Domestic liability dollarization, also known as financial dollarization, refers to the use of foreign assets and liabilities such as the U.S. dollar by residents in the financial system of a country. It occurs when residents of a country extensively use the U.S. dollar or another foreign currency alongside or instead of the domestic currency.
Introduction
Domestic liability dollarization has become an increasingly common phenomenon around the world. Countries with unstable monetary policy, high inflation rates, economic uncertainty, and underdeveloped financial systems are more likely to see high levels of dollarization. For individuals and businesses, holding foreign currency can protect against devaluation and volatility risks associated with the domestic currency. However, dollarization also presents risks for the broader economy related to credit, interest rates, financial stability, and the ability of central banks to act as a lender of last resort.
This guide will provide an in-depth look at domestic liability dollarization, including:
- Causes and risks of dollarization
- Measuring the extent of dollarization
- Impacts on monetary policy
- Relationship to exchange rate regimes
- Dollarization levels around the world
- Strategies for managing a dollarized economy
By the end, you will have a comprehensive understanding of this complex economic phenomenon including its origins, effects, measurement, and policy implications.
Causes and Risks of Domestic Liability Dollarization
Several key factors can motivate residents in a country to use foreign currency:
High Inflation and Currency Devaluation
Countries with histories of high inflation and currency depreciation encourage dollarization as a means of protecting purchasing power. Holding domestic currency assets carries high inflation risks. Foreign currencies like the U.S. dollar provide a more stable store of value.
Financial Underdevelopment
Underdeveloped capital markets and financial instruments in domestic currency also encourage dollarization. Residents will be more likely to prefer foreign currency deposits and debt issuance if domestic currency alternatives are limited.
Economic Volatility
Periods of economic uncertainty related to politics, budgets, oil prices, or other factors can spur dollarization as residents look for safer assets. Demand for dollar-denominated assets tends to rise during periods of instability.
Interest Rates
Higher interest rates available on foreign currency deposits compared to domestic currency deposits may provide an incentive to dollarize. This interest rate differential stems from higher country risk associated with holding domestic currency.
Capital Account Liberalization
Allowing free flows of capital across borders enables residents to more easily hold foreign currency abroad. Countries that have removed capital controls often exhibit higher dollarization.
While using foreign currencies can benefit individual residents and companies, economy-wide dollarization carries risks including:
Currency Mismatching
Borrowers may hold dollar liabilities but earn income in domestic currency. Currency depreciation then makes repaying debts more difficult.
Reduced Monetary Policy Effectiveness
With dollarization, central banks lose control over money supply and credit conditions, limiting the ability to respond to economic fluctuations.
Greater Risk of Financial Crisis
Reliance on foreign capital inflows brings vulnerability to external shocks. Sudden capital flow reversals can collapse credit and asset prices.
Loss of Seigniorage Revenue
As dollarization rises, the domestic central bank earns less revenue from issuing currency since the foreign currency often substitutes for domestic money.
Banking Sector Fragility
Banks are also vulnerable to currency mismatches between foreign currency liabilities and domestic currency assets. Currency fluctuations produce solvency issues.
Overall, while dollarization may sometimes emerge as a rational individual response to economic conditions, high economy-wide dollarization can amplify volatility and financial crises. Policymakers should be cautious about allowing excessive growth in foreign currency use within the domestic financial system.
Measuring the Extent of Dollarization
Dollarization is difficult to measure precisely since foreign currency activity is not always reported in official statistics. However, economists use several metrics as proxies to gauge dollarization levels:
Foreign Currency Deposits/Total Deposits
The ratio of foreign currency deposits made at domestic banks to total deposits gives a sense of the degree of asset substitution away from domestic money. A higher ratio indicates greater dollarization of the banking system.
Foreign Currency Credit/Total Credit
This ratio captures the amount of domestic lending issued in or linked to foreign currencies relative to total credit. Higher foreign currency lending implies greater liability dollarization.
Real Estate Values in Foreign Currency
Another indicator is tracking the share of real estate transactions, property listings, and mortgages denominated in dollars or another foreign currency. Greater foreign currency presence in property markets signals increased dollarization.
Currency in Circulation
As households substitute foreign currencies for domestic money, the ratio of foreign currencies to total currency in circulation will rise. Central banks track this currency substitution.
Offshore Banking Activity
Large flows of domestic residents’ funds into offshore accounts and foreign assets may indicate greater dollarization of savings and financial activities.
Illegal Currency Trading
On the black market, higher premiums paid to acquire foreign currency with domestic currency can signify more pervasive unreported dollarization among households.
Using a combination of these quantitative measures, dollarization levels can be estimated and tracked over time. Country authorities need reliable statistics to ascertain risks and design effective policy responses.
Impacts on Monetary Policy
High levels of financial dollarization can greatly limit the effectiveness of monetary policy in several ways:
Limited Control of Money Supply
The central bank loses control over broad money supply as residents substitute between domestic and foreign money. This constrains ability to influence inflation and output through money growth.
Interest Rate Channel Weakness
With dollarized liabilities, changes in domestic interest rates do not alter credit conditions or spending much because foreign rates stay constant. This reduces central bank influence over demand.
Exchange Rate Channel Limits
Dollarization reduces the impact of exchange rates on competitiveness and trade balances. This dampens the ability to steer economic activity through currency depreciation or appreciation.
Inflation Targeting Difficulties
Achieving an explicit inflation target becomes more challenging. Dollarization deprives central banks of ability to hit targets through money supply and interest changes.
