ssrn-id412369 - Financial Dedollarization FINANCIAL...

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Unformatted text preview: Financial Dedollarization FINANCIAL DEDOLLARIZATION: A CARROT AND STICK APPROACH Eduardo Levy Yeyati 1 Universidad Torcuato Di Tella April 15, 2003 Abstract Financial dollarization (the holding by residents of foreign currency-denominated assets and liabilities) inevitably introduces a currency imbalance for the economy as a whole, amplifying the impact of real shocks. For this reason, it has been placed increasingly at the forefront of the policy debate in emerging economies. This paper argues that a successful strategy to reverse financial dollarization involves a two-way approach that includes: i) the adaptation of the prudential framework to address the externalities that tend to favor financial dollarization through the underpricing of real exchange rate risk, and ii) the development of domestic markets for local-currency substitutes to mitigate the impact of the currency switch on the domestic cost of funds. The paper discusses the main aspects associated with these two components and the menu of policy options in each case. 1 The author wishes to thank Eduardo Fernández Arias for his encouragement and invaluable suggestions, Eduardo Morón, José Licandro and participants at the XVIII Meeting of the IDB’s Latin American Network of Central Banks and Finance Ministries for their helpful comments, and the Inter-American Development Bank for financial support. 2 Financial Dedollarization I. Introduction Most of the earlier literature on de facto dollarization was concerned with currency substitution, as reflected by its focus on the dynamics of money demand (and, in particular, the link between dollarization and inflation) with a view to its monetary policy implications. This also seems to underlie the presumption, usually subscribed by this literature, that dollarization should recede with price stability.2 This presumption was visible at odds with the reality of the 90s: In most cases, dollarization levels remained high or even increased after inflation levels declined.3 This finding, combined with the fact that, as noted by many observers, much of the previous empirical literature faced a definitional conundrum (as money demand equations were estimated based on interest bearing deposits that generally account for the bulk of measured dollarization),4 gradually shifted the center of the debate from currency substitution to asset substitution or, more precisely, financial dollarization. Some definitions are in order at this stage. Here, following the conventions in the literature, currency substitution refers to the use of a foreign currency as a means of payment or unit of account, whereas asset substitution denotes its use as a store of value. Financial dollarization, in turn, simply denotes an empirical observation, namely, the holding by residents of foreign currency-denominated assets and liabilities (including non-bank assets such as commercial paper or sovereign debt). While descriptive in nature, this definition implicitly recognizes the presence of a home currency bias by which that the currency composition of residents and non-residents should differ, with the former more prone to invest in local currency assets than the latter. As a result, it suggests that financial dollarization is associated with the inability of certain countries to develop deep local currency markets.5 There are many reasons why financial dollarization has been placed at the forefront of the policy debate. First, inasmuch as financial dollarization influences the 2 The early literature on de facto dollarization is too extensive to be summarized here. Surveys can be found in Calvo and Vegh (1992 and 1997), Giovannini and Turtleboom (1994), Savastano (1996), and Baliño et al (1999). In what follows, following what has become standard in the dollarization literature, dollar and foreign currency, and peso and local currency are used interchangeably. 3 Explanations of dollarization persistence (referred to in the literature also as “hysteresis”) typically hinge on lack of credibility (e.g., the presence of large inflationary memory, as in Savastano, 1996) or network externalities (e.g., the costs of switching the currency of denomination of everyday transactions, as in Guidotti and Rodriguez, 1992). Both arguments, again, are consistent with a view of dollarization as a currency substitution phenomenon. 4 Calvo and Vegh (1997) already made this point. 5 Moreover, the definition highlights the differences between financial dollarization and the related concept of “original sin,” which denotes the inability to borrow in domestic currency internationally, due to foreign lenders’ unwillingness to lend in the borrower’s currency. See, e.g., Eichengreen et al. (2002) and references therein. By international (or external) debt we refer to debt issued under international (as opposed to local) Law. Thus, debt issued under New York Law would be domestic if the issuer is a U.S. resident and external otherwise. 3 Financial Dedollarization pricing behavior of firms and individuals, dollarized economies are induced to limit wide fluctuations in the nominal exchange rate due to their deleterious impact on inflation performance. As Chang and Velasco (2000) point out, “any scheme to control the rate of inflation at a short horizon must control, to some extent, the nominal exchange rate.” Moreover, and more to the point of the proposed agenda, while some dollarization may be warranted as a hedge exchange rate risk of tradable producers, widespread financial dollarization inevitably introduces a currency imbalance for the economy as a whole (either at the domestic banks’ balance sheets through local currency on-lending of foreign currency funds, or through real exchange rate exposure of dollar borrowers with income largely denominated in non-tradables as in the case of most local producers or the public sector). This concern has been flagged by most of the recent currency and financial crises.6 More precisely, a real exchange rate adjustment due to an adverse external shocks reduces the capacity to pay of foreign currency debtors (alternatively, its leverage ratio), amplifying the real impact of the shock. At the micro level, if the exchange rate or the domestic prices are free to adjust, the balance sheet effect affects producers of nontradables that suffer the relative price adjustment, and to the public sector inasmuch as its revenue is proportional to largely non-tradable product.7 On the other hand, if the exchange rate is fixed and prices are downward inflexible, the effect, while still stronger for non-tradable producers, spills over tradable producers through a protracted quantity adjustment (economic contraction). Inasmuch as this currency imbalance and the associated sensitivity to large real devaluations conditions the willingness of the monetary authorities to use the exchange rate as a shock absorber,8 the authorities’ unwillingness to let the real exchange rate fluctuate may in turn foster financial dollarization, as dollar debtors anticipate either a stable real exchange rate or, if this strategy becomes unsustainable, a government bail out.9 Similar arguments apply to the dollarization of public debt, that is, the empirical observation that many developing economies denominate public obligations in foreign currencies. However, while financial dollarization has generally been attributed to the country’s inability to borrow in its own currency, presumably due to the currency’s weakness,10 in the particular case of public debt one could alternatively argue that the 6 The recent crisis literature has emphasized the two-way association between currency and banking fragility. See, e.g., Kaminsky and Reinhart (2000). 7 It has to be noted that tradable producers may also be affected in the short run as their domestic prices are typically less than perfectly correlated with the international (foreign currency) price of their product. 8 This argument has been proposed by Calvo and Reinhart (2002), among others, to account for “fear of floating,” that is, the tendency to avoid substantial exchange rate volatility through foreign exchange intervention under formally floating exchange rate regimes. 