## _wp10188 — 1. Liabilities and Assets Typically Dollarized ## Source details **Canonical URL:** [_wp10188 — 1. Liabilities and Assets Typically Dollarized](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10188.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10188.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10188.pdf.json) --- ### Definitions, types, and measurement - Dollarization: use by residents of assets (or liabilities) denominated in another country’s currency. - Types: - Financial dollarization: substitution of local currency assets/liabilities for foreign currency assets/liabilities. - Real dollarization: indexation of domestic transactions to the exchange rate. - Transaction dollarization/currency substitution: use of a foreign currency as means of payment. - Measurement: - Asset dollarization: loans by the resident financial sector to resident households and nonfinancial corporations denominated in foreign currency. - Liability dollarization: share of foreign currency denominated deposits and debt in total financial institution liabilities. - Data limitations: nonfinancial sector dollarization and foreign currency in circulation often omitted and hard to observe. - Illustrative magnitudes: - In 2009, ten countries were fully and officially dollarized. - According to IMF International Financial Statistics, 47 countries have foreign currency deposits exceeding 30 percent of total deposits. ### Assets and liabilities typically dollarized (text summary of Table 1) - Household/Firms: - Assets: Foreign currency cash; Foreign currency assets held abroad; Foreign currency bank deposits; Foreign currency credit to households and firms; Foreign currency held abroad by governments; Foreign currency linked assets. - Liabilities: Foreign currency debt. - Banks: - Assets: Foreign currency bank deposits; Foreign currency credit to households and firms; Foreign currency assets abroad; Foreign currency linked assets. - Liabilities: Foreign currency deposits of households, firms, and public sectors; Foreign currency denominated reserve requirements on foreign currency bank deposits; Foreign currency linked liabilities; Net foreign currency bank credits. - Public Sector: - Assets: Foreign currency held abroad by governments; Foreign currency credit to the public sector; Foreign currency assets abroad; Foreign currency linked assets. - Liabilities: Foreign currency external debt; Foreign currency liabilities abroad; External foreign currency debts; Foreign currency indexed debts. ### Causes and potential benefits - Causes: - Poor local currency performance as store of value, means of payment, unit of account. - High and volatile inflation and real exchange rate instability. - Asymmetric exchange rate policy creating a "one‑way bet" favoring foreign currency holdings. - Potential benefits: - Signals increased world economy integration and financial liberalization. - Mitigates exchange rate risk for foreign investors and enhances portfolio diversification. - Allowing foreign currency deposits can remonetize the economy and provide banking funding. - Foreign currency lending may reduce cost of credit and support consumption and investment. - Partial dollarization may be optimal depending on structural factors. ### Costs and risks - Limits monetary policy effectiveness. - Loss of seigniorage; potentially large with high currency substitution. - Reduced payments efficiency and inability to control foreign banknote quality. - Increased balance sheet risks: currency mismatches and indirect credit risk for nonhedged borrowers. - Greater likelihood of liquidity crises due to limited foreign currency lender‑of‑last‑resort capacity. ### Dedollarization: key ingredients - Credible macroeconomic stabilization, two‑way exchange rate volatility, and stable and low inflation. - Dedollarization is typically protracted and persistent even after stability is reestablished. - Policy focus: encourage dedollarization; not on optimal dollarization level or managing risks at a given level. --- ### Macroeconomic stabilization as first step - Core elements: - Fiscal consolidation and tighter monetary policy to reduce and stabilize inflation. - Fiscal consolidation reduces reliance on central bank financing; tighter monetary policy reduces credit growth and aggregate demand, leading to lower inflation and possible nominal appreciation. - Credible policies curb inflationary expectations and lower demand for foreign currency as an inflation hedge. - Exchange rate regimes: - Flexible regimes: restoring monetary autonomy and signaling willingness to accept nominal appreciation can jumpstart dedollarization (examples noted: Brazil and Hungary). Inflation targeting can help. - Fixed or less flexible regimes: a credible peg can reduce stabilization costs, but outcomes depend on peg credibility; linkage to foreign currency limits monetary autonomy. ### Persistence and short-run arbitrage - Stabilization reduces local currency risks but does not automatically raise awareness of financial dollarization risks. - Expectations of local currency appreciation can sustain asset dollarization by creating a "one-way bet" for foreign currency borrowing. - Short-run arbitrage is common; interest rate differentials often do not cover exchange rate fluctuations, encouraging balance sheet dollarization. --- ### Market-based dedollarization policies — exchange rate, monetary, fiscal - Exchange rate flexibility: - Two‑way exchange rate movement makes foreign exchange risk more apparent and discourages financial dollarization. - Evidence suggests greater two-way flexibility may deter foreign currency deposits. - Efficient liquidity management: - Reserve requirements, standing facilities, and open market operations stabilize domestic interbank rates. - Issuing medium-term paper as a benchmark can develop a yield curve (example: Poland). - Adequate official reserves and a well-functioning FX market reduce precautionary FX holdings. - Fiscal consolidation: - Reduces need for government foreign currency borrowing and central bank financing; lowers interest differentials. - Unbiased taxation: - Tax systems should not favor foreign-currency income over domestic-currency income (example cited: Pakistan). - Financial transaction taxes should be levied at least equally on foreign and domestic currency transactions (example: Bolivia). ### Public debt management and financial market development - Active issuance of local currency-denominated bonds (including inflation-indexed) can dedollarize government balance sheets and foster domestic markets (examples: Bolivia, Brazil, Israel, Mexico, Turkey). - Trade-off: may raise debt service costs and could discourage private local-currency borrowing. - Development of deep, liquid bond markets supports alternatives to dollar deposits and longer-term local-currency instruments. - Credible indexation (inflation-indexed bonds) can substitute for dollar-denominated assets (examples: Chile, Colombia, Israel, Mexico). ### Instruments to hedge currency risk - Where hedging instruments are restricted, residents may hold FX as alternative hedges (example: Israel). --- ### Financial policy, prudential regulation, and supervision - Financial liberalization and removal of administrative interest rate controls can raise domestic real interest rates and promote local currency use (examples: Estonia, Haiti, Hungary). - Withdrawal of legal tender status from foreign currency is important; dedollarization is unlikely if foreign currency remains legal tender. - Improve usability of local currency (suitable denominations, quality); examples: Cambodia (larger riel notes). - Government operations in local currency (taxes, wages, public payments) support demand (examples: Angola; Peru switched public lending to local currency). - Reserve requirements: - Avoid regulatory bias favoring FCDs; conditions on LCDs should be at least as favorable. - Examples: require FCD reserve requirements to be denominated in local currency; remunerate LCD reserves at higher rates than FCD reserves (examples: Bolivia, Honduras, Israel, Nicaragua); impose higher reserve requirements on FCDs. - Extending reserve requirement base to nonbank dollar intermediation observed (example: Croatia). - Payments system: - Ensure local currency payments are at least as favorable; avoid central bank favoring FX payments (examples: Angola, Lao P.D.R.). - Peru imposed a 2 percent tax on checks denominated in foreign currency to discourage FX payments. - Prudential rules to internalize FX costs: - Narrow open FX position limits (Croatia, Turkey). - Higher liquidity requirements on FCDs or FX loans (Angola, Uruguay, Croatia). - Charge higher risk premium on dollar deposits in deposit guarantee schemes (Uruguay). - Higher capital and provisioning on FX loans to unhedged borrowers (Angola, Honduras, Vietnam). - Lower loan-to-value ratios for FX loans (Hungary). - Stronger collateral and valuation rules for FX loans. - Supervision: - Strengthen internal controls, monitoring of FX loans, and disclosure to borrowers to internalize balance sheet dollarization risks. - FX regulations: - Avoid preferential treatment for FX holders versus domestic currency holders (example: Philippines). --- ### Forced dedollarization: role and experiences - Forced measures not recommended in isolation; risk interfering with private contracts and undermining credibility. - Often necessary only when dollarization is deeply entrenched and must accompany strong macro stabilization. - Measures that frequently failed: - Mandatory conversion of FCDs into domestic currency often caused capital flight and disintermediation (examples: Bolivia and Mexico 1982; Peru 1985); sometimes reversed (Bolivia, Peru). - Freezing access to FCDs jeopardizes trust and leads to disintermediation; frozen FCDs sometimes indexed for inflation (Argentina) or redeemable in local currency (Pakistan). - Measures that more frequently achieved expected results: - Mandatory holding periods for