Lender of Last Resort Constrained
Providing liquidity as lender of last resort also loses effectiveness with dollarization. Foreign currency limits ability to act, and moral hazard arises backing foreign liabilities.
Fiscal Dominance Risk
Dependence on seigniorage revenue falls, so inflationary fiscal financing of deficits grows tempting. This leads to fiscal dominance over monetary policy.
In these ways, dollarization constrains central banks from conducting countercyclical stabilization policy using standard monetary levers. Additional policy tools may be needed to manage economic fluctuations.
Relationship to Exchange Rate Regimes
The choice of exchange rate regime interacts with the process of dollarization in complex ways:
Fixed Rates Encourage Dollarization
Pegs, currency boards, or full dollarization directly promote liability dollarization by reducing exchange rate flexibility and risk. But inability to adjust the peg can spur later financial crises.
Flexible Rates Discourage Dollarization
Floating exchange rates make domestic currency financial instruments less risky and foreign currencies less appealing. But flexible rates alone do not address root causes of dollarization.
Dollarization Creates Fear of Floating
Authorities are less willing to allow flexible rates with high dollarization due to greater pass-through of currency changes to balance sheets and financial stability risks.
Low Dollarization Permits Greater Flexibility
Conversely, countries with low dollarization have more options for floating exchange rates. The exchange rate can serve as a shock absorber without major negative impacts.
Gradual Depreciation May Aid Transition
Countries seeking to reduce dollarization levels can do so faster under a controlled, pre-announced path of gradual depreciation rather than sudden large adjustments.
Overall, exchange rate regimes both influence and are influenced by dollarization processes. Policymakers need to consider these interactions in setting their optimal regimes. Transitions between regimes require careful management to avoid financial turbulence.
Dollarization Levels Around the World
While dollarization is spreading globally, it remains primarily concentrated in developing economies and emerging markets. Some patterns in dollarization levels:
- Latin America – High levels, especially in Argentina, Bolivia, Peru, Uruguay
- Eastern Europe – Significant in many countries like Georgia and Ukraine
- Africa – Mostly low but rising in some areas like Zimbabwe
- Middle East – Moderate in places such as Lebanon and Tunisia
- Asia – Fairly low overall but rising in Vietnam, Cambodia, Mongolia
In contrast, advanced economies like the U.S., Eurozone, and Japan exhibit little dollarization due to stable monetary policy, developed financial systems, and strong rule of law.
Variations in dollarization result from different historical factors including high inflation episodes, policy choices, institutional quality, and macroeconomic performance. Dollarization generally remains below 50% in most developing countries but still exerts significant economic influence.
Strategies for Managing a Dollarized Economy
Despite risks, eliminating all dollarization is unrealistic in many developing countries. Full de-dollarization can take decades. Given constrained policy options, how can authorities manage a highly dollarized economy? Useful policy strategies include:
Build Credibility of Monetary Policy
Establishing a track record of low inflation and exchange rate stability helps shift savings and borrowing back into domestic currency. This takes time and consistency.
Develop Local Currency Bond Markets
Expanding the availability and liquidity of long-term bonds denominated in domestic currency provides viable alternatives to foreign currency debt.
Allow Some Exchange Rate Flexibility
Modest exchange rate movements in line with fundamentals help reduce perceived risks of local currency and allow monetary autonomy.
Use Capital Flow Management
Remaining open to foreign capital inflows while limiting outflows can reduce offshore holdings and facilitate de-dollarization.
Provide Responsible FX Liquidity
The central bank can continue to supply foreign exchange through open market operations to avoid shortages, within limits.
Enact Macroprudential Regulations
Policies like higher reserve requirements on foreign currency deposits and stricter debt-to-income limits for foreign currency loans improve financial stability.
Support Financial Literacy
Educating households and firms on currency risks improves borrowing choices and constrains unsustainable dollarization levels.
With a comprehensive, patient policy approach countries can manage dollarization risks, gain policy autonomy, develop their financial markets, and promote prudent currency use.
Conclusion
Dollarization is a multi-dimensional phenomenon not always easy to measure or characterize. This guide has delved into the drivers, risks, metrics, policy impacts, trends, and economic management strategies related to rising domestic liability dollarization around the world. Key takeaways include:
- Dollarization emerges from high inflation, currency weakness, financial underdevelopment, economic volatility and interest rate differentials that induce use of foreign currencies as a store of value and means of exchange.
- While offering protections for individuals, economy-wide dollarization can increase financial instability, constrain monetary policy, and exacerbate the impact of external shocks.
- Dollarization can be tracked through indicators like foreign currency deposits, credit shares, real estate transactions, circulation, offshore activity and black market exchange rates.
- Dollarized economies lose many traditional monetary policy levers like money growth, interest rates, exchange rates, and lender of last resort facilities. New policy tools are needed.
- Exchange rate regime choices significantly interact with dollarization pressures in both directions. Gradual transitions are best for reducing dollarization.
- Dollarization remains highest in developing countries and emerging markets, especially Latin America. Advanced economies exhibit little dollarization.
- Although difficult, dollarization can be prudently managed through credibility building, financial development, exchange rate flexibility, capital flow management and macroprudential measures.
Understanding these dynamics allows policymakers to design appropriate responses and balance the risks and benefits that come with dollarization. This knowledge helps traders, investors and the public appreciate country conditions and policy trade-offs as well. With careful management, dollarized economies can still prosper.
