APPENDIX III-1: Dollarization: Causes and Policy Implications
As noted in Section III-C, a distinctive characteristic of remonetization in Azerbaijan is that it has taken place largely through an increase in foreign currency deposits (FCD), contributing to a sharp increase in measured dollarization.12 The literature highlights two main reasons for the observed persistence of dollarization in transition and emerging economies.
The first reason—hysteresis—has to do with the fact that during periods of hyperinflation, as well as extended high inflation, economic agents reduce their holding of money balances denominated in domestic currency, to avoid erosion of their asset holdings. This change of behavior is a slow process that involves institutional changes, and is not reversed quickly when inflation is brought under control. This is similar to the explanation of the asymmetric response of money demand to changes in inflation.
The second reason—asset substitution—is related to the relatively low level of development of domestic financial markets. To the extent that there are few attractive assets available in local currency, investors will have little choice but to invest in assets denominated in foreign currency. Dollarization therefore, as argued by Havrylyshyn and Beddies (2003), opens the way to diversifying portfolios and reducing risks.
There is another possible explanation, especially for countries that have experienced sharp increases in the FCD/M3 ratio against a background of a stable macroeconomic environment, such as Azerbaijan and Kazakhstan. In these cases, an increase in the FCD/M3 ratio could reflect improved confidence in the banking sector, and a conversion of cash dollar holdings into FCD in the banking sector, with no change in dollarization.
As can be seen from Figures III-7, progress in financial market development in the BRO, as measured by the EBRD transition indicator on securities markets and non-bank financial institutions reforms, is negatively correlated with the level of dollarization, seeming to provide support for the asset substitution argument mentioned above. In the case of Azerbaijan, for example, there are limited opportunities to invest in domestic currency-denominated instruments. The stock market is virtually inexistent. and the supply of treasury bills is highly volatile and limited to short-term maturities (3- and 6-months only).
While dollarization is measured as the ratio of FCD/M3, the extent of currency substitution appears to also be very high in Azerbaijan. Transactions of relatively high value, such as, for example, sales of cars and apartments, reportedly continue to be settled primarily in foreign currency. The fact that the banknote with the highest denomination in Azerbaijan is the manat 50,000 note, equivalent to about US$10, is an important factor in reducing the attractiveness of manat notes, thereby contributing to the reportedly high level of currency substitution.
Although dollarization allows domestic economic agents to better diversify their portfolio, there are potential costs from dollarization. A high dollarization ratio complicates, for example, the choice of an appropriate intermediate target for monetary policy. More importantly, it makes the economy vulnerable to exchange rate volatility, undermining the authorities’ ability to effectively respond to financial crises. With foreign currency-denominated loans in Azerbaijan amounting to about 75 percent of total banking sector loans at end-2002, a sharp exchange rate depreciation is likely to have a significant adverse impact on banks’ financial position, as most of these foreign currency-denominated loans are to borrowers whose income is denominated in domestic currency.13 A sharp depreciation therefore, unless accompanied by an immediate and complete pass-through into domestic prices, will cause difficulties for firms trying to service these loans, and lead eventually to increased loan defaults.
Given that there are potential costs to high dollarization, the question is whether the authorities should introduce direct measures aimed at reducing dollarization. The two most common direct measures are higher required reserve rates for foreign currency deposits, and forced conversions of foreign currency deposits into domestic currency deposits. International experience indicates that these measures are ineffective, and have been counterproductive in many cases. Bolivia, Peru, Uruguay and Turkey, for example, have used higher reserve requirements for foreign currency deposits than for domestic deposits, but none of these countries has experienced a reduction in dollarization. Mexico in 1982, Peru in 1985, and Argentina in 2002 introduced forced conversions of foreign currency deposits to domestic currency deposits. These conversions actually entailed a significant loss of government credibility. Mexico has also at times restricted domestic firms’ holdings of foreign currency deposits, without much success.
