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De-Dollarize?. Guillermo Calvo December 2, 2003. Domestic Liability Dollarization. Currency Substitution is the result of historical events that lead domestic residents to become familiar with FX. CS militates against bank stability if FX deposits are not allowed.
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De-Dollarize? Guillermo Calvo December 2, 2003
Domestic Liability Dollarization • Currency Substitution is the result of historical events that lead domestic residents to become familiar with FX. • CS militates against bank stability if FX deposits are not allowed. • Thus, authorities have incentives to allow for FX deposits. • FX deposits lead to FX loans, at least for regulatory reasons. This is the genesis of Domestic Liability Dollarization, DLD.
Fractional Reserve Requirements: More DLD! • Given Fear of Floating, banks probably take excessive currency risk, the latter reinforcing Fear of Floating. • Moreover, if a large devaluation takes place, banks expect that the government will bail them out (e.g., peso-fication), which further enhances taking currency risk by banks.
DLD Dangerous? • Calvo-Izquierdo-Mejia suggests that the probability of Sudden Stop increases significantly with DLD • Especially for economies that cannot rapidly expand their exports, like Argentina 2001/2.
Non-Indexed Financial Contracts? Difficult because • Dollarization is rooted in history, and has increased over time. • Government will have to convince public that monetary and fiscal policy will not lead to past mistakes, or risk taking. • Even that may not succeed due to hysteresis, see Martin Uribe, Guidotti-Rodriguez. • Credibility of present and future governments will have to established! CONJECTURE: Given the tax-revenue volatility in Latin America, non-indexation may call for much lower public debt, or state-contingent govt. expenditure (e.g., wages, interest rate)
Indexed Financial Contracts? • Interest-rate indexation has not avoided serious debt problems (Colombia, Mexico Tequila) • “Pan-ification” could run into difficulties if, e.g., Sudden Stop lowers real wages or real estate prices. • Panification could be implemented in a fully dollarized system by making payments a function of, e.g., CPI or real estate prices. • “How to index” becomes a tricky political issue after Sudden Stop (e.g., Argentina 2002/3) – undermining the credibility of the index itself. NB
Learning to Live with DLD • High reserve requirements on both domestic currency and FX deposits (imposing them only on FX deposits may reinstate the kind of bank instability that FX deposits intended to uproot). • Open up the economy to increase export response if Sudden Stop (Chile, Korea). • e.g., IDB’s Competitiveness Strategy • Stabilization Funds to offset fiscal revenue volatility. • Monetary unions. Full Dollarization
Do No Harm What Can IFIs Do? • Partial and even complete dollarization may dominate other forms of indexation (e.g., El Salvador). • When dollarization is clearly harmful, help countries to live with DLD. • To extricate the disease once-and-for-all without resorting to indexation: • help to develop competitiveness strategies, e.g., better creditors’ protection schemes. • help countries enter into international arrangements that would prevent time-inconsistent exchange rate management. • call for lower debt ratios and/or state-contingent government expenditure.
