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Impact of De-Dollarization Mechanisms on Economy

This research paper explains dollarization and de-dollarization. Expanding the literature on, discussing the factor that leads to dollarization and its effect. How microeconomic and macroeconomic factors changes. And why there is need arise to enforce de-dollarization. And we further discuss the pros and cons of dollarization. And what is the impact after de-dollarization. Introduction Dollarization, since the early 1970s, has been a topic of special interest in the context of developing countries.

During periods of macroeconomic and political uncertainty, many developing countries experienced a partial replacement of their domestic currencies by a foreign currency either as a store of value, unit of account or as a medium of exchange.

However, after a flow in economic literature on currency substitution, where the effectiveness of monetary policy was the issue, the efforts to stabilize inflation relegated dollarization to a secondary role.

In Uruguay, Turkey, Peru even though the topic never lost its appeal, the apparently never-ending appreciation of the national currency started in the midst made the efforts of the advocates of de-dollarization fade as the debt ratios plummeted.

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.The development of (dollar) credit observed in the second half of the nineties was the key to the generalized bankruptcy following the 2002 crisis. Additionally, such risk threatens to, become a liability to the taxpayers in an economy. The paper proceeds as follows. We start by surveying the literature on dollarization.

We finish by setting up the basis for a strategy to reduce the financial vulnerability of our economy. Dollarization Dollarization refers to the use by the residents of one country of assets (or liabilities) denominated in another country’s currency and can take many forms.

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De-dollarization A successful de-dollarization policy makes the local currency more attractive toresidents than foreign currency. De-dollarization entails a mix of macroeconomic andmicroeconomic policies to enhance the attractiveness of the local currency in economictransactions and to raise awareness of the xchange-risk related costs of dollarization, thusproviding incentives to economic agents to de-dollarize voluntarily. It may also includemeasures to force the use of the domestic currency in tandem with macroeconomicstabilization policies. Dollarization significantly differs according to- i) the type of assets (or liabilities) dollarized; ii) whether the foreign currency has the status of legal tender (official dollarization) or whether there is de-facto dollarization; and iii) The extent of dollarization (full or partial).

Dollarization may be a natural consequence of opening the economy when economies participate into the world economy at the cost of more exposition to shocks which may require some level of dollarization what conduces to the development of domestic financial markets. Dollarization can minimize exchange rate risks for investors in general, increasing their confidence and boosting investment and economic growth in developed economies, like USA and Canada, dollarization is seen as a counterpart to heavy cross-border trade whereas in Latin American countries, dollarization is usually perceived as a hedging strategy against high inflation.

Dollarization can be caused by a number of factors:

  1. Political instability and conflict;
  2. Economic and financial instability;
  3. Institutional arrangements, e. g. by according legal tender status to the foreign currency; and
  4. Large donor flows

Possible Effects of Dollarization

CPI Inflation become lower after dollarization GDP Growth become higher after dollarization Inflation Uncertainty gets lower after dollarization In money-Price Relationship Money, becomes endogenous after dollarization The causes of dollarization:

Incomplete Markets

In countries with financial restrictions on national currency denominated external debt. However, when there are financial restrictions, domestic agents would underestimate the risk of borrowing in other currency dollar in order to insure their own financing, generating a negative externality for the economy as a whole.

Portfolio explanations

Even in economies that developed fair alternatives to the dollar, including Chile as the top of the group with its successful experience with the CPI indexed Unidad de Fomento (UF),dollarization had its way whenever there were no explicit bans on dollar denominated assets (as in the case of Brazil). One of the main explanations for this phenomenon is provided by the portfolio approach.

Time Inconsistency and lack of credibility of Monetary Policy

As we stated in point earlier, the time inconsistency problem of monetary policy has been one of the factors that contributed the most to the dollarization in Latin American countries. The systematic use of monetary surprise as a means of both prompting economic activity and reducing the real value of public debt, eroded the credibility of monetary policy, keeping Latin American countries in the high inflation equilibrium of Kydland and Prescott (1977) and Calvo (1978). 4)Warranties and Risk Miscalculation. Caballero y Krishnamurthy (2000) formalizes the idea that, in equilibrium, when there are incomplete markets, agents tend to miscalculate the macroeconomic effect of their microeconomic decisions. According to this authors, a private contract can internalize the currency mismatch risk embedded in the balance sheets of the parts of the contract, but cannot internalize the systemic consequences of a generalized process of dollarization.