9 See, among others, Burnside et al. (1999). Indeed, this implicit guarantee has been at least partially validated in many recent crises (Mexico 1994 and Brazil 1998). Certainly, the forcible pesification of debts in Argentina after the collapse of the currency board agreement was an extreme case in which these beliefs were ex-post fully confirmed. 10 Eichengreen et al. (1999) discuss this and other possible reasons. 4 Financial Dedollarization outcome is the result of a deliberate decision to signal the determination to avoid exchange rate movements, particularly in conjunction with a peg (that is, to mitigate a time inconsistency problem by increasing exit costs).11 The time inconsistency argument, modeled by Calvo and Guidotti (1990), is illustrated most clearly in the case of a fixed exchange rate regime with limited credibility. Since in this case costly domestic currency debt is efficient only as a hedge against a nominal exchange rate devaluation, its issuance immediately signals the government’s doubt about the sustainability of the peg, conspiring against the goal of building confidence in the regime.12 The time inconsistency argument, however, does not explain per se the remarkable differences in the capacity to issue local currency debt across countries. While these differences are often attributed to lack of credibility associated with the country’s track record, the credibility concept and its underpinnings are still quite elusive. Moreover, a focus on international markets and external debt (as opposed to the domestic demand for local currency-denominated assets) may be misleading. First, most industrial countries blessed with the capacity to issue debt in their own currency do that domestically (that is, under local, rather than international, Law). Second, there is a presumption (that begs empirical validation) that their local currency debt (both domestic and external) caters mainly domestic residents.13 Thus, the dollarization of developing countries’ external debt may ultimately be a reflection of their inability to lure domestic savings into local currency debt, that is, the flipside of the financial dollarization phenomenon that is the subject of this study.14 At any rate, due to the above considerations and a growing consensus that a financially dollarized economy suffers from important external vulnerabilities, the center of the financial dollarization debate appears to have shifted from a generally passive stance (a “learning-to-live-with-it” type of approach, focused on the conduct of monetary policy in a bi-currency environment and the strengthening of prudential norms to cope with the associated risks)15 to a more proactive one, oriented to limit the incentives that favor dollarization in the first place and to foster the development of local currency instruments. As a result, both heavily dollarized countries and international financial institutions have exhibited of late an interest in measures aimed at dedollarizing the economy, as well as in the experiences (successful or not) of those countries that attempted to prevent or revert financial dollarization. 11 Alternatively, short-sighted politicians may understate the long-run benefits of issuing more costly peso debt. 12 The argument is developed in De la Torre et al. (2003) to explain the increased dollarization of (both external and domestic) public debt in Argentina under the currency board agreement. 13 Anecdotal evidence suggests that the little local currency debt issued abroad by industrial countries is held largely by residents, typically due to tax considerations. At any rate, lack of proper information on debt holders is, on this issue, a crucial caveat. 14 If so, overcoming financial dollarization would also lead to the expiation of the original sin, which according to this argument will just be another symptom of a weak currency problem (namely, a local currency that is not accepted as a store of value). See De la Torre et al. (2002). 15 Baliño et al. (1999) is a good example. 5 Financial Dedollarization This agenda, however, is still in its infancy. With the exception of Chile and Israel, attempts to limit or undo financial dollarization by introducing local-currency indexed deposits have notoriously failed.16 Moreover, while more open to discussion now than in the early 1990s, financial indexation is still accepted with reluctance in policy circles, due to its potential spillovers to the real economy and its consequences on inflation inertia. On the other hand, many countries that avoided dollarization before by discriminating against, or directly banning on-shore dollar deposits have seen off-shore (dollar) intermediation growing.17 Thus, while there are cases where financial dedollarization has been partially achieved without hampering the development of local markets,18 much more analytical and empirical research is needed to assess whether and how a dedollarization should be pursued. The objective of this paper is to lie down the main components of a dedollarization agenda. To do so, section II revisits the main drivers of the phenomenon identified in the literature. Section III, in turn, discussing the main ingredients of a “carrot-and-stick” dedollarization strategy, namely measures to reduce dollarization incentives by internalizing and properly pricing currency risk (the stick), on the one hand, and to foster the development of local currency markets (the carrot). Section IV concludes. II. Main analytical issues Financial dollarization: Sources of concern Interest on de facto dollarization has been motivated basically in two different ways over the years. The earlier literature was primarily concern with its impact on the demand for money and its implications for the conduct of monetary policy, including its implications on the stability of money demand and the incidence of currency substitution on the pass-through of exchange rate movements on inflation.19 16 An assessment of the effectiveness of Brazil’s indexation is more complex since it combined with a ban of domestic dollar instruments. In addition, Brazil increasingly dollarized its domestic public debt after the 1998 crisis that led to the devaluation of the real, while dollar-denominated foreign borrowing by private sector firms has been on the rise since then. 17 Ecuador and Venezuela are but two examples. While the run on off-dollar deposits was a crucial factor behind the final move to de jure dollarization in the former, the latter has historically been characterized by substantial off-shorization and capital flight. On the other hand, massive disintermediation followed the forceful conversion of dollar deposits in Bolivia (1982) and Peru (1985), where dollar deposits were eventually reintroduced. 18 Besides Chile and Israel, which followed the indexation strategy, partial success has been achieved in countries as dissimilar as Mexico (through the development of local capital markets) and Poland (aided by high real interest rates). 