## Financial Stability in Dollarized Economies

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### Overview
- This Occasional Paper (230) addresses challenges to prudential supervision in highly dollarized economies where central banks and supervisors may be constrained in the use of standard monetary and financial policy tools.
- Purpose: contribute to policy debate on an adequate prudential and crisis management framework for dollarized economies, focusing on whether additional risks require adaptations to commonly recommended prudential frameworks and whether crisis responses should differ in dollarized contexts.
- Emphasis: macroeconomic issues are discussed only insofar as they have a direct bearing on financial sector stability; main focus is on limiting financial vulnerabilities given the macroeconomic environment.
- Scope: primary focus on economies with a local currency but high proportions of domestic financial transactions denominated in dollars (highly dollarized economies). Marginally or fully dollarized economies are used mainly as benchmarks. Offshore financial centers are not the main focus.

### Dollarization types and recent trends
- Definitions:
  - Official (de jure) dollarization: U.S. dollar adopted as predominant or exclusive legal tender.
  - Partial (de facto) dollarization: local currency remains exclusive legal tender but financial and payments transactions are allowed to be denominated in dollars (bicurrency system).
  - Distinctions: payments dollarization, financial dollarization, real dollarization; financial dollarization may be domestic or external.
- Observed trends:
  - Partial dollarization affects a wide set of countries and has increased in recent years.
  - The U.S. dollar is the dominant currency used, though other currencies can be used as complements.

### Key statistics on foreign currency deposits (Table 1 summary)
- Average foreign currency deposits to total deposits (In percent), by region and year:
  - South America (8 countries): 1996: 45.8; 1997: 46.1; 1998: 49.4; 1999: 53.2; 2000: 54.0; 2001: 55.9
  - Transition economies (26 countries): 1996: 37.3; 1997: 38.9; 1998: 43.5; 1999: 44.3; 2000: 46.9; 2001: 47.7
  - Middle East (7 countries): 1996: 36.5; 1997: 37.2; 1998: 37.7; 1999: 37.5; 2000: 38.2; 2001: 41.9
  - Africa (14 countries): 1996: 27.9; 1997: 27.3; 1998: 27.8; 1999: 28.9; 2000: 32.7; 2001: 33.2
  - Asia (13 countries): 1996: 24.9; 1997: 28.0; 1998: 26.8; 1999: 28.8; 2000: 27.8; 2001: 28.2
  - Central America and Mexico (7 countries): 1996: 20.6; 1997: 20.8; 1998: 22.0; 1999: 22.1; 2000: 22.5; 2001: 24.7
  - Caribbean (10 countries): 1996: 6.3; 1997: 7.6; 1998: 6.8; 1999: 6.7; 2000: 6.1; 2001: 6.2
  - Industrial countries (14 countries): 1996: 7.4; 1997: 7.5; 1998: 7.5; 1999: 6.7; 2000: 7.0; 2001: 6.6
- Source notes: data from national authorities; IMF International Financial Statistics database; IMF staff estimates.

### Dollarization levels versus dollarization risks (Box 2 and Table 2 summary)
- Observed cross-regional differences in financial intermediation in foreign currency:
  - Indicators of domestic financial intermediation in foreign currency, 2001 (In percent):
    - Latin America (includes 15 South and Central American countries): Foreign Currency Deposits to GDP: 21.1; Foreign Assets to Foreign Currency Deposits: 53.7; Cross-Border Deposits to Foreign Currency Deposits: 124.0
    - Transition economies (includes 23 transition economies): Foreign Currency Deposits to GDP: 8.8; Foreign Assets to Foreign Currency Deposits: 104.1; Cross-Border Deposits to Foreign Currency Deposits: 130.9
    - Low income (includes 13 African and 12 Asian countries): Foreign Currency Deposits to GDP: 7.8; Foreign Assets to Foreign Currency Deposits: 260.7; Cross-Border Deposits to Foreign Currency Deposits: 472.1
- Interpretation:
  - Dollar intermediation (e.g., ratio of foreign currency deposits to GDP) is substantially higher in Latin American countries than in transition economies and non–Latin American low-income countries.
  - In transition and low-income countries, large shares of foreign currency funding are held abroad rather than loaned out locally (higher foreign assets to deposits and higher cross-border deposit ratios).
  - These structural differences have important implications for liquidity and solvency risks: liquidity risk is less severe where local dollar deposits are small in magnitude or held abroad; liquidity and solvency risks are more limited when banks hold large fractions of foreign currency deposits in liquid assets abroad rather than loaning them locally.

### Implications for financial stability (from Introduction)
- Dollarization is both a reflection of and has key implications for macroeconomic policies, especially monetary policy; this paper addresses macroeconomic issues insofar as they affect financial stability.
- Risks and trade-offs:
  - Allowing financial dollarization to spread can involve trade-offs between financial development and stability.
  - Recent rapid growth in dollarization and ongoing financial crises in several highly dollarized Latin American countries suggest important vulnerabilities.
- Analytical focus:
  - The paper examines specific risks to financial soundness associated with dollarization, approaches to stopping bank runs and stabilizing liquidity in a dollarized economy, and measures to limit banking crisis risks in dollarization-prone economies.
  - Subsequent sections (II–V) cover: specific risks for financial soundness; managing bank runs (liquidity provision, depositor protection, administrative measures); prudential frameworks and reforms; and conclusions.

### Scope and intended use
- The paper’s conclusions are preliminary steps intended for policy dialogue with member countries, standard-setters, and academia and may be revisited with further analysis of country experiences.
- Examples are drawn more heavily from Latin America because banking crises or near-crises have been more frequent or more directly related to dollarization in this region, but issues are relevant to other regions as well.
- The analysis mainly addresses domestic financial dollarization (transactions between residents); external dollarization is discussed only when directly bearing on domestic financial stability.

*International Monetary Fund. Occasional Paper 230, Financial Stability in Dollarized Economies (2004).*

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