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I would like to thank William Alexander, David Bigman, Francesco Caramazza, Paul Cashin, Warren Coats, Daniel Dueñas, Sena Eken, Brenda Gonzalez-Hermosillo, Jang-Yung Lee, Adnan Mazarei, Laura Papi, Ceyla Pazarbasioglu, Philipp Rother, and Mark Swinburne for very helpful discussions and insightful comments on an earlier draft, Angeliki Kourelis and Kiran Sastry for research assistance, Marie Carole St. Louis for editing, and the staff of the Bank of Lebanon for providing the data. I am particularly grateful to Carlo Cottarelli who encouraged the project and afforded useful critical suggestions. Any remaining shortcomings are my sole responsibility. The views expressed in this paper do not necessarily represent those of the International Monetary Fund.
An overview on other country studies on currency substitution and dollarization is given at the beginning of Section 6. For a summarizing discussion of these studies, see Calvo and Végh (1992).
This concept is also behind much of the work on currency substitution in industrial countries. See, for example, Lane and Poloz (1992).
The econometric analysis of this paper was also extended to a definition of the degree of currency substitution that included both residents’ and non-residents’ accounts. However, the results were largely identical to the ones of Definition 1.
Definition 2 can only be calculated for the period from 1982 to 1993, owing to the fact that the IFS series came out in 1982.
As pointed out by Savastano (1992), some authors tried to estimate the amount of foreign currency bills in circulation in certain LDCs, e.g. Melvin and Afcha de la Parra (1989) or, more recently, Kamin and Ericsson (1993) and International Monetary Fund (1994a). However, according to Savastano, the usefulness of these estimations is doubtful, given the extremely restrictive assumptions, e.g. on the velocity of circulation of domestic money balances and other variables.
The amount of US dollars circulating within the Lebanese economy was estimated in IMF (1994a), following the approach of Melvin and Afcha de la Parra (1989); see previous footnote. According to these estimates, the ratio of LL cash to total cash moved broadly in tandem with the ratio of LL deposits to total deposits, implying large fluctuations (see Chapter III). For end-1993, IMF (1994a) estimates that US$-denominated currency in circulation amounted to US$ 2.3 billion, which compares to an alternative estimate of US$ 1 billion quoted in World Bank (1994); this wide discrepancy once again emphasizes the problematic character of these estimations.
This chapter describes the path of dollarization in Lebanon over the last two decades. Further descriptions of monetary developments in general and the use of foreign currency in particular in Lebanon can be found in Saidi (1981, 1984, 1987), Short (1981), Saidi and Huber (1982), Osseiran (1987), Towe (1989), International Monetary Fund (1994a), and World Bank (1994). Short (1981), Saidi (1984), and, more recently, International Monetary Fund (1994a) have estimated traditional money demand functions for Lebanon and found stable relationships between money, prices and output, in the case of the IMF (1994a)-study after the correction of the impact of the civil war and experimenting with different monetary aggregates.
The assumption that domestically held foreign currency deposits also serve, to an increasingly large degree, transaction purposes is illustrated by the fact that the Bank of Lebanon (BoL) established a clearing system for dollar denominated checks in 1990; before 1990, dollar-denominated check clearing had only been offered by two private institutions. Subsequently, from 1991 to 1993, the ratio between the value of dollar checks cleared and the total value of checks cleared ranged between 60 and 80 percent, with a rising tendency.
The course of the exchange rate was, at least partially, also influenced by the relative growth of foreign currency deposits versus domestic currency deposits, as pointed out by Towe (1989). He also indicated that speculative bubbles may to some extent have influenced the path of the exchange rate in the 1980s.
As there are no reliable inflation data available in the case of Lebanon, this paper focusses on the relationship between currency depreciation and dollarization.
As foreign currency deposits are converted into domestic currency to calculate the CS-ratio, the growth rate of the CS-ratio is also partially due to valuation changes.
Over the same period, households decreased their holdings of LL cash by half.
For a discussion of currency substitution in industrial countries, see, for example, Lane and Poloz (1992).
In the case of Yemen, the time series refers to the Yemen Arab Republic and only covers the period up to the unification of the country with The People’s Democratic Republic of Yemen in May 1990.
The figures are based upon quarterly data time series from the IMF International Financial Statistics and represent only the periods for which data were available and immediately accessible. However, in most of the sample countries, the currency substitution process started much earlier than depicted in the graphs.
By legalizing foreign exchange deposits within the national banking system, often as part of an economic stabilization program after situations of severe internal and external disequilibria, or as part of efforts to liberalize the economy, the authorities generally expected a decline in capital flight and, in many cases, a sizable repatriation of funds and an increase in the supply of foreign exchange resources to their respective economies. Furthermore, the authorization and promotion of foreign currency deposits within the national banking systems contributed to the development of the respective banking systems by strengthening financial intermediation. It also enabled the authorities to better monitor and potentially control the substitution of currencies. In addition, the presence of foreign currency deposits increased the pressure on the national governments to keep possibly existing stabilization programs on track.