De-dollarization usually requires a combination of macroeconomic policies and microeconomic measures to enhance the attractiveness of the local currency versus the foreign currency. Against the backdrop of macroeconomic stabilization, several measures can foster de-dollarization. These range from market-based measures that provide incentives to reverse currency substitution to measures that prohibits or strictly limits the use of foreign currency A. Macroeconomic Stabilization.

The first step toward de-dollarization is macroeconomic stabilization, focusing on the credible reduction and stabilization of inflation. Stabilization policies include fiscal consolidation and appropriately tight monetary policy to reduce the inflation rate. Fiscal consolidation lessens the need for government borrowing from the central bank, and a tighter monetary policy reduces credit growth. Both policies restrain aggregate demand, resulting in a drop in inflation and, eventually, the appreciation of the real and/or nominal exchange rate.

Credible policies curb inflationary expectations and lower the cost of stabilization. Against the backdrop of a durable disinflation, the need for hedging against inflation via holding foreign currency is significantly reduced, and demand for assets denominated in local currency can expand. De-dollarization policies need to be set up differently depending on the exchange rate arrangement. Under a genuinely flexible exchange rate regime, the country is typically seeking to restore monetary policy autonomy.

The appreciation of the exchange rate following the contraction of money supply during the stabilization process cans jumpstart de-dollarization. Accordingly, intervention in the foreign exchange market shouldsignal that the central bank is willing to accept nominal exchange rate appreciation Moreover, monetary authorities can envisage targeting inflation directly and thus enhance the stability of the inflation rate, which can be forecast more accurately, consolidating the benefits of the macroeconomic stabilization.

Under less flexible exchange rate regimes, a credible commitment to a fixed exchange rate would reduce the cost of macroeconomic stabilization because the authorities do not have to pay the cost of building reputation. However, the outcomedepends critically on the credibility of the peg. Expectations of devaluation wouldincrease FCDs, while expectations of intervention to help borrowers to pay their foreign exchange debt after devaluation would continue toencourage borrowing in foreign currency. In addition, the continued linkage to the foreign currency does not allow for a (fully) autonomous monetary policy.

Dollarization may continue even if successful stabilization has increased theattractiveness of the local currency. Although stabilization reduces the risks of using the local currency, it does not raise the private sector’s consciousness about the risks of financial dollarization. Also, once the public has becomeaccustomed to using foreign currency in domestic transactions, additional measures may be required to change this entrenched behavior, in particular, in the context of financial dollarization.

As a side effect of macroeconomic stabilization, strengthened confidence in thelocal currency could also support certain form of financial dollarization. Publicexpectations of the local currency’s appreciation provide a one-way bet for borrowing inforeign currency, supporting demand for foreign currency loans. As long as banks benefitfrom easy access to foreign financing (capital inflow), they would also benefit from theappreciation of the local currency by maintaining a short open position, encouraging lending in foreign currency.

Although covered interest rate parity may hold in the medium to long term, generally there is arbitrage in the short-run since interest rate differentials often do notcover exchange rate fluctuations, encouraging economic agents to dollarize their balancesheet. B. Market-Based De-dollarization Policies Exchange rate, monetary, and fiscal policies

Exchange rate flexibility—An exchange rate that can move in either direction wouldrender the foreign exchange risk more apparent, thus introducing a disincentive tofinancial dollarization. lexible exchange rate arrangement with less bias toward currency depreciation discourages financial dollarization. Hardy and Pazarbasioglu (2006) show that greater two-way exchange rate flexibility may deter foreign currency deposits, as they increase the risk of holding foreign currency assets. Confronted by foreign exchange risk on theirassets and liabilities, banks and nonbanks develop hedging facilities over time but, due to the cost of hedging, they would also increase the share of their assets andliabilities denominated in local currency.

However, a trend in the exchange rate couldentrench the expectation of continuous appreciation/depreciation that could fosterdollarization. The impact would nevertheless be different depending on the directionof the trend: the expectation of devaluation would increase liability dollarization(deposit) and currency substitution, while the expectation of appreciation wouldsupport asset dollarization.