19 The pass-through effect is still a question of considerable interest, particularly as inflation targeting regimes have come into fashion. Recent empirical estimates of pass-through and its determinants in 6 Financial Dedollarization By contrast, the recent focus on financial dollarization have stressed its negative prudential implications. In this regard, the most salient negative by-product of financial dollarization is the inherent real exchange rate (RER) exposure that it induces somewhere in the economy. As frequently noted, this systemic exposure may appear either at the bank level (if foreign currency positions are not limited by regulation) or, more typically, directly at the debtor’s level (through the exchange rate risk exposure of dollar indebted non-dollar earners, private or public). In the event of a negative real shock, a fully floating exchange rate adjusts so that the RER achieves its new equilibrium level, reducing the relative price of non-tradables and impinging on the payment capacity of non-tradable producers. The associated balance sheet effects underscore the propensity to limit RER variability by preemptive foreign exchange intervention, or directly by fixing the exchange rate. If prices are nominally flexible, however, the presence of a peg does not alter the story, as the RER adjustment comes through deflation, to the same effect.20 In a weak currency economy, once financial dollarization exceeds certain threshold, this currency mismatch is inevitable. Residents (and non-residents) prefer to save mainly in a foreign currency and, if this is restricted by the monetary authorities, in short-term local currency assets (inducing a maturity mismatch) or directly off-shore, leading to financial desintermediation. Thus, when financial dollarization is allowed, debtors from the non-tradable sector end up with debts denominated in tradables, increasing their exchange rate exposure. On the contrary, when not dollarized, a country with a weak currency displays financial contracts that re-price very frequently (e.g., deposits with interest rates that adjust daily in line with the overnight rate). The third alternative, namely the off-shorization of domestic intermediation when on-shore dollarization is restricted, again introduces, albeit in a hidden way, a systemic currency mismatch problem.21 An additional negative consequence of financial dollarization is its potential impact on the cyclicality of international capital flows. As the previous discussion indicates, negative external shocks tend to increase the leverage ratio of debtors in a financially dollarized country’s (alternatively, to reduce their capacity to pay) as both income flows and assets decline vis à vis debt service.22 In turn, given the procyclicality of the capacity to pay, it is not surprising to see that capital flows also behave developing economies can be found in Goldfajn and Werlang (2000) and Chodhuiri and Hakura (2002), among others. 20 In practice, instead, price rigidities induce a real contraction that compounds with the deleterious balance sheet effect, and even spills over to the tradable sector. 21 De la Torre et al. (2002) discuss these issues. Argentina is a good example of the first type: In the currency board period, financial dollarization was not only tolerated but also fostered by the authorities. A good example of the second type is Brazil, where not only is dollar intermediation severely restricted but interest rate indexation has been widely used in the past as a “policy crutch” to bolster financial intermediation in the local currency. Pre-crisis Ecuador is an example of the third kind. 22 While this procyclicality of the debt burden is no different from Fisher’s well-known debt deflation effect, its impact is amplified whenever the adjustment entails a sudden nominal exchange rate change. 7 Financial Dedollarization procyclically, demanding higher returns in bad times, and ultimately reverting once the impact of higher funding costs on the probability of default leads to rationing. In turn, capital flow procyclicality amplifies the real impact of the shocks, conspiring against the possibility of conducting countercyclical (monetary and fiscal) policies and, by increasing the volatility of returns on financial assets, inhibiting the deepening of long-term markets. By contrast, in a country without financial dollarization, the adjustment to a more depreciated equilibrium RER that comes through nominal depreciation of a flexible exchange rate typically improves (via debt dilution) the debtor’s capacity to pay, partially offsetting the effect of the economic slowdown. Thus, much of the current discussion on financial globalization and its role in the financial vulnerability of developing economies can be linked to the weak currency problem reflected in financial dollarization.23 Countervailing the perils of dollarization discussed above, there are gains provided by a more lenient strategy that allows or even facilitates financial dollarization, primarily its beneficial impact on the deepening of financial markets.24 While the latter goes hand in hand with the mispricing of risk and the financial vulnerabilities discussed in the introduction (and could even be attributed to them), it has been argued that, in some cases, dollarization is so entrenched that any attempt to reduce it may induce massive desintermediation, with a cost for the real economy that exceeds its long-run benefits in terms of greater financial resilience. Moreover, dedollarization may not be the only way out of the aforementioned prudential concerns, as the latter could be addressed, at least in theory, by alternative means (for example, through indexation of dollar instruments to commodity prices correlated with the country’s terms of trade).25 At any rate, the relative advantage of a financial dedollarizing strategy as a fix-all recipe should not be taken for granted. Financial dollarization: The drivers In order to counter financial dollarization one first needs to understand the factors that determine its persistence. A quick survey of the literature indicates that dollarization persistence (sometimes referred to as hysteresis) have been attributed, over the years, to one or more of the following causes: i. Long-lasting inflationary memories in economies with a track record of monetary mismanagement (e.g., Savastano, 1996); 23 Thus, the presence of deep domestic local currency markets could be regarded as a precondition to fully profit from more integrated capital markets. See De la Torre et al. (2002). 24 De Nicoló et al. (2003) find that financial dollarization is indeed associated with deeper financial markets, but only in economies with a history of high inflation. 25 One could argue that, in the limit, the distinction between indexed dollar instruments and peso instruments is rather blurred, particularly if the index is highly correlated with the country’s RER. However, unlike in the case of peso instruments, the exogeneity of the index of choice mitigates the moral hazard that underscores the time inconsistency problem. 8 Financial Dedollarization ii. iii. iv. v. The use of the dollar as unit of account in inflationary economies with high nominal stability (Guidotti and Rodriguez, 1992); Portfolio (hedging) considerations that point at the relatively stable real exchange rates and the incomplete adjustment of nominal interest rates as a source of demand for dollar assets (Thomas, 1985; Ize and Levy Yeyati, 2003); The time inconsistency problem of a peso-indebted government tempted to repudiate its debt ex-post through devaluation and inflation (Calvo and Guidotti, 1990); Market imperfections that lead to risk mispricing: a. Currency-blind financial safety nets such as deposit insurance or lender of last resort policy (Broda and Levy Yeyati, 2003); b. “Too-many-to-fail” considerations that create implicit debtor guarantees derived from the social and political costs of massive bankruptcies (Burnside et al., 2001), and c. Currency-blind or dollar-friendly financial regulation as a result of a signaling problem (as in the “peg trap” described in De la Torre et al., 2003).26 The first two explanations are primarily linked to the currency substitution approach to dollarization that stresses the negative connection between the demand for local currency and inflation in the first case, and between nominal instability and the choice of the unit of account, in the second. As such, they are relevant to the theme of this paper only to the extent to which currency substitution influences the currency composition of savings. The phenomenon of currency substitution, however, appears to be relatively minor even in those Latin American countries that exhibit high financial dollarization levels, as wages and most goods and services are denominated in the local currency.27 On the other hand, recent empirical studies find that the inflation pass-through is highly endogenous, depending, among other things, on the current inflationary context.28 This, combined with the low pass-through coefficients exhibited by Latin American countries in the aftermath of recent currency collapses, suggests that currency substitution and, in particular, dollar pricing, may have been overstated for the region. The last three groups of arguments in the list are inspired by the prudential implications that underscore the present agenda and, as such, are directly linked to the view of dollarization as an asset substitution phenomenon. To them I turn next. 26 In policy circles of dollarized economies dollarization is often attributed to mere habit, an argument partially related to the switching costs story in Guidotti and Rodriguez (1992), inasmuch as deposits provide liquidity services and may therefore be influenced by the unit of account of current transactions. In addition, monetary authorities have in some cases been prompted to introduce (or facilitate) foreign currency deposits due to the need to limit capital flight and to protect banks from runs induced by changes in the currency composition of local portfolios during inflationary episodes. 