monetary policy under de facto dollarization: the cases of ...€¦ · 2 by dollarization the...

Freie wissenschaftliche Arbeit

zur Erlangung des Grades Diplom Volkswirt

mit dem Thema

Monetary Policy under De Facto Dollarization:Monetary Policy under De Facto Dollarization:

The Cases of Peru and CroatiaThe Cases of Peru and Croatia

Eingereicht bei:

Prof. Dr. Peter Bofinger

Lehrstuhl für Volkswirtschaftslehre

Geld und internationale Wirtschaftsbeziehungen

Julius‐Maximilians‐Universität Würzburg Eingereicht von:

Christian Schaub

(Dipl.) Volkswirtschaftslehre

Abgabetermin: 23. Dezember 2009

Contents ii

Contents

Contents ...................................................................................................................................................... ii

Figures and tables.................................................................................................................................. iv

Abbreviations ........................................................................................................................................... v

1 INTRODUCTION................................................................................................................1

2 THEORETICAL BACKGROUND .....................................................................................4

2.1 Theory on dollarization ......................................................................................................4

2.1.1 What is dollarization?............................................................................................4

2.1.2 What causes de facto dollarization?................................................................8

2.1.2.1 The theories ................................................................................................8

2.1.2.2 The financial environment ................................................................ 12

2.1.3 The dynamics and persistence of dollarization ...................................... 15

2.2 Monetary policy and dollarization .............................................................................. 19

2.2.1 Some fundamentals on modern monetary policy .................................. 19

2.2.2 Why should monetary policymakers care about dollarization? ...... 22

2.2.2.1 Monetary policy efficiency and transmission ........................... 23

2.2.2.2 Financial fragility and economic vulnerability......................... 26

2.3 Measuring dollarization................................................................................................... 29

2.3.1 Conventional measures ..................................................................................... 29

2.3.2 Current measures................................................................................................. 31

2.3.3 The use of data in this study............................................................................ 34

3 EMPIRICAL ANALYSIS AND CASE STUDY............................................................... 36

3.1 Analyzing de facto dollarization................................................................................... 36

3.1.1 Trends in worldwide dollarization: Some stylized facts..................... 36

3.1.2 The Peruvian experience with dollarization ............................................ 42

3.1.3 The Croatian experience with euroization................................................ 46

Contents iii

3.2 Monetary policy under the constraints of dollarization and euroization .. 51

3.2.1 Monetary policy in Peru .................................................................................... 52

3.2.1.1 The monetary policy framework and its instruments .......... 52

3.2.1.2 The recent monetary experience in Peru.................................... 57

3.2.2 Monetary policy in Croatia............................................................................... 63

3.2.2.1 The monetary policy framework and its instruments .......... 63

3.2.2.2 The recent monetary experience in Croatia .............................. 68

3.3 Policy issues from both cases – lessons and options .......................................... 74

3.3.1 Comparison and general lessons................................................................... 74

3.3.2 Further policy options: Full dollarization or de‐dollarization? ....... 79

4 CONCLUSIONS AND FUTURE PROSPECTS ............................................................. 82

Appendix.................................................................................................................................................. 86

References............................................................................................................................................... 95

Figures and tables iv

Figures and tables

Figure 1 ‐ Dollarization terminology ..............................................................................................7

Figure 2 ‐ Causes of dollarization and euroization................................................................ 15

Figure 3 ‐ The dynamics of de facto dollarization.................................................................. 16 Figure 4 ‐ The foreign currency balance sheet of a de facto dollarized economy.... 30

Figure 5 ‐ Regional variation of dollarization ratios (average 2000‐2004, in %).... 39 Figure 6 ‐ Successful de‐dollarization in Israel and Poland .............................................. 40

Figure 7 ‐ Increasing dollarization in Ecuador and El Salvador ...................................... 41

Figure 8 ‐ Dollarization and inflation in Peru .......................................................................... 43 Figure 9 ‐ Dollarization in CESEE economies* (average 1994‐2004, in %) ............... 46

Figure 10 ‐ Euroization and inflation in Croatia..................................................................... 47 Figure 11 ‐ Composition of broad money in Croatia ............................................................ 50

Figure 12 ‐ Adjusted inflation targeting in Peru..................................................................... 53

Figure 13 ‐ Interest rate policy and interbank interest rate in Peru ............................. 58 Figure 14 ‐ Foreign exchange interventions and exchange rate in Peru ..................... 60

Figure 15 ‐ Inflation and imported inflation in Peru ............................................................ 62

Figure 16 ‐ International reserves and money supply in Croatia ................................... 65 Figure 17 ‐ Assets of the CNB in September 2009................................................................. 66

Figure 18 ‐ Foreign exchange interventions and exchange rate in Croatia ................ 70 Figure 19 ‐ Reserve requirements in Croatia........................................................................... 71

Figure 20 ‐ High levels of international liquidity in 2008 (in %).................................... 76

Figure A 1 ‐ Persistent dollarization and decreasing inflation worldwide................. 93 Figure A 2 ‐ EUR/USD exchange rate .......................................................................................... 93

Table 1 ‐ Degrees of dollarization in selected countries worldwide (in %)............... 37 Table 2 ‐ Increasing dollarization and decreasing inflation worldwide ...................... 42

Table 3 ‐ Composition of bank deposits in Peru (in %)....................................................... 45 Table 4 ‐ Decreasing interbank interest level and volatility in Peru ............................. 54

Table 5 ‐ Low inflation in Peru and Croatia (annual average CPI, in % change)...... 78

Table A 1 ‐ Deposit dollarization degrees of 136 countries* ............................................ 85

Abbreviations v

Abbreviations

BCRP ‐ Central Reserve Bank of Peru

BIS ‐ Bank for International Settlements

Bps ‐ Basis points

BTP ‐ Treasury bond of the BCRP

CDR ‐ Exchange rate indexed securities

CDBCRP ‐ Certificate of Deposit of the BCRP

CESEE ‐ Central Eastern and Southeastern European

CMIR ‐ Currency and Monetary Instrument Reports

CNB ‐ Croatian National Bank

CPI ‐ Consumer Price Index

EC ‐ European Commission

ECB ‐ European Central Bank

EMU ‐ European Monetary Union

EP ‐ European Parliament

Fx ‐ Foreign exchange

HRK ‐ Croatian Kuna

IFS ‐ International Financial Statistics

IMF ‐ International Monetary Fund

IT ‐ Inflation targeting

MVP ‐ Minimum Variance Portfolio

NIR ‐ Net International Reserves OeNB ‐ Austrian National Bank

PEN ‐ Peruvian Nuevo Sol

UIP ‐ Uncovered Interest Parity

WEO ‐ World Economic Outlook

1 Introduction 1

1 INTRODUCTION

Dealing with currencies is a puzzle, in which monetary policy has a particularly

prominent role to play. Central banks typically have the exclusive right to issue

banknotes and coins in their own currency and therefore usually are in the unique

position to control domestic money supply at all times. However, there is an im‐

portant fact that deserves particular attention:

„Central banks know precisely how many banknotes their printing works pro‐duce. However, they do not know where banknotes are held once they enter into circulation, due to their anonymity.“ (PADOA‐SCHIOPPA 2002)

Recently, academic literature has attempted to shed some light on the location

and amount of currency circulating outside the country of issuance. PORTER AND

JUDSON (1996) provide an early estimation and find that about 55 to 70 percent of

US currency is held overseas. SEITZ (1997) and DOYLE (2000) show that between 30

and 70 percent of the total amount of Deutschemarks was held abroad in the mid‐

1990s. Today, large sums of euro currency are found to circulate outside the euro

area (see, for instance, DVORSKY ET AL. 2008 or STIX 2008).

