## Reducing Dollarization in the Caucasus and Central Asia (Introduction and Conclusion excerpts)

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---

### Overview and definition
- Dollarization is defined as the use of foreign currency as a unit of account, medium of exchange, and store of value.
- Causes cited: weak economic fundamentals, high and volatile inflation, nominal exchange rate volatility, and weak monetary policy framework.
- Feedback loop: dollarization weakens monetary policy effectiveness and undermines the monetary policy framework, creating a vicious cycle.

### Challenges posed by dollarization
- Reduces effectiveness of the interest rate channel when intermediation is mostly in dollars and exchange rate pass-through to inflation increases (Ize and Yeyati, 2005).
- Reduces monetary authorities’ control over domestic liquidity by increasing components over which little direct influence can be exerted and by rendering money demand less stable (Berg and Borenzstein, 2000).
- Increases financial system vulnerability to solvency and liquidity risks; limits central bank’s lender-of-last-resort capacity; currency mismatches in corporate sector can raise non-performing loans (Gulde, Hoelscher, et al., 2004).
- Exposes public sector balance sheets to exchange rate risks and contributes to “fear of floating” due to contractionary balance-sheet impacts from exchange rate fluctuations (Calvo and Reinhart, 2002).
- Exhibits hysteresis: dollarization ratios do not necessarily decline after local currency stabilization and financial deepening because of switching costs and persistent memories (Ize and Yeyati, 1998).

### Lessons from the literature on de-dollarization
- Monetary policy and exchange rate credibility are essential to reduce dollarization (Yeyati, 2006).
- Dollarization is associated with weak economic institutions (De Nicolo et al., 2005).
- Successful market-based de-dollarization followed disinflation and availability of domestic assets with alternative indexation or very high real interest rates (Reinhart, Rogoff and Savastano, 2003).
- Non-market forced conversions in the 1980s largely failed to sustain de-dollarization in several Latin American countries.
- Successful market-friendly de-dollarization in the 2000s (Bolivia, Paraguay, Peru, Uruguay) was supported by:
  - an appreciation trend for deposit de-dollarization;
  - active management of reserve requirement differentials;
  - prudential measures;
  - extension of domestic yield curves;
  - deposit de-dollarization facilitating credit de-dollarization (García-Escribano and Sosa, 2010).
- Comprehensive agendas combining macroeconomic, microeconomic, and administrative measures have been effective to varying degrees (Yeyati, 2021). Examples:
  - Macroeconomic: inflation targeting without exchange rate anchors; avoiding fiscal dominance of the central bank.
  - Microprudential: differential reserve requirements; limits on dollar lending; development of competitive local savings instruments.
  - Administrative/discouraging measures: legal tender restrictions; mandatory price denomination in local currency; widening of dollar purchase/sale spreads.

### Stylized facts for the Caucasus and Central Asia (CCA) region
- Historical context: dollarization in the CCA stems from past extreme instability, hyperinflation, and large exchange rate depreciation in the 1990s.
- Regional averages and trends:
  - A decade ago the share of FX deposits in total deposits was on average 60 percent (measured at the constant exchange rate) across the CCA.
  - Deposit dollarization varied: 32 percent in Armenia to above 80 percent in Georgia (a decade ago).
  - Deposit dollarization declined to 40 percent in 2021 (regional average).
  - Credit dollarization declined from 67 percent in 2010 to 34 percent in 2021 (regional average).
  - Kazakhstan: credit dollarization fell from 73 percent of all credit in 2010 to 13 percent in 2021.
- Drivers of decline: prudent macroeconomic policies, de-dollarization policies, macroprudential measures, and switch to floating exchange rate regimes.
- Policy and regulatory developments:
  - Following the introduction of open foreign exchange position limits, the gap between loan and deposit dollarization has declined considerably since 2010.
  - Credit dollarization declined significantly more than deposit dollarization in Kazakhstan, Azerbaijan, and Georgia, partly due to administrative measures.
  - All countries in the region issue long-term government securities in local currency (Uzbekistan being the latest), but local currency debt remains a small share of total public debt.
  - Negative net international investment position in several countries remains above 70 percent of GDP, exacerbating contractionary balance-sheet impacts from FX depreciations.