27 Typical exceptions are big-ticket items (e.g., real estate) and specific cases such as tariffs of privatized utilities in Argentina. 28 See, e.g., Goldfajn and Werlang (2000). 9 Financial Dedollarization The portfolio argument Ize and Levy Yeyati’s (2003) portfolio approach stresses as the main drivers of financial dollarization of resident investors and borrowers the volatilities of the real cash flow of assets in each currency, which in turn depend on the volatility of inflation (for peso assets) and real depreciation (for dollar assets). This approach leads to one important implication for the design of dollar-competing instruments: ceteris paribus, CPI-indexed deposits should generally dominate dollar deposits, as they minimize (and, if perfectly indexed, eliminate) real return volatility.29 As a result, they conclude that policies that target a stable real exchange rate to preserve competitiveness favor financial dollarization, and suggest, instead, a combination of floating exchange rates and inflation targeting as a combination that minimizes dollarization incentives.30 The implicit assumption made by this argument, notably that depositors measure the risk / return characteristics of financial assets in terms of the local consumption basket, points directly at the distinction between internal and external markets.31 More precisely, in the presence of risk aversion, for given exchange rate and inflation volatilities, instruments denominated in the local currency will look relatively more attractive to local savers (borrowers), as they mirror their stream of future consumption (income) more closely. As a result, it should be easier to introduce local currency instruments in domestic markets than abroad.32 The argument can be readily applied to the debate on dollarization of public debt. Countries with more limited domestic savings would tend to exhibit a larger share of foreign currency-denominated external debt. Indeed, there is some indirect evidence of a link between the currency of denomination and the financial center where it is issued, and some indication that past debt dedollarization processes have been driven by a deepening of the domestic markets.33 29 Note that the same is true for the borrower to the extent that the CPI is closely correlated with the price of the firm’s output. The non-trivial discussion of the choice of the proper index is resumed below. Two additional qualifications seem warranted. First, off-shore deposits (or dollars “under the matress”) are not directly comparable to indexed deposits in local banks due, e.g., to default and confiscation risk. Second, the fact that indexation is least accurate precisely in periods of high nominal volatility detracts considerably from the attractiveness of indexed assets, a concern that should be properly addressed in the design of the instrument. 30 On the other, economies with high pass-through coefficients (either because of their very open nature, or due to widespread dollar pricing as a remnant of past inflation episodes) are likely to exhibit higher dollarization ratios (in the limit, full dollar pricing eliminates the volatility of dollar assets). 31 This distinction was originally made by Thomas (1985) in a two-country setup. 32 The argument, however, ignores other non-financial income of domestic savers. If this income is negatively correlated with the real exchange rate, one should expect savers to diversify by investing in foreign currency assets. This CCAPM-type of argument, however, seem at odds with the very limited international diversification observed in practice. 33 See, e.g., Bordo et al. (2002). In a related paper, Claessens et al. (2003) find that the dollarization ratio of (internal plus external) government bonds is negatively related with the size of domestic financial markets. 10 Financial Dedollarization Similarly, developing countries with a sizeable stock of foreign assets in the hands of local investors are the most likely to profit from the development of local markets, once the underlying reasons for capital flight are properly addressed. This home currency bias argument also yields implications on the nature of the desired target for the introduction of local currency instruments. In particular, while most of the financial dollarization literature has focused on deposit funding, special consideration should be given to the demand of local institutional investors that is likely to be the first to demand local currency securities under a successful dedollarization strategy.34 The time inconsistency argument The time inconsistency argument relies on the fact that local currency instruments suffer from the government’s temptation to inflate away the real burden of the debt. If the government has no way to commit to low inflation, expectations that anticipate this behavior lead to the familiar inflation bias. Focusing on the public debt issue, Calvo and Guidotti (1990) argue in favor of partial dollar indexation as a way to reduce the inflation bias.35 The time inconsistency story, while focused on the currency of denomination of public debt, leave a number of questions unanswered. In particular, it does not fully explain why, in practice, some countries are more subject to the inflation bias than others, relying perhaps too strongly on the expediency of a poor track record. If the cost-benefit analysis of the repudiation-by-inflation decision hinges on the costs of servicing the debt, for a given repudiation cost, low repudiation expectations (low rates) will be selffulfilling as they tilt the balance away from repudiation, while high rates would do the opposite. Thus, a poor track record would be associated with high rates, high probability of repudiation, and high inflation bias, and vice versa. Moreover, if the government cares about inflation, a high inflation bias would dissuade a government from issuing peso debt if inflation concerns dominate prudential concerns related to real exchange rate exposure.36 In this case, debt dollarization could be interpreted as a deliberate choice by the issuer, rather than as the consequence of a lack of a missing market for peso debt, as the original sin view suggests. Then again, a poor track record is, at least from a policy 34 The Chilean case provides an example of the crucial role played by institutional investors in the development of local currency capital markets, as virtually all peso-denominated debt (including that not issued by the sovereign) is in the portfolios of private pension funds. Mexico’s recent experience with locally-issued peso debt points in the same direction. 35 They argue that full indexation may not necessarily be optimal since in that case a government facing an expenditure shock would not be able to apply the inflation tax on debt to smooth out the distorting effect of changes in other conventional taxes. Note that, according to this argument, CPI indexation should eliminate the incentive to monetize and solve the problem. 36 In the standard Calvo and Guidotti’s (1990) model, purchasing power parity holds so that dollar and CPIindexed debt are indistinguishable. As a result, real exchange rate shocks and, accordingly, exchange rate exposure consideration, are ignored. 