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We are grateful to S. Ramirez, V. Etropolska, M. Kitonga, and M.C. St. Louis for their valuable assistance. We also wish to thank P. Hayward, A. Ize, D. Marston, and P. Turner, as well as the participants at the Central Reserve Bank of Peru-IMF joint conference and an IMF seminar for valuable comments and suggestions. We are especially indebted to the supervisory authorities from the 17 countries that responded to our lengthy questionnaire and provided comments on an earlier version of this paper.
See Ize and Powell (2004), for a presentation of the need for prudential measures to reduce the vulnerabilities from dollarization.
Tornell and Westermann (2002) note that the incentive structure is sufficiently strong that small firms belonging to the non-tradable sector borrow more intensively in foreign exchange in periods of boom encouraged by bailout guarantees and sometimes real exchange rate appreciation. This explains the increase of the non tradable to tradable output ratio in these periods.
The survey included six countries with more than half of total deposits in foreign currency (Bolivia, Croatia, Lebanon, Peru, Singapore and Uruguay), six countries with dollarization levels between 30 and 50 percent (Costa Rica, Honduras, Latvia, Romania, Slovenia and Turkey) and five countries with low levels of dollarization (Argentina, Brazil, Chile, Poland, and Sweden).
Reserve requirements have been traditionally regarded as a monetary policy instrument to assist authorities in controlling the money supply, as the range of liquid assets (cash and central bank deposits) accepted to comply with this minimum ratio are also central bank liabilities (base money). However, they have also been seen as a special type of liquidity ratio and as such they have been used as a prudential tool, operating as a buffer stock to face liquidity shocks.
In August 2005, Uruguay approved higher capital requirements for foreign currency loans by establishing a 125 percent weight on these assets. This norm is scheduled to become effective in July 2006.
Banks’ exposure to credit risk may be simultaneously affected by several market variables, including the exchange rate, interest rates, inflation, and the level of economic activity. Authorities may consider these shocks individually or jointly, taking into account the correlations between these variables. While acknowledging this, the focus is put on exchange rate shocks.
A long enough history that includes the events leading to dollarization is likely to also contain large exchange rate variations. However, these events might be hard to replicate under the improved monetary management applied in most highly dollarized countries in the recent past.
An additional complication occurs when authorities are committed not to devalue, as is the case in currency board regimes. From a prudential point of view, authorities may still want to built up a buffer to cover from this unlikely event. The way this buffer is communicated is particularly important in this case, so as not to create mixed signals or self-fulfilling prophecies.
Other potential costs may arise as banks seek to elude the added cost of doing banking business. These include the possibility of disintermediation and regulatory arbitrage, which are more difficult to assess.
Basel II capital standards would captured these effects, under the Internal Ratings-Based (IRB) approach. However, Basel II is to be available for implementation in G-10 countries only in early 2007, and many highly dollarized countries may choose not implement it until much later, not to implement the more sophisticated IRB approaches, or not to implement the Pillar I of Basel II.
In the first case, the liquid assets are managed by banks, whereas in the second case, these are managed by the central bank and are mostly constituted by central bank liabilities.
Four responding countries are members of the European Union (Latvia, Poland, Slovenia and Sweden) and three countries are European, nonEU members (Croatia, Romania, and Turkey). There is also one Asian country (Singapore), one country from the middle east (Lebanon) and eight countries from the western hemisphere region (Argentina, Bolivia, Brazil, Chile, Costa Rica, Honduras, Peru, and Uruguay).
Financial dollarization is measured here as the share of foreign currency deposits over total deposits. The term dollarization is used for all countries, although in some of these countries the foreign currency of choice is not the U.S. dollar, but the Euro.
For instance, Uruguay considers “borrowers receiving loans in foreign currency, whose cash flow to repay loans are in local currency.” Poland regards as unhedged debtor one “that does not have the natural hedging, e.g. cash inflows denominated in foreign currencies, and does not secure his exposure on derivative market.” In contrast, Honduras and Costa Rica, have definitions that refer only to the capacity of the debtor to generate foreign currency.
In Uruguay, higher capital requirements for foreign currency loans are to become effective in July 2006, by establishing a 125% weight on these assets. A similar approach has been adopted by Georgia, a country not in the survey, where a 200 percent risk weight is applied for foreign currency assets for the calculation of the minimum required capital to risk weighted assets ratio.
Article 23rd of Decree 905/02 and related central bank regulations.
Monetary Authority of Singapore (MAS) technical paper on Credit Stress Testing outlines several hypothetical and historical scenarios related to foreign exchange rate changes.
Though some countries require banks to disclose to the public their credit policies and, in general, the major risks that they are exposed to, there is, however, no specific requirement to disclose credit risks emerging from lending to unhedged borrowers.
The rationale being that interest rate levels are more relevant than interest rate changes in explaining changes in NPLs and provisions.
The econometric estimates are based on monthly data on NPLs of the banking system, total loans of the banking system, average lending rates, real GDP (when not available, industrial production index was used instead), exchange rate with respect to the US dollar or to Euro (for pre-1999 data, the Euro rate were replaced with Deutsche mark rates). Data were collected from January 1990 to latest observation available for Brazil, Bolivia, Chile, Peru, Poland, and Slovakia. The choice of this particular country set was guided by data availability among those emerging or developing economies with dollarized/eurorized banking systems. In most cases, complete data sets were only available from the mid 1990s. For Bolivia, only quarterly data were available (1990:Q1 – 2004:Q3). For Peru, data on total provisions, foreign currency NPLs and provisions were also collected. All data were downloaded from the International Financial Statistics (IMF), the web pages of the corresponding central banks, supervisory agencies, and national statistical offices.
One possible rationale for the insignificant effect of inflation on NPL growth in Chile (and, to a lesser extent, in Brazil and Poland) could be the use of inflation indexed-contracts.
A 2004 study by Banco Central de Bolivia on a similar topic (Escobar, 2004) also includes a 1999–2004 dummy to correct for a structural break.
Simulations assume that additional provision requirements due to depreciation cannot be met with profits, only with existing capital.