FCDs (example: Israel); may encourage cash hoarding. - Mandatory use of local currency for listing prices and domestic transactions (examples: Angola, Israel, Lao P.D.R., Peru). - Regulations discriminating against FX use (limits on FX borrowing/lending; excluding FCDs from deposit insurance — example: Venezuela). Risk: exclusion may encourage banks to accept more FCDs if public uninformed. - Interest rate controls on FCDs (examples: Bangladesh, India). - Capital controls (temporary surrender requirements; limiting who can hold FCDs — example: Mexico). --- ### Empirical evidence: exchange rate volatility, inflation, and dollarization - Modeling approach: - Nonlinear (quadratic) relation between financial dollarization and exchange rate volatility to identify thresholds. - Data: - Sample from IMF Monetary and Banking Time Series database. - Foreign currency deposits: 32 countries; foreign currency loans: 21 countries; period November 2001 to March 2009. - Volatility measured as past 125 days standard deviation of the exchange rate as a percentage of its average for the same period. - Key empirical results: - Exchange rate volatility significantly impacts liability dollarization; effect on asset dollarization comparable but less significant. - Estimated volatility thresholds for asset and liability dollarization approximately: standard deviation over six months of 5 percent of the period average. - Changes in REER significantly reduce deposit dollarization and also reduce asset dollarization. - Inflation positively influences liability dollarization with a lag; less significant relation with asset dollarization. - Financial dollarization shows significant inertia (significant autoregressive terms). - Selected numeric regression outputs (selected entries from Table 2): - Observations: 1500, 1500, 2243, 2243. - Adjusted R-squared: 0.16, 0.17, 0.09, 0.10. - Dependent Variable (-1): -0.41 (0.00), -0.42 (0.00), -0.25 (0.00), -0.25 (0.00). - Dependent Variable (-2): -0.11 (0.00), -0.11 (0.00), -0.10 (0.00), -0.09 (0.00). - Inflation(-1): 0.09 (0.02), 0.11 (0.00) [deposit regressions]. - Volatility: -0.22 (0.18), -0.15 (0.34), -0.11 (0.06), -0.09 (0.09). - Volatility^2: 0.02 (0.06), 0.011 (0.30), 0.01 (0.00), 0.01 (0.00). - d(REER) and lags: example entries 0.1 (0.00); d(REER)(-1) -0.12 (0.01); d(REER)(-2) -0.17 (0.00). - Constant (C) examples: 0.31 (0.44), 0.49 (0.22), -0.12 (0.55), -0.10 (0.58). --- ### Case studies: Argentina, Pakistan, and non-crisis successes - Pakistan (1998): - Political shock → capital flight, reserve decline, drying of foreign liquidity. - Authorities withdrew preferential treatment of FCDs, introduced temporary FCD freeze and exchange controls. - Frozen deposits later redeemable in domestic currency or convertible into medium-term dollar bonds. - Preferential tax treatment of FCDs and forward cover schemes discontinued. - After stabilization, FCDs represented a relatively small part of deposits. - Argentina (2001 crisis): - Corralito: limited LCD access and FCD freeze; freeze abandoned in 2002 after conversion of existing FCDs into pesos. - FCD share in private deposits remained significantly below pre-crisis levels, about 10 percent by 2005. - Temporary freezes eroded banking credibility; slow private deposit growth followed. - Non-crisis dedollarization examples: - Chile: peso deposits reached 90 percent of total deposits in 2010 following disinflation, floating regime since 1999, and debt conversion to indexed instruments. - Israel: dollar deposits declined from 39 percent of total deposits in 1984 to 17 percent in 2002; policies included higher reserve rates on FCDs, indexed alternatives, and prudential rules. - Poland: zloty deposits rose to 50 percent of total deposits; FCDs declined to 30 percent of broad money by end-1993 from 72 percent in 1989. - Egypt: FCDs to total deposits declined from 56 percent in 1991 to 22 percent in 1999 and 18 percent by 2004 after fiscal and monetary reforms. --- ### Prudential measures and capital controls — Croatia case study - Policy mix: - Marginal reserve requirements (MRRs) targeted liability dollarization. - Foreign exchange liquid asset requirements (FX LAR) targeted FX assets liquidity. - MMRs applied in stages between June 2004 and June 2006; abolished October 2008. - FX LAR and MRR timeline (selected labels and values): - (1) FX LAR 24% 01/03 - (2) FX LAR 32% 04/03 - (3) Introduction of MRR I at 24% 06/04 - (4) MRR I 30% 03/05 - (5) MRR I 40% 06/05 - (6) MRR II 15%, MRR III 55% 12/05 - (7) MRR IV 55% 06/06 - (8) Same treatment for loans with currency clauses as for f/c loans 09/06 - (9) FX LAR 28,5% 05/08 - (10) MRR abolished 10/08 - (11) FX LAR 20% + exposure ceiling raised from 20% to 30% 02/09 - (0) Ceiling on open position in foreign exchange reduced to 25% from 30% (annotated). - FX LAR: banks required to hold minimum foreign currency assets in liquid assets daily. - MRRs: marginal requirement on additional foreign currency funding; MRR balances held in FX at CNB and not remunerated; initially exempted FX liabilities to residents; extended to financial leasing and indexed loans. - Trade-offs and observed effects: - Market circumvention required constant adjustments. - Shifted FX borrowing from banks to nonfinancial sector (disintermediation), then reversed after MRR abolition. - External debt growth differentials (average monthly growth rates): - Banking sector external debt: - January 1999 to May 2006: 1.81 percent - June 2006 to September 2008: -0.90 percent - October 2008 to February 2009 (after MRR abolition): 4.07 percent - Rest of private sector external debt: - January 1999 to May 2006: 1.11 percent - June 2006 to September 2008: 2.95 percent - October 2008 to February 2009: 0.72 percent - Interpretation: MRR introduction corresponded with increased nonfinancial private sector borrowing; abolition corresponded with renewed bank borrowing. ### Quantifying impact of prudential measures (Croatia regression) - Method: added dummies for dates of prudential measures and one lag to regression. - Main findings: - Asset dollarization more sensitive to MMR than LAR. - Liability dollarization reacted more to LAR than MRR. - Effects appear short-lived; liability dollarization rose again after measures. - REER increases positively correlated with asset dollarization in Croatia. - Selected numeric outputs from Table 3 (dependent variables: d(Foreign currency loans/total loans) and d(Foreign deposits/total deposits)): - Observations: 87 - Adjusted R-squared: 0.09 - d(Foreign currency loans/total loans): - C: -2.23 (0.00) - Dependent Variable (-1)*: -0.15 (0.46) - Inflation: -0.15 (0.04) - M2/M1: 0.62 (0.00) - Volatility: -0.28 (0.11) - d(REER): 0.099 (0.00) - LAR: -0.002 (0.98) - MMR: -0.07 (0.00) - d(Foreign deposits/total deposits): - C: -0.13 (0.89) - Dependent Variable (-1)*: -0.34 (0.00) - Inflation: 0.12 (0.33) - M2/M1: -0.02 (0.93) - Volatility: 0.24 (0.21) - d(REER): 0.06 (0.16) - LAR: -0.41 (0.00) - LAR(-1): 0.46 (0.00) - MMR: 0.03 (0.49) --- ### Conclusions and policy implications (summary of Sects. V, paras 40–42) - Durable dedollarization requires: - Credible macroeconomic stabilization (low, stable inflation). - Adequate liquidity management to reduce domestic interest rate volatility. - Public debt management to facilitate local-currency savings instruments. - Financial policies, prudential regulation, and effective supervision to internalize FX costs. - Administrative measures to ensure local currency availability in suitable denominations and quality. - Removal of regulatory and practice biases favoring foreign currency. - In some cases, forced measures may be necessary but must be accompanied by stabilization. - Evidence: - Exchange rate volatility and inflation significantly affect dollarization. - Prudential regulation and capital controls affect asset and liability dollarization but effects can be short-lived due to circumvention. --- ### Selected regulatory and supervisory instruments and numeric examples (high-level extract) - Liquidity requirements / FX liquid asset ratios: - China 1996–2007: foreign exchange liquid (≤1 year) assets ≥ 60 percent of liquid liabilities and ≥ 30 percent of total FX assets. - Croatia since 2003: FX coverage raised to 24% (Jan 2003), 35% (Feb 2005), lowered to 32% (Mar). - Peru since 1998: FX liquidity requirement ≥ 20 percent of short-term FX liabilities; domestic currency liquidity requirement 8 percent. - Philippines since 2001: 100 percent asset cover for FX liabilities; ≥ 30 percent of cover in liquid assets; FCDUs/EFCDUs: ≥ 70 percent cover in same currency as deposit liability. - Trinidad and Tobago since 1996: liquid asset ratio on FCD = 20 percent (was 25 percent until 2002). - Egypt 1996–2008: FX liquid assets to total FX deposits = 75 percent (reduced to 70 percent thereafter). - Turkey 2007: foreign exchange liquidity ratio ≥ 80 percent. - Uruguay since 2008: depends on maturity; stricter for FX deposits. - Insurance and premiums: - Uruguay 2001: higher insurance premium for FCDs in guarantee schemes. - Venezuela since 2006: FCDs excluded from government deposit insurance. - Collateral, LTV, provisioning: - Pakistan 1998–2002: disallow use of FCD as collateral. - Hungary: LTV = 80% for local currency loans, 60% for euro loans, 40% for other currencies. - Albania 2007: additional provision 5% on unhedged substandard and doubtful loans. - Croatia 2006/2007: risk weight of unhedged FX loans increased by 25 percentage points; unhedged defined as debtors with FX assets < 80% of FX liabilities. - Haiti since 2002: lending may not exceed 50 percent of liabilities in foreign currency. - Mozambique since 2005: 50 percent provision for loans with repayment doubts for non-exporters; 100 percent provision for overdue credits. - Romania 2008: extended provisioning to unhedged borrowers and non-bank financial institutions. - Uruguay 2001: higher capital requirements for dollar loans to nontradable sector. - Forced administrative measures examples (selected): - Approval requirements and bans on FX loans across multiple countries; examples include Bahamas (since 1997), Bangladesh (since 1996 with prior approvals), Turkey (since 1999 restrictions), Korea (since 2008 restrict FX loans to overseas transactions). - Mandatory conversion examples: Argentina 2001–02 (conversion at 1.4 p/US$1 and 1 p/US$1), Mexico 1982, Peru 1985–1987. --- ### Appendix II — Panel unit root tests (selected statistics) - Foreign currency deposit as % of total deposits: - Levin, Lin & Chu t*: -1.82297 p = 0.0342 N = 34 Observations = 2882 - Im, Pesaran and Shin W-stat: -3.84973 p = 0.0001 N = 34 Observations = 2882 - ADF - Fisher Chi-square: 152.601 p = 0.0000 N = 34 Observations = 2882 - PP - Fisher Chi-square: 196.001 p = 0.0000 N = 34 Observations = 2899 - Foreign currency loan as % of total loans: - Levin, Lin & Chu t*: -0.05405 p = 0.4784 N = 21 Observations = 1754 - Im, Pesaran and Shin W-stat: -6.70123 p = 0.0000 N = 21 Observations = 1754 - ADF - Fisher Chi-square: 174.918 p = 0.0000 N = 21 Observations = 1754 - PP - Fisher Chi-square: 220.788 p = 0.0000 N = 21 Observations = 1776 - Inflation: - Levin, Lin & Chu t*: -28.5918 p = 0.0000 N = 32 Observations = 2674 - Im, Pesaran and Shin W-stat: -29.6705 p = 0.0000 N = 32 Observations = 2674 - Standard deviation of exchange rate (125 day % of average): - Levin, Lin & Chu t*: 0.39758 p = 0.6545 N = 34 Observations = 2753 - Im, Pesaran and Shin W-stat: -6.94100 p = 0.0000 N = 34 Observations = 2753 - M2/M1: - Levin, Lin & Chu t*: -3.91227 p = 0.0000 N = 34 Observations = 2637 - Im, Pesaran and Shin W-stat: -2.14867 p = 0.0158 N = 34 Observations = 2637 - REER: - Levin, Lin & Chu t*: 3.90905 p = 1.0000 N = 33 Observations = 2848 - Im, Pesaran and Shin W-stat: 4.00810 p = 1.0000 N = 33 Observations = 2848 - General observation: several series reject unit root nulls (Inflation, Foreign currency deposits, Foreign currency loans, M2/M1, exchange rate standard deviation under some tests); REER fails to reject unit root in reported tests. *Source: IMF working paper — _wp10188 (excerpts provided).* ### 1. Liabilities and Assets Typically Dollarized ......................................................................... ### 1. Liabilities and Assets Typically Dollarized ### Introduction - Dollarization is a rational response by economic agents to political or economic uncertainties and to interest rate arbitrage opportunities. - Dedollarization aims to make the local currency more attractive to residents than foreign currency by combining macroeconomic and microeconomic policies and, in some cases, measures to force use of the domestic currency. - Dedollarization is typically protracted and persistent even after macroeconomic stability and credibility are reestablished. - Key ingredients for dedollarization include credible macroeconomic stabilization, two‑way exchange rate volatility, and stable and low inflation. - The paper focuses on policies that encourage dedollarization; it does not address the optimal level of dollarization or policies to manage risks at a given dollarization level. ### Dollarization: definitions, types, and measurement - Definition: Dollarization refers to the use by residents of one country of assets (or liabilities) denominated in another country’s currency. - Distinctions: - Type of assets or liabilities dollarized. - Official/legal tender status (official dollarization) versus de facto dollarization. - Extent: full or partial dollarization. - Types of dollarization: - Financial dollarization: substitution of local currency assets/liabilities for foreign currency assets/liabilities. - Real dollarization: indexation of domestic transactions to the exchange rate. - Transaction dollarization/currency substitution: use of a foreign currency as a means of payment in domestic transactions. - Measurement: - Financial dollarization is commonly measured by financial institutions’ holdings of foreign exchange assets and liabilities. - Asset dollarization: loans by the resident financial sector to resident households and nonfinancial corporations denominated in foreign currency. - Liability dollarization: share of foreign currency denominated deposits and debt in total financial institution liabilities. - Data limitations: nonfinancial sector dollarization and foreign currency in circulation are often omitted; foreign currency in circulation is difficult to observe. - Illustrative magnitudes: - In 2009, only ten countries were fully and officially dollarized. - According to IMF International Financial Statistics, 47 countries have foreign currency deposits exceeding 30 percent of total deposits (a threshold for highly dollarized countries according to Baliño, Bennett, and Borensztein (1999)). ### Assets and liabilities that are typically dollarized - Table 1 (text summary) — Liabilities and Assets Typically Dollarized (as presented in the source): - Household/Firms — Assets: Foreign currency cash; Foreign currency assets held abroad; Foreign currency bank deposits; Foreign currency credit to households and firms; Foreign currency held abroad by governments; Foreign currency linked assets. Liabilities: Foreign currency debt. - Banks — Assets: Foreign currency bank deposits; Foreign currency credit to households and firms; Foreign currency assets abroad; Foreign currency linked assets. Liabilities: Foreign currency deposits of households, firms, and public sectors; Foreign currency denominated reserve requirements on foreign currency bank deposits; Foreign currency linked liabilities; Net foreign currency bank credits. - Public Sector — Assets: Foreign currency held abroad by governments; Foreign currency credit to the public sector; Foreign currency assets abroad; Foreign currency linked assets. Liabilities: Foreign currency external debt; Foreign currency liabilities abroad; External foreign currency debts; Foreign currency indexed debts. - Source cited in table: Reinhart, Rogoff, and Savastano (2003). ### Causes and potential benefits of dollarization - Causes: - Poor performance of the local currency in its basic functions: store of value, means of payment, unit of account. - High and volatile inflation (real exchange rate instability) motivates residents to denominate contracts in foreign currency to preserve purchasing power. - Asymmetric exchange rate policy that resists nominal appreciation while allowing depreciation can create a one‑way bet favoring foreign currency holdings. - Potential benefits: - May signal or accompany increased integration into the world economy and financial market liberalization. - Can mitigate exchange rate risk for foreign investors and enhance portfolio diversification for residents. - Allowing foreign currency deposits can remonetize the economy, provide funding to local banks, and reverse capital flight. - Lending in foreign currency may reduce the cost of credit and support consumption and investment. - Implication: some level of partial dollarization may be optimal depending on structural factors (economy size, openness, degree of financial integration, market development). ### Costs and risks of dollarization - Dollarization can create significant disadvantages: - Limits the effectiveness of monetary policy. - Loss of seigniorage, potentially large in economies with high currency substitution; use of foreign currency implies implicitly paying seigniorage to foreign issuers. - Reduced efficiency of payments: foreign banknotes may not suit local transaction needs; domestic authorities cannot control banknote quality. - Increased balance sheet risks under partial dollarization: direct exchange rate risk from currency mismatches in banks’ balance sheets; indirect credit risk if borrowers are nonhedged against devaluation. - Greater likelihood of liquidity crises: lender‑of‑last‑resort facilities typically cannot provide unlimited foreign currency funding, increasing vulnerability to runs. ### Policies for dedollarization (overview) - Dedollarization typically requires a combination of: - Credible macroeconomic stabilization (fiscal consolidation, appropriately tight monetary policy to reduce inflation). - Microeconomic/prudential measures that enhance attractiveness of the local currency or internalize balance sheet risks. - In some cases, measures that force or strictly limit the use of foreign currency (forced dedollarization). - Proper sequencing matters: credibility of monetary policy usually needs reestablishment; voluntary measures and some forced measures can be adopted while credibility is being rebuilt. - Policymakers must account for risks of dedollarization measures, including capital flight, disintermediation, and banking sector instability. ### Macroeconomic stabilization as the first step - Key elements: - Reduce and stabilize inflation through fiscal consolidation and tighter monetary policy. - Fiscal consolidation reduces reliance on central bank financing; tighter monetary policy reduces credit growth and aggregate demand, leading to lower inflation and eventual real/nominal appreciation. - Credible policies curb inflationary expectations and lower the cost of stabilization, reducing demand for foreign currency as inflation hedge. - Role of exchange rate regime: - Under genuinely flexible exchange rates: - Restoring monetary policy autonomy and signaling willingness to accept nominal appreciation can jumpstart dedollarization (examples: Brazil and Hungary). - Inflation targeting can enhance inflation stability and help reduce dollarization. - Under less flexible/fixed exchange rate regimes: - A credible peg can reduce stabilization costs, but outcomes depend critically on peg credibility. - Expectations of devaluation increase foreign currency deposits (FCDs); expectations of post‑devaluation interventions (moral hazard) can encourage foreign currency borrowing. - Continued linkage to a foreign currency limits fully autonomous monetary policy; dedollarization may be pursued to recover seigniorage, adapt currency in circulation to domestic needs, introduce a more flexible regime, or mitigate financial stability risks. *Source: IMF working paper — _wp10188 - 1. Liabilities and Assets Typically Dollarized_.