Dollarization and Crises: Ways In and Out Alejandro Izquierdo De-dollarization Strategies and Domestic Currency Debt Markets in Emerging Economies Okinawa, Japan April

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

I 1990-III 1991-I 1991-III 1992-I 1992-III 1993-I 1993-III 1994-I 1994-III 1995-I 1995-III 1996-I 1996-III 1997-I 1997-III 1998-I 1998-III 1999-I 1999-III 2000-I 2000-III 2001-I 2001-III 2002-I 2002-III 2003-I 2003-III 2004-I 2004-III Sudden Stop in Emerging Asia and LAC-7 (Capital Flows, USD million, last four quarters) Note: LAC-7 includes Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. Emerging Asia includes Indonesia, Korea, Malaysia, Philippines and Thailand. Source: Central Banks. Asian Crisis Russian Crisis Millions of USD LAC-7 Emerging Asia

Real Exchange Rate Adjustment (vis-à-vis US dollar, Jan-90=100) Jan-90Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97Jan-98Jan-99Jan-00Jan-01Jan-02Jan-03Jan-04 Emerging Asia LAC-7 Russian Crisis 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 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 Payments system is at stake following devaluation Emerging Asia 21.0% Indonesia15.0% Korea8.8% Philippines32.0% Thailand28.1% LAC-79.9% Argentina21.3% Brazil4.4% Chile2.3% Colombia3.3% Peru18.2% 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. 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 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) 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 Emerging Asia’s reaction to currency depreciation was stronger in terms of the expansion of tradable output Source: Own calculations based on data from WDI and WEO databases. EA Pre-crisis ω: LAC-7 Pre-crisis ω: Emerging Asia LAC-7

Dollarization is an Addiction, Just Like Smoking We know that dollarization is bad for a country’s health: it brings crisis (cancer) 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: 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 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 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 non- tradable sectors and balance-sheet effects But a large share of dollar loans was on lent at home, leading to currency mismatches in non- tradable sectors and balance-sheet effects

Emerging Asia: Bank Foreign Borrowing (Foreign Liabilities / (Total Deposits + Foreign Liabilities)) Note : Average for Indonesia, Korea, Malaysia, Philippines and Thailand. Source: IFS

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? 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 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): 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) 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 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. 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. 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”? 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. 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) 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) 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. Low volatility of inflation relative to the volatility of RER depreciation should lead to de-dollarization.

Israel: Inflation and RER Volatility Note: Variances are calculated over a 5-year moving window. Source: Own calculations based on data from IMF-IFS. Inflation Volatility Real Depreciation Volatility Lowering inflation volatility relative to real exchange rate volatility may be part of the answer

Israel’s De-dollarization and Exchange Rate Band

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 Initially, one year mandatory holding period for dollar deposits Offered CPI-indexed deposits Offered CPI-indexed deposits Banks required active hedging of currency risk for non-tradable activities Banks required active hedging of currency risk for non-tradable activities Active development of financial derivatives markets Active development of financial derivatives markets Made effort to deepen local currency bond 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? 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). 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