Dollarization and Crises:
Ways In and Out
Alejandro Izquierdo
De-dollarization Strategies and
Domestic Currency Debt Markets in
Emerging Economies
Okinawa, Japan
April 8 2005
Outline
I.
Sudden Stop, Devaluation and Dollarization:
Key Facts
II. Determinants of Sudden Stops: Domestic
Liability Dollarization
III. How did we get there?
IV. Ways out: Successful Experiences
Sudden Stop in Emerging Asia
and LAC-7
(Capital Flows, USD million, last four quarters)
Asian
Crisis
120000
Russian
Crisis
100000
LAC-7
60000
40000
20000
0
-20000
Note: LAC-7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Emerging Asia
includes Indonesia, Korea, Malaysia, Philippines and Thailand.
Source: Central Banks.
2004-III
2004-I
2003-III
2003-I
2002-III
2001-III
2001-I
2000-III
2000-I
1999-III
1999-I
1998-III
1998-I
1997-III
1997-I
1996-III
1996-I
1995-III
1995-I
1994-III
1994-I
1993-III
1993-I
1992-III
1992-I
1991-III
1991-I
1990-III
-60000
2002-I
Emerging
Asia
-40000
1990-I
Millions of USD
80000
Real Exchange Rate Adjustment
(vis-à-vis US dollar, Jan-90=100)
210
Russian
Crisis
190
Emerging
Asia
170
150
130
110
LAC-7
90
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-92
Jan-91
Jan-90
70
Note: LAC-7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Emerging Asia
includes Indonesia, Korea, Malaysia, Philippines and Thailand.
Domestic Liability Dollarization
• For some countries, credit in dollars was high as
share of GDP (Domestic Liability Dollarization, or
DLD) before the crisis
• Payments system is at stake following devaluation
Emerging Asia
21.0%
Indonesia
15.0%
Korea
8.8%
Philippines
32.0%
Thailand
28.1%
LAC-7
9.9%
Argentina
21.3%
Brazil
4.4%
Chile
2.3%
Colombia
3.3%
Peru
18.2%
Source: Calvo, Izquierdo and Mejia (2004) and own calculations.
Outline
I.
Sudden Stops and Devaluation: Key Facts
II. Determinants of Sudden Stops: Domestic
Liability Dollarization
III. How did we get there?
IV. Ways out: Successful Experiences
Determinants of Sudden Stops:
DLD and Tradable Output
• Low tradable output levels (as a share of the absorption
of tradables) will place the brunt of adjustment on the
real exchange rate (RER) if a Sudden Stop occurs.
• Together with high DLD they are an explosive cocktail
Tradable Output
• Key difference between Emerging Asia and LAC-7:
Tradable output (Y*) relative to the absorption of tradable
goods (A*) (compensates for higher pre-crisis dollarization)
• Emerging Asia’s reaction to currency depreciation was
stronger in terms of the expansion of tradable output
1.30
ω
Y S
A*
*
*
1.25
Emerging
Asia
1.20
1.15
1.10
1.05
1.00
0.95
0.90
LAC-7
0.85
0.80
1996
1997
1998
1999
2000
2001
2002
2003
EA Pre-crisis ω: 0.93. LAC-7 Pre-crisis ω: 0.88
Source: Own calculations based on data from WDI and WEO databases.
Dollarization is an Addiction,
Just Like Smoking
• We know that dollarization is bad for a
country’s health: it brings crisis (cancer)
• As with any addiction, the first step is to
acknowledge that there is a problem. But in
order to quit, two questions must be
answered:
How do countries get hooked on smoking?
Is there a “patch” to stop smoking?
Outline
I.
Sudden Stops, Devaluation and Dollarization:
Key Facts
II. Determinants of Sudden Stops: Domestic
Liability Dollarization
III. How did we get there?
IV. Ways out: Successful Experiences
Latin America: Macroeconomic
Policies and Currency Substitution
• A history of high
fiscal deficits,
loose monetary
policy and high
inflation lies
behind most
dollarization
episodes in LAC
Domestic Liability Dollarization
Spreading the virus to
the financial sector:
• Banks have typically
matched dollar
deposits with dollar
loans
• But a large share of
dollar loans was on
lent at home, leading
to currency
mismatches in nontradable sectors and
balance-sheet
effects
Emerging Asia: Bank Foreign Borrowing
(Foreign Liabilities / (Total Deposits + Foreign Liabilities))
30%
Asian Crisis
Russian Crisis
25%
20%
15%
Note : Average for Indonesia, Korea, Malaysia, Philippines and Thailand. Source: IFS
Jul-04
Jan-04
Jul-03
Jan-03
Jul-02
Jan-02
Jul-01
Jan-01
Jul-00
Jan-00
Jul-99
Jan-99
Jul-98
Jan-98
Jul-97
Jan-97
Jul-96
Jan-96
Jul-95
Jan-95
Jul-94
Jan-94
Jul-93
5%
Jan-93
10%
Outline
I.
