Domestic liability dollarization
Encyclopedia
Domestic liability dollarization (DLD) refers to the denomination of banking system deposits and lending in a currency other than that of the country in which they are held. It is important to note that DLD does not refer exclusively to denomination in US dollars, as DLD encompasses accounts denominated in internationally traded “hard” currencies such as the British pound sterling, the Swiss franc, the Japanese yen, and the Euro (and some of its predecessors, particularly the Deutschmark).
reporting banks’ local asset positions in foreign currency as a share of GDP. In emerging-market
economies (EMs), a proxy measure of DLD is constructed by summing dollar deposits and bank foreign borrowing as a share of GDP . This proxy is based on the assumption that banks match their assets and liabilities by currency type and transfer exchange rate risk to debtors . In other settings, DLD is defined as the share of foreign currency deposits over total deposits .
. In an economic environment characterized by these features, the domestic currency (often generically referred to as the peso) serves neither as a reliable medium of exchange nor a predictable store of value. The modern approach to DLD, however, emphasizes that DLD, as typically measured based on interest rate-bearing deposit dollarization, is largely a portfolio choice phenomenon related less with inflation levels than with the distribution of inflation (more precisely, of real return differentials), and relates the outcome to the volatility of inflation and the real exchange rate (and, in turn, the exchange rate policy) . Despite the strong intuitive appeal of this idea, there is comparatively little empirical work on this issue. Among the work that has been done, however, Berkmen and Cavallo (2007) do not find evidence that more active intervention in foreign exchange markets (i.e., more fixing) leads to higher liability dollarization.
Others have argued that a closely managed exchange rate is an effect rather than a cause of DLD, a claim empirically supported in Berkmen and Cavallo (2007) . It has additionally been proposed that DLD reflects a lack of faith in the domestic currency and ultimately in the quality of government, and that countries whose governments rank higher on various indices of quality experience lower levels of DLD than their more poorly performing counterparts .
and currency devaluation, as well as permitting long-term lending and borrowing through the use of a relatively stable currency.
In contrast, the real or potential costs of DLD exist largely at the systemic level and over the long term. When DLD is widespread, economic actors are often required to experience a currency mismatch between domestically denominated income and dollar-denominated liabilities, which represent the only available means of long-term borrowing. Currency mismatches are a particular danger for firms and sectors in non-tradable goods and services. Countries with high levels of DLD, moreover, are often afflicted as well with “Original Sin
,” a country’s inability to borrow in its own currency. While the resulting vulnerability may not be apparent in normal times, it can be revealed during turbulent times, even in the absence of a major crisis. In economies with fixed or heavily managed exchange rate regimes, for instance, an abrupt change in regime can reveal the exposure of actors who have not hedged for exchange rate risk. Internal as well as external shocks to the real exchange rate and/or real effective rate can produce similarly disruptive balance sheet effects, with economy-wide implications for liquidity. These problems can become particularly acute in an economy without an effective lender of last resort
and/or one that issues only domestically denominated debt. Extensive DLD additionally impedes adjustment by means of the real exchange rate and increases the likelihood and severity of a Sudden Stop
. Thus, “fear of floating” (that is not allowing the exchange rate to adjust in the face of external shocks, see: floating exchange rate
) may be a consequence of DLD, as countries with unofficially dollarized economies may find a freely moving exchange rate to be too costly. Berkmen and Cavallo (2007) tested the causality between DLD and fear of floating empirically. Their findings support the “fear of floating” argument. Countries with high liability dollarization (external, public, or financial) tend to stabilize their exchange rate. This finding is robust to various proxies for exchange rate management. For the reverse causality, on the other hand, the authors do not find evidence that more active intervention in foreign exchange markets (i.e., more fixing) leads to higher liability dollarization.
Over time, economies with high levels of DLD can display the following problems: i) an unstable demand for money; ii) a high propensity to experience banking crises following a depreciation of the local currency; and iii) slow and volatile output growth without a significant increase in domestic financial system depth .
is necessary, as the uncertainties brought about by inflation
represent perhaps the greatest single determinant of DLD. Yet reducing inflation
alone is generally not considered sufficient to achieve de-dollarization, as economies with high levels of DLD may exhibit hysteresis
once actors adjust their expectations and behaviors to transactions denominated in foreign currency .
In addition, low volatility of inflation
relative to the volatility of RER depreciation may be needed to lead to de-dollarization. To date, only two countries, Israel in the 1980s and 1990s and Poland in the 1990s, have managed to engage in successful de-dollarization without extensive negative consequences ; both countries managed this transition through combining disinflation with a strong exchange rate anchor. Moreover, in addition to a one-year mandatory hold on dollar deposits, Israel undertook a series of “patches” including the following: i) CPI(Consumer Price Index
)-indexed deposits; ii) requirements that banks undertake active hedging of currency risk for non-tradable activities; iii) active development of financial derivatives markets; and iv) efforts to deepen local currency bond markets . Poland’s disinflationary efforts, moreover, coincided with a very high real exchange rate. Under less favorable circumstances, or in the absence of policies designed to facilitate adjustment, forced de-dollarization has provoked extensive capital flight and/or steep declines in financial intermediation.
