Section IV.


See Goldstein and others (1992) for a discussion on the trend toward securitization observed in industrial countries.


For a more detailed comparison between the financial systems in Germany and the United States, see Goldstein and others (1992).


As reported in Goldstein and others (1992) commercial paper programs in Germany started only in 1991. It is interesting to note, however, that notwithstanding the limitations of private securities markets in Germany, the government bond market is large and liquid.


See, for example, Corrigan (1991).


The unique role of banks as providers of “good funds” is analyzed in Garber and Weisbrod (1992).


Notice that in developed economies, low liquidity ratios are often taken as an indicator of problems in a bank; but this is because banks in developed countries operate at much lower cash ratios than those in developing economies. Caution is then necessary when using for developing countries the same kind of ratios used in assessing banks’ performance in industrial countries. The ratio of cash assets to deposits has a completely different meaning when it reaches the high levels found in some developing countries.


Once again, there is an important difference that needs to be taken into account when analyzing ratios in developing countries relative to those in industrial countries. In industrial economies a high loan to asset ratio can imply an unsound bank. Again, however, the extremely low ratios found in some developing countries cannot be interpreted the same way as the moderately low loan to asset ratios of sound banks in developed economies. The main reason is the quality of nonloan assets held by banks. In industrial countries, banks frequently hold bonds from AAA companies or other high quality assets.


Even in countries that supervise banks through other agencies, such as an independent deposit insurance system, a banking commission, or the Ministry of Finance, it is necessary for the central bank to have access to bank supervisors if it is to fulfill its role as lender of last resort.


The evidence indicates that, with the exception of Peru, banks only held a high ratio of cash to assets when they were subject to high reserve requirements.


For a review of the issues and experiences in a number of developing countries that faced banking crises in the early 1980s, see Sundararajan and Baliño (1991).


This issue is discussed further in Baliño (1991).


As the discussion below will show, the diversity of experiences across these countries is enough to guarantee an appropriate representation of the banking difficulties in Latin America.


For a discussion of the factors explaining the evolution of foreign capital flows before and during the debt crisis in several Latin American countries see Rojas-Suarez (1991). A comparison between the capital inflows problem in the 1970s and early 1990s is contained in Calvo, Leiderman, and Reinhart (1992).


A detailed analysis of the capital flight problem experienced by Latin American countries during this period is contained in Rojas-Suarez (1991).


Confidence of the international community in the financial performance of most Latin American countries was not restored during most of the 1980s. Indeed, the large capital flight that followed the outburst of the debt crisis as well as the deceleration of external loans was accompanied by a sharp increase in the resource balance--defined as net exports of goods and nonfactor services--during the period 1983–86; that is, for the Latin American countries, the net transfers of resources abroad was a direct cost associated with their severely reduced access to external credit. Further discussion of these issues is contained in Rojas-Suarez (1991).


Although interest rates were liberalized in Argentina in 1978, controls on bank deposits were reimposed in 1981. See the discussion in Section III.3.


In Chile, during the late 1970s and early 1980s, ex-post real interest rates increased drastically and were accompanied by a significant widening of the spread between domestic interest rates (adjusted for exchange rate changes) and comparable foreign interest rates. The review of the Chilean experience suggests that these high domestic rates emerged when the domestic financial system was liberalized in conjunction with the opening of the capital account. (See Mathieson and Rojas-Suarez (1992)).


The crisis was confined to the collapse of two banks in early 1983. This made remaining banks very cautious in extending new loans.


The impact of bank failures and bank loan losses problems on bank balance sheet quality is difficult to discern from capital to asset ratios because the accounting data appear unreliable. Thus, the large fluctuations in the capital to asset ratios during the period 1980–90 shown in Chart 3 largely reflects accounting procedures rather than true changes in real capital.


For a thorough description of the bailout procedures in Chile, see Morris and others (1992), and Velasco (1991).


Because reserve requirements in Chile were so low, the Central Bank had very few funds with which to aid the banks. Most of its resources came from an expansion of borrowing from overseas, which increased from less than 2 percent of GDP in 1982 to over 27 percent of GDP by 1985. Much of this increase was due to the depreciation of the Chilean peso; however, in dollar terms, foreign borrowing by the financial system increased from almost $6 billion in 1982 to almost $10 billion in 1985. The additional funds were made available through rescheduling agreements with foreign lenders.


Marked to market means that assets are valued at current market prices rather than at book values.


In contrast, in Argentina capital to asset ratios actually increased during the banking crisis indicating that shareholders either gained from the rescue package or the value of nonperforming loans were not marked at market values.


The Central Bank had to provide monetary enhancements to these deals (tax exemptions were also granted). This is similar, however, to the experiences of bank regulators in a number of industrial countries when dealing with resolution of banking crises.