### De-dollarization policies in the region (survey-based findings)
- Most countries in the region have an official de-dollarization policy in place.
- Common measures applied by all countries:
  - Higher reserve requirement ratios on FX liabilities relative to local currency liabilities.
  - Additional capital requirements for FX denominated liabilities vs domestic currency liabilities.
  - Macroprudential and administrative measures to better reflect and evaluate risks associated with foreign currency assets.
- Specific practices:
  - Outright bans on FX lending to certain segments (e.g., mortgages) exist in different forms in several countries; Georgia introduced a floor on FX loans.
  - Differentiated loan-to-value and payment-to-income ratios are less common and are more recent measures.
- Capital market development: concerted efforts to extend the yield curve and develop domestic debt markets have not yet been associated with sufficient results in de-dollarization.

### Box 1 — What is a Natural Level of Dollarization?
- Definition and determinants:
  - A natural level of dollarization is defined such as its benefits outweigh its costs.
  - Benefits: supports financial deepening especially in countries with a low level of capital market development and persistently high inflation.
  - Costs: higher risk on private and public balance sheets due to unhedged currency risk exposure.
  - Gondo et al. (2020) estimate a natural level of dollarization in the CCA following the model in (Ize and Levy Yeyati, 2003); benchmark depends on relative volatility of the real ExR and inflation.
- Natural rates and the role of remittances:
  - Natural rates vary across the CCA, with remittance-dependent countries having higher natural rates.
  - Remittance examples in 2020:
    - Kyrgyz Republic: inflows equivalent to 31 percent of GDP.
    - Tajikistan: inflows equivalent to 26 percent of GDP.
  - Estimates for the natural rate of dollarization (2019) range from 3.0 percent for Kazakhstan to 36.6 percent for Kyrgyz Republic.
- Public debt, local currency markets, and market instruments:
  - Share of public debt in foreign currency remains extremely high for some countries (Kyrgyz Republic, Azerbaijan, Georgia, Armenia) above 70 percent.
  - Issuance of long-term local currency bonds is still a small fraction of public debt; bond markets remain nascent and lack floating rate or inflation indexed bonds.
  - Pension system reforms (Pillar II/Pillar III) can increase domestic savings in local currency (example: Georgia Pillar II reform in early 2019).
- Balance-sheet mismatches and financial development:
  - High dollarization reinforces contractionary effects of exchange rate depreciation.
  - Georgia, Armenia, Kyrgyz Republic and Tajikistan have negative net international investment position above 70 percent of GDP.
  - Financial development has advanced, supporting higher economic growth; relationship between dollarization and financial efficiency is mixed.

### Empirical approach and VAR methodology
- Objective: examine country-specific drivers of short-term fluctuations in deposit and credit dollarization in the CCA region.
- Method: standard recursive VAR with Cholesky decomposition to obtain orthogonalized impulse response functions (OIRFs).
- Variable ordering for identification:
  1. Introduction of prudential measures.
  2. Issuance of public bonds in local currency.
  3. Macroeconomic variables.
  4. Change in deposit dollarization ratio over t and t-1.
  5. Change in credit dollarization ratio over t and t-1.
- Interest rate channel: first difference of the spread between interest rates on foreign currency deposits and domestic currency deposits (in percent).
- Data and estimation:
  - Monthly data from January 2010 to May 2021 for all countries.
  - VAR estimated with three lags (and six lags in an alternative specification).
- Selected variable definitions:
  - ∆RR_t: First difference of the spread between required RR rate on foreign currency deposits and the rate on domestic currency deposits (in percent).
  - d_t: Dummy equal to 1 (for three months) after introduction of prudential measures (other than RR changes); zero otherwise.
  - D_t^(5-10): Dummy equal to 1 if medium-to-long term bonds (5 years or longer) were issued in that month; zero otherwise.
  - inflation_t: Monthly percentage change of the CPI.
  - e_t: Monthly percentage change of the nominal exchange rate.
  - s_t: Standard deviation of daily percentage change of the nominal exchange rate over past 90 days.
  - ∆dprate_t: First difference of the spread between rates on foreign currency deposits and domestic currency deposits (in percent).
  - ∆DL_t: Change over t and t-1 of the deposit dollarization ratio.
  - ∆CL_t: Change over t and t-1 of the credit dollarization ratio.
- Dollarization calculation: computed at constant exchange rates by dividing FX deposit/credit (end-of-month stock) by the same day exchange rate and then multiplying by the exchange rate as of May 31, 2021; deposit/credit dollarization is FX denominated deposit/credit divided by total deposit/credit multiplied by 100.