A second potential channel of de-dollarization is the increasing use of domestic currency lending to the private sector as well as to sovereigns and subnational governments by international financial institutions, particularly the Inter-American Development Bank
. In addition to hedging those institutions’ currency risk, multilateral lending in domestic currency offers a potential solution to a first mover problem and a signal to other economic actors.
Measurement
In developed countries, DLD is defined as Bank for International SettlementsBank for International Settlements
The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...
reporting banks’ local asset positions in foreign currency as a share of GDP. In emerging-market
Emerging markets
Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...
economies (EMs), a proxy measure of DLD is constructed by summing dollar deposits and bank foreign borrowing as a share of GDP . This proxy is based on the assumption that banks match their assets and liabilities by currency type and transfer exchange rate risk to debtors . In other settings, DLD is defined as the share of foreign currency deposits over total deposits .
Determinants
A variety of causes have been proposed for DLD, some more widely accepted than others. Causes often cited in the early literature on DLD, especially in Latin America, include high fiscal deficits, loose monetary policy and a history of inflationInflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
. In an economic environment characterized by these features, the domestic currency (often generically referred to as the peso) serves neither as a reliable medium of exchange nor a predictable store of value. The modern approach to DLD, however, emphasizes that DLD, as typically measured based on interest rate-bearing deposit dollarization, is largely a portfolio choice phenomenon related less with inflation levels than with the distribution of inflation (more precisely, of real return differentials), and relates the outcome to the volatility of inflation and the real exchange rate (and, in turn, the exchange rate policy) . Despite the strong intuitive appeal of this idea, there is comparatively little empirical work on this issue. Among the work that has been done, however, Berkmen and Cavallo (2007) do not find evidence that more active intervention in foreign exchange markets (i.e., more fixing) leads to higher liability dollarization.
Others have argued that a closely managed exchange rate is an effect rather than a cause of DLD, a claim empirically supported in Berkmen and Cavallo (2007) . It has additionally been proposed that DLD reflects a lack of faith in the domestic currency and ultimately in the quality of government, and that countries whose governments rank higher on various indices of quality experience lower levels of DLD than their more poorly performing counterparts .
Implications
Researchers have attributed a variety of both positive and negative effects to DLD. The benefits are largely found at the household and firm levels in the short to medium term. These benefits include insurance against inflationInflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
and currency devaluation, as well as permitting long-term lending and borrowing through the use of a relatively stable currency.
In contrast, the real or potential costs of DLD exist largely at the systemic level and over the long term. When DLD is widespread, economic actors are often required to experience a currency mismatch between domestically denominated income and dollar-denominated liabilities, which represent the only available means of long-term borrowing. Currency mismatches are a particular danger for firms and sectors in non-tradable goods and services. Countries with high levels of DLD, moreover, are often afflicted as well with “Original Sin
Original Sin (economics)
Original sin is a commonly used metaphor in economics literature. It was proposed by Barry Eichengreen, Ricardo Hausmann, and in a series of papers to refer a situation in which "most countries are not able to borrow abroad in their domestic currency."...
,” a country’s inability to borrow in its own currency. While the resulting vulnerability may not be apparent in normal times, it can be revealed during turbulent times, even in the absence of a major crisis. In economies with fixed or heavily managed exchange rate regimes, for instance, an abrupt change in regime can reveal the exposure of actors who have not hedged for exchange rate risk. Internal as well as external shocks to the real exchange rate and/or real effective rate can produce similarly disruptive balance sheet effects, with economy-wide implications for liquidity. These problems can become particularly acute in an economy without an effective lender of last resort
Lender of last resort
A lender of last resort is an institution willing to extend credit when no one else will. The term refers especially to a reserve financial institution, most often the central bank of a country, intended to avoid bankruptcy of banks or other institutions deemed systemically important or 'too big to...
and/or one that issues only domestically denominated debt. Extensive DLD additionally impedes adjustment by means of the real exchange rate and increases the likelihood and severity of a Sudden Stop
Sudden Stop
Sudden Stop is the second studio album by Canadian blues musician Colin James released in 1990 on Virgin Records. The album was recorded in Vancouver and Memphis, Tennessee....
. Thus, “fear of floating” (that is not allowing the exchange rate to adjust in the face of external shocks, see: floating exchange rate
Floating exchange rate
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....
