## Enhancing Monetary Policy Flexibility Through `De-dollarization’

_IMF Blog, September 21, 2016_

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**Canonical URL:** [Enhancing Monetary Policy Flexibility Through `De-dollarization’](https://www.imf.org/en/blogs/articles/2016/09/21/enhancing-monetary-policy-flexibility-through-de-dollarization)

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## Bibliographic details
- Authors: Marcello Estevo, Greetje Everaert
- Published: September 21, 2016

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### 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.*

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## References

- [study](http://www.imf.org/external/pubs/cat/longres.aspx?sk=44097.0)

_Source: https://www.imf.org/en/blogs/articles/2016/09/21/enhancing-monetary-policy-flexibility-through-de-dollarization_