DOLLARIZATION AND UNDEVELOPED CAPITAL (FINANCIAL) MARKETS IN TRANSITION ECONOMIES

1. DOLLARIZATION AND UNDEVELOPED CAPITAL (FINANCIAL) MARKETS IN TRANSITION ECONOMIES Ruslan Piontkivsky, International Centre for Policy Studies, Kyiv, Ukraine; and National University of Kiev-Mohyla Academy, Kyiv, Ukraine GDN Global Development Conference, December 9-12, 2001 The author is thankful for the support to the Economic Education and Research Consortium – Russia

2. Definitions • Dollarization: a situation in which residents of a country hold a share of their assets in the form of foreign currency and foreign currency denominated assets • replacing medium of exchange, unit of account, and store of value functionsof domestic money • Currency substitution (CS)(direct currency substitution): foreign currency is used for payments • replacing the medium of exchange function of domestic money • Asset substitution(AS)(indirect currencysubstitution):foreign currency is mainly used as a store of value

3. Objectives of the Study Why it is important: • Budget deficit financing becomes more inflationary • Probability of a banking crisis increases due to a mismatch of assets and liabilities as well as a lower ability to pay of foreign currency borrowers • The structure of dollarization—whether it represents more CS or AS—is crucial in the choice of exchange rate regime or monetary aggregate as an operating goal of monetary policy Objectives of the study: • Determine dollarization factors in transition economies • Test whether financial market developments are determinants of dollarization in transition economies; • Draw conclusions regarding policies aimed at minimizing adverse effects of dollarization

4. Hypotheses • The level of dollarization is determined by return and risk characteristics of assets denominated in national and foreign currencies; • The level of dollarization depends on the extent of financial markets development;

5. Where This Project Fits Existing Literature • Early CS models (Calvo and Rodriguez, 1977; Leviatan, 1981)—assume only two assets: domestic and foreign currency • Asset portfolio balance models—explicitly assume the existence of bonds denominated in each currency • Sequential portfolio balance model (Miles, 1978) • Dynamic optimization model (Bufman and Leiderman, 1993) • “Unrestricted” portfolio balance model (Branson and Henderson, 1985; Cuddington, 1983;Thomas, 1985) • Balance sheet models (Ize and Levy-Yeyati, 1998)—consider dollarization from two sides of the financial intermediary; the absence of foreign currency in circulation among the assets

6. Theory • Thomas (1985) • Consumers maximize their expected utility by choosing real consumption level c and asset portfolio structure(f —foreign currency, b—foreign bonds) • Optimal choice (dollarization ratio) depends on the difference of real returns on foreign and domestic bonds(R-R), domestic and foreign prices volatility (Sand S, prices’ instantaneous standard deviations), and attitude to risk (V(A)—Arrow-Pratt measure of relative risk aversion)

7. Citations Savastano (1996): • “The relative importance of foreign currency as an inflation hedge will be inversely related to the economy’s level of financial development.” Cuddington (1989): • “Extending the Thomas paper to an environment where there are goods and capital markets imperfections would be one way of yielding an appropriate empirical specification on which to base tests of the importance of CS in LDCs.”

8. Model Specification • We assume that foreign prices are constant • “Net” relative return on domestic bonds can appear to be negative, we change net return into gross return • For small DR and RR, one can approximate

9. Financial Markets Development The extent of financial markets development affects the dollarization level through the following channels: • The change in domestic assets portfolio risk characteristics. Let d consist of a set of assets n (mainly, bank deposits). As n increases—emergence of enterprises’ stocks and bonds as well as government bonds—opportunities for domestic portfolio diversification increase; • Banking system development. If banks offer new instruments allowing its clients to hedge off inflation and/or devaluation (i.e., indexed deposits), then inflation volatility becomes less damaging, therefore, the dollarization decreases; • Due to borrowing constraints, CS and dollarization are not entirely independent. So, the dollarization might depend on the foreign trade turnover, as agents are not able to offset trade flows with financial instruments

10. Data 1 • quarterly data for 6 transition economies—Ukraine, Russia, Czech Republic, Slovak Republic, Poland, and Romania • Most of the data from the International Financial Statistics (IFS) • 1991–1993 until Q4’2000 dollarization ratio: • ratio of the sum of foreign currency deposits in the country to the money supply (to total volume of deposits (incl. those in domestic currency) and domestic currency in circulation)

11. Data 2 Real relative return of domestic bonds • difference between weighted domestic currency deposit rate and LIBOR on three-months’ deposits in the U.S. dollar, taking into account expected devaluation (changes in average quarterly exchange rate of the domestic currency to the U.S. dollar) Inflation volatility indicator • for quarterly data, we calculate it as variance of monthly inflation levels (taking monthly CPI data)

12. Preliminary Estimation Results • Empirical estimations do not support static exchange rate expectations. For Russia, Ukraine, Poland, and Slovak Republic, the best results were achieved for the specification, where rational exchange rate expectations are modeled, while for Romania and Czech Republic adaptive expectations fit better; • For all the countries in consideration, except for Slovak and Czech Republic, inflation volatility and relative returns are significant and correctly signed at least at 5% (for Ukraine), while for Russia, Romania, and Poland p-value is less than 1%; • Poland has the best results in the sample; • Incorporation of the foreign cash in circulation into the dollarization ratio, used for estimation, leads to different results for Ukraine and Russia. In case of Russia, the statistical properties of the regression improve, while for Ukraine they deteriorate.

13. Policy Implications • Relative return on assets and inflation volatility are determinants of dollarization in transition economies • Results of the Thomas model imply an alternative explanation of the hysteresis. According to the model, the increased relative return on domestic assets does not lead to the reduced dollarization if it is accompanied with an increase in inflation volatility. • Estimation results offer a potential to fight the dollarization resorting to such instruments as high domestic interest rates, predictable exchange rate, and stability (not necessarily decline) of inflation rate • Inflation targeting and sending signals to market about exchange rate dynamics seems to be a preferred instrument

14. Financial Market Development and dollarization (D) • T. Beck, A. Demirguc-Kunt, R. Levine “A New Database of Financial Development and Structure”, June 1999 • Transition economies (8): Russia, Ukraine, Poland, Romania, Czech Republic, Latvia, Lithuania, Estonia • Developing countries (5): Turkey, Egypt, Argentina, Bolivia, Chile • Averages over the 1990s, when available

15. D and Deposit Money Banks’ Assets

16. D and Private Credit

17. D and Stock Market Value Traded

18. D and Foreign Trade Turnover