These are the new shareholders, the so-called “capitalistas populares”) who brought shares when banks were recapitalized in the mid-1980s.


The negative asset position indicates that the banks were net creditors of the central bank.


It needs to be recognized, however, that the sustained losses of the central bank have acted as a constraint to reduce the Chilean inflation rate to industrial country levels.


In Sweden, by the end of 1992, capital injections and government guarantees to support troubled banks amounted to 6.4 percent of GDP.


The assumed discount factor equals 13.5 percent, which is the average nominal cost of liabilities of the national banks in 1992.


Actual payments to the central bank were 78 billion pesos in 1992 because only a proportion of banks’ net income was required to be used as payments to the central bank. However, in calculating the amount of debt that is potentially serviceable, it is appropriate to consider the entire cash flow available for debt service. Using the lower figure would imply that the unserviceable debt equals about 6 percent of GDP.


The Colombian banking system is made up of commercial banks, savings banks (CAVs), development finance companies (CFs), and trade finance companies (CFCs).


The sale of the Banco de Bogota was criticized as providing a large subsidy to purchasers.


The Banco Central Hipotecario (BCH) was sold to the Social Security Institute (ISS). The State will retain the ownership of the Banco Popular.


Although a large number of transactions were performed using the U.S. dollar, bank deposits denominated in foreign currency--which had been allowed since December 1977--decreased significantly during the period August 1985-December 1990 when fully convertible foreign currency deposits were prohibited. In particular, foreign currency deposits could be converted into intis (the domestic currency at the time) only at the official exchange rate (measured as the number of intis per U.S. dollar), which fell sharply below the rate in a parallel (black) market. Large disintermediation from the banking system followed and, rather than declining, U.S. dollar transactions intensified through the development of informal real and financial markets. Indeed, two forms of holding U.S. dollars were clearly identified by Peruvian residents: U.S. currency notes which could be obtained in the well-established domestic black market for U.S. dollars and deposits in foreign banks reflecting capital flight. Fully convertible foreign currency deposits were re-established at the beginning of 1991.


As discussed on Section II, ratios of nonperforming loans to total loans do not provide a good indicator of bank soundness in developing countries because banks could be rolling-over problem loans. In this connection, recent restructurings of the banking system that force banks to recognize problem loans as such in the accounting procedures may lead to the misleading conclusion that bank difficulties have increased.


The sharp decline in the deposits to GDP ratio in Mexico in 1988 (Chart 8) is somewhat overstated because of a bank liability, called banker’s acceptances, which had many of the characteristics of a bank deposit, but was not classified as such. In 1988, banker’s acceptances, unlike bank deposits were not subject to interest rate ceilings and, in that year, the rules guiding their issuance were liberalized.


In contrast to most Latin American countries, Venezuela is currently experiencing a severe banking crisis. The Venezuelan case, however, is not analyzed in this paper.


A well-documented debate relates to the factors behind such inflows. On the one hand, it has been argued that the capital inflows responded, at least to a significant extent, to the decline in interest rates in the United States, which in turn is associated with the trough of the economic cycle in that country; to a large extent, therefore, the capital inflows would be transitory (see Calvo, Leiderman and Reinhart (1993a); from a portfolio theory point of view, this hypothesis would imply that given the decline in the expected rate of return on alternative assets, investors would find it attractive to allocate a fraction of their wealth into the high-return-high-risk Latin American assets. On the other hand, it has been argued that capital inflows have responded mostly to the improved economic environment in many Latin American countries following the reform efforts undertaken in those countries. In other words, this hypothesis suggests that foreign investors have been attracted by the decline in the overall risk of investing in the area (see, for example, Corbo and Hernandez (1993)). Although no agreement has yet been reached, recent developments seem to indicate that both views, rather than being substitutes hypothesis, are complementary. For example, volatility in Mexico’s stock market increase significantly in mid-November 1993 when doubts about the passing of NAFTA in the U.S. Congress reached their peak. Also, following a small (25 basis points) upward adjustment of interest rates by the U.S. Fed on February 4, 1994, stock prices declined and the Mexican peso dropped significantly. While the first event supports the second view as it relates the behavior of capital inflows to the long-term policy stance in Mexico, the second event supports the first view.


For a discussion of the issues associated with the recent capital inflows see, Calvo, Leiderman, and Reinhart (1993).


If the central bank controls growth by imposing high reserve requirements on deposits, the growth of the narrow money supply relative to foreign currency assets on the balance sheet of the central bank is controlled directly. If the central bank issues liabilities to the nonbank public, i.e., sterilizes through open market operations, it controls the growth of the money supply indirectly since it does not create bank reserve deposits around which banks can increase their issuance of transaction accounts.