* ### 20. Dollarization may continue even if successful stabilization has increased the ### 20. Dollarization may continue even if successful stabilization has increased the attractiveness of the local currency ### Persistence of dollarization despite stabilization - Stabilization reduces risks of using the local currency but "it does not raise the private sector’s consciousness about the risks of financial dollarization." - Once the public is accustomed to using foreign currency in domestic transactions, "additional measures may be required to change this entrenched behavior, in particular, in the context of financial dollarization."13 ### Expectations, appreciation, and short-run arbitrage - Strengthened confidence in the local currency can support some forms of financial dollarization via public expectations of local currency appreciation, which provide a "one-way bet" for borrowing in foreign currency.21 - Banks benefit from easy access to foreign financing (capital inflow) and can maintain short open positions to benefit from appreciation, encouraging lending in foreign currency. - Covered interest rate parity may hold in the medium to long term, but short-run arbitrage is common because "interest rate differentials often do not cover exchange rate fluctuations," encouraging balance sheet dollarization. ### Central and Eastern Europe (CEE) experience - CEE countries experienced financial dollarization before October 2008 despite relatively stable macroeconomic frameworks. - Prospects of EU accession, privatization receipts, and successful stabilization entrenched expectations of continuous appreciation vis-à-vis the euro. - Positive interest rate differentials for the local currency vis-à-vis the euro encouraged euro borrowing, particularly for nontradable goods production. - "The key variable influencing financial sector asset dollarization is the expectation of real exchange rate appreciation." Asset dollarization can occur under a peg if agents expect inflation to remain higher than foreign inflation (example: Croatia). ### Side effects of stabilization on observed dollarization levels - Successful macroeconomic stabilization and liberalization may temporarily boost dollarization by reversing capital flight and restoring local intermediation, as some foreign currency previously held abroad returns to the banking system, "increasing at least temporarily the level of dollarization."13 ### Additional policies and measures to reduce dollarization (overview) - Dedollarization policies can be market-based or forced and depend on how entrenched dollarization is. They range "from exchange rate policies to administrative measures to discourage the use of foreign currencies" (see Appendix I, Table I-V). ### B. Market-Based Dedollarization Policies — Exchange rate, monetary, and fiscal policies - Exchange rate flexibility - "An exchange rate that can move in either direction would render the foreign exchange risk more apparent, thus introducing a disincentive to financial dollarization."14 - A flexible regime with less bias toward depreciation discourages financial dollarization (Rennhack and Nozaki, 2006). - Greater two-way flexibility may deter foreign currency deposits by increasing risk of holding foreign currency assets (Hardy and Pazarbasioglu, 2006). - Trend expectations matter: expectation of devaluation increases liability dollarization and currency substitution; expectation of appreciation supports asset dollarization. - Efficient liquidity management - Strengthening day-to-day liquidity management makes local currency more attractive as short-term interest rates become less volatile. - Tools: reserve requirements, standing deposit and lending facilities, open market operations stabilize domestic interbank rate. - Issuing medium-term paper as a benchmark can improve monetary signaling and develop a yield curve (example: Poland). - A well-functioning foreign exchange market and adequate official reserves reduce precautionary foreign exchange holdings. - Fiscal consolidation - Fiscal restraint reduces need for government foreign currency borrowing and central bank financing, contributing to lower interest rate differentials. - Unbiased taxation - Tax systems should not favor income from foreign currency over local currency; e.g., interest on FCDs or bonds should not be tax-exempt if domestic-currency income is taxed (example: Pakistan). - Financial transaction taxes should be levied at least equally on foreign and domestic currency transactions (example: Bolivia). ### Public debt management and financial market development - Public debt management - Active issuance of local currency-denominated bonds (possibly inflation indexed) can dedollarize government balance sheets and foster domestic paper markets (examples: Bolivia, Brazil, Israel, Mexico, and Turkey). - Trade-off: may raise debt service due to higher interest rates and could discourage private borrowing in local currency, encouraging private foreign currency loans. - Development of a domestic financial market - Deep, liquid bond markets provide alternatives to dollar deposits and support longer-term local currency instruments (supporting pension funds, etc.). - Alternatives to dollar-denominated assets - A credible indexation system to local prices (inflation-indexed bonds) can enhance investment in local currency instruments (examples: Chile, Colombia, Israel, and Mexico).15 - Widespread or poorly timed indexation can complicate macroeconomic management and deter foreign investors. - Instruments to hedge currency risk - Where exchange controls restrict hedging instruments, residents may build foreign exchange holdings as alternative hedges (example: Israel). ### Financial policy and prudential regulation - Financial liberalization - Removing administrative interest rate controls helps domestic real interest rates become positive, promoting local currency use (examples: Estonia, Haiti, and Hungary). - Greater domestic financial competition enhances attractiveness of local currency (examples: Egypt and Poland). - Withdrawal of legal tender status from foreign currency - Dedollarization is unlikely if foreign currency remains legal tender.16 - Increased usability of the local currency - Ensure continuous availability of appropriate denominations and, if necessary, introduce new currency with suitable banknote denominations (examples: Cambodia—larger riel banknotes). - Government operations in local currency - Government should operate and transact in local currency (taxes, wages, public payments) to support demand (examples: Angola; Peru switched its public lending program to local currency). - Use of foreign aid in local currency - In-country use of aid denominated in local currency can promote dedollarization, especially in small or post-conflict highly dollarized countries. - Reserve requirements - Avoid regulatory bias favoring FCDs. Conditions on LCDs should be at least as favorable as on FCDs while avoiding undue distortions. - Measures used in practice: require banks to denominate reserve requirements on FCDs in local currency; remunerate reserve requirements on LCDs at a higher rate than those on FCDs (examples: Bolivia, Honduras, Israel, and Nicaragua); impose higher reserve requirements on FCDs to encourage banks to attract LCDs.17 18 - Extending reserve requirement base to nonbank institutions involved in dollar intermediation has been observed (example: Croatia). - Payments system - Domestic payments systems should ensure local currency payments on terms at least as favorable as for foreign currency payments. Central banks should not favor foreign currency payments (examples: Angola and Lao P.D.R.). - Example: Peru imposed a 2 percent tax on checks denominated in foreign currency to discourage foreign currency use in payments. - Prudential regulations - Ensure proper management of foreign exchange risk and internalize true cost of foreign currency business to level the playing field for domestic currency.19 - Examples of measures: - Narrow open foreign currency position limits (Croatia and Turkey).20 - Higher liquidity requirements on FCDs (Angola and Uruguay) or on foreign exchange loans (Croatia). - Charging a higher risk premium on dollar deposits in deposit guarantee schemes (Uruguay). - Higher capital and provisioning requirements on foreign currency loans to unhedged borrowers (Angola, Honduras, and Vietnam). - Lower loan-to-value ratios for foreign exchange denominated loans (Hungary). - Stronger collateral and valuation rules for foreign exchange loans. - Effective supervision - Stricter internal controls, monitoring of foreign exchange loans, and improved risk disclosure to borrowers help internalize balance sheet dollarization risks. - Foreign exchange regulations - No preferential treatment for holders of foreign currency versus domestic currency funding; avoid allowing residents to make outward capital transactions from foreign exchange resources while prohibiting the same for domestic currency holdings (example: Philippines). ### C. Forced Dedollarization - Forced measures are not recommended in isolation from market-based measures due to risks of interfering with private contracts and undermining property rights and policy credibility. They may be necessary only when dollarization is deeply entrenched and must be accompanied by strong macroeconomic stabilization. - Measures that frequently failed - Mandatory conversion of FCDs into domestic currency often resulted in capital flight and disintermediation (examples: Bolivia and Mexico in 1982; Peru in 1985); authorities sometimes reversed these measures (Bolivia and Peru). - Suspending access to FCDs (freezing withdrawals) jeopardizes trust in the banking system and often leads to disintermediation and capital flight; frozen FCDs could be indexed