11 Financial Dedollarization perspective, a rather unsatisfying answer to the key question, namely, what determines that one country enjoys one equilibrium or suffers the other.37 On the other hand, this approach does not (nor is its aim to) address the issue of private financial dollarization. In principle, dollarized public debt may indeed facilitate local currency borrowing as agents could perceive the fiscal cost of a devaluation as a guarantee that inflationary policies would not be pursued. While the time inconsistency argument could be extended to the case of a local currency-indebted private sector if the government perceives private debt-dilution as expansionary (or welfare enhancing), it seems unlikely that this argument by itself could explain high and increasing levels of private debt. The market imperfection argument A strand of explanations points to market imperfections related with the presence of externalities and an inadequate regulatory framework that fail to address them. The case of full (and currency-blind) deposit insurance discussed in Broda and Levy Yeyati (2003) illustrates the argument. If the activation of deposit insurance is more likely in the event of a sharp devaluation due to its correlation with debtor’s (and, in turn, banks’) solvency, dollar depositors are provided full protection against exchange rate risk in the worst states of nature at the expense of the deposit insurance agency. Thus, banks do not factor in the higher cost of dollar funding in bad states of nature, effectively reducing the peso-dollar spread and making dollar assets relatively more attractive.38 To mitigate this problem, the larger value of a currency-blind deposit insurance for dollar depositors should be factored in the insurance premium. Alternatively, coverage of dollar deposits should be equalize to that of peso deposits for a given currency-blind premium. However, pricing currency risk into the deposit insurance contribution may not be enough to undo the dollarization incentives. The implicit debtor guarantee argument introduces a quota of realism by highlighting the time inconsistency of the government’s decision regarding its involvement in the resolution of a banking crisis with widespread negative externalities. Much as in a standard Samaritan’s dilemma, the government may find it ex-post optimal to intervene in favor of dollar debtors if a nominal devaluation threatens to precipitate massive bankruptcies and a systemic financial crisis, with the associated costs in terms of social distress and loss of value.39 Thus, in contrast with the previous argument, dollar debtors (and, for that matter, banks) may not default even after a sharp devaluation. Debtors that anticipate this possibility may be lured by what they 37 This is particularly so iif we are willing to accept that investors are forward looking. The rapid rebound of capital inflows in many countries that faced debt crisis and even default relatively recently casts doubt on the relevance of track records to determine accessibility to international markets. 38 The same can be shown to happen in the absence of a deposit guarantee, inasmuch as the liquidation of the failed bank recognizes the larger peso value of the claims of dollar depositors. 39 Note that this induces an externality even if the government does not intervene ex – post, since the cost of massive bankruptcy, distributed as it is over the entire population, is not fully internalized by the borrower. 12 Financial Dedollarization judge to be artificially low dollar lending rates.40 Again, the problem is linked to the mispricing of exchange rate risk, in this case due to an implicit subsidy to dollar lending that is eventually financed through taxes (or through the partial confiscation of deposits as was the case recently in Argentina). This market imperfection is similar in nature to the familiar too–big–to–fail problem, except that in this case is compounded by the fact that the victims of the devaluation, while not necessarily large individually, are just too many to be ignored. The political economy of this decision, while relatively simple, is possibly the key factor in driving the massive debtor bailouts that follow a currency crisis in a financially dollarized economy.41 Inasmuch as there are no credible ways to prevent the government from undertaking such a massive transfer of wealth, preemptive actions (such as penalties for dollar intermediation) should be introduced ex-ante to correct this imperfection. Finally, the signaling argument was originally proposed for financial dollarization for the particular case of pegs. In a nutshell, the story stresses the fact that the government’s quest to build confidence on the sustainability of a fixed parity is at odds with any discrimination across currencies. In principle, this argument could be interpreted as an extension of Calvo and Guidotti’s (1990) to private financing. As argued by De la Torre et al. (2003), financial dollarization may be regarded as a constitutive ingredient of a fixed exchange rate strategy that borrows credibility from the existence of prohibitively high exit cost (of which the balance sheet effects derived from the inherent currency imbalance are a key component), thus overcoming the temptation to abandon the peg. Thus, financial dollarization could be interpreted as a deliberate action or, as the authors put it, “as a high-stakes strategy to overcome a weak currency problem.” III. Courses of action Many of the arguments previously discussed tend to be analytical and beg a more rigorous empirical exploration. In addition, no Latin American country has in recent years launched an explicit strategy to reduce dollarization, and most of the attempts on this front were at best half-hearted and, in some cases, misguided. Hence, the relative importance of the various drivers mentioned above (or others still not identified) is still an open question. However, as a preliminary benchmark, the discussion highlights two main fronts on which a potential dedollarizer should center his efforts. On the one hand, there is the question of incentives linked to the risk mispricing problem, which may stimulate excessive dollarization or explain its persistence. Addressing this question entails mainly 40 Indeed, the experience of recent currency crisis such as those in Mexico, Brazil, and Argentina provide strong support for this type of beliefs. 41 In a rational expectations context, however, the mere anticipation of these transfers should deter domestic savers from keeping their funds on-shore. However, the same political economy reasons explain why savers are not necessarily the net losers, as in practice the transfer tends to be spread over the whole taxpayer universe through the relatively more obscure expedient of public indebtedness. 13 Financial Dedollarization (but not exclusively) the revision and adaptation of existing prudential regulations in a way that eliminates distortions that hamper the use of the local currency for financial transactions. In order to attain this goal while minimizing the costs in terms of financial desintermediation, there is, on the other hand, the question of the design and introduction of local currency instrument and the development of (primarily domestic) markets for these instruments. Thus, any potential dedollarization strategy should adopt a carrot-andstick approach, increasing the cost of dollar intermediation while expanding the menu of peso substitutes and enhancing their attractiveness. In what follows, I describe in more detail the main issues associated with each of this two aspects. The Stick: Prudential Regulation Standard prudential best practices, as well as those actually implemented in financially dollarized economies, typically address currency imbalances at the bank level through limits on open currency positions, but tend to be silent on the credit risk associated with dollar loans to non-dollar producers. In addition, in those economies where dollar intermediation is allowed, regulatory frameworks are often currency-blind, possibly due to its short-term benefits in terms of deeper financial intermediation. Examples abound. In an extensive survey of deposit insurance around the world, Garcia (1999) finds that less than twenty out of seventy-two countries with bi-currency financial systems discriminate against foreign-currency deposits by excluding them from the insurance coverage. Similarly, uniform under-remunerated reserve