The observation that domestic residents hold a significant share of their assets

in the form of foreign currency denominated assets is referred to as dollarization

(cf. BALINO ET AL. 1999: 1). The worldwide preference for foreign currency as a me‐

dium of exchange, store of value or unit of account – i.e. de facto dollarization – has

increased in relevance in the last decades and is particularly widespread in devel‐

oping and emerging economies1. Two regions are found to show larger‐than‐

normal degrees of de facto dollarization: Latin American and Eastern European

transition economies (see section 3.1). Having a good reputation as stable and in‐

ternationally accepted currencies, the US dollar and the euro are at the center of

this issue.

Several emerging market crises in the 1990s (e.g. Southeast Asia 1997/98 and

Argentine 2001/02) and mounting evidence that exchange rate targeting is not a

panacea have led to the fact that literature on monetary and exchange rate policy is

more and more concerned with the environment under which policymakers oper‐

1 This paper abstains from a clear distinction between developing and emerging market economies.

1 Introduction 2

ate. Hence, the academic debate on de facto dollarization has intensified in recent

years, whereby the empirical studies by REINHART ET AL. (2003) and LEVY YEYATI

(2006) are particularly worth mentioning. Traditional literature argues that dol‐

larization poses an extra challenge for monetary policy effectiveness and leads to a

weaker transmission (see section 2.2.2). In addition, a major concern of monetary

policy in dollarized2 economies is the balance sheet effect that entails increased

financial vulnerability – in short, dollarization creates an inevitable currency mis‐

match that can unfold into a catastrophic scenario for the whole economy (cf.

GALINDO AND LEIDERMAN 2005: 10‐14). Hence, there is good reason why monetary

policymakers should care about this phenomenon.

This study is titled ‘Monetary policy under de facto dollarization: the cases of

Peru and Croatia’. On the one hand, it gives a broad review of the existing literature

on dollarization and analyzes the recent experience of several bi‐currency econo‐

mies in general. On the other hand, by studying the conduct of monetary policy in

two countries with strikingly high dollarization levels – Peru and Croatia – in de‐

tail, it provides new insights into the current challenges that dollarization poses to

monetary policy. Comparing countries from two different regions allows the

author to study the overseas use of the dollar and the euro simultaneously and,

above all, to give some general advice to be abstracted from the concrete examples.

Within the limits of a descriptive paper, this study attempts to contribute to the

recent empirical analysis, thereby attempting to shed further light on the discus‐

sion on monetary policy under the constraints of dollarization. The structure of the

present paper is formed by two main building blocks: First, part 2 aims to provide

important theoretical background, whereupon part 3 deals with the empirical

analysis and studies the cases of Peru and Croatia in‐depth.

The theoretical part is, in turn, divided into three sections: Section 2.1 gives an

overview of the existing theory on de facto dollarization – thereby, it clarifies the

confusing terminology first, then analyzes a number of causes and finally studies

the dynamics and persistence of de facto dollarization. Section 2.2 leads over to

monetary policy: before the concerns of policymakers in dollarized economies can

2 By dollarization the author will always refer to de facto dollarization rather than de jure dollariza‐tion. Referring to de jure dollarization will be indicated properly.

1 Introduction 3

be discussed properly in section 2.2.2, it is necessary to give a brief introduction to

modern monetary policy in the first instance. Thereafter, section 2.3 addresses the

challenges of the empirical debate on dollarization, thereby laying the foundations

for subsequent analysis. Here, conventional and current dollarization indicators

are discussed, whereby section 2.3.3 identifies the adequate measure for the pur‐

pose of this paper and explains the origin of the data used later.

The empirical part is also composed of three sections: some stylized facts on

the trends of de facto dollarization worldwide and the analysis of the Peruvian and

Croatian bi‐currency experience form section 3.1. It is shown that Peru and Croatia

are placed among the countries with the highest degree of dollarization. Thereaf‐

ter, section 3.2 focuses on monetary policy under the constraints of dollarization

and euroization – thus, the monetary policy framework and its instruments as well

as the recent conduct of monetary policy are examined for both cases respectively.

The differences in the monetary strategies of Peru and Croatia are compared in

section 3.3: the cross‐country section makes it possible to find some general policy

advice and to discuss further monetary policy options for highly dollarized econo‐

mies. Part 4 provides a brief summary of the most important findings and intends

to conclude with an outlook of the future of monetary policy in Peru and in Croatia.

2 Theoretical background 4

2 THEORETICAL BACKGROUND

Academic circles have widely discussed de facto dollarization and its implications

for monetary policy. The first part of this paper gives a broad review of the theo‐

retical literature and an insight into the challenges of existing empirical work.

Thereby, it lays the foundations for subsequent analysis of the cases of Peru and

Croatia, which forms the second part of this study. At first, the theoretical part

deals with the main characteristics of dollarization and clarifies the terminology,

its drivers and dynamics.

2.1 Theory on dollarization

2.1.1 What is dollarization?

In the last few decades, the term dollarization has been used to specify a number of

different phenomena. Thus, it is crucial to shed some light on the confusing termi‐

nology. In general, dollarization can be defined as “the holding by residents of a

significant share of their assets in the form of foreign currency‐denominated as‐

sets” (BALINO ET AL. 1999: 1). Moreover, a distinction is usually made between offi‐

cial (de jure) and unofficial (de facto) dollarization.

For a period of more than two decades, the term dollarization is associated

with the fact that domestic residents of a specific country hold foreign currency

cash or foreign‐denominated assets as part of their asset portfolio (cf. REINHART ET

AL. 2003: 4). At the end of the 1990s, however, the debate begins to concentrate

increasingly on the issue of full (de jure) dollarization. This form of dollarization

occurs if a country abstains from issuing its own domestic money and adopts a

foreign, more stable currency as the country’s official legal tender instead (cf.

GULDE ET AL. 2004: 1). This foreign currency most typically is the U.S. dollar. The

discussion on de jure dollarization focuses primarily on the policy issue of choos‐

ing an optimal exchange rate regime for developing or emerging market econo‐

mies.3

3 The debate has been inspired by a few countries that adopted the dollar as their national currency in the late 1990s. Today, the three most noteworthy independent economies that have officially dollarized are Panama (since 1904), Ecuador (since 2000) and El Salvador (since 2001). BERG AND


Renewed academic interest in the concept of partial (de facto) dollarization4

arises at about the same time. This involuntary form occurs when the authorities

maintain national money as the only official legal tender of the country, while do‐

mestic residents choose to use one or several foreign currencies alongside domes‐

tic one (cf. ZAMAROCZY AND SA 2003: 26). Thus, a bi‐currency system effectively takes

hold of the economy.5

Defining characteristics to identify and subdivide dollarization further can be

derived from the definition of money. Although defining money itself raises a se‐

ries of difficulties, a standard approach in literature is to define money by its func

tions.6 In situations with partial dollarization, two or more currencies are being

used to perform different functions of money – so, foreign currency may be used as

a means of payment, store of value or unit of account.