for inflation (Argentina) or redeemable in local currency (Pakistan). - Measures that more frequently achieved expected results - Mandatory holding period for FCDs - May be coupled with introduction of indexed domestic currency instruments (example: Israel). - Disadvantage: may encourage holding foreign currency in cash rather than bank deposits. - Mandatory use of local currency in domestic transactions and for listing prices - Requirements to list prices in local currency and obligations to make payments in local currency have been used (examples: Angola, Israel, Lao P.D.R., Peru). - Displaying prices in local currency can aid dedollarization even if payments sometimes remain in foreign currency (example: Lao P.D.R). - Regulations discriminating against foreign currency use - Measures include limits on foreign currency borrowing/lending (examples: Angola, Argentina, Israel, Lebanon, Turkey, and Vietnam) and excluding dollar deposits from deposit insurance (example: Venezuela).21 - Risk: unless the public is well informed, exclusion of FCDs from guarantees may encourage banks to accept more FCDs. - Interest rate control on FCDs - Caps on interest local banks may offer on foreign currency deposits used to encourage liability dedollarization (examples: Bangladesh and India). - Capital controls - Temporary surrender requirements on foreign exchange proceeds of residents can rapidly reduce FCDs.22 - Access to FCDs can be limited to certain agents (example: Mexico); banks’ cross-border credit transactions can be prohibited or require prior approval. IV. EXCHANGE RATE VOLATILITY, PRUDENTIAL MEASURES, AND DOLLARIZATION: CROSS-COUNTRY EVIDENCE - A. Case Studies *Italic line omitted by pipeline.* ### 25. Argentina and Pakistan have carried out dedollarization in the context of a ### _wp10188 - 25. Argentina and Pakistan have carried out dedollarization in the context of a ### Case studies: Argentina and Pakistan - Argentina and Pakistan carried out dedollarization in the context of a currency and banking crisis. - Pakistan (1998): political shock → capital flight, declining reserves, drying up of foreign liquidity. - Authorities withdrew preferential treatment previously provided to FCDs. - Introduced a temporary freeze on FCDs and a number of exchange controls. - Frozen deposits later could be withdrawn in domestic currency or converted into medium-term dollar-denominated bonds. - Opening of new FCDs was allowed, but preferential tax treatment of FCDs and the convenient forward cover scheme for banks were discontinued. - Following macroeconomic stabilization, conditions normalized and the stock of FCDs represented only a relatively small part of deposits. - Argentina (2001 crisis context): - Limited access to LCDs (corralito) and freeze on FCDs to limit capital flight and prevent bank runs. - Freeze abandoned in 2002 after conversion of existing FCDs into pesos. - Share of FCDs in private deposits remained significantly below pre-crisis level, reaching about 10 percent by 2005. - In both Pakistan and Argentina: - The temporary freeze on deposits eroded the credibility of the banking system, reflected in the slow pace of private deposit growth after the crises. ### Dedollarization in non-crisis contexts: Chile, Israel, Poland, Egypt - General finding: - Success of dedollarization in noncrisis contexts typically cannot be attributed to microeconomic measures alone; it is often a by-product of macroeconomic stabilization. - Chile: - Process began with successful disinflation, more flexible exchange rate, monetary policy aimed at lower inflation. - Government undertook a debt conversion scheme to change foreign-currency-denominated debt into indexed debt. - Adopted inflation targeting and allowed the peso to float freely in 1999, but indexation persisted and was ultimately reduced by targeting a fixed nominal interest rate. - Peso deposits increased and reached 90 percent of total deposits in 2010. - Israel: - Gradual stabilization program brought down inflation from about 400 percent in 1984 to single digits in the late 1990s. - Policies aimed at decreasing the foreign-currency-denominated part of public debt and supporting introduction of hedging instruments. - Implemented higher reserve rates on FCDs and offered alternatives: dollar indexed deposits and inflation indexed bonds. - Prudential rules on foreign-currency-denominated loans to ensure adequate hedging. - Dollar-denominated deposits declined from 39 percent of total deposits in 1984 to 17 percent in 2002. - Poland: - Early 1990s macroeconomic stabilization, financial liberalization, and opening of the capital account. - Domestic interest rates raised well above foreign currency interest rates. - Zloty deposits increased to 50 percent of total deposits, while FCDs declined to 30 percent of broad money by end-1993 from 72 percent in 1989. - Egypt: - Share of FCDs to total deposits declined from 56 percent in 1991 to 22 percent in 1999 and further to 18 percent by 2004. - 1991 fiscal and monetary reforms reduced inflation and liberalized the financial system (removing credit ceilings, interest rate controls, and differential reserve requirements). - Liberalization led to positive real interest rates and decline in FCDs. ### Measuring the effect of nominal and real exchange rate volatility on dollarization - Assumption and modeling approach: - Increasing exchange rate volatility reduces both foreign exchange deposits and loans up to a threshold; beyond that threshold, volatility reflecting trend appreciation/depreciation can lead to financial dollarization. - A nonlinear (quadratic) equation between financial dollarization and exchange rate volatility is estimated to determine the threshold. - Data: - Sample from the Monetary and Banking Time Series database of the IMF. - Includes data on foreign currency deposits for 32 countries and on foreign currency loans for 21 countries during the period November 2001 to March 2009. - Sample includes slightly more flexible and managed exchange rates than fixed exchange rates. - Specification uses past 125 days standard deviation of the exchange rate as a percentage of its average for the same period. - Financial dollarization variables: share of foreign currency loans in total loans and share of foreign currency deposits in total deposits. - Regression equation (as presented): - ttititititiitiiti eMREERdvolvolFDdcFDd,21,3 2 ,2,11,0, 1)()()( - Alternative compact form: ttititiiti eREERdvolvolcFDd)()(_ ,3 2 ,2 ,1 , - Key empirical results (Table 2 highlights): - Exchange rate volatility has a significant impact with expected sign on liability dollarization; comparable for asset dollarization though less significant. - Exchange rate thresholds for asset and liability dollarization appear close; for this sample, thresholds approximately stand at a standard deviation on a six month period of 5 percent of the period average. - Changes in the real exchange rate are significant in both regressions: tend to reduce deposit dollarization and also seem to reduce asset dollarization. - Inflation has a mostly positive influence on liability dollarization with a lag, supporting that macroeconomic stability is conducive to dedollarization; inflation shows a positive but not significant relation with asset dollarization. - Financial dollarization, especially asset dollarization, exhibits significant inertia as shown by significant autoregressive terms. - Selected numeric regression outputs (Table 2): - Constant (C): 0.31 (0.44), 0.49 (0.22), -0.12 (0.55), -0.10 (0.58) - Dependent Variable (-1): -0.41 (0.00), -0.42 (0.00), -0.25 (0.00), -0.25 (0.00) - Dependent Variable (-2): -0.11 (0.00), -0.11 (0.00), -0.10 (0.00), -0.09 (0.00) - Inflation: -0.03 (0.82), -0.08 (0.56), 0.01 (0.71), 0.02 (0.59) - Inflation(-1): 0.09 (0.02), 0.11 (0.00) [reported for deposit regressions] - M2/M1: -0.05 (0.30), -0.07 (0.14), 0.001 (0.00), 0.001 (0.00) - M2/M1(-1): -0.001 (0.00), -0.001 (0.006) - Volatility: -0.22 (0.18), -0.15 (0.34), -0.11 (0.06), -0.09 (0.09) - Volatility^2: 0.02 (0.06), 0.011 (0.30), 0.01 (0.00), 0.01 (0.00) - d(REER) and lags: example entries 0.1 (0.00); d(REER)(-1) -0.12 (0.01); d(REER)(-2) -0.17 (0.00); additional deposit regression entries: 0.1 (0.00), -0.22 (0.00) - Observations: 1500, 1500, 2243, 2243 - Adjusted R-squared: 0.16, 0.17, 0.09, 0.10 - Note: Panel unit root tests and other specification details are referenced as presented in Appendix II and IV within the source. ### The effect of prudential measures and capital controls: Croatia case - Policy mix and instruments: - Authorities relied on a combination of prudential measures and capital controls while maintaining a stable exchange rate. - Marginal reserve requirements (MRRs) targeted liability dollarization. - Foreign exchange liquid asset requirements (FX LAR) targeted the asset side of financial institutions’ balance sheets. - Objective: encourage banks to internalize foreign exchange risk by adjusting pricing (increase f/c loan interest rates). - FX LAR: - Obliged banks to maintain a minimum level of their foreign currency assets in liquid assets on a daily basis. - MRRs: - Introduced in stages between June 2004 and June 2006. - Marginal requirement based on additional foreign currency funding attracted by banks (difference between average daily balance in calculation period and initial calculation period). - Different MRRs varied by initial calculation period and rates. - All MRRs maintained in foreign currency accounts with the Croatia National Bank (CNB) and were not remunerated. - MRRs contained an element of capital controls: applied only on foreign exchange liabilities to nonresidents; foreign exchange liabilities to residents were exempt. - Measures were eliminated in October 2008 when foreign exchange inflows dried up due to the global financial crisis. - MRRs were extended in 2005 to financial leasing companies and applied to foreign exchange indexed loans when they developed as alternatives to foreign exchange