Enhancing Monetary Policy Flexibility Through `De-dollarization’

IMF Blog, September 21, 2016

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Enhancing Monetary Policy Flexibility Through `De-dollarization’

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Bibliographic details

• Authors: Marcello Estevo, Greetje Everaert
• Published: September 21, 2016

Summary and context

• Topic: Borrowing and saving in foreign currencies—so-called dollarization—and its implications for monetary policy and financial stability in emerging market economies.
• Sample and period analyzed: 33 emerging-market economies, 1997 to 2015.
• Central trade-off highlighted: Allowing exchange rates to adjust to shocks versus curbing exchange-rate flexibility to protect the financial sector from balance-sheet effects associated with dollar-denominated liabilities.

Key empirical findings on exchange-rate flexibility and dollarization

• Greater exchange-rate flexibility reduces incentives to lend in dollars.
• Specific empirical observations:
  • The exchange rate moved more in countries that subsequently experienced a significant reduction in dollar loans (measured as a reduction of loan dollarization of at least 20 percentage points over the sample period, to below 20 percent).
  • Statistical estimates confirm that more exchange-rate flexibility causes more rapid de-dollarization.
• Robustness: These estimates hold after controlling for:
  • the differential in domestic and foreign interest rates,
  • the macroeconomic framework in individual countries (such as whether the country is an inflation targeter),
  • measures of external volatility,
  • the amount of inflation volatility,
  • other measures of domestic risks.
• Policy implication from results: Restoring (nearly) full exchange-rate flexibility—and, along with it, the risks of lending and borrowing in foreign currency—would provide incentives to save and borrow in local currency.

Policy trade-offs and risk management

• Policymakers’ dilemma in highly dollarized economies:
  • Allow full exchange-rate adjustment to external shocks and expose the financial sector to negative balance-sheet effects (borrowers whose liabilities are in dollars but incomes in depreciated local currency).
  • Or curb exchange-rate flexibility, which may hinder de-dollarization and limit central bank control over economic activity and inflation.
• Recommendation from research: Allow the exchange rate to adjust fully when facing external shocks if the objective is to reduce dollarization and gain greater control of monetary policy.
• Remaining challenge: How to manage risks from mismatched balance sheets (corporations and households borrowing in dollars while earning in local currency).

Case study — Peru

• Historical context:
  • Following the hyperinflation of the late 1980s and early 1990s, dollarization levels around 90 percent.
  • Macroeconomic reforms included a fiscal responsibility law and an inflation-targeting regime adopted in 2002.
  • Result: Peru’s inflation rate, averaging 2¾ percent annually since 2002.
• Dollarization dynamics:
  • Dollarization receded but remained around 40 percent in 2014.
  • To limit financial risks from dollarization, the central bank curtailed exchange-rate volatility for many years—potentially limiting de-dollarization.
• Recent policy mix and outcomes:
  • Since 2013, Peru implemented macroprudential measures and explicit de-dollarization targets.
  • Measures to make foreign-currency lending more expensive and less attractive for banks:
  • taxing foreign exchange lending,
  • imposing stricter requirements (such as more stringent loan-to-value ratios) on foreign currency loans,
  • increasing the percentage of foreign currency deposits banks must maintain with the central bank (higher reserve requirements),
  • raising costs of dollar lending for banks that failed to meet de-dollarization targets.
  • Central bank operations to support local currency liquidity: offering currency repos (buying dollars with soles with a promise to reverse the transaction).
• Outcome:
  • Loan dollarization declined from 40 percent in 2014 to about 29 percent in recent months without a credit crunch, supporting the growth recovery following the 2014 economic slowdown.
• Implication for Peru and similar countries: Further exchange-rate flexibility would likely reduce dollarization further and could lessen the need for accompanying macroprudential measures to handle balance-sheet mismatches.

Policy recommendations and takeaways

• To promote de-dollarization and strengthen monetary policy effectiveness:
  • Allow exchange rates to adjust more fully to external shocks to internalize currency risk and incentivize saving and borrowing in local currency.
  • Complement exchange-rate flexibility with targeted macroprudential measures to manage balance-sheet mismatches and preserve financial stability during the transition.
• Country sequencing: Use a combination of policy tools—exchange-rate flexibility, macroprudential measures, and fiscal and monetary credibility—to achieve sustained reductions in dollarization without triggering financial distress.

Source: Enhancing Monetary Policy Flexibility Through `De-dollarization’, Marcello Estevão, Greetje Everaert, September 21, 2016.

References

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