Financial Dollarization and European Union Membership

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

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

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

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

5. Deposit dollarization around the world

6. Background Literature on FD • The literature has been largely divided in examining the causes and consequences of FD. • Consequences of FD • Affects the conduct of monetary policy as it causes unstable money demand and higher price elasticity to monetary shocks • 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) • Slower and more volatile output growth rates • Associated with fear of future depreciation and a “fear of floating”

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

8. Only recently the potential effect of EU membership on FD has been considered, with mixed findings. • 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) • Higher trade and financial transactions with the EU • Greater convergence of exchange rates to the euro • Expectation of diminishing currency risk as prospective EU members allow more capital mobility

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

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

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

12. EU accession process time Start Conclusion Member

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

14. We use six alternative panel estimation techniques • FE, RE, FGLS, GMM, FE-2SLS, RE-2SLS • The dataset is an unbalanced panel of monthly observations for 11 CEECs over 1993-2006… • …six of which have recently become members of the EU • Armenia, Bulgaria, Czech Rep., Estonia, Georgia, Kyrgyz Rep., Latvia, Poland, Romania, Russia, and Ukraine. • 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 • The effects of the variables included in the sets X and D are as expected by theory and past studies. • The beginning and the conclusion of the EU accession process lead to lower DD, while eventual membership has no robust effect. • The negative impact survives different estimation techniques and is fairly stable across regressions

18. Benchmark findings: loan dollarization • The effects of the supply side variables DD andnfa and of those included in the sets X and D are largely as expected by theory and past studies. • The beginning of the EU accession process and membership itself have no robust impact on LD. • Only the conclusion of the negotiation process has a robustly negative effect on LD. • 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 • Additional control variables • Alternative definition for the high-dollarization dummy • Limit sample period to post-1996 years • Control for outliers by dropping a country at each time • Control for Estonia which exhibits high mismatch in FD

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