1999 International Monetary Fund

Order Information



O C C A S I O N A L   P A P E R     
171
 
   
Monetary Policy in Dollarized Economies

By a Staff Team led by Tomás J.T. Baliño, Adam Bennett, and Eduardo Borensztein
and comprising Andrew Berg, Zhaohui Chen, Alain Ize, David O. Robinson, Abebe Aemro Selassie, and Lorena Zamalloa

Contents
I   Overview
 
II   Trends and Explanations
Currency Substitution Versus Asset Substitution
Foreign Currency Deposits
Cross-Border Deposits
Dollar Currency in Circulation
 
III   Risks and Benefits of Dollarization
Benefits
Risks
 
IV   Monetary and Exchange Rate Policy in a Dollarized Economy
Exchange Rate Regime
Choice of Monetary Target
 
V   Operational Issues in Dollarized Economies
Implementation of Monetary Policy
Implications for the Payments System
Prudential Supervision
Implications for the Central Bank
 
VI   Measures to Affect Dollarization
Alternative Financial Instruments
Policies That Create an Interest Rate Wedge
Direct Restrictions on Foreign Currency Deposits
Policies to Encourage the Use of Local Currency Cash
 
VII   Program Design in the Presence of Dollarization
General Program Design
Design of Performance Criteria
Dollarization and Program Performance
 
VIII   Conclusions
 
References
 
Box
II   1.   Flows of U.S. Dollar Cash to Argentina
 
Tables
I   1.   Reported Ratios of Foreign Currency Deposits (FCD) Broad Money in Countries with IMF Arrangements Since 1986
II   2.   Cumulative Net Inflows of U.S. Dollar Currency, 1989­96
V   3.   Payment and Regulatory Arrangements in Selected Dollarized Economies
  4.   Reserve Requirements on FCD for Selected Countries
VII   5.   Recommendations for the Design of IMF Programs in the Presence of Dollarization
 6.   Some Features of Dollarized Economies
  7.   Gross Reserves in Months of Imports of Countries Reporting Information on FCD/Broad Money Ratios
  8.   Selected Indicators of Measures Influencing Dollarization
  9.   Selection of Performance Criteria in Sample Countries
  10.   Inflation in Countries Reporting Information on FCD/Broad Money Ratios
  11.   Velocity in Countries Reporting Information on FCD/Broad Money Ratios
  12.   Inflation Target Versus Outcome for the First Program Year in IMF Arrangements
  13.   Money Multiplier
 
Figures
II   1.   Dollarization and Stabilization
  2.   FCD and Cross-Border Deposits
V   3.   Bolivia: Dollarization Trends
VI   4.   Chile: Indexation and Dollarization
  5.   Egypt: Asset Substitution and Real Deposit Rates
  6.   Hungary: Interest Rate Differential and Asset Substitution
  7.   Bolivia, Mexico, and Peru: Share of Deposits
VII   8.   Turkey: FCD/M3 Ratio and Lira Deposit Rates

 

I.  Overview

Dollarization, the holding by residents of a significant share of their assets in the form of foreign-currency-denominated assets, is a common feature of developing countries and transition economies and is thereby typical--to a greater or lesser extent--of many countries that have IMF-supported adjustment programs.1 Of those countries that have had arrangements with the IMF at one time or another during the past ten years, at least half are dollarized, and a significant number are highly dollarized (Table 1).2 This paper explores the general question of the costs and benefits of dollarization for a country's economy. In addition, it examines the issues that dollarization poses for the formulation and conduct of monetary policy, as well as for IMF program design.3

Table 1. Reported Ratios of Foreign Currency Deposits (FCD) Broad Money in Countries with IMF Arrangements Since 1986

Country 1990 1991 1992 1993 1994 1995

Highly dollarized economies (FCD/broad money > 30 percent) (18)1
Argentina 34.2 35.1 37.1 40.4 43.2 43.9
Azerbaijan . . . . . . . . . 14.8 58.9 50.3
Belarus2 . . . . . . . . . 40.6 54.3 30.7
Bolivia 70.8 76.8 80.8 83.9 81.9 82.3
Cambodia . . . . . . 26.3 38.8 51.8 56.4
 
Costa Rica . . . 37.7 31.9 29.5 30.3 31.0
Croatia . . . . . . . . . 53.8 50.2 57.4
Georgia . . . . . . . . . . . . 80.1 30.8
Guinea-Bissau 41.5 34.7 31.6 30.9 31.1 31.2
Lao P. D. R. 42.0 39.4 36.8 41.4 34.4 35.6
 
