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Financial Dollarization and European Union Membership

Financial Dollarization and European Union Membership. Kyriakos C. Neanidis Economics Centre for Growth and Business Cycle Research University of Manchester. Definitions Official (or de jure ) dollarization

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Financial Dollarization and European Union Membership

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  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

  17. 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.

  18. 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

  19. 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.

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