Efficient liquidity management—strengthening day-to-day liquidity managementby the central bank would make local currency more attractive as short-term interest rates become less volatile.

The introduction of reserve requirements, standing depositand lending facilities, and open market operations may help stabilize the domesticinterbank rate. Furthermore, issuing medium-term paper as a benchmark for interestrates can improve monetary policy signaling and develop a yield curve. Similarly, the development of a well-functioning foreign exchange market and anadequate level of official reserves would ensure easy access to foreign exchange,diminishing the need to hold foreign exchange for precautionary reasons.

Fiscal consolidation—Fiscal restraint can help reduce the need for governmentborrowing in foreign currency, thus directly reducing dollarization of governmentliabilities. It also lessens the need for central bank financing of government debt andcontributes to decreasing differential between domestic and foreign interest rates. Unbiased taxation— tax system that does not treat income from foreign currencymore beneficially than income from local currency would not create a bias towardholding foreign currency assets.

For example, interest earned on FCDs or bondsshould not be exempted from taxation if taxes are levied on similar income fromdomestic-currency-denominated sources. Financial transaction taxes, ifany, should be levied at least equally on foreign and domestic currency transactions. Public debt management and financial market development Public debt management—Active public debt management that aims at issuing localcurrency-denominated bonds (if necessary, inflation indexed) would de-dollarize thegovernment’s balance sheet, foster the market for domestic paper, and allow for moreexchange rate flexibility.

However, this may result in higher debt service due to the higher interest rates on the governmentdebt to compensate forexchange rate risk and may not be an option for countries where investors are unwilling to take exposure in local currency. It may however,reduce the consequences of devaluation or depreciation of the exchange rate on theofficial debt service. It may also foster some loan dollarization recurrence as the highlocal currency interest rate required to switch from foreign currency to local currency for the public debt would discourage private sector borrowing in local currency andencourage private loans in foreign currency.

Development of a domestic financial market—A deep and liquid bond marketprovides flexible alternative investment opportunities to dollar deposits. Increasing the choice of local currency denominated securities traded on the domestic capitaland money markets may contribute to the decrease in dollar-denominated assets. Encouraging the development of the domestic investor base, such as pension funds,would likely support demand for longer-term local currency instruments and markets.

Alternatives to dollar-denominated assets—In the absence of confidence in localcurrency-denominated assets, a credible indexation system can enhance investments in such assets. Ideally, indexation should be to local prices because this avoids the reference to foreign currencies and the likely co-movement between government revenues and debt servicing costs. However, country experiences show that indexation may continue even if it is no longer necessary. In these circumstances, widespread indexation can also complicate macroeconomic management by introducing rigidities in the onetary transmission mechanism. The idiosyncrasies of indexation,

Instruments to hedge currency risk—Where exchange controls restrict hedginginstruments, residents may have an incentive to build up foreign exchange holdings asan alternate hedge facility. Financial policy and prudential regulation

Financial liberalization—Freeing banks from administrative controls on thedetermination of interest rates makes it more likely that domestic real interest rateswill be positive, thus helping to promote the use of the local currency .

A more competitive domestic financial system will also enhance the attractiveness of the local currency Withdrawal of the legal tenderstatus from foreign currency. De-dollarization is unlikely to be achieved if the foreign currency remains the legal tender of the country,since it entrenches its legitimate use in local transactions.

Increased usability of the local currency—To decrease currency substitution, a domestic currency that is attractive for use needs to be provided. This means thecontinuous availability of domestic currency in the denominations best adapted to theneeds of market participants.

For example, larger denominations of riel banknotesincreased the demand for local currency in Cambodia. Introducing a new currency may enhance the use of the local currency by providing banknote denominations more suitable for local transaction needs than foreign currency banknotedenomination.

Government operations in local currency—The government should operate in local currency to the extent possible. Raising taxes in local currency can support anincrease in the demand for local currency, as can public payments for wages, goods,and services in local currency.