In fact, early theoretical literature on dollarization focuses primarily on for‐

eign currency as a medium of exchange. This strand of research is widely known as

literature on currency substitution (cf. CALVO AND VEGH 1992: 1). Later however, the

use of foreign currency as a store of value becomes the center of interest. For many

years, this literature – often labeled as asset substitution – only studies situations in

which residents hold foreign currency financial assets rather than foreign currency

financial liabilities (cf. ALVAREZ‐PLATA AND GARCIA‐HERRERO 2008: 4). However, the

emerging economies’ private and public sectors largely borrow in foreign cur‐

rency, not least demonstrated by the 1998 crisis in Southeast Asia. Consequently,

the concept of liability dollarization plays a crucial role in recent studies on partial

dollarization (cf. LEVY YEYATI 2006: 64).

After all, DE NICOLO ET AL. (2005: 1699) probably put forward the most useful

and coherent definition of dollarization. They make a distinction between three

forms of partial dollarization. BORENSZTEIN (2000), LEVY YEYATI AND STURZENEGGER (2003) and SALVATORE ET AL. (2003), to name only a few authors, have done noteworthy work in this field of research.

4 The terms partial, unofficial and de facto dollarization are used interchangeably. Referring to de jure dollarization, this study also uses full or official dollarization.

5 Following what has become standard in the literature on de facto dollarization, the term dollariza‐tion shall serve as shorthand for the use of any foreign currency. Thus, the term is also describes countries that are in fact euroized – i.e. when primarily the euro is used alongside the national le‐gal tender.

6 Money performs as medium of exchange, store of value and unit of account. See, for instance, BOFINGER (2001: 3‐19) for a detailed discussion.


“It is useful to distinguish among three generic types of dollarization that broadly match the three functions of money: payments dollarization (also known in the literature as currency substitution) is residents’ use for transaction pur‐poses of foreign currency in cash, demand deposits, or reserves at the central bank; financial dollarization (also referred to as asset substitution) consists of residents’ holding of financial assets or liabilities in foreign currency; real dol‐larization is the indexing, formally or de facto, of local prices and wages to the dollar.” (IBID.)

The above quotation introduces a more recently created term of financial dol

larization that comprises both asset and liability substitution. Moreover, it should

be mentioned that financial dollarization may be of domestic or external nature,

depending on whether financial contracts are made between residents (including

the domestic government) or cover contracts between residents and non‐residents

(cf. IBID.). Regarding real dollarization, prices may be quoted directly in foreign

currency (formally) or be indexed indirectly to a foreign currency (de facto).

This detailed distinction has become standard in recent literature on dollari‐

zation and is not merely a problem of definition. On the contrary, it will continue to

draw the reader’s attention throughout various stages of this paper. The function a

foreign currency performs within the local economy (i.e. the underlying type of

substitution) indicates the motives and drivers behind dollarization. Thus, a good

knowledge of both the extent and nature of dollarization is required to analyze its

implications for monetary policy and, ultimately, to make prudent monetary policy

decisions. Thus, in line with CALVO AND VEGH (1997: 154), this distinction is re‐

garded as a key to interpreting and understanding the main issues of this fascinat‐

ing field of study. Figure 1 helps to illustrate the present terminology on dollariza‐

tion.


Figure 1 Dollarization terminology

Source: own illustrations

Nevertheless, it is important to note that the different types of dollarization –

official dollarization aside – usually do not occur independently. Currency substitu‐

tion is generally accompanied by asset substitution, since it is natural to hold fi‐

nancial assets in the currency in which payment is made (cf. BALINO ET AL. 1999:

14). Asset substitution, however, does not necessarily involve currency substitu‐

tion – domestic economic agents may save in foreign currency while transactions

are made in the domestic one. IZE AND PARRADO (2002: 25‐26) study the relations

between real dollarization and financial dollarization and find that real dollariza‐

tion generally contributes to financial dollarization. However, as they also observe

asymmetries between the two, many questions regarding real dollarization re‐

quire further research and links to other forms remain unclear. All in all, a close

connection between the different forms of dollarization cannot be ignored in prac‐

tice.

Finally, this paper defines the prevailing feature of a de facto dollarized econ‐

omy by the households’, firms’ or the government’s voluntary use of a foreign cur‐

rency – primarily the dollar or the euro – as a store of value, unit of account or me‐

dium of exchange alongside the national legal tender. The next section deals with

the most important drivers of de facto dollarization.


2.1.2 What causes de facto dollarization?

Regarding the causes of dollarization, a few introductory notes should be taken

into consideration. National currencies can simply be regarded as tradable goods

(cf. CALVO AND VEGH 1992: 1). In the absence of restrictions, the domestic legal ten‐

der competes internationally with other currencies – e.g. hard currencies7 such as

the dollar or the euro. This, in turn, means that dollarization may be regarded as

the outcome of a process of competition (cf. MUELLER 1999: 287). If the foreign cur‐

rency is expected to perform better – e.g. as a means of payment, store of value or

unit of account – domestic agents may abandon local currency and use a foreign

one.

As causes of dollarization differ from case to case, the following list does not

claim to be complete. However, the author aims to outline the main theories on the

one hand and attempts to highlight several local or temporary developments that

primarily affect the financial environment and availability of foreign currency on

the other. The distinction between currency substitution (i.e. foreign cash being

used for transaction purposes) and asset substitution (i.e. foreign money primarily

serving as a store of value) continues to play an important role.

2.1.2.1 The theories

Early theoretical literature primarily interprets dollarization as a currency substi‐

tution phenomenon. In this respect, a reasonable explanation for the abandonment

of the national currency is found to be at the top of the list:

“In general terms, dollarization is a response to economic instability and high in‐flation (…). In conditions of hyperinflation, dollarization is typically quite wide‐spread because the public seeks protection from the cost of holding assets de‐nominated in domestic currency.” (BALINO ET AL. 1999: 5)

This argument is easy to understand. As KEYNES (1923: 41) argues, one of the

ways in which the public can protect itself from the inflation tax8 is to employ for‐

eign money in transactions where it would be more natural and convenient to use

7 A hard currency is defined to be an internationally accepted currency that has a good reputation as reliable and stable money.

8 The author abstains from a detailed description of the term ‘inflation tax’. For further explanations see, for instance, BOFINGER (2001: 369‐383).


the local currency. Thus, high and volatile levels of inflation9 are said to be the

chief reason for dollarization. The theory developed thereafter is well known as

the ‘currency substitution view’ and focuses primarily on the use of foreign cur‐

rency as a means of payment. Since the Fisher equation10 holds, standard models

in this vein explain the ratio between domestic and foreign currency nominal bal‐

ances (c) as a function of the nominal interest rates in domestic (i) and foreign (i*)

currency.

(1) c = f (i, i*), where f’<0 and f’’>0

Under the assumption that the uncovered interest parity (UIP)11 holds, infla‐

tion is ultimately reflected in the nominal exchange rate and expected inflation (in

turn, expected depreciation) should promote currency substitution (cf. LEVY YEYATI

2006: 77). In short, theory on currency substitution states that the demand for

domestic currency for transaction purposes is negatively correlated with the coun‐

try’s inflation rate. Put differently, this view basically attributes a country’s current

degree of dollarization to its high and chronic inflation – in particular, expected

inflation and nominal depreciation are regarded as the key drivers.

However, this cannot be the only reason why domestic savers choose to hold

financial assets in other currencies.

“After all, financial assets bear interest rates and as long as investors are com‐pensated for the inflation premium, there should not be any reason why they should hold financial assets in other currencies.” (OZSOZ ET AL. 2008: 5)

In other words, it is argued that the composition of interest‐bearing assets

should be immune to the inflation level and nominal devaluations (see, for in‐

stance, THOMAS 1985), which is a clear challenge to the currency substitution view.

