Financial Sector Assessment

Dollarization: Implications for Stability

Dollarization can have important implications for financial stability. A dollarized economy can be defined as one where (a) households and firms hold a fraction of their portfolio (inclusive of money balances) in foreign currency assets, (b) the private and public sector have debts denominated in foreign currency, or (c) both. Dollarization can be “official” when the U. S. dollar is adopted as the legal tender or “partial” when the local currency remains the legal tender, but transactions are allowed to be denominated in dollars, thus effectively allowing a bicurrency system to take hold. It is useful to distin-

guish among three generic types of dollarization that broadly match the three functions of money: (a) payments dollarization (currency substitution) is the resident’s use of foreign currency for transaction purposes in cash, demand deposits, or central bank reserves; (b) financial dollarization (asset substitution) consists of the resident’s holdings of financial assets or liabilities in foreign currency (either domestic or external); and (c) real dol­larization is the indexing, formally or de facto, of local prices and wages to the dollar.36 Dollarization can be measured using a variety of statistics, including the ratio of onshore foreign currency deposits to total onshore deposits, the ratio of foreign currency deposits to broad money, the ratio of domestic government debt in foreign currency to total gov­ernment debt, and the share of private sector debt in total external debt.37 Additional risks to financial stability resulting from dollarization and the implications for financial policy are discussed below.

Empirical evidence suggests that financial dollarization may increase the vulnerability of financial systems to solvency and liquidity risks. Cross-country estimates of the effect of dollarization on key financial soundness indicators are consistent with the hypothesis that increased dollarization increases financial vulnerability. The variance of deposit growth is positively and significantly correlated with dollarization, suggesting that dollarized finan­cial systems may be more exposed to credit cycles and liquidity risk. A cross-country com­parison of estimates of nonperforming loans (NPLs) or a composite systemic risk measure will show that dollarized economies also tend to be more exposed to solvency risk.

The limited backing of banks’ dollar liabilities by U. S. dollars and their convertibility at par subjects the financial system to a very specific type of liquidity risk. Systemic liquid­ity risk arises when the demand for local assets falls because of a perceived increase in country or banking risk, thus prompting foreign banks to recall short-term lines of credit and depositors to convert their deposits into dollars or to transfer them abroad. Unless liquid dollar liabilities are backed by sufficient liquid dollar assets abroad, banks could run out of dollar liquid reserves and could fail to pay off dollar liabilities. Similarly, central banks could run out of international reserves to provide dollar lender-of-last-resort sup­port to distressed banks. When those international reserves are depleted, deposit (or loan) contracts may need to be broken and disruptive or confiscatory measures taken, thereby imposing a heavy cost on the financial system.

Dollar deposits are often more vulnerable to runs than local currency deposits, even in the absence of exchange rate adjustments. In highly dollarized countries, local currency deposits are mostly held for transaction purposes and are less affected by expected yield differentials than dollar deposits, which are predominantly held as store of value and are close substitutes for deposits abroad or dollars cash. Moreover, even when the demand for local currency deposits is affected, the small size of these deposits in the most highly dol­larized countries limits the threat they represent for banks’ liquidity.

The lack of dollar monetary instruments can further inhibit the scope for interest rate defenses against deposit withdrawals. An interest rate defense may be ineffective once a run has started, because the central bank has limited ability to raise the interest rate on dollar deposits. Banks are often reluctant to raise interest rates on dollar deposits, because of concerns that increasing rates may be interpreted as a sign of weakness, thus further exacerbating deposit withdrawals.

Capital account liberalization exposes the domestic financial sector to greater competition and risk tak­ing. In the absence of appropriate bank supervision, banks can expand risky activities at rates that exceed their capacity to manage them, including the use of derivatives and other complex cross-border transac­tions that are difficult to monitor and regulate. Large capital inflows can also lead to rapid credit growth, possibly to unproductive sectors of the economy such as real estate and government-supported industries, thus contributing to asset price bubbles and financial sector difficulties.3 Capital account liberalization can also increase banks’ credit risk through aggressive for­eign currency lending to unhedged borrowers.

