Financial Dedollarization: A Research Agenda Eduardo Levy Yeyati Universidad Torcuato Di Tella Presentration XVIII Meeting of the Latin American Network of Central Bank and Finance Ministries April 10, 2003

What have we learned? Usual suspects Usual suspects Persistent fiscal deficit; financial contagion; bad luck (external shocks); government corruption and ineptness; international market hysteria Persistent fiscal deficit; financial contagion; bad luck (external shocks); government corruption and ineptness; international market hysteria Problem: None explains all episodes Problem: None explains all episodes  Tolstoi’s principle: Happy countries are all alike; every unhappy country is unhappy in its own way Are they so different after all? Are they so different after all?

Weak currency problem Local currency (peso) means of payment and unit of account, but not store of value (dollar). Local currency (peso) means of payment and unit of account, but not store of value (dollar). Symptom: Financial dollarization (holding by residents of dollar assets and liabilities). Symptom: Financial dollarization (holding by residents of dollar assets and liabilities). Not as obvious as it sounds: Not as obvious as it sounds: Argentina 2002 & Uruguay 2002 Argentina 2002 & Uruguay 2002 Peru? Peru? Bolivia? Bolivia?

The concern RER exposure… …amplifies cycles (through debt deflation or balance sheet effects) …induces procyclical (domestic and international) capital flows due to correlation between leverage ratio (credit risk) and external shocks

The concern Procyclical capital flows Procyclical capital flows Amplify cycles further Amplify cycles further Inhibit coutercyclical (monetary and fiscal) policies Inhibit coutercyclical (monetary and fiscal) policies Hamper the deepening of long-term markets (volatility) Hamper the deepening of long-term markets (volatility) Without financial dollarization, RER adjustment improves (via debt dilution) the leverage ratio, with the opposite effect. Without financial dollarization, RER adjustment improves (via debt dilution) the leverage ratio, with the opposite effect.

The drivers Portfolio hedging (Thomas, 1985; Ize and Levy Yeyati, 1998) Portfolio hedging (Thomas, 1985; Ize and Levy Yeyati, 1998) Time inconsistency (Calvo and Guidotti, 1990) Time inconsistency (Calvo and Guidotti, 1990) Currency-blind regulations: Currency-blind regulations: Liquidation and safety nets (Broda and Levy Yeyati, 2002) Liquidation and safety nets (Broda and Levy Yeyati, 2002) Implicit debtor guarantees (“too-many-to-fail”) (Burnside et al., 1999) Implicit debtor guarantees (“too-many-to-fail”) (Burnside et al., 1999) Signaling problem (De la Torre et al., 2002) Signaling problem (De la Torre et al., 2002)

The stick Prudential regulation Capital adequacy ratios: Capital adequacy ratios: Weights based on ratio between dollar debt service and verifiable dollar income (contestable and easy to circumvent) Weights based on ratio between dollar debt service and verifiable dollar income (contestable and easy to circumvent) Quantitative limits based on reported export income Quantitative limits based on reported export income

The stick Prudential regulation Deposit insurance: Deposit insurance: Coverage: exclusion of dollar deposits (alt., peso cap) Coverage: exclusion of dollar deposits (alt., peso cap) Funding: higher premiums for dollar deposits Funding: higher premiums for dollar deposits

The stick Prudential regulation Liquid asset requirements: Liquid asset requirements: Use: stop-loss clause on dollar deposits Use: stop-loss clause on dollar deposits Funding: higher ratios for dollar deposits Funding: higher ratios for dollar deposits

The stick Prudential regulation Time inconsistency (implicit insurance, non- credible stop-loss clause) Time inconsistency (implicit insurance, non- credible stop-loss clause) Impact through marginal cost

The carrot Saving and lending in pesos Desintermediation  Need to introduce long- term peso instruments that cater domestic savers Desintermediation  Need to introduce long- term peso instruments that cater domestic savers Indexed assets to lengthen maturities Indexed assets to lengthen maturities

The carrot Indexation Supported by theory Supported by theory Successful in Chile, Israel; unsuccessful in Argentina, Uruguay (70s and early 80s)  Institutional (fiscal, monetary and contractual) credibility, and strategic perspective Successful in Chile, Israel; unsuccessful in Argentina, Uruguay (70s and early 80s)  Institutional (fiscal, monetary and contractual) credibility, and strategic perspective Tradeoff between liquidity and index customization Tradeoff between liquidity and index customization Adaptation of monetary policy Adaptation of monetary policy

The carrot Indexation is not the only way to go Development of deep forward markets Development of deep forward markets Introduction of non-bank products such as fiduciary funds and specialized financial institutions Introduction of non-bank products such as fiduciary funds and specialized financial institutions The role of institutional investors as liquidity providers at the start-up stage The role of institutional investors as liquidity providers at the start-up stage Redistribution of credit towards tradables: Good long- run incentives but poor politics. A role for a second-tier public bank? Redistribution of credit towards tradables: Good long- run incentives but poor politics. A role for a second-tier public bank?

Where do we stand? Current dilemma: Bullish but crisis-prone dollarized markets vs. anemic liquidity-based peso markets Current dilemma: Bullish but crisis-prone dollarized markets vs. anemic liquidity-based peso markets Can we de-dollarize Bolivia overnight? Avoid well-intentioned but ultimately misguided policy experiments Can we de-dollarize Bolivia overnight? Avoid well-intentioned but ultimately misguided policy experiments Two-way approach: Address externalities through prudential regulation (stick) pari passu with the introduction and promotion of peso instruments (carrot) Two-way approach: Address externalities through prudential regulation (stick) pari passu with the introduction and promotion of peso instruments (carrot)

Where do we stand? The process is underway: The process is underway: Uruguay’s differential LARs and UI assets Uruguay’s differential LARs and UI assets Peru’s long peso deposits Peru’s long peso deposits Argentina’s CPI-indexed Central Bank bills Argentina’s CPI-indexed Central Bank bills Mexico’s development of peso non-bank capital markets Mexico’s development of peso non-bank capital markets Role of IFIs: Lending in indexed pesos? Role of IFIs: Lending in indexed pesos?