requirements favor dollar funding, as the cost associated with the holding of liquid reserves is proportional to the funding cost in each currency, widening peso-dollar spreads. In turn, lender of last resort assistance does not discriminate against highly dollarized banks, despite the higher real exchange rate risk born by the latter. Less straightforward is the effect of general liquid assets requirements, characteristically high in financially dollarized economies. The fact that liquid reserves are used indistinctly in the case of a run detracts from the benefits of investing in pesos. The limiting case of currency-specialized banks illustrate this problem: inasmuch as peso deposits are of a transactional rather than an investment nature, peso banks, unlike dollar banks, should be less vulnerable to sudden changes in devaluation expectations. Bicurrency banks, instead, are likely to exhaust their liquidity to cope with a speculative run, triggering a preventive run of otherwise stable peso deposits. At any rate, by inducing a disproportionate tax on local currency intermediation or by failing to fully price exchange rate risk, prudential norms tend to generate a contingent aggregate liability that ultimately is assumed by the public sector in case of a sudden realignment of the real exchange rate. However, the use of prudential norms to limit the currency exposure at the firm level points directly to the trade-off between lower credit risk and reduced access to financing by non-dollar earnings. While exporters (and other dollar earners) should not be 14 Financial Dedollarization affected by this prudential tightening (and, indeed, should be benefited as dollar savings are freed from other uses), other borrowers with non-dollarized incomes (including producers of non-tradables and most individuals) will see their access to financing severely limited.42 As a result, a reasonable concern about the availability of sources of peso financing may lead policymakers to prefer an intermediate stance, raising the cost of dollar funding for the latter group without making it prohibitively costly. This leads to a second trade-off, namely, between strict quantitative limits (such maximum loan dollarization ratios or restrictions on the application of dollar funds) and proportional tax-like measures (such as higher risk weights or higher liquidity requirements on dollar assets). The question also applies to the prudential treatment of foreign vis à vis domestic borrowing, still subject to debate.43 In both cases, the time inconsistency problem is central to the analysis. As noted, even if prudential norms are revised so as to eliminate their pro-dollarization bias, one still has to deal with the perception of implicit guarantees generated by widespread financial dollarization, which, when anticipated, lead to the underestimation of exchange rate risk. Dollar mortgage loans provide a telling example: Is it reasonable to expect the government not to step in when a sudden depreciation of the local currency places a large fraction of the population at the risk of losing their homes? But, if the answer is negative, how can prudential norms credibly dissuade individuals from borrowing in dollars unless a quantitative limit on dollar lending is introduced? At any rate, while policy credibility is still an issue for debate, time inconsistency considerations may argue in favor of a quantitative cap on exchange rate exposure, particularly in those countries that offered exchange rate guarantees in the past.44 In sum, given the positive correlation between exchange rate risk and credit risk in financially dollarized economies, the value of any safety net (and, in turn, its fiscal cost) is typically higher for dollar instruments and has to be priced accordingly. Thus, in order to avoid cross-subsidies, exchange rate risk exposure should be factored in the provision of (both deposit and bank) insurance. Moreover, implicit insurance and other time inconsistency problems may render market-based measures (higher risk weights, larger bank contributions to the insurance fund) ineffective, justifying a move to quantitative exposure limits. 42 Hence, the emphasis of this paper on the importance of a two-sided strategy that fosters local currency intermediation at the same time (or even before) new prudential norms are phased in. 43 For example, liquidity requirements on foreign borrowing has been advocated invoking prudential reasons (and the need to avoid a differential treatment that stimulates foreign over domestic borrowing), but has been resisted as a barrier to capital mobility. 44 Argentina is a good example of the latter: all dollar debt was converted to CPI-indexed pesos after the devaluation. In addition, most mortgages were soon thereafter re-indexed to a (much flatter) salary index. 15 Financial Dedollarization With this in mind, a revision of safety nets and regulations deserve careful attention in the context of any dedollarization strategy. A number of aspects (some new, some already in place in many countries) are worth mentioning.45 Deposit insurance schemes can be amended in a number of ways. First, as in many countries, they may be specialized to include only peso bank deposits, (alternatively, deposit insurance may be provided up to a maximum local currency amount per claimant independently of the currency of denomination of the original claim). In addition, for a given insured amount, bank contributions could be higher for dollar deposits. As noted, however, the value of this measures lies in their impact on the marginal funding cost to the bank rather than in their disciplining effect on depositors, as in practice cases in which depositors suffer a substantial loss as a results of a bank failure are the exception rather than the rule.46 Along the same lines, liquid asset requirements can differ according to the denomination of bank liabilities, with greater shares associated with dollar liabilities. As before, inasmuch as bank liquidity is used to cope with deposit withdrawals in either currency, higher liquidity requirements can address banks’ exposure to a deposit run only partially. Their main impact, again, would come from the marginal cost of dollar funding. Exchange rate-related credit risk could be considered in the computation of capital adequacy ratios, for example, by raising weights for dollar loans to non-dollar earners. While the precise implementation of this measure (particularly, the way in which a borrower is assigned a “dollar earner” status) is not trivial, the criterion should be aimed at controlling potential currency imbalances. Therefore, extra weights could be a function of the ratio between dollar debt service and dollar income generated in the recent periods, much in the same way as dollar debt over exports is taken as a proxy of the capacity to pay of a sovereign. As a result, one should expect to see dollar lending rates increase with the “tradability” of the borrower. Assuming that a profit maximizing bank will translate the higher marginal funding cost directly to lending rates, the authorities may still face the problem of the contestability of the “export earner” status. If those cases in which a market-based pricing mechanism cannot be legally implemented, more drastic, quantitative limits on foreign currency lending, based on the export income of the borrower, may be warranted. As noted, even tradable producers may face a significant real exchange rate exposure in the event of a sudden devaluation, as the pass-through of exchange rate is far from perfect in the short run. This potentially higher credit risk of dollar debtors should be taking into account in the computation of general provisions, with higher provisioning 45 The discussion of prudential measures below assumes the existence of a limit on net foreign exchange positions at the bank level. 46 Note that, both here and in the discussion of other prudential measures below, the expected impact of the proposed revisions on dollarization incentives comes from its ex-ante incidence on relative intermediation costs in each currency rather. 