Searching for alternatives, recent literature has produced a number of analyti‐

cal models, which tend to stress the store of value function of money – in turn,

these models concentrate on asset substitution. In general, the so‐called ‘portfolio

9 High and volatile inflation is often a result of fiscal imbalances (cf. CALVO AND VEGH 1992: 2). Evi‐dence shows that large and persistent rather than slight and short‐termed fiscal deficits lie at the roots of inflation and ultimately cause dollarization (cf. YINUSA 2008: 24).

10 The Fischer equation stipulates that the nominal interest rate equals the sum of the real rate of interest and expected rate of inflation (cf. FISCHER 1896: ch. III).

11 The UIP basically explains changes in the exchange rate by the interest rate difference between foreign and domestic interest rates. See, for example, BOFINGER (2001: 391‐403).


view’ assumes that risk and return considerations about domestic and foreign as‐

sets are responsible for the substitution of financial assets. In this respect, IZE AND

LEVY YEYATI (2003: 327‐331) recently have presented a minimum variance portfo‐

lio (MVP) approach. They start from the assumption that risk‐averse resident

agents can choose between interest bearing bank deposits in foreign currency and

local currency. Moreover, these investors are assumed to maximize their asset

portfolio according to the following utility function:

(2) U = E(r) – Var(r)/2,

where r is the real return of the portfolio of assets in domestic and foreign

currency. In turn, the real return on local currency‐denominated assets is influ‐

enced by changes in the domestic inflation rate, whereas the real return on for‐

eign‐denominated assets depends on unexpected changes in the real exchange rate

(cf. LEVY YEYATI 2006: 78). Minimizing the variance of portfolio returns, the eco‐

nomic agent opts for a currency composition that depends on the volatility of infla‐

tion and real depreciation rates.

As a result, it is shown that if the variation of the local inflation is high in rela‐

tion to the real exchange rate volatility, risk‐averse domestic investors consider

local‐currency assets as more risky and less attractive than foreign‐currency de‐

nominated assets. Hence, within this framework, incentives for (financial) dollari‐

zation come from the volatility of inflation in relation to real exchange rate depre‐

ciation rather than expected inflation rates and nominal depreciation as stated by

the currency substitution view.

Moreover, revising the model from a different perspective, some interesting

implications can be found. As IZE AND LEVY YEYATI (2003: 344) explain, the

“results suggest that financial dollarization is likely to persist as long as inflation volatility remains high in relation to real exchange rate volatility, even in low inflation environments.” (IBID.)

At the same time, it is clear that a stable domestic inflation and volatile real

exchange rate should make the domestic currency the economy’s preferred store

of value (cf. RENNHACK AND NOZAKI 2006: 6). This indicates that a flexible exchange

rate could minimize the incentives for dollarization, whereas a fixed exchange rate

could foster asset substitution. To sum up, it can be said that, regarding the causes


of financial dollarization, risk and return considerations must be taken into ac‐

count. From the portfolio view results that the relative volatilities of inflation and

the real exchange rate depreciation play a crucial role.

Another reason for high dollarization levels is seen in the quality of institu‐

tions. LEVY YEYATI (2006: 82) introduces the term ‘institutional view’ to embrace a

number of different ways in which the quality of institutions may serve as a cata‐

lyst for dollarization.12 An early contribution is made by CALVO AND GUIDOTTI (1990).

They highlight the fact that weak governments may not be able to credibly assure

debt holders that it will not inflate away the real burden of debt. Hence, investors’

expectations lead to high interest rates on domestic currency and trigger an infla‐

tion bias. In this case, the government may take the costly path of dollarizing its

debt obligations in order to commit to its low inflation program (LEVY YEYATI 2006:

82‐83). Thus, public debt dollarization occurs as borrowers would now prefer to

take a chance with foreign currency.

DE NICOLO ET AL. (2003: 13) put forward another reasonable explanation that is

based on implicit government guaranties. It is assumed that the government re‐

gards the event of a large devaluation as a catastrophic systemic scenario for the

highly dollarized economy.13 Moreover, domestic lenders are assumed to antici‐

pate the authority’s ‘fear to float’, therefore expecting to be bailed out in such an

event. In other words, the weak government is not able to credibly state that it will

not bail out private agents if the domestic currency depreciates sharply. Thus, the

risks of foreign currency debt are not fully internalized. Domestic borrowers bene‐

fit from stable and low interest rates in foreign currency and rely on the govern‐

ment’s free insurance in the event of large depreciations. This type of dollarization

comes from a moral hazard scenario, which the government is almost unable to

avoid. Hence, the resulting type of dollarization could also be referred to as moral

hazard dollarization.

Taken together, it seems clear that low quality and the lack credibility of

institutions (both fiscal and monetary policy) is a key determinant in the process

of dollarization. Confidence cannot be built overnight. On the contrary, long‐term 12 Although LEVY YEYATI (IBID.) is the first to use the term ‘institutional view’ other authors, such as CALVO AND VEGH (1992: 3), have emphasized the importance of institutional factors earlier.

13 This may be attributed to the balance sheet effect, which is discussed in section 2.2.2.2.


credibility of institutions is a characteristic feature of any hard currency. To put it

in the words of GREENSPAN (1998):

“While dollar currency circulating in such a [poorly performing] country is credi‐bly backed by the U.S. government, any domestic dollar deposits or other claims are subject to the whim of the domestic government that could with the stroke of a pen abolish their legal status.” (IBID.)

Hitherto, three groups of theories have been presented in order to explain the

reasons for high de facto dollarization. The next section deals with drivers of dol‐

larization that are related to the financial environment.

2.1.2.2 The financial environment

In addition to above explanations, dollarization always partly reflects the sur‐

roundings in which financial markets operate. Academic literature provides a

number of drivers that can be associated with the financial environment and the

extent of availability of foreign currency for the country’s residents. These factors

are worth mentioning, although some of them may be of temporary or local nature.

Firstly, contrary to the theories of section 2.1.2.1 increased confidence rather

than weak institutions may also cause a rise in dollarization ratios. Especially in

post‐stabilization periods both domestic and foreign investors may regain trust,

which leads to large foreign currency inflows to emerging and developing econo‐

mies and therefore fosters dollarization (cf. MENON 2008: 230). Secondly, econo‐

mies with poorly developed financial markets are more prone to high dollarization.

In particular, importers are supposed to build up large stocks of internationally

accepted vehicle currencies as they face the risk of being temporarily unable to

obtain enough foreign money to pay their trading partners (cf. MUELLER 1999:

288). Moreover, the fact that financial instruments to hedge against exchange rate

fluctuations or inflation variability (e.g. indexed instruments) are not available

domestically makes the use of foreign currency more attractive. Thirdly, restric

tions are lifted to a great extent and in large parts of the developing world during

the early 1990s (cf. BALINO ET AL. 1999: 11). If, for instance, the holding of foreign

currency deposits is eased, the degree of dollarization is expected to rise. Obvi‐

ously, this seems to be a response to increased competition between currencies

and to the fact that the public takes this opportunity to diversify its asset portfolio

– thus, that can be regarded as part of an overall post‐stabilization process of re‐


monetization of the economy.14 Fourthly, advancing globalization significantly con‐

tributes to the rise in dollarization in the following two ways: On the one hand, as

EICHENGREEN AND HAUSMANN (1999) and EICHENGREEN ET AL. (2003) observe, emerg‐

ing economies are often unable to use local currency to borrow abroad or to bor‐

row domestically over the long term, which is commonly referred to as “original

sin”. Hence, as international financial markets are not open to exotic currencies,

emerging markets’ public debt is usually dollarized. On the other hand, payments

across borders (i.e. for trade) are predominantly carried out in dollars, euros or

other internationally accepted vehicle currencies. Thus, foreign currency inflows,

often resulting in high degrees of dollarization, are an almost unavoidable outcome

especially for small countries that are largely open to trade or based on export (e.g.

countries that are rich in raw material) (cf. IZE AND LEVY YEYATI 2005: 11; BECKER

2007: 223). In short, dollarization is driven to a considerable extent by increased

financial and trade integration in small and open economies.

