Financial DollarizationEduardo Levy YeyatiUniversidad 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 • 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
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)
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
Amplifies cycles Source: Levy Yeyati (2004)
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)
Dollarization & Financial Depth Hong Kong Lebanon Vanuatu Notes:. The cofficient on dollar_avg is -0.005 with a t-statistic of -5.27.
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)
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?
Financial DollarizationEduardo Levy YeyatiUniversidad Torcuato Di Tella Presentation at the Office of the Chief Economist Inter American Development Bank November 2, 2004
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
Deposit dollarization Dollar Deposits over Total Deposits Time deposits Savings deposits Demand deposits Source: De la Torre, Levy Yeyati and Schmukler (2002).
Real cash in circulation Includes quasi-monies. Source: De la Torre, Levy Yeyati and Schmukler (2002).
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)