16 Financial Dedollarization ratios associated with dollar loans, in order to isolate bank performance against exchange rate shocks much in the same way as dynamic provisioning does against real shocks in general.47 High bank liquidity requirements have been increasingly favored by financially dollarized economies as a way to compensate for the limited capacity of the central bank to fulfill its role as lender of last resort in the event of a systemic run. However, recent crisis episodes in Argentina and Uruguay attest to the limits of using the liquidity buffer to contain massive deposit outflows. Indeed, if the Argentine crisis showed us that the evolution of deposits differ according to type (with transactional deposits exhibiting significantly more stability), in Uruguay the authorities correctly exploited this difference ex-post by suspending convertibility of (mostly dollar-denominated) time deposits and assigning the remaining systemic liquidity to back demand and savings accounts, freezing the run while preserving the payments system. This principle could be readily applied ex-ante, without the need to resort to a dual system of transactions (peso) banks and investment (dollar) banks as sometimes proposed, by specializing the use of bank liquidity. A limit on the amount of liquidity that could be used to meet a run on time deposits or, more specifically, a stop-loss clause for time deposits that suspends their convertibility automatically (for example, once the liquidity ratio reaches a certain threshold) could reassure transaction depositors that bank liquidity would not be exhausted by the time they decide to make use of their funds.48 At any rate, this scheme could be readily used in a proactive way to stimulate the use of the local currency. For example, by earmarking the liquidity associated with peso deposits to meet withdrawals by peso depositors or, more drastically, by inverting the cross subsidy introducing a stop-loss clause on dollar (but not peso) deposits. It goes without saying that all of these measures merit a rigorous analysis that is ultimately related to the context of the individual economies attempting to dedollarize. Moreover, common to all of them is the general time inconsistency concern that plagues many prudential recommendations. How can a restricted deposit insurance scheme credibly rule out the possibility of an exchange rate guarantee once the short-run impact of a devaluation is imminent? How can an automatic reprogramming of time deposits be implemented (through the intervention of the regulatory authority) without impinging on the rest of the financial system? Having said that, all of them share the aim to introduce a peso-dollar wedge in intermediation costs to incorporate externalities previously swept under the rug of contingent fiscal liabilities. As such, the magnitude of this wedge should be based on a 47 On dynamic provisioning, see, e.g., Fernández de Lis et al. (2000). Note that a stop-loss clause is only different from early intervention by the bank supervisor in that it is announced ex-ante (leaving out discretionality and reducing time inconsistency) and, as a result, provides demand depositors with an explicit guarantee. Many other alternative ways of earmarking bank liquidity can be thought of to the same effect. 48 17 Financial Dedollarization clear understanding of the costs of these externalities. Moreover, while dollar funding could be judged to be artificially inexpensive in many cases, the risk of excessive real exchange rate exposure has to be weighted against the risk of financial distress and the cost of narrow peso markets if dedollarization relies too much on the stick of prudential regulation. Conversely, the net benefits of a dedollarization strategy depend crucially on its success in introducing alternative peso instruments to reroute savings within the domestic market. The carrot: Development of local currency markets Perhaps the main deterrent of a dedollarization policy is the fear of impending desintermediation: how to address the potential problem of underfinancing of the nontradable sector if dollar lending to these sectors is limited or banned by regulation, and long-term local currency markets do not materialize? Thus, while the prudential approach discussed in the previous section tends to diminish the incentives for dollar vis à vis peso intermediation, it needs to be complemented with the introduction of peso instruments that are attractive for both savers and borrowers. A key objective of a dedollarization agenda is then to assess the conditions for a successful introduction of these instruments, based on past experiences and on current country-specific considerations. For example, the Chilean and Israeli precedents suggest that CPI-indexed assets may have good chances to compete with dollar assets, and eventually reduce financial dollarization. However, comparable experiences in Argentina and Uruguay in the late 70s ended with a compulsory de-indexation as inflation picked up. Argentina provides yet another example of the type of contractual uncertainty that conspires against the use of indexation as a means to deepen and lengthen the peso market: in 2002, dollar mortgages were pesified and indexed to the CPI, only to be reindexed to a flatter wage index a few months down the road. Thus, indexation, presumably aimed at limiting the government’s temptation to inflate, can be the victim of contractual fragility.49 At any rate, institutional credibility (both fiscal, monetary and contractual) is essential for indexation to succeed. Efforts to foster demand for local currency deposits does not necessarily imply the recourse to indexation. In countries with a low inflation track record, peso deposits can gradually become an alternative to the dollar. While, as noted, successful dedollarizations (particularly those that did not resort to indexation) are few, the examples of Poland and Egypt in the 90s point in that direction.50 However, some sort of indexation, possibly 49 Interestingly, though, the same can be said of dollarization as a disciplinary mechanism, as many compulsory conversions in Latin American countries in the past, and the recent Argentine pesification attest. 50 Both in Egypt and Poland peso deposits increased their participation aided by high real interest rates, in the former due to the lifting of the interest rate ceilings that had underscored the deepening of dollarization in the first place, in the latter due to the implementation of a successful stabilization policy. While still an 18 Financial Dedollarization subject to a minimum maturity, may be needed if the goal is to extend the average maturity of deposit financing. Dedollarization attempts based on forcible conversions of dollar deposits to the local currency tend to yield rather dismal short-term results when not accompanied by measures to enhance peso intermediation. This was the case of Bolivia, Peru and Mexico in the 80s, where dedollarization was followed by massive capital flight and desintermediation. However, although dollar intermediation was eventually reintroduced in the first two countries, peso intermediation gradually took root in Mexico helped by quantitative limits on dollarization and years of nominal stability. Indeed, the successful dollarization process in Israel started after the government imposed a forcible conversion of deposits at a below-market exchange rate. Similarly, the deposit conversion in Pakistan in 1998 appears to have fared reasonably well so far, although it may still too early to judge. In this light, the recent Argentine pesification episode poses a real test for dedollarization. While intermediation is still far below the levels achieved in the 90s, indicating that residents still hold their financial savings largely in foreign currency assets, there are reasons to expect that a low inflation environment could, if preserved, fuel the demand for peso instruments. The creation of liquid peso markets involves not only (indexed and non-indexed) local currency deposits and loans. Alternative non-bank sources of local currency financing are likely to become increasingly important in the aftermath of systemic banking crises (as in the case of post-Tequila Mexico). Indeed, the historical evidence on dedollarization of public debt highlights