This is linked to the special determinants of euroization and raises the ques‐

tion of whether euroization is different? Particularly, the surge of euroization in

Eastern Europe15 (see section 3.1.1) might be particularly attributed to the in‐

creasing integration with the European Union (EU) or, more precisely, the Euro‐

pean Monetary Union (EMU).

„The East also looks towards the European Union. The advent of the euro (...) has marked an acceleration of the economic and institutional unification of the European continent. Citizens in eastern Europe deliberately prefer the euro to another international currency as they are aware of the increasing links between their region and the European Union. These links are of financial, economic and institutional nature.“ (PADOA‐SCHIOPPA 2002)

There is no doubt that increased trade and financial links with the euro area

drive euroization in Eastern Europe. BECKER (2007: 244) states that high labor mi‐

gration and remittances might exacerbate euroization and even increased tourism

from euro citizens may play a role. In the case of Kosovo and Montenegro authori‐

ties have euroized monetary systems in order to promote separation from Yugo‐

slavia (cf. BECKER 2007: 253), which indicates that euroization may even be toler‐ 14 Finally, this development may eventually lead to a deepening of formerly poorly developed do‐mestic financial markets.

15 The term ‘Eastern Europe’ is used in a broad sense, embracing Central, Eastern and Southeastern European countries.


ated for political reasons. Furthermore, the prospect of joining the EMU appears to

be a crucial factor that goes hand in hand with the growing euro‐orientation of ex‐

change rate regimes across Eastern European countries (cf. LEVY YEYATI 2006: 105‐

106). Therefore, de facto euroization in Eastern Europe could be regarded as a

temporary phenomenon on a country’s way to become a member of the EMU.

However, LEVY YEYATI (IBID.) finds that the key reasons, which have been identified

by the theories in section 2.1.2.1, account reasonably well for this region. In other

words, while high euroization levels in Eastern Europe certainly reflect the geo‐

graphical proximity to the euro area in parts, classical drivers explain the ‘substitu‐

tion phenomenon’ fairly well at the same time.

In conclusion, high dollarization and euroization always result from various

drivers. The theoretical views provide a good basic understanding of the key driv‐

ers. In general, inflation volatility and expectations, unexpected depreciation of the

domestic currency and weak institutions (i.e. low credibility of monetary and fiscal

institutions) promote the domestic use of foreign currency. Moreover, factors re‐

lated to the financial environment can exacerbate dollarization. In this regard, dol‐

larization or euroization may appear to be a response to a given unchangeable en‐

vironment (e.g. large capital inflows) and sometimes seems to have some positive

impacts on the economy, such as financial market deepening. Before this study

continues with a discussion of the dynamics and persistence of dollarization, figure

2 attempts to summarize the causes presented in sections 2.1.2.1 and 2.1.2.2.


Figure 2 Causes of dollarization and euroization


2.1.3 The dynamics and persistence of dollarization

In general, dollarization does not arise overnight – it takes some time until the

causes develop their effects. The process of dollarization, however, often follows a

characteristic path.

BECKER AND VISCA (2004: 205‐210) state that the typical process of dollarization

or euroization begins with a period of political and economic instability – hence,

inducing high and volatile inflation rates. In the absence of restrictions on the hold‐

ing of foreign exchange (fx), the domestic currency is first abandoned in its func‐

tion as a store of value. The reason for this initial reaction is simply that highly

variable and uncertain real returns on domestic assets make the national currency

most vulnerable as a store of value (cf. CALVO AND VEGH 1992: 2). Thus, assets (in‐

cluding cash and deposits) are held in foreign currency for saving purposes – i.e.

asset substitution. Soon after, credits will be substituted (i.e. liability dollarization)


as banks usually avoid currency mismatches16 and borrowers benefit from low and

stable foreign currency interest rates. In consequence, this means that financial

dollarization occurs first of all.

The abandonment of the national currency as a store of value serves as a cata‐

lyst to undermine the other functions of domestic money. It is obvious that a stable

currency gives a more reliable indication of the actual purchasing power in the

face of high inflation rates. Provide a more convenient unit of account, prices start

to be quoted in foreign currency (cf. BECKER AND VISCA 2004: 205‐210). This process

usually begins with the indexation of big‐ticket items (such as automobiles or real

estate) and results in a full‐fledged real dollarization of the whole economy.

Since assets and liabilities are dollarized yet and the calculations are already

done in foreign currency, it is not surprising that some transactions will be carried

out in foreign exchange not long after. Again beginning with big ticket rather than

relatively cheap items, foreign money is gradually introduced as the domestic

economy’s prevailing medium of exchange (cf. BECKER 2007: 227; CALVO AND VEGH

1997: 153). To put it in another way, payments dollarization is typically the third

and last stage of a long‐lasting process of dollarization, rather than an instant reac‐

tion to temporary economic disturbances (see figure 3).

Figure 3 The dynamics of de facto dollarization


As inflation is supposed to be the key driver, conventional wisdom based on

currency substitution theory (see again section 2.1.2.1) suggests that dollarization

can easily be reversed. In particular, it predicts that the public shifts into foreign

currency when inflation rates increase. In turn, the process should reverse and the

public should shift back to domestic currency as soon as domestic inflation moder‐

16 Currency mismatches are explained in greater detail in section 2.2.2.2.


ates. However, empirical evidence17 generally does not support this view. In con‐

trast, once dollarization takes hold of the economy, it often appears to be a persis

tent phenomenon and seems impossible to reverse. As FISCHER (2006: 5) puts it,

dollarization “typically has a long life, generally surviving long after the period of

instability that gave rise to the phenomenon.”

Literature has developed several explanations to this puzzle, which is often re‐

ferred to as “dollarization hysteresis”18 (cf. FEIGE ET AL. 2002: 55). Traditional cur‐

rency substitution theories attribute irreversibility to longlasting memories of past

inflation (cf. SAVASTANO 1996). Accordingly, past inflation rather than current infla‐

tion rates induce high inflation expectations and payments dollarization even after

years of macroeconomic stability.

Moreover, GUIDOTTI AND RODRIGUEZ (1992: 1) formally explain dollarization

hysteresis to be a consequence of the fixed cost of switching to another currency.

According to the currency substitution view it is assumed that the switch from

domestic to foreign currency as a means of payment, which results from high do‐

mestic inflation, is a costly and lasting process. Thus, as long as the benefits from

switching back to the low‐opportunity‐cost currency do not compensate the costs

associated with changing the currency denomination of transactions, the domestic

inflation rate may fluctuate without inducing any changes in the degree of dollari‐

zation. In other words, there is a band for the inflation differential within and

above which dollarization persists as transaction costs exceed any incentive to

switch between currencies. This observation is contrary to Gresham’s Law19 as

good money drives out the bad (cf. GUIDOTTI AND RODRIGUEZ 1992: 2).

