"Dollarisation in Emerging Market Economies" Part 2: IMPLICATIONS

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1 Part 2: IMPLICATIONS FISCAL IMPLICATIONS OF CURRENCY SUBSTITUTION DOLLARISATION AND FINANCIAL DEEPENING DOLLARISATION AND FINANCIAL FRAGILITY Solvency risk Liquidity risk Liquidity risk and solvency risk are interrelated IMPLICATIONS FOR INFLATION STABILISATION 1970s-1990s: two main strategies for inflation stabilisation Dollarisation favours an exchange rate anchor On the possibility of inflation targeting 1

2 FISCAL IMPLICATIONS OF CURRENCY SUBSTITUTION Effective money supply is much larger than domestic money supply Money demand is more elastic (because of the public s propensity to substitute foreign for domestic currency). Fiscal consequences: Lower seigniorage revenues (inflationary finance): the government will be able to collect less seigniorage if a foreign currency may also provide liquidity services Currency substitution may not only lead to higher inflation, for a given budget deficit, but also to more volatile inflation Lower costs of tax evasion, easier participation in the unreported or underground economy, facilitated corruption and rent seeking weakened government s ability to command real resources from the private sector and deeper fiscal deficits distorted macroeconomic information systems more difficult macroeconomic policy formulation Use data on FCC holdings for estimating the size and growth of underground economies 2

3 Part 2: IMPLICATIONS FISCAL IMPLICATIONS OF CURRENCY SUBSTITUTION DOLLARISATION AND FINANCIAL DEEPENING DOLLARISATION AND FINANCIAL FRAGILITY Solvency risk Liquidity risk Liquidity risk and solvency risk are interrelated IMPLICATIONS FOR INFLATION STABILISATION 1970s-1990s: two main strategies for inflation stabilisation Dollarisation favours an exchange rate anchor On the possibility of inflation targeting 3

4 DOLLARISATION AND FINANCIAL DEEPENING Dollarisation should keep deposits onshore by offering depositors an inflationary hedge. High inflation damages financial sector development: High inflation + credit market imperfections reduced agents incentives to lend, and increased incentives to borrow. reduced availability of credit and additional, lower quality borrowers into the pool of credit seekers. increased severity of credit market frictions fewer loans, less efficient resource allocation, diminished intermediary activity (Boyd, Levine and Smith, Journal of Monetary Economics 2001) evidence from negative experiences: - forced conversion of FCDs to HCDs lead to a sharp contraction of onshore domestic intermediation (Mexico and Bolivia in 1982 and Peru in 1985) - repression of the use of the dollar without developing alternative indexation mechanisms lead to rapid growth of offshore banking intermediation (Ecuador, Guatemala, Costa Rica) 4

5 legal and political institutions, endowments According to the law and finance theory, the spread of legal traditions had enduring influences on national approaches to private property rights and financial development - British colonizers advanced a legal tradition that stresses private property rights and fosters financial development, whereas in contrast - French, Spanish and Portuguese colonizers that spread the French Civil law implanted a legal tradition that is less conducive to financial development. The endowment theory emphasizes the roles of geography and the disease environment in shaping institutional development endogeneity: common factors to dollarisation and financial depth inflation dollarisation & financial depth apparent negative correlation between financial depth and inflation, and between financial depth and dollarisation For high inflation countries: more dollarisation is associated with deeper banking systems (M2/GDP, Non government credit/gdp) 5

6 Part 2: IMPLICATIONS FISCAL IMPLICATIONS OF CURRENCY SUBSTITUTION DOLLARISATION AND FINANCIAL DEEPENING DOLLARISATION AND FINANCIAL FRAGILITY Solvency risk Liquidity risk Liquidity risk and solvency risk are interrelated IMPLICATIONS FOR INFLATION STABILISATION 1970s-1990s: two main strategies for inflation stabilisation Dollarisation favours an exchange rate anchor On the possibility of inflation targeting 6

