Abstract
This paper reviews evidence of dollarisation in Former Soviet Union (FSU) countries, and finds that it is still very high, the well-known hysteresis effect. However high dollarisation – defined as the use of any foreign currency – is not only due to inertial lack of confidence. There is also some tentative evidence that suggests foreign currency is used – in both cash and deposit form – as one of the very few alternative instruments for portfolio diversification in an embryonic financial market. It is also shown that, contrary to the received wisdom, high dollarisation does not seriously impede effective conduct of monetary policy: money demand in FSU countries is stabilising, and the most important objective, meaningful inflation control, has been widely achieved. Thus, high dollarisation is not per se as damaging as often thought, and in fact has a beneficial dimension in promoting financial market development. Nonetheless, high dollarisation remains a concern since it provides mechanisms for magnifying vulnerabilities in the event of a crisis even if it might not be the direct cause of a crisis. This necessarily implies that some policy options (such as immediate exchange rate devaluation) are not viable or very costly in a crisis.
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Notes
See, for example, Balino et al. (1999) and Sahay and Végh (1995) on dollarisation in developing countries; these earlier studies demonstrate that dollarisation is by no means unique to the FSU.
The most recent example is Feige (2003), this volume; the concept probably first appeared in the literature in Calvo and Végh (1992).
There are cases of currency substitution – usually at very low levels – based not on lack of confidence but on ease of transactions. Canada, Switzerland, and other small advanced and stable economies with fairly open trade and financial borders have always exhibited holdings and use of neighbouring currencies for transaction purpose. The lesson here is that some dollarisation per se is not necessarily a reflection of poor economic conditions or policy in a home country.
It is worth pointing out that currency substitution usually coexists with asset substitution. Asset substitution, on the other hand, does not necessarily imply the presence of currency substitution (see Balino et al., 1999).
In studying dollarisation in the Kyrgyz Republic, Mongardini and Mueller (2000) also estimate foreign currency cash in circulation, using transaction records from foreign exchange bureaus.
In Estonia, Lithuania, and to some extent Latvia, euro currency is likely to play an important role in the currency supply. Including it would of course make the ratios even higher (Feige, 2002, 2003).
Feige's (2003) most recent paper now does provide values for the 1990s and through 2001, as does Oomes (2003) for Russia. These data should certainly be used in future analysis.
See Feige (2003, p. 19).
Both different initial conditions and policies – production structures and the importance of the military industry prior to independence, as well as a general lack of institutions, infrastructure, and to some extent political will – caused the sharper decline of output in FSU countries at the outset of transition. See, for example, Havrylyshyn et al. (1999).
In a 13 June 2002 article (Markets Get the Jitter about Brazil), the Financial Times points out that ‘Russia, which has been the favorite market for the past two years, has held up best in recent weeks. The country, which defaulted on its domestic debt in 1998, is today seen as a safe haven for emerging markets investors.’
Financial Times, 20 September 2002, p. 5.
In the event, this study could not capture the aftermath of the Russian crisis, which perhaps caused the dollarisation ratio in the Kyrgyz Republic to rise as seen in Table 2. Oomes (2003) refers to other such studies, as well as analogous approaches learning of new financial instruments.
The available evidence on each dollarisation as seen in Feige (2003) and Oomes (2003) leads to the same conclusion as ours in the section Dollarisation levels and trends.
See, for example, Berglof and Bolton (2001) and IMF (2000).
See, for example, Fry (1997) and BIS (2002) on some country experiences in creating markets for government debt aimed at facilitating the development of corporate debt markets. In Latvia, the government has even issued long-term bonds beyond financing needs to foster long-term finance in domestic currency. In contrast, Kazakhstan issued euro bonds for its pension system to buy.
The average growth rate between 1999 and 2001 was 6.2 percent (IMF European II Department database).
Russian Economic Barometer, various issues; Ukraine: IMF Country Report 01/28, 5 February 2001.
Berglof and Bolton (2001) emphasise the lack of proper enforcement of legal and regulatory frameworks in the CIS, limiting the scope to clean up the banking system of the remaining unsound institutions. Also see IMF (2000) and World Bank (2002).
Presumably, dollarisation implies a certain degree of capital mobility. As domestic foreign currency deposits are close substitutes to foreign currency deposits abroad, there is a closer link between interest rates; thus, there is less scope for the domestic monetary authority to control domestic interest rates.
