1. Financial Dollarization Eduardo Levy Yeyati Universidad Torcuato Di Tella
Presentation at the Office of the Chief Economist
Inter-American Development Bank
November 2, 2004

2. Outline Financial dollarization Definition and measurement Drivers
Concerns
Prognosis

3. Definition
Currency substitution (CS): foreign currency (dollar) as means of payment/unit of account
Asset substitution (AS): dollar as store of value
Financial dollarization: holding by residents of dollar assets and liabilities  AS but not necessarily CS
Argentina 2002 & Uruguay 2002

4. Measurement Deposit Dollarization

5. Measurement Other Sources (% GDP)

6. Drivers Hedging (Ize and LY, 1998, 2003)
Reverse causality: Fear of floating may perpetuate FD
Time inconsistency (Calvo and Guidotti, 1990)
CPI indexation?
Implicit guarantees (Burnside et al., 1999), peg trap (De la Torre et al., 2003),
Currency-blind regulation & safety nets (Broda and LY, 2001, 2003)
Institutions (Rajan, 2004)
Offshorization (LY, 2004)

7. Drivers

8. Drivers - Institutions

9. Concerns
RER exposure
Amplifies cycles (debt deflation or balance sheet effects)
Procyclical capital flows due to correlation between leverage ratio and external shocks  Pocyclical monetary policy
Increases financial fragilities

10. Amplifies cycles
Source: Levy Yeyati (2004)

11. Increases financial fragility
FD associated with greater banking fragility (z-scores and NPL ratios) and deposit volatility (de Nicoló et al., 2003)
FD increases the propensity to suffer sudden stops (Calvo, et al., 2003)

12. Increases financial fragility

13. Dollarization & Financial Depth
Hong Kong
Lebanon
Vanuatu
Notes:. The cofficient on dollar_avg is with a t-statistic of

14. FD: Where do we stand?
The preliminary evidence confirms some of the concerns and cast doubt on the financial depth argument
Persistent and widespread among developing countries
Linked to AS (volatile inflation & stable RER)
Greater sensitivity of money demand, slower and more volatile growth, greater financial fragility
No significant gains in terms of domestic financial depth (no impact of restrictions on FD)

15. FD: Where do we go from here?
Two-way approach: Prudential regulation (stick) & promotion of peso instruments (carrot)
Latam experiences:
Chile (indexation)
Mexico (restrictions & local currency bond markets)
Uruguay (prudential regulation & indexation)
Argentina (restrictions on FD & indexation)
Ultimately, a “fear vs. greed” dilemma?
Rol of IFIs?

16. Financial Dollarization Eduardo Levy Yeyati Universidad Torcuato Di Tella
Presentation at the Office of the Chief Economist
Inter American Development Bank
November 2, 2004

17. Weak Currency Problem
Weak currency: Not accepted either internationally or domestically as a reliable store of value (De la Torre et al., 2002)
Shortermism in the local currency
Duration mismatch  Roll-over risk
Floating rates, CPI indexation
Dollar indexation (FD)  Currency risk

18. Deposit dollarization
Dollar Deposits over Total Deposits
Time deposits
Savings deposits
Demand deposits
Source: De la Torre, Levy Yeyati and Schmukler (2002).

19. Real cash in circulation
Includes quasi-monies.
Source: De la Torre, Levy Yeyati and Schmukler (2002).

20. Drivers - Hedging

21. Estabilización Nominal Bolivia

22. RER Exposure FD & Original sin
Eichengreen et al. (2003): Only external mismatch is important, but...
...currency balance is needed at the micro level (domestic longs & shorts do not cancel out in practice)