17 In this paper, section 3.1 addresses the persistence of dollarization empirically and finds that dollarization ratios remain high or even rise, despite major reductions in inflation and restored economic and political stability. In addition, MENON (2008: 228), SOSIC AND KRAFT (2006: 492) and MONGARDINI AND MUELLER (2000: 218) evaluate the persistence of the cases of Cambodia, Croatia and the Kyrgyz Republic. Only a few economies are found to succeed in undoing dollarization – most noteworthy, Poland and Israel (see section 3.1).

18 In general, the term hysteresis describes an effect, which remains once the initial cause giving rise to the effect is removed (cf. DAVIS ET AL. 1998: 235‐242).

19 Gresham’s Law originally states that the public uses coins minted below value instead of coins containing metal equivalent to their value as legal tender for payments purposes. Thus, more valuable coins are usually hoarded and the bad money drives out the good (cf. BRITANNICA 2009).


In addition, network externalities20 provide a related explanation. Here, it is

assumed that users of the same currency enjoy positive spillover effects. On the

one hand, this means that the more people use a foreign currency as their medium

of exchange, the lower are the transaction costs. On the other hand, switching be‐

tween currencies implies costs that may inhibit a return to the local currency even

after stabilization (cf. FEIGE 2002: 55). In short, once dollarization has reached a

certain threshold, the transaction cost of using foreign money falls below the cost

of switching back to national currency and dollarization becomes irreversible. This

explanation results in multiple equilibria, i.e. stable steady states exist at a low dol‐

larization and high dollarization equilibrium.

With respect to asset substitution, the portfolio view (see again section 2.1.2.1)

gives another reasonable explanation for dollarization hysteresis. Despite signifi‐

cantly reduced inflation levels, financial dollarization may survive as long as the

volatility of domestic inflation is higher than the volatility of the real exchange rate.

This can also explain why asset substitution may persist even in the case of de‐

creasing currency substitution. Furthermore, in that sense hysteresis may also be a

result of exchange rate‐based stabilization efforts of monetary policy makers.

Finally, some of the drivers that have been mentioned in section 2.1.2 are also

held responsible for the persistence of dollarization and euroization. Among them

one can find the weak institutions (i.e. the lack of credibility in the sustainability of

the government’s stabilization plan) and financial adaptation (i.e. the development

of new financial instruments). As the creation of new financial products is a costly

investment, domestic agents will continue to use these instruments, thereby de‐

creasing the demand for local money. Moreover, steady capital inflows due to in‐

creased confidence – especially foreign direct investment and capital flight rever‐

sals – account for the cases of rising financial dollarization ratios in post‐

stabilization periods (cf. BALINO ET AL. 1999: 7‐8; CALVO AND VEGH 1992: 12‐13).

In the end it can be concluded that dollarization hysteresis is not necessarily a

puzzle. This section has shown that there are various reasonable explanations for

20 A network externality is an „externality derived from being connected to other economic agents, for example through a telephone system or the internet. (...) The larger the proportion of the population connected to such a network, the greater the benefits to each of them“ (BLACK ET AL. 2009).


irreversibility, depending on the underlying type of dollarization (i.e asset or cur‐

rency substitution). In the words of MENON (2008: 232):

“Basically, it [dollarization hysteresis] suggests that history matters, and that there can be nonlinearities, or “stickiness”, in the system, that should be taken into account in order to understand the process, or its unravelling.” (IBID.)

So far, it should be clear that different types of partial dollarization exist and

that a variety of events can induce the process of dollarization, which typically fol‐

lows a characteristic path. As a result, dollarization often becomes a permanent

feature of the economy. The next section studies deals with monetary policy,

thereby focusing particularly on the challenges that dollarization imposes for

monetary policymakers.

2.2 Monetary policy and dollarization

In the following section, the relation between de facto dollarization and monetary

policy will be properly clarified. Before it can be explained why monetary policy‐

makers should care about de facto dollarization, it is necessary to discuss what

central banks should do in general and how modern monetary policy should be

conducted, especially considering emerging market economies.

2.2.1 Some fundamentals on modern monetary policy

Today, there is wide consensus that the overriding long‐term goal of monetary

policy should be price stability – i.e. a low and stable inflation rate.21 Another im‐

portant goal to modern monetary policy is to reduce the volatility of aggregate

output over the short and medium run – i.e. stabilizing nominal income (cf. FISCHER

1994: 263‐266). It is commonly accepted nowadays that there is no long‐run

trade‐off between output (employment) and inflation.22 Current literature usually

summarizes this wide consensus by a simple loss function that expresses a central

bank’s decision problem in maximizing social welfare:

21 This goal directly follows from the benefits of price stability and the growing acceptance that inflation involves high costs (see, for instance, BOFINGER 2001: 131‐148; MISHKIN 2007: 41). A worthwhile discussion of the transformation in the conduct of monetary policy during the past decades can be found in MISHKIN (2007a: 1‐27).

22 FRIEDMAN (1968) and PHELPS (1967) argue that there exists a natural rate of unemployment no matter what inflation was.


(3) L = (πt – π*)2 + λy2 , with y=(Y-Y*)/Y* and λ≥0

Accordingly, central banks aim at minimizing the sum of the inflation gap (i.e.

the difference between actual inflation rate (π) and the inflation target (π*)) and

the output gap (y). As both differential variables are squared, positive and negative

deviations are weighted similarly and large disparities weight heavier than small

ones. The factor λ determines the weight of the two targets in the objective func‐

tion of the monetary authority (cf. BOFINGER 2001: 128; SVENSSON 1999: 621).

Furthermore, it is crucial to emphasize that another goal of central banks

should be financial stability (cf. MISHKIN 2007: 48). Since the most serious economic

contractions are related to financial instability, acting as a lender of last resort23

has become an important element in the conduct of modern monetary policy.

In order to maintain its goals effectively a central bank should possess a few

institutional features. The authority should have the ability to independently put

into use its monetary policy instruments, yet its final goals must not be set inde‐

pendently. In the words of MISHKIN (2007: 41), a central bank should be “goal de‐

pendent but instrument independent.” Moreover, a clear commitment (e.g. by law)

to price stability enhances central bank accountability. In combination with the use

of a nominal anchor, accountability is highly relevant to the building of the public’s

expectations. The importance of accountability also suggests that central banks

should stress transparency and clear communications.

For the sake of brevity monetary regimes cannot be presented in detail.24

However, some basic elements of the conduct of monetary policy are discussed in

the following. Regarding the conduct of monetary policy in emerging markets, the

adoption of an explicit nominal anchor appears to be a crucial element – i.e. a single

variable that helps policymakers pin down the price level (cf. MISHKIN 2007: 41‐

49). The most common forms of nominal anchors are the commitment to a fixed

exchange rate, a money‐growth target or a numerical inflation target. In conse‐

quence, several monetary strategies have been developed.

23 A lender of last resort should provide the necessary funds to solvent but temporary illiquid fi‐nancial institutions, e.g. in a general liquidity crisis (cf. BOFINGER 2001: 236‐237).

24 For an extensive discussion of the advantages and shortcomings of different monetary regimes see, for instance, BOFINGER (2001: 240‐268) or MISHKIN (2007: 227‐252).


Targeting the exchange rate has a long history and is found to be an effective

means of stabilizing the economy and reducing inflation – e.g. through a currency

board.25 However, unhappy events in the late 1990s (e.g. in Mexico 1994‐95,

Southeast Asia 1997‐98 and Argentine 2001‐02) suggest that exchange rate target‐

ing is problematic for emerging markets. This is due to the fact that such a regime

makes countries more prone to speculative attacks and can promote full‐fledged

economic crises due to liability dollarization and balance sheet vulnerabilities26 (cf.