### Key empirical findings — Impulse responses
- Reserve requirement differential (∆RR):
  - Increasing the spread between reserve requirement ratios on FX and local currency deposits contributed to:
    - Deposit de-dollarization in Armenia, Georgia, Kyrgyz Republic.
    - Credit de-dollarization in Georgia and Kyrgyz Republic.
  - Impact is immediate but not highly significant; deposit responses last a few months while cumulative long-term effects may be long-lasting.
- Prudential measures dummy (d_t):
  - Introduction of prudential measures (other than RR changes) fostered financial de-dollarization.
  - Immediate and significant impact on credit de-dollarization in Georgia, Kazakhstan, Kyrgyz Republic with effects lasting a few months.
  - No clear effect on deposit dollarization, likely because measures mainly affect loans.
- Exchange rate appreciation shocks:
  - Immediate and significant deposit de-dollarization in Armenia and Kazakhstan.
- Interest rate channel (∆dprate_t):
  - Shock to spread between local and foreign currency deposit rates:
    - Azerbaijan: deposit dollarization significantly increases at time of shock; effects last two months.
    - Kazakhstan: similar short-lived increase.
- Development of domestic debt markets:
  - Efforts to extend yield curve and develop domestic debt markets have not yet produced sufficient de-dollarization, likely due to low market development.
- Exchange rate volatility (s_t) and inflation:
  - Effects are mixed and country dependent; no uniform pattern across countries.

### Key empirical findings — Forecast error variance decomposition
- For changes in deposit dollarization:
  - Changes in exchange rates and changes in spreads between local and foreign currency deposit rates explain, on average, 5-6 percent on a 3-6 month horizon.
  - Contribution of shocks to inflation is roughly 3-5 percent.
  - Local currency bond market issuance contributes about 3-4 percent.
- For changes in credit dollarization:
  - Inflation shocks explain 5 percent.
  - Changes in prudential regulation (including reserve requirement changes) explain 4 percent.
  - Changes in deposit dollarization account for roughly 3-6 percent of fluctuations in credit dollarization on a 3-6 month horizon.
- Overall: forecast errors for changes in deposit and credit dollarization are largely attributable to own innovations and the macroprudential/macro variables above.

### Conclusion — Key findings and trends
- Dollarization in the CCA region has been declining rapidly, albeit from a very high level.
- Average deposit and loan dollarization in the CCA is about 39 percent and 37 percent respectively (as of end- 2020), decreasing from 61 and 81 percent over the past decade.
- The gap between loan and deposit dollarization has declined considerably since 2010.
- In Kazakhstan, Azerbaijan and Georgia credit dollarization has declined significantly more than deposit dollarization partly as a result of administrative measures.
- All countries in the region have adopted specific de-dollarization measures, including higher reserve requirement ratios for FX liabilities vs domestic currency liabilities:
  - In Azerbaijan reserve requirement differential is 0.5 percent.
  - In Georgia it is close to 20 percent.
- Countries have introduced macroprudential and administrative measures, additional capital requirements for unhedged FX borrowers, and limits for net foreign exchange positions of banks.

### Policy implications and components of successful de-dollarization
- De-dollarization is gradual and requires low and stable inflation for an extended period of time.
- Main components to consider:
  - (i) credible monetary and exchange rate frameworks;
  - (ii) absence of fiscal dominance;
  - (iii) deep domestic financial markets that can provide long-term vehicles for investing.
- Other measures: advance financial development, enhance central bank communication, calibrate macroprudential and administrative tools.
- Final observation: deposit dollarization is driving credit dollarization, not the other way around; sustained stabilization and market development are necessary to reverse dollarization trends.

*Source: Conclusion, "Reducing Dollarization in the Caucasus and Central Asia", Working Paper No. WP/2022/154*

### Introduction............................................................................................................

