Dollarization in Transition Economies: Evidence and Policy Implications

IMF Working Papers, September 1, 1995

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After most restrictions on foreign currency holdings were relaxed in the early 1990s, foreign currency deposits in transition economies increased rapidly.
The paper examines evidence on dollarization for 15 transition economies.
Depending on the institutional constraints, foreign currency deposits as a proportion of broad money reached a peak of between 30 and 60 percent in 1992-93.
Unlike experiences documented in Latin America, dollarization fell substantially following successful stabilization plans in Estonia, Lithuania, Mongolia, and Poland.
The decline in dollarization is attributed primarily to portfolio choice behavior: higher real returns on domestic-currency assets resulting from lower inflation and more market-determined interest rates.

Foreign currency deposits are largely a portfolio choice, not solely a transactional necessity.
Institutional constraints shape the peak degree of dollarization observed across countries.
Stabilization outcomes (lower inflation, market-determined interest rates) can reverse dollarization trends.

Successful stabilization policies that lower inflation and promote market-determined interest rates can reduce dollarization.
Strengthening domestic-currency asset returns is a key policy channel to encourage reallocation from foreign currency deposits to domestic currency.
Institutional reforms that support monetary stabilization and market-based interest rate formation are central to reversing dollarization.

Source: Dollarization in Transition Economies: Evidence and Policy Implications, IMF Working Papers 1995, 096 (1995).