) may be a consequence of DLD, as countries with unofficially dollarized economies may find a freely moving exchange rate to be too costly. Berkmen and Cavallo (2007) tested the causality between DLD and fear of floating empirically. Their findings support the “fear of floating” argument. Countries with high liability dollarization (external, public, or financial) tend to stabilize their exchange rate. This finding is robust to various proxies for exchange rate management. For the reverse causality, on the other hand, the authors do not find evidence that more active intervention in foreign exchange markets (i.e., more fixing) leads to higher liability dollarization.
Over time, economies with high levels of DLD can display the following problems: i) an unstable demand for money; ii) a high propensity to experience banking crises following a depreciation of the local currency; and iii) slow and volatile output growth without a significant increase in domestic financial system depth .
Policy measures
Policy interventions to reduce DLD have taken a variety of recommended and actual forms and have met with varying degrees of success. It is generally agreed that controlling inflationInflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
is necessary, as the uncertainties brought about by inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
represent perhaps the greatest single determinant of DLD. Yet reducing inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
alone is generally not considered sufficient to achieve de-dollarization, as economies with high levels of DLD may exhibit hysteresis
Hysteresis (economics)
In economics, hysteresis refers to the possibility that periods of high unemployment tend to increase the rate of unemployment below which inflation begins to accelerate, commonly referred to as the natural rate of unemployment or non-accelerating inflation rate of unemployment )...
once actors adjust their expectations and behaviors to transactions denominated in foreign currency .
In addition, low volatility of inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
relative to the volatility of RER depreciation may be needed to lead to de-dollarization. To date, only two countries, Israel in the 1980s and 1990s and Poland in the 1990s, have managed to engage in successful de-dollarization without extensive negative consequences ; both countries managed this transition through combining disinflation with a strong exchange rate anchor. Moreover, in addition to a one-year mandatory hold on dollar deposits, Israel undertook a series of “patches” including the following: i) CPI(Consumer Price Index
Consumer price index
A consumer price index measures changes in the price level of consumer goods and services purchased by households. The CPI, in the United States is defined by the Bureau of Labor Statistics as "a measure of the average change over time in the prices paid by urban consumers for a market basket of...
)-indexed deposits; ii) requirements that banks undertake active hedging of currency risk for non-tradable activities; iii) active development of financial derivatives markets; and iv) efforts to deepen local currency bond markets . Poland’s disinflationary efforts, moreover, coincided with a very high real exchange rate. Under less favorable circumstances, or in the absence of policies designed to facilitate adjustment, forced de-dollarization has provoked extensive capital flight and/or steep declines in financial intermediation.
Prospects
In recent years there has been a revival of interest in lending in domestic currency, especially in Latin America, and there is evidence that public debt has in fact become less dollarized. This revival may represent an attempt to “lean against the wind” in the face of expectations of currency appreciation as well as a response to the collapse of Argentina’s Convertibility regime, which illustrated the macroeconomic risks of extensive DLD.A second potential channel of de-dollarization is the increasing use of domestic currency lending to the private sector as well as to sovereigns and subnational governments by international financial institutions, particularly the Inter-American Development Bank
Inter-American Development Bank
The Inter-American Development Bank is the largest source of development financing for Latin America and the Caribbean...
. In addition to hedging those institutions’ currency risk, multilateral lending in domestic currency offers a potential solution to a first mover problem and a signal to other economic actors.
See also
- Asset–liability mismatch
- DollarizationDollarizationDollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency. The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency.The biggest economies to have...
- Emerging market debtEmerging Market DebtEmerging market debt is a term used to encompass bonds issued by less developed countries. It does not include borrowing from government, supranational organizations such as the IMF or private sources, though loans that are securitized and issued to the markets would be included...
- External debtExternal debtExternal debt is that part of the total debt in a country that is owed to creditors outside the country. The debtors can be the government, corporations or private households. The debt includes money owed to private commercial banks, other governments, or international financial institutions such...
- Floating exchange rateFloating exchange rateA floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....
- InflationInflationIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
- List of countries by external debt
- Odious debtOdious debtIn international law, odious debt is a legal theory that holds that the national debt incurred by a regime for purposes that do not serve the best interests of the nation, should not be enforceable. Such debts are, thus, considered by this doctrine to be personal debts of the regime that incurred...
- Original SinOriginal Sin (economics)Original sin is a commonly used metaphor in economics literature. It was proposed by Barry Eichengreen, Ricardo Hausmann, and in a series of papers to refer a situation in which "most countries are not able to borrow abroad in their domestic currency."...
- Sudden stopSudden stop (economics)A sudden stop in capital flows is defined as a sudden slowdown in private capital inflows into emerging market economies, and a corresponding sharp reversal from large current account deficits into smaller deficits or small surpluses. Sudden stops are usually followed by a sharp decrease in output,...
- Third-world debt