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Financial D o llarization Eduardo Levy Yeyati Universidad Torcuato Di Tella Presentation at the Office of the Chief Economist Inter-American Development Bank November 2, 2004 Outline Financial dollarization Definition and measurement Drivers Concerns Prognosis Definition

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Financial d o llarization eduardo levy yeyati universidad torcuato di tella l.jpg

Financial DollarizationEduardo Levy YeyatiUniversidad Torcuato Di Tella

Presentation at the Office of the Chief Economist

Inter-American Development Bank

November 2, 2004


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Outline

  • Financial dollarization

    • Definition and measurement

    • Drivers

    • Concerns

    • Prognosis


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Definition

  • Currency substitution (CS): foreign currency (dollar) as means of payment/unit of account

  • Asset substitution (AS): dollar as store of value

  • Financial dollarization: holding by residents of dollar assets and liabilities AS but not necessarily CS

    • Argentina 2002 & Uruguay 2002


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MeasurementDeposit Dollarization


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MeasurementOther Sources (% GDP)


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Drivers

  • Hedging (Ize and LY, 1998, 2003)

    • Reverse causality: Fear of floating may perpetuate FD

  • Time inconsistency (Calvo and Guidotti, 1990)

    • CPI indexation?

  • Implicit guarantees (Burnside et al., 1999), peg trap (De la Torre et al., 2003),

  • Currency-blind regulation & safety nets (Broda and LY, 2001, 2003)

  • Institutions (Rajan, 2004)

  • Offshorization (LY, 2004)




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Concerns

  • RER exposure

    • Amplifies cycles (debt deflation or balance sheet effects)

      • Procyclical capital flows due to correlation between leverage ratio and external shocks Pocyclical monetary policy

    • Increases financial fragilities


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Amplifies cycles

Source: Levy Yeyati (2004)


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Increases financial fragility

  • FD associated with greater banking fragility (z-scores and NPL ratios) and deposit volatility (de Nicoló et al., 2003)

  • FD increases the propensity to suffer sudden stops (Calvo, et al., 2003)


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Increases financial fragility


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Dollarization & Financial Depth

Hong Kong

Lebanon

Vanuatu

Notes:. The cofficient on dollar_avg is -0.005 with a t-statistic of -5.27.


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FD: Where do we stand?

  • The preliminary evidence confirms some of the concerns and cast doubt on the financial depth argument

    • Persistent and widespread among developing countries

    • Linked to AS (volatile inflation & stable RER)

    • Greater sensitivity of money demand, slower and more volatile growth, greater financial fragility

    • No significant gains in terms of domestic financial depth (no impact of restrictions on FD)


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FD: Where do we go from here?

  • Two-way approach: Prudential regulation (stick) & promotion of peso instruments (carrot)

  • Latam experiences:

    • Chile (indexation)

    • Mexico (restrictions & local currency bond markets)

    • Uruguay (prudential regulation & indexation)

    • Argentina (restrictions on FD & indexation)

  • Ultimately, a“fear vs. greed” dilemma?

  • Rol of IFIs?


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Financial DollarizationEduardo Levy YeyatiUniversidad Torcuato Di Tella

Presentation at the Office of the Chief Economist

Inter American Development Bank

November 2, 2004


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Weak Currency Problem

  • Weak currency: Not accepted either internationally or domestically as a reliable store of value (De la Torre et al., 2002)

    • Shortermism in the local currency

      • Duration mismatch  Roll-over risk

      • Floating rates, CPI indexation

    • Dollar indexation (FD)  Currency risk


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Deposit dollarization

Dollar Deposits over Total Deposits

Time deposits

Savings deposits

Demand deposits

Source: De la Torre, Levy Yeyati and Schmukler (2002).


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Real cash in circulation

Includes quasi-monies.

Source: De la Torre, Levy Yeyati and Schmukler (2002).




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RER Exposure

  • FD & Original sin

    • Eichengreen et al. (2003): Only external mismatch is important, but...

    • ...currency balance is needed at the micro level (domestic longs & shorts do not cancel out in practice)


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