While dollarization complicates the conduct of monetary policy, and may also exacerbate the situation in the case of a financial crisis, direct measures aimed at curbing dollarization should be avoided. Despite its costs, an increase in foreign currency deposits has a positive impact on financial deepening, providing the domestic banking system with resources available for lending, which is an important ingredient for sustainable economic growth. In addition, experience indicates that the effectiveness of direct measures is likely to be transitory at best, as domestic residents eventually find ways to circumvent them. The most effective “de-dollarization” measure therefore, is for the authorities to focus on the development of domestic financial markets, while maintaining strong macroeconomic policies.
Berglof, Erik and Bolton, Patrick, 2002, “The Great Divide and Beyond: Financial Architecture in Transition,” Journal of Economic Perspectives, Volume 16, Number 1, Winter 2002.
Bordo, M.E. and Jonung, Lars, 1987, “The Long-Run Behavior of the Velocity of Circulation: The International Evidence,” Cambridge: Cambridge University Press.
Fries, Steven and Taci, Anita, 2002, “Banking Reform and Development in Transition Economies,” EBRD Working Paper No. 71, (London, European Bank for Reconstruction and Development).
Ghosh, Atish R., IMF Working Paper 80 1997, “Inflation in Transition Economies: How Much? and Why?,” (Washington, International Monetary Fund).
Havrylyshyn, Oleh and Christian H., Beddies, 2003, “Dollarization in the Former Soviet Union: From Hysteria to Hysteresis”, Comparative Economic Studies, forthcoming.
Jonsson, Gunnar, 1999,“Inflation, Money Demand, and purchasing Power Party in South Africa,” IMF Working Paper 122 (Washington, International Monetary Fund).
Keller, Peter et.al, IMF Working Paper, 2003, “Monetary Policy Developments in the CIS”, forthcoming, (Washington, International Monetary Fund).
Laidler, David E. W., IMF Working Paper, 1993, “The Demand for Money: Theories, Evidence and Problems,” Harper Collins College Publishers.
Tseng, Wanda and Corker, Robert, 1991, “Financial Liberalization, Money Demand, and Monetary Policy in Asian Countries,” IMF Occasional Paper 84 (Washington, International Monetary Fund).
In this chapter, M2 refers to currency in circulation plus all manat-denominated deposits in commercial banks. M3 refers to M2 plus foregin currency deposits in commercial banks.
Defined as the increase in nominal reserve money balances during the period, i.e., RMt - RMt-1, where RM stands for nominal reserve money.
Defined as the loss in value of the public’s cash holdings due to inflation, calculated as follows: ITt = (πt/(1 + πt))* RMt-1, where ITt is the nominal inflation tax at period t; πt is the inflation rate during period t; and RMt-1 is reserve money stock in the previous period.
There was a depreciation of about 3 percent in the manat/US$ exchange rate from June 1998 through July 1999, compared to an appreciation of about 8 percent and 5 percent, respectively, in 1996 and 1997. Prices fell between October 1998 and July 1999, with the 12-month CPI inflation at -9.5 percent in July 1999.
While the 12-month inflation at end-2002 amounted to about 15 percent in both Russia and Tajikistan, there has been a trend decline in inflation in both countries, following the sharp spike in inflation in the wake of the Russian crisis of mid-1998.
The level of the EBRD indices, rather than their change, was used in this analysis. The reason is that countries which have experienced the highest improvement in these indices since 1996 are those that have been catching up with the front-runners, starting from a very low base. Thus there is a negative correlation between the level of reforms and the change in the reform index, and this would have distorted the coefficient on the change in reforms.
A fixed effects specification was chosen after the Wald test on the appropriateness of linear restrictions suggested that it is superior to a simple OLS pooled test.
In Russia this corresponds to 1999, as information for later years is not in the 2002 EBRD Transition Report. In Lithuania, state-owned banks also accounted for nearly 40 percent of total banking sector assets in 2000, but this ratio had declined to about 5 percent at end-2001.
With Azerbaijan’s oil sector being financed almost exclusively from abroad, its non-oil exports in 2002 amounted to about USS 250 million, compared to an outstanding stock of bank loans denominated in foreign currency equivalent to US$320 million.
Examples are the establishment of a large tax payer unit, reorganizations and consolidation of tax offices, adoption of new work processes, introduction of bonded warehouses and customs brokers, and partial automation of customs procedures.