An indicator of sterilization is constructed by using foreign reserve assets to Ml rather than to the monetary base because the latter ratio would be affected by how the sterilization policy is carried out. If sterilization is carried out through imposition of high reserve requirements, which are part of the monetary base, the ratio would be biased downward compared to a situation in which the policy were carried out through the issuance of central bank liabilities directly to the public, which are not part of the monetary base. The choice of an indicator of sterilization using Ml or any other monetary aggregate in the denominator, however, seems arbitrary.


For example, as stressed by Calvo (1991), sterilization conducted through open market operations may lead to central bank losses as the central bank liabilities used for sterilization purposes usually pay higher rates of interest than the central bank returns from holding foreign exchange assets. Moreover, as sterilization through open market operations tends to raise domestic interest rates, the inflows of capital may increase further.


If the economy is dollarized, a significant component of the foreign currency inflow may remain outside the central bank as the increase in the demand for domestic currency may be less than the inflow.


If the franchise value of the banking system is strong, even the adverse impact on banks of a sudden reversal of the real exchange appreciation would be minimized. Sound banks would take into account the probability of such occurrence when extending credit to economic agents whose real net income is largely dependent on revenues from the nontradable sector of the economy. Therefore, either credit to the riskier sectors would be limited or the risk would be properly reflected in an accumulation of capital.


Indeed, the discussion in Section III made it evident that the methods used by central banks in some Latin American countries had a major role in the extent and duration of the crisis.


Banks hold reserves for settling transactions among individual banks. The demand for reserves depends on the overall liquidity of an economy’s money markets and the lending policies of the central bank. See Garber and Weisbrod (1992), Chapter 13.


Moreover, as reserve requirements tend to lower the interest rate paid on deposits, they would constraint additional inflows of capital.


They would, however, be willing to hold some reserves without being compensated with interest payments because they are necessary for payments clearing purposes.


In contrast to a reserve requirement policy, a policy of paying interest rate on bank reserves may create incentives for further capital inflows as it raises the yield on bank deposits.


As in the case of a policy that pays interest rates on reserves, sterilization through open market operations may also attract further inflows of capital.


Central bank losses in Chile and Colombia--two active sterilizers--reached 2.2 and 0.8 percent of GDP in 1991, respectively. By 1992, these ratios had declined to 1.1 and 0.5 percent of GDP, respectively. Notice, however, that these losses cannot be fully attributed to sterilization practices.


The reader is reminded that unsterilized intervention results in an expansion of the central bank’s balance sheet.


When a foreign investor purchases equity, he must exchange a hard currency deposit for a local deposit to pay for his purchase. As a result, the local bank obtains hard currency funds that can result in an expansion in the local banking system.


The role of credit extended through the equity markets on an speculative attack on the exchange rate is discussed in Section V.


For evidence on this point from several East Asian economies, see Steven R. Weisbrod and Howard Lee, “The Role of Financial Intermediaries during Asset Deflations: Case Studies of Japan, Korea, and Taiwan,” in Portfolio Investment in Developing Countries. World Bank Discussion Papers No. 228.


The two IFC indexes include the largest and most-actively traded stock in each market covering about 60 percent of total market capitalization.


The function of providing liquidity is still important, but the demand for bank loans to provide liquidity declines as capital markets develop. Capital markets develop because markets are liquid enough to settle payments at the end of the day with securities rather than with “good funds.” This argument is presented in detail in Section II.


Banker’s acceptance was an important funding instrument for banks in 1989 when reserves requirements on deposits reached 100 percent. When these requirements were eliminated, the market for banker’s acceptances shrank substantially and bank deposits regained their importance as a funding source for banks.


Moreover, the spread between commercial paper and short-term deposits was about 400 basis points in early 1994.


This equity ratio is chosen to conform to the capital guidelines of the Bank for International Settlements.


This calculation assumes that 92 percent of the loan is funded at the bank’s marginal cost of funds and the remaining 8 percent of funds is raised in the equity market. Banks earn 13.5 percent on the entire loan, which is the commercial paper rate. They pay 11.5 percent, the BA rate, on 92 percent of the funds used to make the loan as well as 75 basis points of non-interest expenses on the entire amount of the loan. Based on this revenue stream and the funding and non interest costs, banks earn about 27 percent on the remaining 8 percent of funds used to make the loan, which represents the equity funding.


For a relative comparison, in the United States, corporate bonds are about 19 percent of GDP.


Foreign firms use ADRs to become listed on a U.S. stock exchange without being subject to the Security and Exchange Commission’s disclosure requirement. To issue ADRs, however, foreign firms must hold a deposit with a U.S. chartered bank to guarantee payment of dividends. Receipts verifying the existence of these deposits are the instruments that are actually traded.


Notice that, from an analytical point of view, a lack of credibility in the commitment of an announced policy--say, the exchange rate or the fiscal stance--is similar to the perception that the behavior of a key nonpolicy fundamental--say, the capital inflows--is transitory. On the destabilizing eff