Latvia . . . . . . . . . 27.2 27.5 31.1
Mozambique3 . . . 11.8 16.7 23.2 25.3 32.6
Nicaragua . . . 28.7 37.4 45.6 48.6 54.5
Peru . . . 59.9 65.0 70.2 64.2 64.0
São Tomé and Príncipe . . . . . . . . . . . . 38.3 31.9
 
Tajikistan . . . . . . . . . . . . . . . 33.7
Turkey 23.2 29.7 33.7 37.9 45.8 46.1
Uruguay 80.1 78.5 76.2 73.3 74.1 76.1
 
     Median 41.7 36.4 36.8 40.4 48.6 39.7
     Average 48.6 43.3 43.0 43.4 49.4 45.5
 
  Moderately dollarized economies (FCD/broad money < 30 percent) (34)1
Albania 2.1 1.3 23.8 20.4 18.5 . . .
Armenia . . . . . . . . . . . . 41.6 20.4
Bulgaria 12.0 33.4 23.4 20.3 32.6 28.4
Czech Republic3 . . . . . . . . . . . . 7.2 5.9
Dominica . . . 3.0 3.9 3.5 2.5 1.5
 
Ecuador . . . . . . . . . 2.8 5.4 . . .
Egypt . . . 50.7 37.3 26.7 23.4 25.1
El Salvador . . . 1.4 1.0 0.9 0.6 1.7
Estonia . . . . . . 23.0 3.8 9.9 11.4
Guinea4 . . . 6.5 6.9 10.0 9.4 9.6
 
Honduras . . . 3.1 5.1 7.6 11.4 13.0
Hungary 12.2 16.5 14.3 18.7 20.4 26.6
Jamaica . . . . . . 21.3 19.5 28.1 25.0
Jordan 12.5 13.0 12.8 11.5 12.2 15.2
Lithuania . . . . . . . . . . . . 27.0 25.9
 
Macedonia, FYR . . . . . . . . . . . . . . . 18.1
Malawi . . . . . . . . . . . . 10.6 8.0
Mexico2 . . . 3.9 4.1 3.6 6.2 7.2
Moldova3 . . . . . . . . . . . . 10.3 11.0
Mongolia . . . . . . 7.5 33.0 19.5 20.5
 
Pakistan5 2.6 8.9 11.9 13.9 13.6 . . .
Philippines 17.4 18.0 21.0 22.6 20.9 21.5
Poland 31.4 24.7 24.8 28.8 28.5 20.4
Romania . . . 3.9 17.9 29.0 22.1 21.7
Russia . . . . . . . . . 29.5 28.8 20.6
 
Sierra Leone . . . . . . . . . 3.3 7.8 16.5
Slovak Republic . . . . . . . . . 11.5 13.0 11.1
Trinidad and Tobago . . . . . . . . . 6.9 12.6 13.6
Uganda 12.0 10.5 11.5 15.7 13.3 13.5
Ukraine . . . . . . . . . 19.4 32.0 26.9
 
Uzbekistan2 . . . . . . 20.1 5.1 22.5 15.5
Vietnam . . . . . . 25.9 20.9 20.4 19.7
Yemen 10.8 12.1 19.7 20.7 20.9
Zambia . . . . . . . . . . . . 8.1 16.2
 
     Median 12.1 9.7 14.3 15.7 13.6 16.5
     Average 12.8 13.3 15.9 15.0 17.2 16.4
 
Memorandum
Selected industrial countries
     Greece 11.5 13.2 14.8 16.6 15.0 21.6
     Netherlands 8.7 7.2 7.2 3.9 4.7 4.4
     United Kingdom 11.4 7.7 10.5 10.9 12.6 15.4

Sources: IMF, IMF Staff Country Reports and International Financial Statistics (IFS).
1Classification based on observations for 1995; countries in bold are those selected for review.
2Latest year's observation for March.
3Latest year's observation for June.
4Latest year's observation for September.
5Fiscal year.

 
The paper focuses on dollarization of the monetary sector, and in particular on holdings by residents of foreign currency deposits (FCD) and, where data are available, of foreign currency cash. The paper recognizes, however, that dollarization of monetary assets often is part of a larger process of financial market integration. For example, dollarization in the loan portfolio of banks is an important phenomenon, and the paper touches on this too. Cross-border deposits (bank deposits of residents in foreign countries) also play an important role as close substitutes for domestic FCD. The paper explores the various monetary policy strategies that may be pursued in the presence of dollarization, considers the implications of dollarization for the practical application and instruments of monetary policy, and examines the manner in which dollarization has influenced the design of IMF programs. The paper's conclusions are as follows.

  • The benefits of dollarization include closer integration with international markets, exposure to competition from these markets, and the availability of a more complete range of assets for domestic investors. In countries in which inflationary experience has destroyed confidence in the local currency, dollarization can sometimes help to remonetize the economy, restore local intermediation, and reverse capital flight. The costs of dollarization include the loss of seignorage and a potential for greater fragility of the banking system. Such fragilities can limit the policy options available to the authorities, as well as put an additional burden on the central bank as lender of last resort.