7 DOLLARISATION AND FINANCIAL FRAGILITY Dollarisation arises as a protection against a variety of risks Explaining apparent higher financial vulnerability of partially dollarized economies requires identifying specific systemic risks. solvency and liquidity risks Solvency risk: currency mismatches + large currency depreciations Currency mismatches can affect banks balance sheets - directly (but: regulatory limits on open foreign exchange positions), - indirectly by undermining the quality of their dollar loan portfolio: lending domestically a large share of their dollar deposits, effectively transferring the currency risk to their unhedged clients and retaining the resulting credit risk (the more so when financial dollarisation is more widespread than real dollarisation) 7

8 demand for loans in the non tradable sector > supply of HCLs banks have large domestic dollar liabilities and need to balance their foreign exchange position + rates of return on foreign assets > rates of return on domestic dollar assets banks lend in foreign currency to the non tradable sector financial dollarisation + currency risk is transferred to borrowers and enhanced if real dollarisation is limited and/or collateral is denominated in local currency 8

9 A similar wedge may affect governments: tax revenue is in local currency but the public sector borrows in foreign currency to - limit short-run debt-servicing costs or - signal their commitment to a stable exchange rate. When the domestic banking system holds large claims against the government, public sector insolvency can thus immediately lead to banking insolvency 9

10 Liquidity risk: FCDs are only partially covered by liquid dollar assets (maturity transformation) Systemic liquidity problems in dollarized economies arise when the demand for local deposits falls: Drop in confidence (due to country risk or banking risk) local deposits + flight to foreign cash or CBDs banks may run out of dollar liquid reserves + the central bank may run out of foreign currency reserves to provide Lender of Last Resort support in foreign currency need to break deposit contracts (e.g. forced conversion) + validate depositors fears and justifies bank runs. 10

11 Experiences: Mexico and Bolivia 1982, Turkey 1994, Bolivia and Argentina 1995, Bulgaria 1996, Peru and Russia 1998, Uruguay, Bolivia and Paraguay 2002 (see below IMF OP 230 p7) Triggers for runs: - rapidly deterioration macroeconomic conditions, esp. public debt (Mexico 1982, Argentina 2001) - unfounded rumours of deposit confiscation or political turmoil (Bolivia 2001) - contagion (Uruguay and Paraguay 2001) FCDs are more vulnerable to runs than HCDs - HCDs small relative size, held for transactions purposes, less affected by expected yield differentials - FCDs larger size (and fewer in number, hence more sensitive to rumours and portfolio reallocations by a few large depositors), held as store of value (close substitutes for FCC or CBDs), more sensitive to expected yield differentials 11

12 Bank runs in Partially dollarized economies (IMF OP 230) 12

13 Liquidity risk and solvency risk are interrelated: Devaluation solvency of banks and borrowers depositors concern risk of deposit withdrawals (in anticipation or as a consequence of devaluation) 13

14 Part 2: IMPLICATIONS FISCAL IMPLICATIONS OF CURRENCY SUBSTITUTION DOLLARISATION AND FINANCIAL DEEPENING DOLLARISATION AND FINANCIAL FRAGILITY Solvency risk Liquidity risk Liquidity risk and solvency risk are interrelated IMPLICATIONS FOR INFLATION STABILISATION 1970s-1990s: two main strategies for inflation stabilisation Dollarisation favours an exchange rate anchor On the possibility of inflation targeting 14

15 IMPLICATIONS FOR INFLATION STABILISATION 1970s-1990s: two main strategies for inflation stabilisation Money-based stabilisation (flexible exchange-rate regime) Some sort of control over the monetary aggregates, Slow convergence of the inflation to the rate of growth of the money supply Real appreciation of the domestic currency No clear-cut response of the current account (rather a short term improvement) Initial contraction in real activity, followed by a later recovery Exchange-rate based stabilisation (fixed or predetermined exchangerate regime) Announcement of a predetermined path for the exchange rate (a declining rate of devaluation) Slow convergence of the CPI inflation rate to the rate of devaluation Initial increase in real activity, followed by a later contraction (boom-bust cycle) Real appreciation of the domestic currency Deterioration of the current account 15