the relevance of deep domestic capital markets, as in most the process entailed the substitution of new local currency debt for old foreign currency debt. That was the path chosen by countries such as Australia (due to a growing concern about currency mismatches after floating its currency in 1984) and Mexico (after the cautionary lesson of the 1994 Tequila crisis). How should peso instruments be introduced? The question encompasses several issues. First, there is the question of indexed vs. non-indexed instruments. While indexation is clearly a prime candidate in the context of a dedollarization strategy, as the experiences of Chile and Israel suggest, it is not the only way to go. At any rate, it has the advantage lies in its contribution to the lengthening of financial contracts rather than the depth of the markets.51 Alternatively, indexation of dollar-denominated instruments to a price closely correlated with the debtor’s income could in principle attain what could be labeled synthetic dedollarization, delinking the real cash flows of the asset (measured in units of incipient process, it is still worth noting a growing demand for long-run high-interest rate peso deposits in Peru. 51 Interestingly, financial dollarization in convertible Argentina did not provide a significant lengthening of bank deposits, suggesting, in line with this paper’s emphasis on non-bank financing, that longer-term funding has to be sought elsewhere. 19 Financial Dedollarization the debtor’s output) from the evolution of the exchange rate without changing the currency of denomination. While in practice these instruments may be more opaque for the average investor than plain-vanilla CPI-indexed assets and, as such, more difficult to market, they are, like the latter, free from moral hazard (as the government cannot partially dilute them through high inflation) and thus potentially attractive for sophisticated investors. Crucial in this regard is the exogeneity of the index of choice.52 Indexation entails a tradeoff between market depth (which calls for a minimum number of indexes) and the correlation between the index and the cash flows faced by individual investors and borrowers to minimize volatility (which calls for several customized indexes). Thus, while CPI-indexed assets may be an attractive catch-all option for small savers, they may suffer from inadequate demand on the borrowers’ side. Conversely, assets that follow the evolution of specific prices or sectors may look opaque or subject to manipulation to the public. The point is also related to the need to match indexed assets and liabilities at the bank level, which requires a wide acceptance of indexed borrowing, where standard CPI-indexation may be insufficient. In addition, indexation leads to (and can be fostered by) the need to adapt monetary policy, for example, through the issuance of public short-term indexed paper that serves as a benchmark for the computation of an indexed yield curve (if only for this reason alone, a single-index policy presents important benefits). Irrespective of the willingness of the public to adopt the new peso instruments, a dedollarization strategy is likely to face a serious liquidity problem at the start-up stage, as markets for local currency securities, at least in the short run, will not be able to profit from the existence of fully developed international markets for foreign-currency emerging market paper. For this reason, the government has a decisive role to play. In particular, it will have to incur the cost of a liquidity premium to be paid by early borrowers. In this regard, regulations governing the financial choices of institutional investors may contribute to reduce this early costs to the extent that it does not detract from their capacity of these investors to fulfill its role. For example, private pension funds could be used, as they are in many countries, to create a non-speculative demand for high quality long-term peso paper, contributing to increase the liquidity of these markets. Assuming that a dedollarization strategy is ultimately successful, we still has to face the transition problem: how to finance the non-tradable sector if savings in the local currency are, as expected, slow to take off? In addition to transition considerations (such as the speed of the introduction of dedollarizing measures to avoid a credit crunch), there may be long-run concerns arising from the credit bias that a dedollarization strategy may introduce between dollar-earners and the rest, particularly if dollar lending is made more costly (or directly banned) for the latter. While these transition considerations are 52 Indexation to a tax revenue index, for example, offers no such advantage. In this line, see Borensztein and Mauro (2002) on GDP-indexed bonds, and Caballero and Panageas (2003) on copper-indexed debt for the case of Chile. 20 Financial Dedollarization essential to the success of this strategy, one has to bear in mind that financially dollarized systems mask contingent liabilities that sooner or later find their way through to the fiscal accounts. Ultimately, the debtor’s currency imbalance represents a hidden subsidy (with cumulative costs that are made visible only in periods of systemic distress), which can be granted more transparently through the fiscal budget, reducing the incidence of crises along the way. IV. Final remarks The previous discussion outlines the contents of a research agenda that is long overdue, particularly in light of recent developments in financial markets. The conclusions of this agenda should inform important aspects of exchange rate and monetary policy management, and should help adapt existing prudential regulations to the emerging market context. Whereas financial dollarization has become a relevant issue for emerging markets as a whole, a solid background that helps avoid well-intentioned but ultimately misguided policy experiments is still lacking. Providing policymakers with some pointers in that direction was the purpose of this paper. At the onset, any dedollarization strategy should entail a two-way approach. On the one hand, a revision of prudential regulation to address ex-ante the externalities associated with financial dollarization that favor the use of the dollar. On the other, the resulting increase in dollar funding cots (the “stick”) will likely have negative real and financial effects unless this revision is phased in pari passu with the introduction and promotion of peso instruments to channel the currency switch (the “carrot”). This paper tried to summarize some of the recurrent issues that arise whenever financial dollarization is discussed and suggestions as to how they could be dealt with, but left out many others (including some that may arise as the agenda specializes to the case of individual countries). Needless to say, any successful dedollarization strategy should be accompanied by sound monetary policies, as the Chilean and Israeli experience attest. However, as witness the Argentine convertibility, the Uruguayan crawling peg or the Peruvian managed float, sound monetary policies are necessary but not sufficient. At any rate, a proactive agenda with specific measures aimed at mitigating the presence of externalities and enhancing the attractiveness of local currency assets is needed to complement conducive macro policies. 21 Financial Dedollarization REFERENCES Baliño, Tomas, Adam Bennet, and Eduardo Borensztein, 1999. “Monetary Policy in Dollarized Economies,” IMF Occasional Paper 171. Bordo, Michael, Christopher Meissner and Angela Redish (2002). How “Original Sin” was Overcome: The Evolution of External Debt Denominated in Domestic Currencies in the United States and the British Dominions 1800-2000. Mimeo. Borensztein, Eduardo and Paolo Mauro (2002). Reviving the Case for GDP-Indexed Bonds. IMF Policy Discussion Paper 02/10. Broda, Christian and Eduardo Levy Yeyati (2003). Endogenous Deposit Dollarization. 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This note was uploaded on 05/29/2011 for the course ECON 101 taught by Professor Eduardofernándezarias during the Spring '11 term at Universidad Torcuato Di Tella.

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