Capital account liberalization may facilitate a faster transmission of economic and financial system shocks, thereby increasing asset price volatility.1 Exchange rate risks tend to be more pronounced when a fixed exchange rate peg has been maintained for a considerable period of time and if market per­ception of an implicit exchange rate guarantee has promoted inadequate hedging. If the banking system

Box 3.2 Capital Account Liberalization and Financial Stability

 

is weak, the monetary authorities may be reluctant to increase interest rates to stabilize the exchange rate.

The supervisory agency needs to have prudential standards and technical skills to cope with the chal­lenges that accompany capital account liberaliza­tion. Experience shows that careful planning of the sequencing and the pace of reforms could be critical to successful liberalization efforts, as further discussed in chapter 12. Before liberalizing the capital account, particular attention should be given to the effective­ness of existing capital controls, the soundness of the macroeconomic environment and consistency of macroeconomic policies, the prudential and super­visory framework, the financial system’s level of development, and the ability of both financial and nonfinancial corporations to manage potential risks and shocks that may arise. Successful capital account liberalization requires complementary monetary and financial sector reforms. Policies should be focused on improving internal governance of financial insti­tutions, developing deep and liquid financial mar­kets, and fostering market discipline.

 

a. In Korea, before the 1997 crisis, capital inflows helped finance sectors that subsequently experienced difficulties. In Sweden, the large credit expansion that followed financial deregulation contributed to the asset price bubble in the 1980s.

b. Cross-border contagion may be exacerbated if portfolio managers in developed countries bundle instruments from different countries in the same risk class.

 

The main solvency risk faced by dollarized financial systems results from currency mismatches in the event of large depreciations. Currency-induced credit risk is generally the key source of vulnerability because borrowers are highly susceptible to defaulting on dollar-denominated loans in the event of a large depreciation. Banks with large domestic dollar liabilities must balance their foreign exchange positions either by extending dollar lending to local currency earners or by holding dollar assets abroad. Thus, to maintain their profitability (especially in light of generally lower rates of return on foreign assets than on local dollar assets) and to satisfy the pent-up demand for loans, banks gener­ally end up lending domestically a large share of their dollar deposits, thus effectively transferring the currency risk to their unhedged clients and retaining the resulting credit risk. Borrowers’ currency mismatch is enhanced by the fact that prices and wages may continue to be set in local currency even when financial dollarization is widespread. Counterparty exposure is also amplified if collateral is denominated in domestic currency, and it declines relative to the loan after a depreciation. Banks’ direct exposure to currency risk is generally limited by tight regulatory limits on open foreign exchange positions, but off balance-sheet positions (e. g., in derivatives) are often misreported and may cause exposures to be underestimated.

In the event of large depreciations, widespread currency mismatches can have sys­temic effects that compound the deterioration of banks’ financial situation. Because of balance-sheet effects, large devaluations in highly dollarized economies are more likely to be contractionary, further undermining borrowers’ capacity to service their debts. Because it impairs the solvency of both borrowers and banks, the credit risk deriving from a large devaluation also increases the scope for a credit crunch and heightens the risk of deposit withdrawals by concerned depositors. Thus, solvency and liquidity risks are closely inter­related.

The interaction between prudential risks and the monetary regime, which instills fear of floating, subjects the financial system to risks similar to those incurred under a rigid exchange rate system. The more financially dollarized an economy is, the more vulner­able to large exchange rate fluctuations it becomes; hence, the less disposed the monetary authorities are to let the exchange rate float. Empirical evidence indicates that both nominal and real (bilateral) exchange rates are less volatile in more dollarized economies (see Gulde and Ize 2004). Instead, interest rates must bear the brunt of the adjustment to shocks, thereby raising interest rate risk both for local currency and for dollar intermedia­tion and then heightening credit cycles. Credit booms are accentuated by the fact that incoming dollar flows feed domestic lending and, through the banking multiplier, boost dollar intermediation.

The dollarization of public debt can be an important collateral source of financial fragility when banks have large holdings of public securities. Sharp exchange rate depre­ciations can undermine the sustainability of the public debt and, in turn, can undermine the solvency of banks when the latter hold large volumes of public securities.

In countries with a high degree of dollarization, stability assessments should indicate the extent to which dollarization is a potential source of vulnerability and should suggest appropriate measures. Where available, reports also should provide supporting quantita­tive information such as the degree of co-circulation, shares of foreign currency deposits and loans, short-term foreign assets and liabilities of the main financial institutions, net foreign assets, and net open foreign currency positions of banks.

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