For a detailed description of the debt correction and monetary correction system in Brazil, see, for example, Lees (1990).
For a discussion of currency substitution and dollarization in economies in transition, see Box 9 in IMF World Economic Outlook (1994) and Sahay and Végh (1994).
For example, interest rates on money balances in domestic currency temporarily exceeded 100 percent in Bolivia and Uruguay and were well above 1000 percent in Argentina and Peru.
For example, in Poland, effective January 1990, enterprises were no longer allowed to increase their foreign currency deposits, which led to an immediate and continuous decline in the dollarization ratio.
A previous study on currency substitution in Lebanon, covering the period from 1977 to 1986, was conducted by Osseiran (1987).
Recent econometric analyses on currency substitution in the sample countries of the previous section include studies on Argentina (Kamin and Ericsson (1993), Ahumada (1992), Melnick (1990), Piterman (1988), Fasano-Filho (1987), Canto and Nickelsburg (1987), Ramirez-Rojas (1985)), Bolivia (Melvin (1988), Melvin and Afcha (1989), Melvin and Ladman (1991), Melvin and Fenske (1992), Savastano (1992), Clements and Schwartz (1992)), Chile (Piterman (1988)), Mexico (Gruden and Lawler (1983), Ramirez-Rojas (1985), Melvin (1988), Savastano (1992), Ortiz (1983)), Peru (Rojas-Suarez (1992), Savastano (1992)), Uruguay (Piterman (1988), de Melo (1986), Ramirez-Rojas (1985), Savastano (1992)), Egypt (El-Erian (1988), Haque (1990)), and Yemen A.R. (El-Erian (1988)). Agénor and Khan (1992) focused on ten developing countries (Bangladesh. Brazil. Ecuador, Indonesia. Malaysia. Mexico. Morocco. Nigeria, Pakistan, and Philippines). Other studies on developing countries refer to the Dominican Republic (Canto (1985)), Brazil (Calomiris and Domowitz (1989)), Ecuador (Canto and Nickelsburg (1987)), Venezuela (Marquez (1987), Canto and Nickelsburg (1987)), and Israel (Piterman (1988)). Currency substitution in economies in transition is dealt with in Sahay and Végh (1994) and International Monetary Fund (1994b). For examples of currency substitution in industrialized countries see Lane and Poloz (1992), Batten and Hafer (1984, 1985, 1986), Bordo and Chaudhri (1982), Brillemburg and Shadier (1979), Brittan (1981), Daniel and Fried (1983), Marquez (1985), and Melvin (1985).
The β-parameter is included only on an experimental basis. Most of the estimations are run with β equal to 1.
This implies assuming static expectations, as deposit stocks refer to end-of-period data.
According to representatives of the Lebanese banking community, the interest rate on U.S. dollar deposits in Lebanon is linked to LIBOR minus a margin of 1/8 of a percentage point; the margin has been relatively constant over time.
These studies generally used the past peak inflation rate to measure the ratchet effect, but indicated the possibility to also use the past peak depreciation rate. As in the case of Lebanon no reliable inflation data on a monthly basis are available, only the depreciation rate can match the approach used in other studies.
The scanning involved raising n from 1 to 4 years in annual steps and from 4 to 6 years in quarterly steps.
The specification search also included lagged values of the interest rate differential and the exchange rate depreciation, but they were dropped due to low t-statistics.
For simplicity, the tables report only the final stage of the specification search.
A scale variable is omitted, as in Cagan’s (1956) money demand model for hyperinflating countries.
The instruments used for the exchange rate included all the strictly exogenous variables of the main model, plus the lagged values of the exchange rate.
In different runs of the estimation, seasonal adjustment as well as different LIBOR and LL interest rates were tried. However, the results did not differ significantly.
The expected sign for the interest rate differential and the expected depreciation is negative as a result of the logistic transformation of the dependent variable.
The Chow test was performed on the regressions by dividing the observation period into two unequal halves. The splitting date was chosen with the intention to separate the civil war period from the following period of relative peace. As a consequence, the splitting date chosen is the signing of the Taif Peace Accord in October 1989, which formally ended the civil war.
The 3-month LIBOR is taken here as an example, but a similar range also exists for other LIBOR maturities.
It can also be assumed that such a sophisticated investor does not restrict his portfolio decisions to LIBOR-linked deposits but tries to benefit from higher returns in other currencies and other forms of assets.
The ratchet length of 5 ½ years implied by equation (15) is not taken as indicative for the appropriate length of the ratchet effect, as the estimation results are ambiguous and biased, as explained below. This once again supports the thesis of relative inferiority of the model specification using the exchange rate ratchet.
Largely identical results were also obtained when other values of β were randomly tried out.
The long-term effect is calculated by dividing the coefficient estimate for the expected depreciation variable by 1 minus the coefficient estimate of the stock adjustment variable.