### Introduction

### Overview and definition
- Dollarization is defined as the use of foreign currency as a unit of account, medium of exchange, and store of value.
- Causes cited: weak economic fundamentals, high and volatile inflation, nominal exchange rate volatility, and weak monetary policy framework.
- Feedback loop: dollarization weakens monetary policy effectiveness and undermines the monetary policy framework, creating a vicious cycle.

### Challenges posed by dollarization
- Reduces effectiveness of the interest rate channel when intermediation is mostly in dollars and exchange rate pass-through to inflation increases (Ize and Yeyati, 2005).
- Reduces monetary authorities’ control over domestic liquidity by increasing components over which little direct influence can be exerted and by rendering money demand less stable (Berg and Borenzstein, 2000).
- Increases financial system vulnerability to solvency and liquidity risks; limits central bank’s lender-of-last-resort capacity; currency mismatches in corporate sector can raise non-performing loans (Gulde, Hoelscher, et al., 2004).
- Exposes public sector balance sheets to exchange rate risks and contributes to “fear of floating” due to contractionary balance-sheet impacts from exchange rate fluctuations (Calvo and Reinhart, 2002).
- Exhibits hysteresis: dollarization ratios do not necessarily decline after local currency stabilization and financial deepening because of switching costs and persistent memories (Ize and Yeyati, 1998).

### Lessons from the literature on de-dollarization
- Monetary policy and exchange rate credibility are essential to reduce dollarization (Yeyati, 2006).
- Dollarization is associated with weak economic institutions (De Nicolo et al., 2005).
- Successful market-based de-dollarization followed disinflation and availability of domestic assets with alternative indexation or very high real interest rates (Reinhart, Rogoff and Savastano, 2003).
- Non-market forced conversions in the 1980s largely failed to sustain de-dollarization in several Latin American countries.
- Successful market-friendly de-dollarization in the 2000s (Bolivia, Paraguay, Peru, Uruguay) was supported by an appreciation trend for deposit de-dollarization, active management of reserve requirement differentials, prudential measures, extension of domestic yield curves, and deposit de-dollarization facilitating credit de-dollarization (García-Escribano and Sosa, 2010).
- Comprehensive agendas combining macroeconomic, microeconomic, and “sand-on-the-wheels” measures have been effective to varying degrees (Yeyati, 2021). Examples of policies:
  - Macroeconomic: inflation targeting without exchange rate anchors; avoiding fiscal dominance of the central bank.
  - Microprudential: differential reserve requirements; limits on dollar lending; development of competitive local savings instruments.
  - Administrative/discouraging measures: legal tender restrictions; mandatory price denomination in local currency; widening of dollar purchase/sale spreads.

### Stylized facts for the Caucasus and Central Asia (CCA) region
- Historical context: dollarization in the CCA stems from past extreme instability, hyperinflation, and large exchange rate depreciation in the 1990s.
- Regional averages and trends:
  - A decade ago the share of FX deposits in total deposits was on average 60 percent (measured at the constant exchange rate) across the CCA.
  - Deposit dollarization varied: 32 percent in Armenia to above 80 percent in Georgia (a decade ago).
  - Deposit dollarization declined to 40 percent in 2021 (regional average).
  - Credit dollarization declined from 67 percent in 2010 to 34 percent in 2021 (regional average).
  - Kazakhstan: credit dollarization fell from 73 percent of all credit in 2010 to 13 percent in 2021.
- Drivers of decline: prudent macroeconomic policies, de-dollarization policies, macroprudential measures, and switch to floating exchange rate regimes.
- Policy and regulatory developments:
  - Following the introduction of open foreign exchange position limits, the gap between loan and deposit dollarization has declined considerably since 2010.
  - Credit dollarization declined significantly more than deposit dollarization in Kazakhstan, Azerbaijan, and Georgia, partly due to administrative measures.
  - All countries in the region issue long-term government securities in local currency (Uzbekistan being the latest), but local currency debt remains a small share of total public debt.
  - Negative net international investment position in several countries remains above 70 percent of GDP, exacerbating contractionary balance-sheet impacts from FX depreciations.