loans. - Timeline of key policy steps and instrument levels (as labeled in figures): - (1) FX LAR 24% 01/03 - (2) FX LAR 32% 04/03 - (3) Introduction of the MRR I at 24% 06/04 - (4) MRR I 30% 03/05 - (5) MRR I 40% 06/05 - (6) MRR II 15%, MRR III 55% 12/05 - (7) MRR IV 55% 06/06 - (8) Same treatment for loans with currency clauses as for f/c loans 09/06 - (9) FX LAR 28,5% 05/08 - (10) MRR abolished 10/08 - (11) FX LAR 20% + exposure ceiling raised from 20% to 30% 02/09 - (0) Ceiling on open position in foreign exchange reduced to 25% from 30% (annotated for liability figure) - Effects and trade-offs: - Because market participants seek circumvention, constant adjustments to prudential provisions were necessary. - The mix of prudential measures and capital controls appears to have succeeded in shifting risks to the nonfinancial sector at the expense of increased disintermediation. - Evidence from external debt growth differentials: - Average monthly growth rate of external debt of banks: - January 1999 to May 2006 period: 1.81 percent - June 2006 to September 2008 period: -0.90 percent - Rest of private sector external debt monthly growth: - June 2006 to September 2008 period: 2.95 percent - January 1999 to May 2006 period: 1.11 percent - After abolition of all MRRs (October 2008 to February 2009): - External debt of banking sector grew by a monthly average of 4.07 percent. - External debt of the nonfinancial private sector rose by a monthly 0.72 percent. - These shifts indicate a policy-related move to nonfinancial corporation borrowing after MRR introduction and a move back to bank borrowing after MRRs were abolished. *IMF Working Paper content as provided.* ### 38. To quantify the impact of prudential measures on dollarization, we added to ### _wp10188 - 38. To quantify the impact of prudential measures on dollarization, we added to ### Methodology for Quantifying Prudential Measures' Impact - Added to equation two (section IV C) a set of dummy variables for the dates when prudential measures were introduced. - Dummy variables indicate the average change in asset or liability dollarization in the month of the introduction of the prudential measures compared to the rest of the period. - Also introduced the dummy lagged by a period to control for the lagging effect of the measures. - No further lags were considered significant. ### Empirical Findings (Croatia) - Financial dollarization shows a moderate response to prudential measures in Croatia. - Asset dollarization has been more sensitive to the MMR than to the LAR. - Liability dollarization seems to have reacted to the LAR more than to the introduction of the MRR. - The lag indicates that the effect of the measures may have been short-lived as liability dollarization increased again rapidly after the introduction of the measures. - An increase in the REER is positively correlated with asset dollarization for Croatia. ### Table 3 — Regression on the Effect of Prudential Measures on Dollarization in Croatia - Dependent variable: d(Foreign currency loans/total loans) - C: -2.23 (0.00) - Dependent Variable (-1)*: -0.15 (0.46) - Inflation: -0.15 (0.04) - M2/M1: 0.62 (0.00) - Volatility: -0.28 (0.11) - d(REER): 0.099 (0.00) - LAR: -0.002 (0.98) - LAR(-1): 0.043 (0.67) - MMR: -0.07 (0.00) - MMR(-1): 0.18 (0.55) - Dependent variable: d(Foreign deposits/total deposits) - C: -0.13 (0.89) - Dependent Variable (-1)*: -0.34 (0.00) - Inflation: 0.12 (0.33) - M2/M1: -0.02 (0.93) - Volatility: 0.24 (0.21) - d(REER): 0.06 (0.16) - LAR: -0.41 (0.00) - LAR(-1): 0.46 (0.00) - MMR: 0.03 (0.49) - MMR(-1): -0.05 (0.41) - Observation: 87 - Adjusted R-squared: 0.09 - Source: Staff calculation. ### Conclusions and Policy Implications (Sections V, paragraphs 40–42) - Durable dedollarization requires credible macroeconomic stabilization and implementation of additional policies. - Restoring the proper functioning of a currency is central: stable and low inflation increases confidence in the local currency and reduces the need for hedging through foreign exchange holdings. - While a certain level of dedollarization can be achieved under a fixed exchange rate regime, a flexible exchange rate arrangement appears more conducive to dedollarization. - An exchange rate policy that allows two-way movements introduces a disincentive to financial dollarization by rendering foreign exchange risk more apparent. - Specific policies and measures that may be necessary to end persistent dollarization: - Adequate liquidity management to decrease volatility of domestic interest rates. - Public debt management to facilitate savings in local currency denominated instruments. - Financial policies, prudential regulations, and effective financial sector supervision to internalize costs of foreign exchange transactions. - Administrative measures to ensure local currency is available in convenient denominations and quality for local payments. - Change regulations and practices that favor foreign currency transactions to avoid bias in favor of foreign currency. - In certain cases, measures to force the use of the domestic currency may be necessary in tandem with macroeconomic stabilization. - Evidence from the analysis: - Exchange rate volatility and inflation have significant effect on dollarization. - Prudential regulation (in conjunction with capital controls) affects both asset and liability dollarization, but effects are relatively short-lived as market participants may find ways to circumvent them, requiring further regulatory adjustments. ### Appendix I — Selected Country Experiences (high-level summary) - Macroeconomic policies and public debt management instruments include exchange rate flexibility, monetary policy adjustments, interest rate incentives, fiscal tax measures, and switching public debt from dollar-indexed to local- or inflation-indexed instruments. - Financial policy instruments include developing alternative financial instruments (inflation-indexed substitutes, interest-rate indexed instruments), developing hedging markets (derivatives), and developing local currency financial markets. - Prudential regulation instruments documented include: - Ceilings on banks’ FX exposure (net open FX position limits as a percentage of banks’ capital) with country examples and specific limits described. - Ceilings on pension funds’ currency exposure with country-specific limits and ranges. - Ceilings on foreign currency lending ratios and limits in several countries. - Reserve requirements and differentiated reserve regimes favoring local currency liabilities in several countries, including specific rate examples and changes over time. - Liquid asset requirements and foreign currency liquidity rules for banks and deposits. *Source: _wp10188 (excerpts provided).* ### 2005. The marginal ### 2005. The marginal ### Liquidity requirements and liquid asset ratios for foreign currency deposits (FCD) and FX liabilities - China 1996-2007: Banks’ foreign exchange liquid (1 year or less) assets should not be less than 60 percent of liquid liabilities and 30 percent of total foreign exchange assets. - Croatia since 2003: The required FX coverage of banks’ FX liabilities was increased (24 percent of banks’ foreign borrowing had to be held in foreign liquid assets) (Jan 2003). The coverage was further raised to 35 percent in February 2005, then lowered to 32 percent in March. - Cyprus since 2003 / Mexico since 1998: Banks must invest in liquid assets – as determined by the BOM and denominated in foreign currency – an amount calculated through the maturity structure of their liabilities payable in foreign currency. - Peru since 1998: The liquidity requirement is at least 20 percent of short term liabilities for foreign exchange. The liquidity requirement is only 8 percent for domestic currency. - Philippines since 2001: Depository banks with FCDUs and EFCDUs must maintain at all times 100 percent asset cover for their foreign currency liabilities. At least 30 percent of the cover requirement must be in the form of liquid assets. For FCDUs and EFCDUs of commercial and expanded commercial banks respectively, at least 70 percent of the cover must be maintained in the same currency as the deposit liability. - Trinidad and Tobago since 1996: A liquid asset ratio of 20 percent on FCD is required. It was 25 percent until 2002. - Egypt since 1996: The minimum required ratio of liquid assets to total deposits in foreign currencies was 75 percent between 2003 and 2008. Since, it has been reduced to 70 percent. - Honduras since 1997: The liquidity ratio requirement applied to assets in foreign currency is 25 percent against 20 percent with regards to assets in Egyptian pounds. - Lebanon since 1999: Liquid assets in foreign exchange may not be less than 30 percent of the total clients’ deposits net interbank credit accounts, CDs, bonds, and subordinated loans maturing in less than one year. Brought down to 25 percent in 2001, 15 percent in 2002 and 10 percent in 2003. - Honduras since 1997 (additional detail): Liquidity requirements for FCD is 24 percent. It was 50 percent in 1997, 38 percent in 1998 and 30 percent in 2006. In 2009 some banks were exempted from the requirement. - Turkey 2007: The foreign exchange liquidity ratio, which is the ratio of foreign exchange assets to foreign exchange liabilities, must be at least 80 percent. Asset and liability account calculations take into account liquidity capacity and demand features. - Uruguay since 2008: Depends on maturity of obligations. Stricter for foreign currency deposits for all maturities. ### Premiums, insurance, and exclusion from deposit insurance - Uruguay 2001: Premium for FCDs participating in guarantee schemes; higher insurance premium on FCD. - Staff recommendation for Peru 2007 (listed without further detail in source). - Venezuela since 2006: FCD accounts are not insured by the government (exclusion from the government’s deposit insurance scheme). ### Collateral, loan-to-value, and provisioning measures affecting