MISHKIN 2007: 17; MISHKIN 2007b: 228‐233). Another form to control the exchange

rate is a managed floating exchange rate regime, which can be defined in a broad

sense as follows:

“The system under which a country's exchange rate is not pegged, but the mone‐tary authorities try to manage it rather than simply leaving it to be set by the market. This can be done in two ways. Firstly, small fluctuations in the exchange rate can be smoothed out by the authorities buying the country's currency when its price would otherwise fall and selling it when its price would otherwise rise. Secondly, the authorities can also influence the exchange rate through their mac‐roeconomic policies.” (BLACK ET AL. 2009a)

The main features of the former type, which is also referred to as ‘direct man‐

aged float’, are that monetary policymakers do not announce a specific band of

path for the exchange rate and effects on traditional policy instruments are often

sterilized (cf. WOLLMERSHAEUSER 2003: 13‐14). It should be noted that a managed

floating cannot be used as a nominal anchor solely (cf. BOFINGER AND

WOLLMERSHAEUSER 2001: 52).27

Monetary targeting (i.e. the targeting of a reference value for a monetary ag‐

gregate, such as base money) became particularly fashionable in some big econo‐

mies after the collapse of the Bretton Woods system in 1973. The German Bundes‐

bank successfully applied this approach up to 1998. As the relationship between

the targeted aggregate and the goal variable (i.e. inflation or nominal income) is

likely to be weaker and more unstable, monetary targeting is probably less advis‐

able for emerging market economies than for industrialized countries (cf. MISHKIN

2007b: 234).

25 For a description of the exact functioning of a currency board regime, see section 3.2.2. 26 Section 2.2.2.2 explains this concern in detail. 27 The latter form (‘dirty float’) will not be addressed further.


The rational expectations revolution together with the recognition of the time‐

inconsistency problem in monetary policy contribute to the expansion of inflation

targeting in the 1990s.28 New Zealand first adopts this strategy in 1989, using an

explicit numerical inflation target as a strong nominal anchor to pin down inflation

expectations. Inflation targeting in various forms has successfully been adopted in

a number of countries and appears to be a useful concept for industrialized as well

as emerging economies (cf. BERNANKE AND MISHKIN 2007). In general, the adoption

of a nominal anchor helps to directly promote low and stable inflation expecta‐

tions, reduces the time‐inconsistency problem and credibly constrains the discre‐

tion of the central bank.

Finally, the mechanisms through which monetary policy affects the economy

are called monetary transmission mechanisms. Specifically, there are four main

channels of monetary transmission: the quantity theory channel, the interest rate

channel, the exchange rate channel and the expectations channel (cf. BOFINGER

2001: 71‐115; MISHKIN 1995: 4). Depending on the underlying monetary regime

the one or the other channel may be more dominant and important to monetary

policymakers. Having presented a brief overview of monetary policy, policymak‐

ers’ main concerns related to dollarization are analyzed now.

2.2.2 Why should monetary policymakers care about dollarization?

The consequences of unofficial dollarization are manifold. In general, two major

groups of monetary policy concerns can be identified. On the one hand, there is the

widely held view that dollarization makes monetary and exchange rate policy less

effective and transmission more complex. On the other hand, there are those con‐

cerns that refer to the risks for macroeconomic and financial stability. As the pre‐

vious section has shown, the ultimate goal of monetary policy is social welfare.

Thus, monetary policy should be equally concerned about both groups.

28 BARRO AND GORDON (1983) did fundamental work on the time‐inconsistency problem. LUCAS (1972, 1973, 1976) develops the idea of rational expectations.


2.2.2.1 Monetary policy efficiency and transmission

Traditionally, policymakers tend to be predominantly concerned about the fact

that dollarization hinders the effectiveness of monetary policy. This conventional

view is based particularly on early currency substitution models and the observa‐

tion that dollarized countries were often characterized by significantly higher in‐

flation than non‐dollarized economies.

AS BALINO ET AL. (1999: 14) note, dollarization makes the demand for domestic

money more volatile. They argue that the public shifts frequently between curren‐

cies for a number of not easily identifiable reasons (e.g. in order to avoid the nega‐

tive effects of inflation). This may be attributed to lower costs of switching be‐

tween currencies in dollarized economies. As a result, the exchange rate volatility

under a floating exchange rate regime is expected to be higher in dollarized

economies (cf. CALVO AND VEGH 1996: 158). A strong positive association between

exchange rate volatility and currency substitution as well as instable domestic

money demand is a key implication of early theoretical literature on currency sub‐

stitution and poses an additional challenge for monetary policy effectiveness.

Although originating from currency substitution, this argument can also be

made regarding asset substitution:

“Specifically, as the flight to readily available foreign‐currency assets becomes less costly, the demand for reserve money in a dollarized economy should be more sensitive to a monetary expansion or to a change in the exchange rate.” (LEVY YEYATI 2006: 87)

Put differently, the elasticity of the inflation rate to changes in the monetary

aggregate should be higher under dollarization (cf. IBID.). This might limit the scope

for monetary policy effectiveness, as there is a lack of self‐stabilizing effects in the

dollarized economy. At the same time, however, it suggests that the price response

to a monetary shock (e.g. through the reduction of the growth rate of money) may

have a stronger stabilizing effect under dollarization. Indeed, this would even indi‐

cate increased monetary policy efficacy.

A more recent strand of literature on monetary policy effectiveness in the

presence of dollarization emphasizes the weaker monetary transmission. Consider‐

ing the monetary aggregate channel, the main rationale is that domestic authorities

are not in the position to control the foreign currency component of broad money.


On the one hand that should seriously complicate the central bank’s effectiveness

in controlling inflation. On the other hand, however, monetary authorities might be

able to control the monetary base, whose volatility is found to be similar across the

levels of dollarization (cf. REINHART ET AL. 2003: 34‐35). Thus, managing base

money or the reserve requirement rate of banks might be an effective instrument

for the central bank (cf. ALVAREZ‐PLATA AND GARCIA‐HERRERO 2008: 19). However,

assessing the case of Cambodia, ZAMAROCZY AND SA (2003: 16) conclude that control‐

ling narrow aggregates is also difficult due to limited financial intermediation –

this observation is supposed to be similar in other developing countries.

Turning to the interest rate channel, it is obvious that the domestic central

bank can only set the interest rate for domestic money. Therefore, policymakers

might be unable to control the relevant market interest rate for consumption and

investment decisions. IZE AND LEVY YEYATI (2005: 17) state correctly that

“the effectiveness of the interest rate channel is diluted when most intermedia‐tion is in dollars. Dollar loans can expand freely as a result of dollar inflows and increases in domestic interest rates may have little effect on the perceived cost of dollar loans.” (ibid.)

Hence, it appears to be true that the monetary transmission via the interest

rate channel is weaker under de facto dollarization.

Finally, monetary policy can influence the economy through the exchange rate

channel.29 Since prices of typical non‐traded goods (such as housing rentals, real

estate or fees for services) are also indexed or set in foreign currency, the exchange

rate pass‐through to domestic prices is expected to be higher in countries with

widespread real dollarization. Hence, the domestic price index should respond

more strongly to a given change in the exchange rate. Assuming a flexible exchange

rate regime and taking into account what has been explained above (i.e. that the

exchange rate is expected to be more volatile under dollarization), this imposes a

major additional challenge to monetary policy. With respect to real dollarization in

Israel, FISCHER (2006: 8) illustrates the severity of the problem through the follow‐

ing example:

29 Under the well‐known open economy BMW framework with flexible exchange rates, monetary tightening is associated with an appreciation of the domestic currency, which is assumed to create a fall in the domestic price level (cf. BOFINGER ET AL. 2009).