16 the dynamics questions the sustainability, credibility of the programme. lack of credibility contributes to explaining the dynamics Theoretical models (Calvo and Vegh 1999) show that: currency substitution plays a key role in determining the magnitude of the recession that results from a money-based stabilization: rate of growth of the money supply expected inflation nominal interest rate switch from foreign money and toward domestic money. under sticky prices, the real domestic money supply cannot increase so that output must fall to equilibrate the money market. The higher the elasticity of currency substitution, the larger the shift into domestic money and, thus, the more pronounced the recession. Note: due to the costs of switching from one currency to the other, the initial fall in nominal interest rates may induce little substitution lessens the initial recession 16

17 In the case of exchange-rate-based stabilization, If the stabilization is fully credible (perceived as permanent), the presence of currency substitution will result in a wealth effect as the public gets rid of foreign currency thus reducing seigniorage payments to the foreign government. This wealth effect causes a permanent increase in consumption. If the stabilization is not fully credible (perceived as temporary), as the inflation rate remains high, due to lack of credibility, the real exchange rate appreciates, which eventually causes a recession. Currency substitution greater volatility of floating exchange rate - frequent and unexpected shifts in the use of domestic and foreign money for transaction purposes - domestic money demand is more interest rate elastic the exchange rate is more sensitive to expected changes in money supply 17

18 Dollarisation favours an exchange rate anchor Currency substitution preference for exchange rate anchor - the relevant concept of money include FC holdings if exchange rate can fluctuate the monetary authority does not control the broad money supply - a better signal for guiding expectations more widely and quickly available than monetary aggregates an approximate measure for the price level when inflation is high financial dollarisation preference for exchange rate anchor fear of floating liability dollarisation economy more vulnerable to exchange rate fluctuations authorities prefer to fix 18

19 dollarisation trap: exchange rate volatility dollarisation - the home and foreign monies become more substitutable - the authorities are bound by the need to protect the financial system and to keep inflationary expectations low accentuated credit booms reinforce banking fragility: inflow of dollars (repatriation, foreign lending) bank lending real exchange rate appreciation relaxed credit constraints burden of dollar debt + collateral value in non tradable sector time inconsistency and moral hazard: devastating impact of exchange rate collapse on bank lending commitment to a stable exchange rate is perceived as commitment to bail out excessive financial dollarisation 19

20 importance of the dollarisation of public debt: short horizon of administrations under-estimate probability of large devaluation discount cost of currency crisis to subsequent administrations borrow in foreign currency to signal commitment to a stable exchange rate banks hold large amounts of public securities (perceived as liquid): sharp depreciation public debt sustainability bank solvency increased fragility 20

21 On the possibility of inflation targeting An inflation targeting regime comprises five elements (Mishkin 2004) 1) the public announcement of medium-term numerical targets for inflation; 2) an institutional commitment to price stability as the primary goal of monetary policy, to which other goals are subordinated (instrument independence of the central bank); 3) an information inclusive strategy in which many variables, and not just monetary aggregates or the exchange rate, are used for deciding the setting of policy instruments; 4) increased transparency of the monetary policy strategy through communication with the public and the markets about the plans, objectives, and decisions of the monetary authorities; 5) increased accountability of the central bank for attaining its inflation objectives. A strategy for inflation stabilisation that spread to transition and emerging market economies at the end of the 1990s. Czech Republic, Israel (1998), Brazil, Chile (1999), Hungary, Mexico, South Africa, Thailand (2000), Colombia (2001), Peru, Poland, Philippines (2002) 21

22 Monetary Regimes, Emerging Market Countries, Stone and Bhundia (2004) IMF WP/04/191

23 Prerequisites: - fiscal stability - a safe and sound financial system De facto dollarised economies with an inflation target cannot afford to allow wide exchange rate fluctuations because of their detrimental impact - on inflation performance (exchange-rate pass-through) - on the financial system stability (currency mismatches) 23

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