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)| false Sahay, Ratnaand Carlos Végh, 1996. “ Dollarization in Transition Economies: Evidence and Policy Implications,” in ( Paul Mizenand Eric J. Pentecost eds.), The Macroeconomics of International Currencies, Theory, Policy and Evidence, pp. 193- 224( Gloucestershire, UK: Edward Elgar).
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)| false Savastano, Miguel, 1996, “ Dollarization in Latin America: Recent Evidence and Policy Issues,” in ( Paul Mizenand Eric J. Pentecost eds.), The Macroeconomics of International Currencies, Theory, Policy and Evidence, pp. 225– 55. ( Gloucestershire, UK: Edward Elgar).
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We thank Tam Bayoumi, Olav Gronlie, and Alain Ize for comments on an earlier draft, and Giovanni Dell’Ariccia and Carlos Végh for helpful discussions on the topic. We are also grateful to Yutong Li and Marlene George for valuable assistance. The usual caveats apply.
In the case of transition economies in Eastern Europe, links with the Deutsche Mark (and more recently with the euro) have been stronger, whereas in Latin America links with the U.S. dollar have been overwhelming. In this paper, we use the term “dollarization” as a generic for greater foreign currency participation in domestic financial intermediation, regardless of whether it refers to the U.S. dollar or the euro.
Highly dollarized economies include Argentina, Bolivia, Peru, and Uruguay, all of which display ratios of foreign currency deposits to broad money in excess of 50 percent. To date, only one country in Latin America (Panama) has fully replaced the domestic currency by the US dollar and another (Ecuador) is completing its dollarization process. Indicators of the extent of dollarization in a large sample of countries are provided are Baliño et al. (1999)
Useful overviews are provided in Calvo and Végh (1992) and Savastano (1996). As noted by those authors, the use of the term dollarization in the literature is sometimes confusing: in some studies it refers to currency substitution (or the dollarization of narrow money), whereas in others it also encompasses the dollarization of less liquid assets (such as time deposits). The problem with this is that currency substitution and the dollarization of time deposits tend to be determined by different sets of variables. Yet, because of deficient data on foreign currency holdings, several empirical studies use broad money indicators to test hypotheses regarding currency substitution.
Costly banking and its central role in financial intermediation have featured prominently in the recent literature on the monetary transmission mechanism in emerging markets (e.g., Mishkin, 1997; Edwards and Végh, 1997). In this literature, banks take deposits and lend in domestic currency only. Here we extend these features to a two-currency framework.
This approach to modeling the banking firm follows a long tradition starting with Klein (1971). A useful review and references are provided in Freixas and Rochet (1997). In this paper we extend this basic framework to the two currency case building on earlier work by Terrones (1994).
The assumption of perfectly competitive deposit markets is not unreasonable for some emerging markets and has been adopted in other studies (see Barajas et al. 1999, and references therein). One main reason is that long histories of high inflation and unexpected devaluations have encouraged depositors to arbitrage more effectively between domestic banks as well as between onshore and offshore accounts. In several countries, competition in local deposit markets appears to have been further intensified in recent years by financial liberalization and foreign entry (Claessens et al., 1998).
The assumption that banks maximize profits in dollars rather than in domestic currency seems very appropriate in an economy where the dollar has taken an increasing role as unit of account and store of value. The greater participation of foreign banks in emerging markets in recent years adds further realism to this assumption, since these institutions seek to maximize profits denominated in a foreign reserve currency which is often the U.S. dollar.
To simplify the algebra and make the presentation crispier, we assume that rLδ ≈ 0, rDδ ≈ 0, and rEδ ≈ 0. This will not affect, however, the thrust of our results.
We relax this assumption later in the paper and discuss how this affects our main results.
The inclusion of the shares of non-performing portfolio (1–α, 1–α*) in the operating cost functions can be rationalized in two ways. One is that it represents the cost of setting aside a certain amount of loan provisions required by the outside regulator. Alternatively, the term could be thought of as capturing the costs of collecting the loan principal.
Consistent with regulations in various (but not all) countries we simply assume that net foreign borrowing B* is not subject to reserve requirements or any quantitative restriction. However, this assumption can be readily modified. Assuming, for instance, an infinitely elastic supply of international capital, the imposition of reserve requirements on banks’ foreign borrowing is tantamount to an increase in the external interest rate.
For a discussion of advantages and shortcomings of the conjectural variation approach, see Quirmback (1988). Its use here has been motivated by the intuitive and simple way in which it allows us to represent different market structures within a unified framework.
If all banks have an equal share of the loan market, L = nLi. Substituting in (8.a), we obtain that Λi = nLi − Li = Li(n–1). Hence, Λi/Li = n− 1. The same relations apply to dollar lending.
Due to space constraints, we shall not report here the effects of changes in reserve requirements. The results of this exercise can be obtained from the authors upon request.
This rules out the existence of complex kinks in aggregate cost curves which would complicate considerably the algebra possibly without adding any further significant insight.
For the sake of concisiveness we do not provide here the expressions for deposit dollarization. Needless to say, when loan dollarization increase, liability dollarization will also increase. However, the composition of liabilities between deposits and net foreign borrowing will change, as shown by equations (10.a) and (10.b). The derivations of the expressions for deposit dollarization are available from the authors upon request.
In the case of Asia, banks’ net foreign liabilities continued to contract trough the first half of 2000, nearly two years after the worst of the crisis was over (see IMF, 2000, Chapter 2).
Catão (1997) and Keeton (1999) provide evidence that as real GDP grows faster (slower), so does borrowers’ repayment capacity, leading to lower (higher) delinquency ratios. Looking at the issue from the supply-side, Rajan (1994) cautions, however, that the positive correlation between demand growth and the quality of the loan portfolio can be weakened if, yielding to reputational pressures, bankers loosen credit standards to maximize short-term profits at the expense of long-term solvency. In this case, while the short-run effect of an exogenous demand pull on loan performance tends to be positive, it may end up being small or even perverse in the longer-run if the banking system is poorly regulated and moral hazard fosters reckless lending.
This is because peso borrowers will either benefit from the devaluation (if part of their net revenues is US dollar denominated) or, at worst, will be neutral (if all their liabilities and assets are all peso-denominated).
Since this equation is very large and unwieldy, we preferred to omit it here, but is available from the authors upon request.
As before, we shall not discuss here the special cases for deposit dollarization. Those results are available from the authors upon request.
Episodes in which domestic currency deposits increase relative to foreign currency denominated deposits in the run-up to devaluation are not unheard of. Rogers (1992), for instance, has found evidence of a negative and statistically significant relation between devaluation expectations and the ratio of dollar-denominated to peso-denominated deposits in Mexico for the period 1973–1985.
In empirical implementations of the model, this can be readily accommodated by either redefining γ* net of loan recovery costs or incorporating recovering costs into the marginal cost term
Caballero and Krishnamurthy (1998) developed a model where there is a domestic market for tradable collateral and the latter is transacted between tradable and non-tradable sectors. This allows non-tradable sectors to collateralize their loans, thus being able to borrow in dollar and at lower lending rates. However, the underdevelopment of such a market in most emerging economies to date has prevented large scale ownership of tradable collateral by non-tradable firms. This is at the root of the segmentation hypothesis discussed earlier and built into the model.
The rationale behind the existence of economies of scope between loans and deposits (which helps justify universal banks) is discussed in Fama (1985). The assumption that they are negligible across currencies, however, is consistent with hedging strategies generally adopted by financial intermediaries and also accords well with the segmentation hypothesis discussed earlier in the paper, which sets apart the types of clients that usually operate in domestic and foreign currency markets.