### De-dollarization policies in the region (survey-based findings)
- Most countries in the region have an official de-dollarization policy in place.
- Common measures applied by all countries:
  - Higher reserve requirement ratios on FX liabilities relative to local currency liabilities.
  - Additional capital requirements for FX denominated liabilities vs domestic currency liabilities.
  - Macroprudential and administrative measures to better reflect and evaluate risks associated with foreign currency assets.
- Specific practices:
  - Outright bans on FX lending to certain segments (e.g., mortgages) exist in different forms in several countries; Georgia introduced a floor on FX loans.
  - Differentiated loan-to-value and payment-to-income ratios are less common and are more recent measures.
- Capital market development: concerted efforts to extend the yield curve and develop domestic debt markets have not yet been associated with sufficient results in de-dollarization.

### Empirical approach and key empirical findings
- Data limitations: absence of data on the stock of foreign currency circulating in the economy prevents analysis of currency substitution (foreign currency as a medium of exchange); analysis focuses on financial dollarization (ratio of FX deposits and loans to total deposits and loans).
- Methodology:
  - Uses a standard recursive VAR to examine roles of macro-variables, prudential measures, and financial capital market development on credit and deposit de-dollarization.
  - Innovation accounting techniques employed: impulse response functions and forecast error variance decompositions.
- Main empirical results:
  - Increasing the spread between reserve requirement ratios on foreign currency and local currency has contributed to deposit and credit de-dollarization in several countries.
  - Various prudential measures have contributed to deposit de-dollarization in several countries.
  - Deposit dollarization increases in some countries in response to a shock change in the spread between local and foreign currency.
  - The impact of an exchange rate appreciation shock on deposit de-dollarization is immediate and significant in some countries.
  - Countries’ efforts to extend the yield curve and develop the domestic debt market have not been associated with sufficient de-dollarization results.
  - Effects of exchange rate volatility and inflation on financial dollarization are mixed.
  - Deposit dollarization is driving credit dollarization.

### Structure of the paper (as presented)
- Section II: Stylized facts.
- Section III: Survey results on authorities’ de-dollarization policies.
- Section IV: Empirical approach and results.
- Section V: Conclusion.

*IMF Working Paper — Reducing Dollarization in the Caucasus and Central Asia (Introduction section)*

### Box 1. What is a Natural Level of Dollarization?

### Box 1. What is a Natural Level of Dollarization?

### Definition and determinants
- A natural level of dollarization is defined such as its benefits outweigh its costs.
- Benefits: supports financial deepening especially in countries with a low level of capital market development and persistently high inflation.
- Costs: poses various drawbacks for policymakers, including a higher risk on the private and public balance sheets due to unhedged currency risk exposure.
- Gondo et al. (2020) estimate a natural level of dollarization in the CCA following the model in (Ize and Levy Yeyati, 2003). They define a dollarization benchmark level for deposits that depend on the relative volatility of the real ExR and inflation.

### Natural rates and the role of remittances
- Natural rates of dollarization vary across the CCA, with countries dependent on remittances having higher natural rates of dollarization.
- Examples of remittance importance in 2020:
  - Kyrgyz Republic: inflows equivalent to 31 percent of GDP.
  - Tajikistan: inflows equivalent to 26 percent of GDP.
- Estimates for the natural rate of dollarization (2019) range from 3.0 percent for Kazakhstan to 36.6 percent for Kyrgyz Republic.
- Households receiving remittances are more likely to hold foreign currency for portfolio diversification.

### Public debt, local currency markets, and market instruments
- The inability to borrow in own currency ("original sin") is present in the CCA; the share of public debt in foreign currency remains extremely high.
  - For some countries (Kyrgyz Republic, Azerbaijan, Georgia, Armenia) public debt in foreign currency remains above 70 percent.
- Gradual de-dollarization of public debt is expected to go in tandem with decline in deposit dollarization as local currency bond markets develop.
- Domestic-currency bond issuance:
  - Countries have intensified efforts to develop domestic capital markets; Georgia, Kazakhstan, Armenia, and Azerbaijan started issuing long-term bonds about a decade ago.
  - Issuance of long-term local currency bonds is still a small fraction of public debt; bond markets remain nascent and lack sufficient development.
  - Most CCA countries lack availability of floating rate or inflation indexed bonds that could help hedge FX volatility without holding foreign currency.
- Pension system reforms (Pillar II/Pillar III) can increase domestic savings in local currency; example: after Pillar II reform in Georgia in early 2019 the Pension Fund accumulated sizable funds preparing to invest in lari denominated bonds gradually.
- Development of derivatives and indexed local instruments can enable compliance with FX lending restrictions without reducing overall lending.