Sudden Stops, Devaluation and Dollarization:
Key Facts
II. Determinants of Sudden Stops: Domestic
Liability Dollarization
III. How did we get there?
IV. Ways out
Latin America: Currency Substitution
and Hysteresis
• Reducing inflation (the
factor that made
countries engage in
DLD) should be part of
the strategy. But is it
enough?
• Hysteresis: cumulative
experience in using
dollars reduces the cost
of transactions in dollars
(Uribe, 1997). Reducing
inflation is not enough to
reduce dollarization
What Didn’t Work
• Reinhart, Rogoff and Savastano (2003):
- Forced de-dollarization does not seem to be
the answer): Bolivia and Peru
- Even when forced de-dollarization succeded,
there were costs:
- The size of the domestic banking system
fell (credit to the private sector in Mexico
halved two years after conversion in 1982)
- Capital flight: substantial holdings of
offshore deposits
• Taxes on holdings of US$ deposits leads to
disintermediation via off-shore deposits (Peru)
What Did Work: The case of Israel
• Reinhart et al (2003) identify only two successful
cases of lasting declines in dollarization without
heavy costs in financial intermediation or capital
flight: Israel and Poland
• Flexible exchange rates have been proposed as the
main factor leading to lower liability dollarization.
• But the choice of a fixed exchange rate regime may
be the consequence rather than the cause for
liability dollarization, because the costs of floating
are high when heavily dollarized.
• How did Israel do it? Were there any additional
“patches”?
Inflation & RER Volatility
• If individuals care about buying a basket of goods,
they will allocate their savings so that they minimize
the risk of being unable to buy that basket.
• The return on dollar deposits depends on the dollar
price of that basket (RER depreciation)
• While the return on domestic-currency deposits
depends on the “peso” price of that basket (inflation)
• Low volatility of inflation relative to the volatility of
RER depreciation should lead to de-dollarization.
Israel: Inflation and RER
Volatility
0.006
Inflation
Volatility
0.005
0.004
0.003
0.002
Jan-04
Jan-03
Jan-02
Jan-01
Jan-00
Jan-99
Jan-98
Jan-97
Jan-96
Jan-95
Jan-94
Jan-93
Jan-91
Jan-90
Jan-89
Jan-88
Jan-87
Jan-86
0
Jan-85
0.001
Jan-92
Real
Depreciation
Volatility
Note: Variances are calculated over a 5-year moving window.
Source: Own calculations based on data from IMF-IFS.
• Lowering inflation volatility relative to real
exchange rate volatility may be part of the answer
.4
.3
.2
Dollarization
.5
.5
.
Israel’s De-dollarization and
Exchange Rate Band
Dollarization 45%
44% (1985)
Dollarization 18%
17% (2001)
Or was it Also the “Patches”or
Additional Measures?
But Israel also pursued additional policies (Galindo
and Leiderman (2003)), many of them “patches”
to reduce the costs of floating:
• Initially, one year mandatory holding period
for dollar deposits
• Offered CPI-indexed deposits
• Banks required active hedging of currency
risk for non-tradable activities
• Active development of financial derivatives
markets
• Made effort to deepen local currency bond
markets
And it worked: deposit dollarization went down to
18% of total deposits (2001) from 45% (1985)
The Current Situation: Long-run
Trend or Short-run Opportunism?
Renewed interest in domestic currency
lending (e.g., the case of Colombia, 2004):
- Is it “Leaning against the wind” policies
and appreciation expectations? Or,
- Based on the Argentine experience: can it
be more costly to lend in dollars?
The Role of IFIs?
• Multilateral lending in domestic currency,
hedging currency risk with the recipient
country: To what extent does this shield EMs
from the effects of dollarization?
• Issuance of domestic-currency multilateral
debt in the recipient country (on lent in
domestic currency): Will it crowd out
issuance of public debt? (country risk vs.
exchange rate risk).
Dollarization and Crises:
Ways In and Out
Alejandro Izquierdo
De-dollarization Strategies and Domestic
Currency Debt Markets in Emerging
Economies
Okinawa, Japan
April 8 2005