  • Dollarization can complicate the choice of intermediate targets of monetary policy by introducing a foreign currency component into the money supply. The suitability of a target that includes, or excludes, foreign currency depends on the target's relationship with output and prices, and this is essentially an empirical matter. It is possible, however, that no reliable aggregate can be found. This problem, which is by no means confined to dollarized economies, brings into question the policy of monetary targeting as opposed to, for example, relying on a wider set of indicators. Although this issue is beyond the scope of this paper, there are good reasons to believe that
    dollar-denominated assets should play some role among the set of relevant indicators for monetary policy under any alternative approach.

  • While the general considerations regarding the choice of exchange rate system also apply to dollarized economies, the prevalence of currency substitution (the use of foreign-currency-denominated assets for transactions) tends to strengthen the case for a fixed-rate system. Such an exchange rate arrangement would protect the economy from the effects of potentially excessive exchange rate and money market volatility. When attempting stabilization from hyperinflation, in particular, a fixed exchange rate can be an effective instrument in highly dollarized economies. The same conclusion does not apply when dollarization reflects only asset substitution (the holding of foreign-currency-denominated assets as stores of value).

  • Dollarization requires the adoption of special prudential measures. The banking system must be able to withstand significant exchange rate adjustments, as well as possibly larger-than-
    normal swings in capital flows. To deal with the latter, commercial banks or the central bank need to hold a larger-than-normal volume of international reserves, or to arrange external lines of credit. Limits to banks' foreign exposure positions need to be monitored carefully, as do off-balance-sheet operations that could entail foreign exchange risk. Since devaluations cannot shrink the value of dollar claims, steps have to be taken to ensure that banks do not incur undue risks in lending to dollar borrowers that do not have the capacity to honor their obligations when devaluations occur.

  • Should dollarization be discouraged? The answer depends on the role of dollarization in the economy. Asset substitution may be a natural accompaniment of the opening of financial markets, and in this respect it should be welcome. Moreover, globalization of financial markets will likely lead to some dollarization.4 Nonetheless, as with other forms of capital market liberalization, the proper sequencing of policies is essential. Asset substitution--and more especially, currency substitution--may also reflect the absence of macroeconomic stability and the existence of distortions in financial markets. In these circumstances, dollarization may complicate stabilization and cause additional volatility. However, in circumstances where it becomes very difficult to reestablish quickly stability of the national currency, economic well-being would likely be reduced by any administrative measures to reduce dollarization, and a case might be made for acceptance of continued dollarization in the quest for stability.

  • Macroeconomic stability is the first priority in dealing with dollarization, but this may not, in and of itself, be sufficient to reverse it. Other measures, such as the liberalization of domestic interest rates, the establishment of a competitive domestic currency payments system, and the development of domestic financial instruments are also steps that can help "dedollarize" an economy. More direct measures to reverse dollarization, however, can be problematic. Regulatory limits on FCD or punitive reserve requirements on dollar deposits may simply drive dollars offshore, while forced conversions will undermine confidence and may also encourage capital flight.

  • In general, IMF programs have treated dollarization as a symptom to be lived with rather than directly attacked and have concentrated on macroeconomic stabilization, in common with programs for nondollarized economies. In fact, dollarized countries with IMF programs have done only slightly worse in terms of meeting inflation targets than nondollarized economies with programs, although there is evidence of higher volatility in the former group. In some cases, concerns have arisen regarding the soundness of the banking system in dollarized economies. In other cases, the conventional practice of treating required reserves on FCD as a domestic, rather than foreign, liability may have put program objectives at risk. More broadly, program design in the presence of dollarization requires a more thorough analysis than usual in the selection of intermediate monetary targets and of the relationship of dollarization with ultimate targets.


1The foreign currency is usually, but not always, the U.S. dollar. The term "dollarization" serves as a shorthand in this paper for the use of any foreign currency.

2Of the 99 countries that have had IMF arrangements since 1986, 52 reported data on foreign currency deposits (FCD) to the IMF. In those countries reporting data, the median level of FCD over broad money in 1995 was 21.8 percent.

3Several of the issues discussed in this paper (for example, foreign currency risks) arise also in other foreign exchange operations, even if the economy is not dollarized in the sense discussed above.

4Other special circumstances may lead to dollarization. For instance, European countries that will not initially participate in the
euro arrangements but that trade heavily with euro members are likely to see part of the demand for money shift to euros. In addition, very small economies in which tourism from abroad is an important sector are also likely to be dollarized.