### Balance-sheet mismatches and financial development
- When balance sheets are highly dollarized, agents prefer hard currency to maintain real consumption under macro uncertainty; balance-sheet mismatches reinforce contractionary effect of exchange rate depreciation.
- Georgia, Armenia, Kyrgyz Republic and Tajikistan have negative net international investment position above 70 percent of GDP, exacerbating balance-sheet impacts of depreciation.
- Financial development in the region has advanced (financial deepening, inclusion, banking efficiency) and has supported higher economic growth.
- Theoretical ambiguity: deposit dollarization can reflect shallower domestic financial intermediation if FX deposits are transferred overseas, but dollarization can also support financial development in weak policy environments.
- Dollarization and financial efficiency relationship is mixed; net interest margins are not uniformly higher in high-dollarization countries; association between dollarization and access to finance is not straightforward.

### De-dollarization policies and measures in the region
- A qualitative survey covered Armenia, Azerbaijan, Georgia, Kazakhstan, Tajikistan, Uzbekistan, and Kyrgyz Republic on macroprudential and administrative de-dollarization measures.
- Most countries have an official de-dollarization policy in place; all countries apply higher reserve requirement ratios for FX liabilities relative to domestic currency (examples):
  - Azerbaijan: reserve requirement differential is 0.5 percent.
  - Georgia: reserve requirement differential is close to 20 percent.
- Other survey findings and country-specific measures:
  - Deposit insurance / guarantee differentials:
    - Tajikistan and Azerbaijan: deposit insurance premium for FX deposits is higher than for local currency deposits.
    - Armenia: differentiated deposit guarantee contribution system charging banks that attract FX deposits with higher-than-market interest rates.
    - Kazakhstan: higher deposit insurance coverage for tenge-denominated deposits.
  - Additional capital requirements for unhedged FX borrowers:
    - Armenia: risk weights of FX denominated exposures are 50 percent higher compared to local currency exposures for unhedged borrowers.
    - Georgia: additional risk weighting ranging from 40 percent to 100 percent depending on the bank-specific dollarization ratio for loans to unhedged borrowers.
    - Kazakhstan (2016): doubled risk-weight for unhedged borrowers to 200 percent.
    - Tajikistan (2018): increased risk weights for FX loans from 100% to 150%.
  - Liquidity coverage and FX obligations:
    - Georgia, Armenia, Kazakhstan: higher liquidity coverage ratios for FX obligations.
    - Uzbekistan: LCRs for FX and local currency must be held separately; levels same for both.
  - Net foreign exchange position limits:
    - Applied in almost all countries; limits range from 10 percent to 25 percent of bank’s own capital.
  - Bans and restrictions on FX lending:
    - Georgia: minimum loan size limit of 200,000 lari (about $70,000) for FX borrowing.
    - Kazakhstan: 2016 ban on FX mortgages for individuals without income in given currency; current regulation sets a higher risk weight (200%) to such FX loans.
    - Tajikistan (2017): restricted extension of FX mortgage loans to FX unhedged borrowers.
    - Uzbekistan and Kyrgyz Republic: mortgage and consumer loans in foreign currency to individual borrowers are prohibited.
    - Azerbaijan: banned mortgages in FX.
    - Armenia: banned consumer loans in FX.
  - Differentiated LTV and DTI measures:
    - Georgia: 85 percent LTV limit for local currency loans and 70 percent LTV limit for FX loans; stricter payment-to-income for unhedged loans.
    - National Bank of Tajikistan approved similar instruments in 2021, not yet in effect.
- Conclusion: measures support de-dollarization; it is a long-term effort and policies are heading in the right direction.