loan dollarization - Pakistan 1998-2002: Disallowing the use of FCD as collateral. - Hungary: Loan to value ratio is set at 80 percent for local currency loans, 60 percent for euro loans, and 40 percent for other currency loans (loan to value requirements; loan dollarization). - Extending provisioning requirements for foreign exchange (FX) credits to unhedged foreign-currency-denominated and indexed loans: - Albania 2007: An additional provision of 5 percent is required on all unhedged substandard and doubtful loans. - Croatia 2006, raised further in late 2007: Increased risk weight of unhedged foreign currency-denominated and indexed loans by 25 percentage points. All such loans extended to debtors with foreign exchange assets covering less than 80 percent of their foreign exchange liabilities are considered unhedged. Same treatment for indexed loans as for f/c ones (09/2006). - Haiti since 2002: Lending may not exceed 50 percent of liabilities in foreign currency. - Mozambique since 2005: Bank must record a 50 percent provision on lending when there are strong doubts about repayments or when borrowers are non exporters, and a 100 percent provision for overdue credits. - Thailand since 1997: Commercial lending denominated in foreign currencies to particular industries may be partially (50 percent) included as foreign assets. - Romania 2008: Provisioning requirements for FX credits extended to unhedged borrowers and broadened to include non-bank financial institutions. - Uruguay 2001: Higher capital requirements for dollar loans to the non tradable sector. - Stricter loan classification: - Romania: The authorities have refined regulations on provisioning and loan classification to take the exchange rate risk of the borrower into account. ### Supervisory measures: raising awareness, measurement, monitoring, disclosure, and enforcement - Croatia 2006: Supervisors issued guidelines requiring banks to (i) set up and maintain a comprehensive system of ongoing identification, measuring, monitoring, and controlling of currency-induced credit risk; (ii) develop a reliable system for granting loans exposed to the currency-induced credit risk; (iii) adequately manage the relationship between risk and the price of such loans; (iv) have in place a system of ongoing monitoring of this risk; and (v) develop adequate methods for management of this risk and build them into their credit policies and procedures. - Israel 1990-2002: Strengthening supervision to ensure that banks maintain covered positions in their foreign currency activities. - Poland: Monitoring of banks’ quality of FX risk management, internal controls. The authorities developed a credit information database and formed a unit to monitor vulnerabilities from credit risk associated with FX denominated lending. Moral suasion: From 2001, supervisors’ warning of banks and written guidance from head of supervision. - Enhancing the offsite and on site monitoring toolkit to improve monitoring of banks’ unhedged foreign exchange exposures (applied in Croatia, Hungary, Poland and Romania): 1. Off-site tools: new or extended reporting forms, or targeted surveys. 2. On-site inspections: increased focus on borrowers’ foreign exchange exposures including asking banks to inquire and report on the largest customers’ FX exposures. - Poland: Periodic surveys of banks’ FX exposure by supervisors to obtain specific information on banks’ foreign currency lending, including borrowers’ appetite for foreign currency loans, percentage of customers hedging their exchange rate risks, the form of hedging offered to customers, foreign currency loans protected by guarantees, costs for hedging loans as ratio to the loan, loan classification and provisions made, foreign exchange positions by currency, receipts/costs of foreign exchange transactions, extent of engagement in arbitrage transactions. Surveys followed up by action on procedures and banks stress tests. - Hungary 2005: Information on foreign currency risks to be included on the web page of the financial supervisory authority. - Poland: Press coverage of risks to households. - Hungary from January 2005: 1. The contracts for mortgage loans in foreign currency must specify the risks to which their borrowers are exposed to. 2. Banks are required to disclose their interest rate charges (APRC) on foreign currency loans. ### Forced dedollarization and administrative restrictions on foreign currency use - Interest rate control (deposit dollarization): Control on foreign currency deposit interest rate in Bangladesh 1996-2009 and India 1996-2009. - Approval requirement for foreign currency loans (restrictions on foreign currency loans): - Bahamas since 1997: Exchange control approval is required to make loans to residents in foreign exchange. - Bangladesh since 1996: Lending is subject to prior approval from the BB. - Burkina Faso (since 2000), Guinea-Bissau (since 2006), Guyana (since 2008), Mali (since 2006), Niger (since 2006), Senegal (since 2006), Togo (since 1998): MOF authorization and BCEAO approval are required. For Guyana, no permission is needed when lending to an AD. Mali prohibited foreign currency lending between 2003 and 2005. Niger restricted such borrowing to resident individuals authorized to hold accounts in foreign currency. - Cote d’Ivoire since 2001: MEF authorization and BCEAO approval are required. - Morocco since 2003: FEO is required for these transactions. Overdrafts are not permitted in foreign exchange accounts (since2005). - Fiji since 1996: Loans for more than F$5 million require the specific permission of the RBF. Until 1996, the threshold was F$2 million. - Papua New Guinea since 2002: Subject to BPNG approval. Settlement must be in kina. - Samoa since 1999: Approval by the CBS is necessary. - Ukraine since 2002: Written permission from the NBU and a banking license are required. - Foreign currency loans allowed only for specific activities: - Korea since 2008: Foreign currency loans are restricted to funding overseas transactions and capital investment by domestic firms. - Macedonia since 2002: Commercial banks may lend in foreign exchange to residents for current payments aboard. If legal entities intend to use the loan proceeds domestically, the loan proceeds must be received in denars. - Nepal since 2000: Exporters, tourism-related businesses and specific industries are entitled to such credits. - Pakistan since 2004: Only allowed for financing exports and imports against foreign currency deposits of banks. Such loans were banned from 1997 to 1999. - Suriname since 2007: Banks may extend foreign exchange loans to residents subject to specific qualification requirements. From 2003 to 2007, only foreign exchange banks could grant such loans. - Turkey since 1999: Resident banks may not extend credit in foreign currency to residents, except to those who are exporters, investors, Turkish entrepreneurs working abroad, residents conducting business related to international tenders held in Turkey and residents who are conducting business related to defense industry projects that have been approved by the Undersecretariat of the Defense Industry. - Vietnam since 2008: Only allowed to pay for imports of goods and services, for direct investment abroad, or to repay advance external loans, which comply with the regulation on external borrowing and repayment, where the borrower is able to repay in foreign currency and where the local loan is more economical than external borrowing. The requirements used to be tighter. - Limited foreign currency lending to unhedged borrower: Peru 1985-1987; Turkey 1999-2003 limited to hedged borrowers (foreign exchange earners); Dominican Republic 2008: 85 percent of loans in FX must be to borrowers generating FX. - Maturity cap on foreign currency loans: Cyprus (since 2005) — Maturity is capped at 15 years. - Foreign currency lending only to resident exporters: - Angola since 1999: Banks are authorized to provide credit in foreign currency to exporters, up to a limit of 50 percent of the lending bank’s deposits in that specific currency. - Argentina 2002-2006. - Honduras 1997-2006: Forty percent of funds from foreign exchange deposits may be given as credit to export-related activities, and 10 percent may be used for any purpose. In 2003, both these rates were raised to 50 percent and 15 percent respectively. In 2006 these requirements were abolished. - Jordan 2008. - Rwanda since 2005: The NBR must authorize the transaction. - Sri Lanka since 2000. - Prohibition of lending in foreign currency: Brazil 2008 (Does not apply to on-lending of external foreign currency loans); Dominica 2008; Gabon 2008; Namibia 2008; Sierra Leone since 1997; Timor-Leste since 2003. - Restrictions on purchases of locally issued securities denominated in foreign exchange (administrative approval required): Examples include Bangladesh since 1996; Barbados since 1998; Benin (since 1998), Burkina Faso (since 2000), Guinea-Bissau (since 2006), Mali (since 1999), Niger (since 2006), Senegal (since 2001), Togo (since 1998); Gabon since 2003; Guatemala since 2002; Morocco since 1996; Ukraine since 2007. - Rating requirements: Indonesia since 2008 — Banks may purchase locally issued bonds denominated in foreign exchange, subject to the requirement that the securities be investment grade and not be issued by their own group. - Prohibition of purchases of locally issued securities in foreign currency: Kyrgyz Republic since 1998 — Locally issued securities must be denominated in local currency. - Regulations discriminating against foreign currency accounts (deposit dollarization): Require administrative approval for the opening of local foreign currency accounts — list of countries includes Afghanistan (since 2003), Argentina (since 2006), Azerbaijan (since 1996), Bahamas (since 1996), Bangladesh (1996-2001), Barbados (since 1996), Belize (since 1996), Benin (since 1996), Bhutan (since 1997), Burkina Faso (since 1996), Cape Verde (since 1998), Central African Republic (since 2007), Chad (since 1998), China (since 1996), Comoros (since 1998), Congo Republic (since 2005), Costa Rica (since 2008), Cote d’Ivoire (since 1996), Dominica (since 1996), Dominican Republic (1998-2000), Equatorial Guinea (since 2004), Eritrea (since2005), Ethiopia (since 1996), Fiji (since 1996), Gabon (since 2003), Guinea-Bissau (since 1996), Lesotho (1998-2003), Mali (since 2000), Namibia (since 1998), Nepal (since 1997), Niger (since 1998), Poland (1996-1999), Samoa (always), Senegal (since 1996), Swaziland (1996-2000), Togo (since 1996). - Ban on foreign currency accounts of residents: Cameroon (1996-1998); Gambia (1998-2001); Paraguay (2007-2009); Tonga (1998-2000). - Regulations discriminating against foreign currency as a means of payment (transaction dollarization): - Ban on foreign currency holdings: Burkina Faso (since 2002), Senegal (since 2003). Residents must surrender all foreign exchange earned abroad or domestically to an authorized intermediary bank within eight days of receipt. In Senegal, this applies for holdings exceeding CFAF 300,000. - Comoros since 2004: Any foreign currency acquired must be converted at authorized financial institutions. - Ban on transfers of currency deposits between residents: Israel 1990-2002. - Limit on cash withdrawals: Argentina 2001–02 — Until 2002 for LCD and freeze until 2003 for FCD (inflation indexed). Pakistan 1998-2003 — FCD freeze: redeemable in rupee immediately or for medium term bonds. - Requirement to list prices in domestic currency: Peru 2000-2005, Brazil (since 2003), China (since 2001), Ghana (since 2001), Malawi (since 2001). - Granting legal tender status to the local currency only: Angola (2001). - Ban on the use of foreign currency in domestic transactions: Armenia since 2001 — Since 2005, noncash payments between legal entities, between sole entrepreneurs, and between sole entrepreneurs and legal entities may be denominated in foreign currency. Azerbaijan (since 2001), Samoa (always), Trinidad and Tobago (since 2003), Tunisia (since 2001), Ukraine — Settlements among residents within the country may be effected in foreign currency only with the approval from the respective authorities. - Columbia 2003-2005: Exceptions are: transactions between and among mineral sector firms and services related firms; sales of fuel used in international transportation; purchases and sales of oil and gas by Ecopetrol and companies engaged in downstream and upstream activities; authorized local insurance and reinsurance contracts; and charges related to international transport services and payments through special accounts registered at the BR. - A long list of countries where payment in foreign currency is allowed only in prescribed cases: Bahamas (since 2007), Belarus (since 2001), Benin (since 2005), Bhutan (since 2003), Brazil (since 2003), Burkina Faso (since 2006), Burundi (since 2003), China (since 2001), Comoros (since 2004), Cote d’Ivoire (since 2005), Equatorial Guinea (2009), Ethiopia (since 2001), Gabon (since 2003), Georgia (since 2003), Ghana (2001-2006), Guinea (since 2003), Guinea-Bissau (since 2006), Malawi (since 2001), Mali (since 2002), Morocco (since 2004), Namibia (since 2003), Niger (since 2006), Papua New Guinea (2002-2007), Senegal (since 2003), Sri Lanka (since 2004), Thailand (since 2001), Togo (since 2006), Uzbekistan (since 2002), Venezuela (since 2003), Zimbabwe (2002-2009). - For Namibia, invoices can be in foreign currency but actual payment must be in domestic currency. - Additional country list where actual payment between residents in foreign currency is permitted only when the residents involved maintain a foreign exchange account: Croatia (since 2001), Iran (since 2004), Kazakhstan (since 2001), Macedonia (since 2003), Malaysia (since 2005), Moldova (since 2002), Romania (since 2005), Russia (since 2003), Serbia (since 2003), Slovenia (2005-2008), Sudan (since 2005), Tajikistan (since 2004), Vietnam (since 2003). Allowed only in prescribed cases. - Cyprus 2001-2004, Pakistan (since 2006), Swaziland (since 2003): Actual payment between residents in foreign currency is permitted only when the residents involved maintain a foreign exchange account. For Pakistan, foreign currency accounts holders can freely transfer to each other funds but all obligations among residents must be settled in Pakistani rupees. - Lao PDR 1997-2000; 2004-2009. - Belize (until 2001), Belize (since 2003): Residents with earnings in foreign exchange may pay only their taxes, utility bills, and other expenses in US dollars. For Belize, until 2006, the prohibition on the use of foreign exchange also applied to foreign currency earners. - Mandatory conversion (financial dollarization): Conversion of FCD and foreign-currency-denominated assets: - Argentina 2001–02: In peso at 1.4 p/US$1 and 1p/US$1. - Mexico 1982. - Peru 1985-1987 (FCDs reintroduced in 1987). *Italic: Extracted from the content unit _wp10188 - 2005. The marginal* ### Appendix II. Panel Unit Root Tests ### Appendix II. Panel Unit Root Tests ### Foreign currency deposit as a percentage of total deposits - Null: Unit root (assumes common unit root process) - Levin, Lin & Chu t* -1.82297 0.0342 34 2882 - Null: Unit root (assumes individual unit root process) - Im, Pesaran and Shin W-stat -3.84973 0.0001 34 2882 - ADF - Fisher Chi-square 152.601 0.0000 34 2882 - PP - Fisher Chi-square 196.001 0.0000 34 2899 - **Note:** Probabilities for Fisher tests are computed using an asymptotic Chi-square distribution. All other tests assume asymptotic normality. ### Foreign currency loan as a percentage of total loans - Null: Unit root (assumes common unit root process) - Levin, Lin & Chu t* -0.05405 0.4784 21 1754 - Null: Unit root (assumes individual unit root process) - Im, Pesaran and Shin W-stat -6.70123 0.0000 21 1754 - ADF - Fisher Chi-square 174.918 0.0000 21 1754 - PP - Fisher Chi-square 220.788 0.0000 21 1776 - **Note:** Probabilities for Fisher tests are computed using an asymptotic Chi-square distribution. All other tests assume asymptotic normality. ### Inflation - Null: Unit root (assumes common unit root process) - Levin, Lin & Chu t* -28.5918 0.0000 32 2674 - Null: Unit root (assumes individual unit root process) - Im, Pesaran and Shin W-stat -29.6705 0.0000 32 2674 - ADF - Fisher Chi-square 773.892 0.0000 32 2674 - PP - Fisher Chi-square 822.114 0.0000 32 2690 - **Note:** Probabilities for Fisher tests are computed using an asymptotic Chi-square distribution. All other tests assume asymptotic normality. ### Standard deviation of the exchange rate on a 125 day period as a percentage of the average exchange rate on the same period - Null: Unit root (assumes common unit root process) - Levin, Lin & Chu t* 0.39758 0.6545 34 2753 - Null: Unit root (assumes individual unit root process) - Im, Pesaran and Shin W-stat -6.94100 0.0000 34 2753 - ADF - Fisher Chi-square 224.822 0.0000 34 2753 - PP - Fisher Chi-square 107.259 0.0017 34 2834 - **Note:** Probabilities for Fisher tests are computed using an asymptotic Chi-square distribution. All other tests assume asymptotic normality. ### M2 as a percentage of M1 - Null: Unit root (assumes common unit root process) - Levin, Lin & Chu t* -3.91227 0.0000 34 2637 - Null: Unit root (assumes individual unit root process) - Im, Pesaran and Shin W-stat -2.14867 0.0158 34 2637 - ADF - Fisher Chi-square 98.4822 0.0092 34 2637 - PP - Fisher Chi-square 91.8443 0.0287 34 2650 - **Note:** Probabilities for Fisher tests are computed using an asymptotic Chi-square distribution. All other tests assume asymptotic normality. ### REER - Null: Unit root (assumes common unit root process) - Levin, Lin & Chu t* 3.90905 1.0000 33 2848 - Null: Unit root (assumes individual unit root process) - Im, Pesaran and Shin W-stat 4.00810 1.0000 33 2848 - ADF - Fisher Chi-square 48.7958 0.9443 33 2848 - PP - Fisher Chi-square 45.9971 0.9711 33 2871 - **Note:** Probabilities for Fisher tests are computed using an asymptotic Chi-square distribution. All other tests assume asymptotic normality. ### General observations from tests (as presented) - Several series reject the unit root null under both common and individual unit root assumptions (e.g., Inflation, Foreign currency deposits, Foreign currency loans, M2 as a percentage of M1, Standard deviation of exchange rate) based on reported statistics and probabilities. - REER shows statistics and probabilities consistent with failure to reject the unit root null across reported tests. ### Appendix III. Country sample (NOVEMBER 2001─MARCH 2001) — Selected entries - Foreign currency deposits / Foreign currency loans / Exchange rate behavior (as listed) - AZERBAIJAN / AZERBAIJAN / Managed - BANGLADESH / (listed under loans) / Managed - BARBADOS / (deposits) / Fixed - BELARUS / BELARUS / Fixed - BOLIVIA / BOLIVIA / Managed - BURUNDI / (deposits) / Managed - CAMBODIA / (loans) / Managed - CANADA / (deposits) / Flexible - CAPE VERDE / (deposits) / Fixed - CHILE / CHILE / Flexible - COSTA RICA / COSTA RICA--C / Managed - CROATIA / (deposits) / Fixed - DOMINICA / (deposits) / Fixed - GRENADA / (deposits) / Fixed - GUATEMALA / GUATEMALA / Managed - HAITI / HAITI / Managed - HONDURAS / HONDURAS / Fixed - INDONESIA / INDONESIA / Managed - JAMAICA / (deposits) / Managed - KENYA / (deposits) / Managed - KUWAIT / (deposits) / Fixed - LESOTHO / (loans) / Fixed - LITHUANIA / LITHUANIA / Fixed - MEXICO / (loans) / Flexible - MOLDOVA / (deposits) / Managed - NICARAGUA / NICARAGUA / Managed - PARAGUAY / PARAGUAY / Managed - QATAR / (deposits) / Fixed - ROMANIA / (deposits) / Flexible - SEYCHELLES / (deposits) / Fixed - SOUTHAFRICA / (deposits) / Flexible - SURINAME / (loans) / Fixed - THAILAND / (loans) / Managed - UKRAINE / UKRAINE / Fixed - URUGUAY / URUGUAY / Managed - ZAMBIA / (loans) / Flexible - (The Appendix lists additional countries and classifications in the same format.) *Source: _wp10188 - Appendix II. Panel Unit Root Tests* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2010/_wp10188.pdf_