How to De-Dollarize Financial Systems in the Caucasus and Central Asia?
POLICY RECOMMENDATIONS
Empirical results in this paper indicate that the CCA and other regions of the world share a number of common drivers of dollarization. These include frequent depreciations and high volatility of exchange rates as drivers of FX deposits, while high inflation increases FX banks’ lending. Both FX deposits and loans show strong persistence, and weak financial systems exacerbate financial dollarization.
In contrast to regions elsewhere, inflation volatility in the CCA increases both FX deposits and loans, while higher inflation, per se, only affects FX loans. Results also indicate that the asymmetric nature of exchange rate policies in some CCA countries induces depositors to hold a higher share of FX deposits to preserve their purchasing power. Finally, high levels of FX deposits encourage banks to lend to domestic borrowers in foreign currency to maintain matched balance sheet positions.
In light of these results, and building on successful de-dollarization initiatives in Latin America and Emerging Europe, a menu of policies aimed at macroeconomic stabilization, with a complement of prudential regulations is essential for the CCA countries.
Although there is no single formula for success, de-dollarization is a process that is largely endogenous to monetary policy and the degree of development of the financial system. From a macroeconomic perspective, although there is no unique formula for success, credible monetary and exchange rate frameworks, low and stable inflation, and deeper domestic financial markets are essential ingredients of any de-dollarization strategy. An inflation-targeting regime with flexible exchange rates and the absence of fiscal dominance would provide the best framework for market-driven financial de-dollarization (Kokenyne and others, 2010). Flexible exchange rate regimes that imply two-way risks contribute to lower dollarization levels. Broadly, regulations should make domestic agents internalize the risks of dollar intermediation, and authorities should actively promote the local currency (Ize and Yeyati, 2005). Dollarization should eventually decline in response to confidencebuilding and market-based policies that address the underlying problems that cause residents to seek out foreign-currency assets as a hedge against domestic macroeconomic instability or uncertainty. Monetary authorities can also decrease interest rate volatility by supporting domestic liquidity in the financial system and developing forward FX markets that allow residents to adequately hedge exposures.
CCA countries need further deepening of their financial systems to counter FX dollarization. Introduction of local currency–denominated securities with credible indexation systems, development of markets for instruments to hedge currency risks, enhancement of non-banking institutions and capital markets, improvement of credit information systems, strengthening of supervision, removal of administrative controls on interest rates, and introduction of unbiased taxation on income earned from FX deposits, bonds, or other financial transactions versus local currency taxes are all measures that can help discourage dollarization. As Garcia-Escribano and Sosa (2011) and Garcia-Escribano (2010) show, loan de-dollarization is facilitated by measures that foster capital markets, particularly long-term local-currency bond issuance. Luca and Petrova (2008) emphasize that developing forward and futures FX markets encourages de-dollarization by offering residents more sophisticated hedging mechanisms in the domestic currency. Kokenyne and others (2010) recommend that authorities actively manage public debt, create domestic bond markets, and promote alternatives to dollar-denominated assets, as well as hedging instruments for currency risk.
CCA policymakers should be aware that successful de-dollarization takes time, and therefore proper sequencing of policies is important. A study by the IMF (2006) suggests that a credible and successful macroeconomic policy of disinflation is likely to reduce dollarization over time. In this context, proper sequencing of policies is essential. For example, countries with less flexible exchange rate regimes can start by gradually widening the exchange rate bands, managing liquidity more efficiently, and improving the monetary transmission mechanism through more effective policy rates. Generally, policies that target the de-dollarization of deposits contribute to de-dollarization of loans (Garcia-Escribano and Sosa, 2011).
Effective communication by CCA central banks will be critical. More transparent and effective communication by central bank officials is also important for building public trust in the credibility of monetary policymaking. Ize and Yeyati (2005) note that de-dollarization is very closely linked to improving monetary credibility, arguing that reforms should build the institutional capacity of the central bank to pursue independent monetary policy. Establishing credibility may entail switching monetary regimes and introducing an explicit price stability mandate. A monetary policy framework rooted in credible communication of future actions can help enhance the attractiveness of the domestic currency through the expectations channel.
Increasing the attractiveness of the domestic currency is essential. Over the short term, CCA countries should focus on measures that make the local currency more attractive and reduce the asymmetry of exchange rate policy. Cayazzo and others (2006), Rennhack and Nozaki (2006), and García-Escribano and Sosa (2011) summarize some de-dollarization examples of successful countries in Latin American and Emerging Europe. Successful initiatives and prudential regulations in these countries include holding reserve requirements for FX deposits in local currency, imposing higher reserve requirements on FX deposits, and remunerating the reserve requirement on local currency deposits at a higher rate than for FX deposits. Some Latin American countries required banks to carry routine evaluations of currency risks, or, alternatively, to set up reserves as a percentage of foreign currency credit that has not been evaluated. Liquidity requirements have also been regulated, requiring banks to hold liquid assets of certain percentages on their short-term liabilities, with higher requirements for foreign currency than for domestic currency liabilities. Other measures include raising insurance premiums on FX deposits, limiting FX lending to un-hedged borrowers, requesting credit bureaus to provide currency-specific information on all debt, and requiring banks to conduct routine evaluations of currency risks.
It is important to encourage market-based de-dollarization as opposed to forced dedollarization. In an unstable macroeconomic environment, policy measures that force dedollarization may lead to capital flight, financial disintermediation, and banking sector instability (Kokenyne and others, 2010). De-dollarization measures that have failed in the past include the forced conversion of foreign currency deposits and the suspension of access to foreign currency deposits. Authorities should use caution in introducing interest rate or capital controls, policies that place limits on foreign currency borrowing or lending, and requirements to use local currency in domestic transactions. Furthermore, the regulatory burden associated with the de-dollarization process may lead to disintermediation or potentially more risky intermediation (Ize and Yeyati, 2005). Policymakers should thus be attuned to opportunities for regulatory arbitrage.
Finally, implementation challenges exist. When implementing de-dollarization measures, policymakers need to account for risks from potential financial disintermediation and instability, and/or capital flight. De-dollarization policies also face the difficult task of changing ingrained behaviors; in dollarized economies, the public becomes used to dealing in foreign currency and may resist the costs of switching to the domestic currency. Finally, because of the persistence of dollarization, de-dollarization may proceed very gradually, and policymakers may need to sustain reform momentum over many years.
This Working Paper should not be reported as representing the views of the IMF
Source: International Monetary Fund
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