### Empirical approach and VAR methodology
- Objective: examine country-specific drivers of short-term fluctuations in deposit and credit dollarization in the CCA region.
- Method: standard recursive VAR following Garcia et al. (2010) with Cholesky decomposition to obtain orthogonalized impulse response functions (OIRFs).
- Variable ordering for identification (following Garcia et al. (2010), with modification to include interest rate channel):
  1. Introduction of prudential measures.
  2. Issuance of public bonds in local currency.
  3. Macroeconomic variables.
  4. Change in deposit dollarization ratio over t and t-1.
  5. Change in credit dollarization ratio over t and t-1.
- Interest rate channel: first difference of the spread between interest rates on foreign currency deposits and domestic currency deposits (in percent).
- Data and estimation:
  - Monthly data from January 2010 to May 2021 for all countries.
  - Variables are stationary and VAR residuals are normal.
  - VAR estimated with three lags (and six lags in an alternative specification to check robustness).
- Variable definitions (selected):
  - ∆RR_t: First difference of the spread between required RR rate on foreign currency deposits and the rate on domestic currency deposits (in percent).
  - d_t: Dummy equal to 1 (for three months) after introduction of prudential measures (other than RR changes); zero otherwise.
  - D_t^(5-10): Dummy equal to 1 if medium-to-long term bonds (5 years or longer) were issued in that month; zero otherwise.
  - inflation_t: Monthly percentage change of the CPI.
  - e_t: Monthly percentage change of the nominal exchange rate.
  - s_t: Standard deviation of daily percentage change of the nominal exchange rate over past 90 days.
  - ∆dprate_t: First difference of the spread between rates on foreign currency deposits and domestic currency deposits (in percent).
  - ∆DL_t: Change over t and t-1 of the deposit dollarization ratio.
  - ∆CL_t: Change over t and t-1 of the credit dollarization ratio.
- Note on dollarization calculation: computed at constant exchange rates by dividing FX deposit/credit (end-of-month stock) by the same day exchange rate and then multiplying by the exchange rate as of May 31, 2021; deposit/credit dollarization is FX denominated deposit/credit divided by total deposit/credit multiplied by 100.

### Key empirical findings — Impulse responses
- Reserve requirement differential (∆RR):
  - Active management produces mixed responses depending on country.
  - Increasing the spread between reserve requirement ratios on FX and local currency deposits contributed to:
    - Deposit de-dollarization in Armenia, Georgia, Kyrgyz Republic.
    - Credit de-dollarization in Georgia and Kyrgyz Republic.
  - Impact is immediate but not highly significant; deposit responses last a few months while cumulative long-term effects may be long-lasting.
- Prudential measures dummy (d_t):
  - Introduction of prudential measures (other than RR changes) fostered financial de-dollarization.
  - Immediate and significant impact on credit de-dollarization in Georgia, Kazakhstan, Kyrgyz Republic with effects lasting a few months.
  - No clear effect on deposit dollarization, likely because measures mainly affect loans.
- Exchange rate appreciation shocks:
  - Immediate and significant deposit de-dollarization in Armenia and Kazakhstan.
  - Increased confidence in domestic currency reduces demand for FX deposits.
- Interest rate channel (∆dprate_t):
  - Shock to spread between local and foreign currency deposit rates:
    - Azerbaijan: deposit dollarization significantly increases at time of shock; effects last two months.
    - Kazakhstan: similar short-lived increase.
- Development of domestic debt markets:
  - Concerted efforts to extend yield curve and develop domestic debt markets have not yet produced sufficient de-dollarization, likely due to low market development.
- Exchange rate volatility (s_t) and inflation:
  - Effects are mixed and country dependent; no uniform pattern across countries.
  - Inflation effects on financial dollarization are mixed and often not persistent; authors do not report these results in detail.

### Key empirical findings — Forecast error variance decomposition
- For changes in deposit dollarization:
  - Changes in exchange rates and changes in spreads between local and foreign currency deposit rates explain, on average, 5-6 percent on a 3-6 month horizon.
  - Contribution of shocks to inflation is roughly 3-5 percent.
  - Local currency bond market issuance contributes about 3-4 percent.
- For changes in credit dollarization:
  - Inflation shocks explain 5 percent.
  - Changes in prudential regulation (including reserve requirement changes) explain 4 percent.
  - Changes in deposit dollarization account for roughly 3-6 percent of fluctuations in credit dollarization on a 3-6 month horizon.
- Overall: forecast errors for changes in deposit and credit dollarization are largely attributable to own innovations and the macroprudential/macro variables above.

