Understanding Dollarization

Emre Ozsoz, Erick W. Rengifo

• Publisher: De Gruyter Oldenbourg
• Year: 2016
• ISBN:
  9783110434033
• Edition: 1
• Topic: Économie
• Subtopic: Macroéconomie

A very commonly observed phenomenon in developing and emerging market economies is the use of another country's currency (whether the US dollar or another currency) in lieu or in addition to the local currency. The most common type of this financial phenomenon is partial (de facto) dollarization where foreign currencies are used side by side with local currency for saving and borrowing purposes in addition to serving as medium of exchange.

Governments in these countries have been encouraging dollarization for years by allowing their citizens to save and borrow from local banks in foreign currency. Yet the existence of multiple currencies on banks' balance sheets on both the asset and liability side poses risks to the health and stability of the banking system.

This book evaluates the practical aspects of partial dollarization in countries such as Turkey, South Korea, Peru, and Cambodia among others. Starting with the origins of the phenomenon, the impact on banking systems and financial depth of the credit markets are discussed along with risks to the banking systems. Challenges faced by Central Banks and banking regulators are evaluated using recent country studies.

1A Primer on Dollarization

1.1Introduction

Traditionally, each country and economic territory has issued and circulated its own currency. By its most common definition, a currency is a form of fiat money issued by a government and used within a certain economic region. Money can be described by its functions as a medium of exchange (to buy and sell goods and services), as a unit of account (to keep track of revenues, costs and profits), and as a store of value (to save, and smooth consumption over time).

However, it is important to note that in an increasingly globalized marketplace, where not only goods and services but also people and capital move across borders, governments have lost their monopoly over the currency used among their citizens. This is particularly true for emerging economies.1

Currency substitution, or Dollarization, refers to the use of another country’s currency in exchange of or in addition to the local currency. This phenomenon has become widespread in today’s global economy.

This definition can be expanded to include the degree by which “real and financial transactions are actually performed in dollars relative to those performed in local currency” (Ortiz, 1983).

The term “dollarization” was coined after the US Dollar, since it has traditionally been the most preferred replacement currency of choice. Nowadays, the term “dollarization” generically refers to the use of another country’s currency (not necessarily the US Dollar) in addition to or in exchange of a local currency.

According to FED’s estimates as of 2011, almost $538 billion of US currency in print was held outside the US, and nearly two-thirds of all $100 bills were in use outside US borders (Judson, 2012). Considering that 6.7 billion people live outside the US, this translates into an average of 80.3 US dollars in every non-American’s pocket worldwide.

Another way of examining the use of foreign currency is to observe the currencies used for international trade transactions (trade dollarization). Table 1.1 shows the percentage use of foreign currencies in global trade finance, and provides an illustration of the relative importance of these currencies on an international scale.

In what follows in this chapter, we explain the concept of dollarization in detail and consider several important aspects of dollarization. The remainder of the chapter proceeds as follows. Section 1.2 defines different types of dollarization. Section 1.3 provides an overview of the causes of dollarization, and Section 1.4 discusses the peculiarities of banking in a dollarized economy. Section 1.5 provides a brief historic description of dollarization around the globe, and Section 1.6 discusses the impact of different exchange rate regimes and their relationship with dollarization.

Table 1.1: Percentage participation of several currencies in trade finance.

Currency	%
EUR	42.09
USD	31.12
GBP	8.48
JPY	2.41
AUD	2.18
CAD	1.89
CHF	1.83
SGD	1.04
SEK	0.98
HKD	0.96
NOK	0.87
THB	0.76
RUB	0.61
CNY	0.51
DKK	0.51

Data as of September 2012.

Source: SWIFT.

1.2Asset vs Currency Substitution

Before we proceed with a more detailed analysis of dollarization and its causes, it is important to distinguish between two causes that determine the demand for foreign currencies and assets: currency and asset substitution.

Asset substitution is centered on portfolio allocations where investments in foreign currency denominated assets are determined based on their positive and larger expected returns and their marginal contribution to the risk of the overall portfolio.2 This phenomenon is particularly notable in high inflation environments, where local economic agents look for ways of obtaining positive real interest rates.3 In order to achieve real returns, local investors typically select assets that are denominated in hard currencies—for example, the US dollar or Euro—that provide a greater degree of protection against inflation and isolate their portfolios from local currency risk.

On the other hand, currency substitution refers to the use of foreign currency to replace the roles of local currency with regard to its use as a unit of exchange and as a unit of account. We explain some of the reasons behind this in the following chapters.

1.3Official and Partial Dollarization

The dollarization phenomenon is observable in different forms. Some countries may choose to give up their local currency entirely and adopt another country’s currency as legal tender. This type of dollarization is known as “official” or “de jure” dollarization and is observable in more than ten countries (Table 1.2).

Countries decide to embark on a path of full dollarization for a number of valid reasons. Amongst these motives are the desire to eliminate sudden and strong currency depreciations, to reduce the interest rates on their (public and private) international loans by reducing depreciation risk premiums, to attract more foreign direct investment and portfolio investment and to cut the costs of servicing debt. Dollarization can be judged as a commitment towards low inflation, fiscal discipline and transparency (Berg and Borensztein, 2000).

Heavily dollarized economies carefully consider depreciation risk. Economies with high ratios of dollarized loans (public and private) and large capital inflows are particularly vulnerable to sudden depreciation pressures. As we describe in more detail later, a sudden and large depreciation of local currency automatically raises the value (in local terms) of the outstanding balance on a dollar-denominated loan, which negatively affects not only public finances, but also the finances of citizens and firms who have foreign currency denominated loan obligations. Consequently, such currency depreciation can cause banking crises and social unrest as citizens see their wealth eroded.

Table 1.2: A selection of countries and territories that are officially dollarized.

Countries that have adopted the US dollar as legal tender	Countries that have adopted the euro as legal tender	Countries using a third currency as legal tender
British Virgin Islands	Andorra	Cook Islands (New Zealand Dollar)
Caribbean Netherlands	Kosovo	Nauru (Australian Dollar)
East Timora	Mónaco	Lesotho (South African Rand)
Ecuadora	Montenegro	Macau (Hong Kong Dollar)
El Salvador	San Marino	Palestinian Territories (Israeli
		Shekel)
Marshall Islands	Vatican City	Turkish republic of Northern
		Cyprus (Turkish lira)
Micronesia
Palau
Panamaa
Turks and Caicos

a Uses its own coins.

Source: Edwards and Magendzo (2003).

However, even though currency risk is reduced by full dollarization, it is possible that the interest rates charged on public debt will not decrease due to the existence of other risk factors. For instance, a country’s default or sovereign risk (measured as the spread between yields on local currency bonds over US Treasuries) may implicitly reflect other fundamental information about the health of the economy. This information could include the existence of political instability, a lack of national security, growing income inequality, poverty and social unrest or other such socio-economic variables. Such risks may not be p...