1. Financial Dollarization and European Union Membership Kyriakos C. Neanidis Economics Centre for Growth and Business Cycle Research University of Manchester

2. Definitions l Official (or de jure) dollarization l Foreign currency is given exclusive legal tender status (Panama 1904, Ecuador 2000, El Salvador 2001) l Unofficial (or de facto) dollarization l Foreign currency is used alongside the national currency without being legal tender l Three types of unofficial dollarization l Currency substitution: use of foreign currency as medium of exchange l Asset substitution: use of foreign currency as store of value (focus on the asset side of balance sheet)

3. l Financial dollarization: holdings by a country’s residents of financial assets and liabilities denominated in foreign currency (not just in dollars) l Due to important measurement problems, the literature uses as a proxy the FD of the banking sector l Deposit dollarization (DD): ratio of foreign currency deposits to total deposits of residents at domestic banks l Loan dollarization (LD): ratio of foreign currency loans to total loans of domestic banks to residents

4. Review of Basic Data l Even though the early literature on financial dollarization has tended to focus on Latin America... l …due to its experience of currency substitution as a result of a history of high inflation… l …FD is not a localized phenomenon. l FD is significant and persistent in developing countries around the globe.

5. Deposit dollarization around the world

6. Background Literature on FD l The literature has been largely divided in examining the causes and consequences of FD. l Consequences of FD l Affects the conduct of monetary policy as it causes unstable money demand and higher price elasticity to monetary shocks l Currency mismatches in firms’ and banks’ balance sheets that in the presence of exchange rate fluctuations can lead to banking and financial crises (Asia 1997; Turkey 2000) l Slower and more volatile output growth rates l Associated with fear of future depreciation and a “fear of floating”

7. l Causes of FD l Inflation rate (currency substitution view) [+] l Depreciation rate (valuation effects) [+] l Interest rate differential (departure from uncovered interest rate parity) [- DD and + LD] l Trade and financial openness [- DD and + LD] l Degree of legal restrictions on foreign-currency holdings [-] l Alternative hedging opportunities (forward market) [-] l High-dollarization environments [+] l Quality of public institutions [-] l Central bank exchange rate intervention [+] l Minimum variance portfolio (MVP) dollarization share (portfolio view) [+]

8. l Only recently the potential effect of EU membership on FD has been considered, with mixed findings. l EU membership, by leading eventually to euro adoption, triggers higher FD in anticipation of admission to the EMU (Genberg 2004, Levy Yeyati 2006, Rosenberg and Tirpák 2008) l Higher trade and financial transactions with the EU l Greater convergence of exchange rates to the euro l Expectation of diminishing currency risk as prospective EU members allow more capital mobility

9. l On the other hand, EU admission lends credibility to the acceded country’s policymakers… l … as they are perceived to commit to policies that contribute to long-run macroeconomic stability, as these are necessary requirements of the process. l EU admission acts as a commitment device to enhance institutional quality, promoting faith in the domestic currency. l In this way, the prospect of joining the EU diminishes FD (Levy Yeyati 2006, Ravenna 2008, Honig 2009).

10. Main Question l Given the conflicting views on the impact of EU membership on FD… l …we test the significance of joining the EU while controlling for the most important drivers of FD. l We control for the three stages of the EU process l Beginning of membership negotiations l Conclusion of accession negotiations l EU membership l We examine these effects on both DD and LD.

11. Methodology and Data l Three stages of the admission process l Dummy that takes the value of 1 for the period after the beginning of the EU accession process and before its conclusion. l Dummy that takes the value of 1 for the period after the conclusion of the EU accession process and before full EU membership. l Dummy that takes the value of 1 for the period after full EU membership.

12. StartConclusionMember time EU accession process

13. l We employ the specifications: l DD (LD): deposit (loan) dollarization l X: set of standard control variables of FD l Rate of inflation, rate of depreciation, MVP dollarization, interest rate differential, international financial integration l D: set of dummy variables that control for l Regulatory and high-dollarization environments l EU: set of three EU membership-related dummies

14. l We use six alternative panel estimation techniques l FE, RE, FGLS, GMM, FE-2SLS, RE-2SLS l The dataset is an unbalanced panel of monthly observations for 11 CEECs over 1993-2006… l …six of which have recently become members of the EU l Armenia, Bulgaria, Czech Rep., Estonia, Georgia, Kyrgyz Rep., Latvia, Poland, Romania, Russia, and Ukraine. l Data on DD and LD are collected by the IFS and National Central Bank reports.

15. Deposit and loan dollarization

16. Benchmark findings: deposit dollarization l The effects of the variables included in the sets X and D are as expected by theory and past studies. l The beginning and the conclusion of the EU accession process lead to lower DD, while eventual membership has no robust effect. l The negative impact survives different estimation techniques and is fairly stable across regressions

18. Benchmark findings: loan dollarization l The effects of the supply side variables DD and nfa and of those included in the sets X and D are largely as expected by theory and past studies. l The beginning of the EU accession process and membership itself have no robust impact on LD. l Only the conclusion of the negotiation process has a robustly negative effect on LD. l Banks require a greater degree of government commitment as to the pursuit of policies of stability compared to depositors – due to higher currency risk.

20. Additional robustness of main findings l Additional control variables l Alternative definition for the high-dollarization dummy l Limit sample period to post-1996 years l Control for outliers by dropping a country at each time l Control for Estonia which exhibits high mismatch in FD

21. Final Remarks l EU membership per se has no bearing on FD. l The prospect of EU membership, however, diminishes both DD and LD… l …as the private sector views EU entry negotiations as a commitment by their policymakers in following policies of macroeconomic stability. l Our findings offer support to the credibility view of EU membership on FD.