_This summary is based on Box 1 and related sections from the provided IMF Working Paper content._

### Conclusion

### Conclusion

### Key findings on dollarization levels and trends
- Dollarization in the CCA region has been declining rapidly, albeit from a very high level.
- Average deposit and loan dollarization in the CCA is about 39 percent and 37 percent respectively (as of end- 2020), decreasing from 61 and 81 percent over the past decade.
- Countries in the region have achieved macroeconomic stability gains thanks to their efforts to maintain fiscal discipline and advance structural reforms.
- The gap between loan and deposit dollarization has also declined considerably since 2010.
- In Kazakhstan, Azerbaijan and Georgia credit dollarization has declined significantly more than deposit dollarization partly as a result of administrative measures.

### Regulatory and administrative measures adopted
- All countries in the region have adopted specific de-dollarization measures.
- Based on a qualitative survey conducted for the purpose of our analysis, all countries apply higher reserve requirement ratios for FX denominated liabilities vs domestic currency liabilities.
  - In Azerbaijan reserve requirement differential is 0.5 percent.
  - In Georgia it is close to 20 percent.
- To better reflect and evaluate the risks associated with foreign currency assets, all countries in the region have introduced macroprudential and administrative measures.
- They also apply additional capital requirements for unhedged FX borrowers and introduced limits for the overall net foreign exchange position of banks.
- While there is some room for further regulatory measures to mitigate risks arising from FX lending particularly in countries where credit dollarization exceeds deposit dollarization, countries like Georgia already applies almost all available regulatory tools.
- Even in the countries that apply most of these tools, calibration of the tools may be considered.

### Empirical analysis — short-term drivers of financial de-dollarization
- Our empirical analysis shows that various prudential measures, increased spreads between local and foreign currency deposits, and exchange rate appreciation play a role in de-dollarization in the region.
- More specifically, looking at short-term drivers of financial de‐dollarization in the CCA, our results suggest that:
  - (i) increasing the spread between reserve requirement ratios on foreign currency and local currency have contributed to deposit and credit de-dollarization in several countries;
  - (ii) various prudential measures such as discouraging bank lending in foreign currency to unhedged borrowers, raising provisions on foreign currency denominated loans, introducing differentiated capital risk weights on foreign currency loans, among others, have contributed to credit dollarization in several countries (Georgia, Kazakhstan, Kyrgyz Republic);
  - (iii) the impact of an exchange rate appreciation shock on deposit de-dollarization is immediate and significant in Armenia and Kazakhstan;
  - (iv) deposit dollarization increases in Azerbaijan and Kazakhstan in response to a shock change in the spread between local and foreign currency;
  - (v) countries’ concerted efforts to extend the yield curve and develop the domestic debt market have not been associated with sufficient results yet;
  - (v) the effects of exchange rate volatility and inflation on financial dollarization are mixed. In Kazakhstan, an exchange rate volatility shock helps bring down deposit dollarization, while in Azerbaijan it raises deposit dollarization.
- Finally, our analysis, similar to other studies, show that deposit dollarization is driving credit dollarization, not the other way around.

### Policy implications and components of successful de-dollarization
- International experience shows that de-dollarization is a gradual process and requires low and stable inflation for an extended period of time.
- To further promote de-dollarization in the CCA, the following main components of successful de-dollarization should be considered:
  - (i) credible monetary and exchange rate frameworks;
  - (ii) absence of fiscal dominance;
  - (iii) deep domestic financial markets that can provide long-term vehicles for investing.
- Overall, dollarization is difficult to reverse, and it requires prolonged and sustained stabilization policy efforts.
- CCA countries need to make their domestic currency appealing, advance financial development (Poghosyan, forthcoming), and enhance communication by their central banks (Akepanidtaworn and Cabezon, forthcoming), among other measures identified above.

*Source: Conclusion, "Reducing Dollarization in the Caucasus and Central Asia", Working Paper No. WP/2022/154*

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_Source: https://www.imf.org/-/media/files/publications/wp/2022/english/wpiea2022154-print-pdf.pdf_