Annex: A Model for Determination of Foreign Currency Deposit Ratios45
We modify the model in Ize and Levy-Yeyati (2003) to analyze the dollarization issue in Cambodia. The key modification is that depositors evaluate their portfolios in U.S. dollar terms instead of in local currency terms. There are two types of deposits, one in local currency (riel), the other in U.S. dollars. Let
where r is the averaged real return of the deposit portfolio, λ is the share of deposits in the foreign currency account, TD is the amount of total deposits, and c is the risk aversion measure. Given interest rates, depositors maximize the return on their deposits by choosing what share of their deposits to hold in the foreign currency account. The optimal share of foreign currency deposits in total deposits, λ*, can be written in the following way:
We use the following approximations:
where eUSD/Riel denotes the rate of change in the nominal exchange rate (U.S. dollar per Riel); λUS denotes the inflation rate in the United States. Substitute equations (4) and (5) into equation (3), and the optimal share of foreign currency deposits is derived as a function of nominal exchange rate changes and the inflation in the United States.
An increase in exchange rate volatility leads to a higher share of foreign currency deposits. This result is intuitive. If depositors measure everything in U.S. dollar terms, everything else being equal, higher exchange rate volatility only adversely affects the value of the riel account, but not the US dollar account.
International Monetary Fund, 1999, Monetary Policy in Dollarized Economies, Occasional Paper No. 171, September,(Washington DC, International Monetary Fund).
Ize Alain and Eduardo Levy-Yeyati, 1998, “Dollarization and Financial Intermediation: Causes and Policy Implications,” IMF Working Paper 98/22, March, (Washington DC, International Monetary Fund).
Reinhardt, Carmen M. Kenneth Rogoff and Miguel A. Savastano, 2003, “Addicted to Dollars,” National Bureau of Economic Research Working Paper 10015, October, (Cambridge, MA: NBER).
Prepared by Wafa Fahmi Abdelati (APD).
The criteria used to identify successful reversal include reducing foreign currency deposit to broad money by 20 percent and remaining below that level until the end of the sample period.
In a recent paper, Ize and Levy-Yeyati (2003) argued that greater exchange rate flexibility would reduce incentives for dollarization. They advocated a floating exchange rate combined with an inflation targeting approach to foster the use of the local currency, based on a theoretical model that derives depositors’ optimal portfolio. In the Annex to this note, we show that this relation between exchange rate flexibility, inflation volatility and de-dollarization does not hold in the case of Cambodia when the model is adjusted to allow depositors to evaluate their portfolio in US dollar terms instead of in local currency terms.
Domestic dollarization in this case refers to the ratio of foreign currency deposits in broad money and the share of government debt that is foreign-currency-denominated.
Prepared by Zhiwei Zhang (APD).