In addition, as pointed out above, exchange rates have been gradually depreciating without being excessively volatile since the end of the Russian crisis.
Also see Reinhart and Savastano (2003), who do not find evidence in support of the ‘received wisdom’ by looking at measures of velocity in a broad set of countries.
Intermediate targets range from NDA and reserve money in Armenia and Azerbaijan, the dollar exchange rate (de facto) in Belarus, reserve money in Kazakhstan and Moldova, money in Russia (although the exchange rate is heavily managed), and implicitly the exchange rate in Ukraine.
While the Baltics are in the process of gradually aligning their reserve requirement regimes with ECB rules (RR of 2 percent), CIS countries tend to have higher reserve ratios on average, around 10 percent. Russia, for example, has a reserve ratio of 10 percent for corporate clients and 7 percent for deposits of individuals, both in domestic and foreign currency. The Kyrgyz Republic applies a reserve ratio of 10 percent for all deposits except for foreign currency deposits with a term of over 1 year. Azerbaijan uses a uniform system, applying a reserve ratio of 10 percent on all deposits. Georgia requires its banks to hold 14 percent of attracted funds.
The loss of seigniorage can also pose a risk to national budgets in that other sources of finance have to be found. However, macroeconomic stability and sufficient financial sector development, implying a lower base for the inflation tax, sets this argument into perspective. Monetisation in CIS countries, however, is still low, thereby limiting potential losses from forgone seigniorage.
See, for example, Balino et al. (1999).
Uruguay is a good example. Deposit outflows were particularly strong in domestic banks that had to rely on the central bank for liquidity support, which has driven down international reserves.
Powell (2002), for example, argues that the ‘safety valve’ view of depreciation might be so costly in highly dollarised economies that it is not a safety valve at all.
However, an excessively overcapitalised banking system, while less susceptible to crises, tends to be inefficient.
The Baltics, for example, developed sound banking systems through allowing foreign ownership of banks, which has fostered governance and sound lending practices and has enhanced risk management practices.
These data, however, have to be interpreted with caution due to different accounting standards, potential double counting, and the exclusion of some banks.
A good example is Berg and Borenstein (2000), who have assessed the costs and benefits of full dollarisation. Whether or not full dollarisation could be beneficial depends on country specifics, most notably the present degree of dollarisation. Countries that already use the dollar extensively presumably do not lose much in terms of seigniorage, and the financial risk of banks and corporates associated with devaluation could be eliminated. As full dollarisation is unlikely to be considered an option for CIS countries, the issue is beyond the scope of this paper.
Uzbekistan may be a good example here. Administrative controls are extensive and measurable dollarisation is therefore low. However, it is by no means evident that, as argued by some advocates of the Uzbek policy, the administrative controls enhanced economic performance. Certainly they contributed to spreads of black market rates over 100 percent until recently.
In addition, as we argued above, there is still insufficient supply of domestic currency assets that would permit portfolio diversification.
Ize and Levy-Yeyati (1998) also find that the adoption of an inflation targeting regime can help to limit dollarisation by reducing inflation volatility relative to real exchange rate volatility. At this time, however, this is not too relevant in the case of FSU countries.
Both effects could reverse what we observe right now, namely the return of capital to countries of the FSU, and continued financial deepening.
The same result can be obtained if the remuneration on foreign currency deposits is lowered.
References
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1The authors are staff members of the International Monetary Fund. The views expressed in this paper are theirs only and do not reflect the position of the International Monetary Fund or its Board of Directors. We are grateful to the participants in the Dubrovnik Economic Conference, June 2002, and an IMF seminar in January 2003 for their comments on an earlier draft of this paper, and in particular to Peter Keller, Rick Haas, Ed Feige, Johannes Mueller, and Nienke Oomes, as well as an anonymous referee. We thank Divina Marquez for her patience and efficiency in producing several iterations of this draft. Mandana Dehghanian and Anna Unigovskaya provided excellent assistance on the datawork.
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Havrylyshyn, O., Beddies, C. Dollarisation in the Former Soviet Union: from Hysteria to Hysteresis. Comp Econ Stud 45, 329–357 (2003). https://doi.org/10.1057/palgrave.ces.8100018
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DOI: https://doi.org/10.1057/palgrave.ces.8100018