In Peru, the government switched its publiclending program to local currency. Use of foreign aid in local currency—Foreign aid if used in foreign currency in therecipient country in may increase dollarization. In small or post-conflict countries,which often have a high degree of dollarization, foreign aid can play a large role inthe economy. When possible, the in-country use of the aid should be denominated inthe local currency to promote de-dollarization.

Reserve requirements— a regulatory bias of the reserve requirement framework for FCDs needs to be avoided.

Local currency deposits (LCDs) should be subject toconditions which are at least as favorable as those applied on FCDs, while avoidingundue distortions, including those stemming from excessively high reserverequirements. Measures such as requiring banks to denominate reserve requirementson FCDs in local currency,remunerating the reserve requirement on LCDs at a higher rate than the FCD reserve requirement, or imposing higher reserve requirements on FCDs, would encouragebanks to attract LCDs, thereby increasing the deposit interest rate differential. Extending the reserve requirement base to nonbank financial institutions involved indollar intermediation, such as leasing companies, or to unhedged creditors has alsobeen observed in country practices.

Payments system—The domestic payments system should ensure local currency payments at terms which are at least as favorable as those for foreign currencypayments. The central bank should offer convenient and low-cost payment servicesfor domestic currency payments and should not favor payments in foreign currency(Angola and Lao P. D. R. ). Peru imposed a two percent tax on checks denominated inforeign currency to discourage the use of foreign currency in payments.

Prudential regulations—Measures aimed at ensuring proper management of foreignexchange risk and internalizing the true cost of doing business in foreign currency canhelp to create a level playing field for the domestic currency and eventuallyencourage de-dollarization. These include

  1. narrow open foreign currency positionlimits,
  2. higher liquidity requirements on FCDs or foreign exchange loans
  3. charging a higher risk premium ondollar deposits participating in deposit guarantee schemes
  4. highercapital and provisioning requirements on foreign currency loans especially toun hedged borrowers
  5. lower loan-to-value ratioto secure foreign exchange denominated loans , and
  6. stronger collateraland valuation rules for foreign exchange denominated loans.

Effective supervision—this can significantly contribute to the internalization of therisks resulting from balance sheet dollarization. Substantial efforts have been made ineconomies where foreign credit has been growing fast to monitor the risk taken bybanking and nonbanking institutions. In particular, stricter internal controls have beenimposed on banks to address the risk related to foreign exchange loans, and improvedrisk disclosure to borrowers has been required.

Foreign exchange regulations—No preference should be given to holders of foreigncurrency over those who only have access to domestic currency funding. Forexample, allowing residents to make outward capital transactions from their ownforeign exchange resources while prohibiting the same transactions for domesticcurrency holdings can provide incentives to residents to accumulate foreign exchange for future transactions.

Forced De-dollarization Measures to force de-dollarization are not recommended in isolation from market-based measures.

Many of the measure involve interference withprivate contracts, often retroactively, and can diminish the confidence of market participants in the protection of property rights and contracts, with deleterious effects on the credibility of economic policies more generally. Nevertheless, there may be instances when then use of thedollar is so entrenched that market-based de-dollarization measures by themselves areinsufficient, and more forceful government intervention becomes necessary. However, these measures are likely to prove ineffective or even counterproductive unless accompanied by a strong macroeconomic stabilization plan.

As a result, dollarization ratios of creditand deposit—across all sectors and maturities—have declined, with larger decline forcommercial credit and time and saving deposits. Based on the results, the road ahead to further deep Impact of de-dollarization The findings confirm that de-dollarization has been the result different approaches. Macroeconomic stability, proxies by inflation, different measures of exchangerate changes, and sovereign credit risk (EMBI), had a significant impact on de-dollarization.

Prudential measures, such as the introduction of asymmetric reserverequirements and provisions for currency-induced credit risk, had an impact on banks’incentives to borrow and lend in soles. Last, the development of the local capital marketin soles had a mixed impact on bank de-dollarization. The issuance of long-termtreasuries in soles lowered dollarization of credit, probably by facilitating bank fundingand pricing of long-term loans in soles. However, other sol market instruments led tohigher bank dollarization—these may have competed with bank loans in soles, having animpact on the pool of bank borrowers.

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Impact of De-Dollarization Mechanisms on Economy. (2020, Jun 01). Retrieved from

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