“We [The Bank of Israel] are inflation targeters, with the inflation target being 1‐3 percent. But given the volatility of oil prices and the exchange rate, we have found it difficult to stay within the range. Just in the last two month, as a result of the fall in the price of oil and the weakening of the dollar, our price level fell by 1.5 percentage points.” (IBID.)

In addition, liability dollarization might affect the use of the exchange rate as a

policy instrument, thereby limiting the scope for monetary policy action. Again,

assuming the open‐economy BMW framework with flexible exchange rates, an ex‐

change rate depreciation should create an expansionary impact on the economy.

However, the impact of the exchange rate depreciation can reverse in economies

with high liability dollarization as private agents might have currency mismatches

in their balance sheets. More precisely, this means that large exchange rate depre‐

ciations could include a contractionary balance sheet effect30, hence outpacing the

actually desired expansionary effect. Summing up, it appears that a higher pass‐

through effect makes inflation in dollarized economies more volatile and less con‐

trollable for policymakers relative to other economies.31 Another major policy con‐

cern is attributed to liability dollarization, which could lead to a reversal of the

traditionally expansionary impact of domestic currency depreciations.

Moreover, a frequently mentioned concern to policymakers in partially dollar‐

ized economies is the ability to raise revenues from seigniorage.32 The increased

use of foreign currency lowers the demand for the domestic counterpart and

therefore induces a loss of seigniorage (cf. BALINO ET AL. 1999: 13). This argument is

related to the drawbacks of full dollarization and can be interpreted as a threat to

the effectiveness of monetary policy and the value of monetary autonomy (cf. BERG

AND BORENSZTEIN 2000: 15‐18; MASSON ET AL. 1997: 23). However, the author re‐

gards the loss of seigniorage as a secondary concern about dollarization.

Although a vast amount of theoretical literature suggests that monetary policy

is less effective in partially dollarized economies, empirical evidence finds a rather

weak support of this view. REINHART ET AL. (2003: 23‐27) examine the monetary

30 An in‐depth study of the balance sheet effect is provided in section 2.2.2.2. 31 HONOHAN AND SHI (2001: 12) empirically confirm that there is a positive correlation between dol‐larization and pass‐through effects. More precisely, they show that an increase of deposit dollari‐zation by ten percentage points increases the estimated pass‐through by about 6%.

32 “Seigniorage are the profits accruing to the monetary authorities from its right to issue legal ten‐der currency” (BERG AND BORENSZTEIN 2000: 15).


policy track record of 85 countries in achieving its main goals between 1980 and

2001. Indeed, they find that dollarized countries display significantly higher and

more volatile rates of inflation on average. Output fluctuations, however, are quite

similar across countries with different levels and types of dollarization. Analyzing

revenues from seigniorage, they do not find systematical differences across various

levels of dollarization. In the past two decades, inflation has been successfully

brought down in a number of countries with consistently high dollarization levels

(see, for instance, the analysis in section 3.1). Thus it could be interpreted that dif‐

ferent forms and degrees of dollarization do not affect the authorities’ ability to

control inflation and stabilize output significantly.

That said, greater instability of the domestic money demand and stronger ex‐

change rate fluctuations should not be completely neglected. Taking into consid‐

eration weaker monetary transmission channels, it has been demonstrated that

there are serious obstacles for the efficient conduct of monetary policy in dollar‐

ized economies. Hence, these are good reasons why the conventional view (i.e. that

monetary policy is less effective and more challenging in a dollarized environ‐

ment) has not lost ground in academic literature. However, the probably most se‐

vere drawback of monetary policy under de facto dollarization is the detrimental

impact of the balance sheet effect that will be analyzed in the following section.

2.2.2.2 Financial fragility and economic vulnerability

The debate on the monetary policy obstacles of dollarization has gained new mo‐

mentum in recent years. As academic research has centered more on liability dol‐

larization, enhanced financial and macroeconomic vulnerabilities have been em‐

phasized as the main risks of dollarization. Financial dollarization may exacerbate

a country’s vulnerability on three levels: the bank level, the firm level and the pub‐

lic debt level.

First, dollarized financial systems are particularly exposed to solvency and li‐

quidity risks on the bank level. If there is a currency mismatch33 in the balance

sheets of commercial banks, a large depreciation can trigger solvency problems

33 A currency mismatch occurs when assets and liabilities are denominated in different currencies such that an entity ’s net worth or net income (or both) is sensitive to changes in the exchange rate (cf. GOLDSTEIN AND TURNER 2004: 1).


due to increased real debt burden. Hence, direct solvency risk occurs if a bank funds

itself or receives deposits in foreign currency but lends on in local currency at the

same time (cf. GALINDO AND LEIDERMAN 2005: 13). However, in order to minimize

exchange rate risk and to satisfy prudential regulation requirements on open for‐

eign exchange positions, financial institutions typically offer loans in foreign cur‐

rency in the presence of high deposit dollarization. Although the currency mis‐

match is transferred from the bank level to the borrowers in that way, enhanced

solvency risks for banks indirectly remains. Now, debtors instead of banks face di‐

rect currency risk, which worsens their ability to repay loans. This, in turn, height‐

ens credit risk for commercial banks and leads to a deterioration of their loan port‐

folio (cf. DE NICOLO ET AL. 2005: 1712). In short, dollarization entails an increased

solvency risk in any way – either directly of indirectly.

Further systemic risks to the banking system can result from the banks’ liquid

ity risk. Usually, banks in emerging markets do not fully cover foreign currency

deposits by liquid assets in foreign exchange. However, depositors might poten‐

tially withdraw their fx deposits or transfer them abroad (e.g. due to a general lack

of confidence in the banking system) and overseas banks could recall short‐term

lines of credit (e.g. in the face of increased country risk). As large amounts of for‐

eign denominated liabilities would fall due and banks would need to pay out that

money, domestic banks might quickly run out of liquid reserves in foreign cur‐

rency (cf. GULDE ET AL. 2004: 6). In turn, depositors’ fear of a foreign exchange li‐

quidity crisis (i.e. that banks might fail to provide sufficient foreign currency li‐

quidity) might heighten the probability of bank runs in dollarized economies.

At the same time, it is important to note that even central banks may run out

of international reserves in the event of a general liquidity crisis – hence, they

would fail to act effectively as a lender of last resort in a dollarized environment. In

consequence, a simple bank liquidity crisis may lead to a widespread banking cri‐

sis and finally trigger a fully fledged economic crisis with all the negative effects on

output and employment (cf. DE NICOLO ET AL. 2005: 1713). Both, banks’ liquidity and

solvency risk are interrelated and constitute a major concern to monetary policy

makers.


Aside from the bank level, similar imbalances may arise on the firm level. It

should already be clear from the above discussion that foreign currency indebted

firms, whose income is largely denominated in local currency, might suffer from

severe balance sheet problems (cf. LEVY YEYATI 2006: 66). A sharp real depreciation

would increase their foreign currency debt burden in the local currency counter

value and cause serious default risk, especially if firms are not fully hedged.34 In

consequence, increased defaults of companies impact banks’ loan portfolio and

heighten financial sector vulnerability. Since prudential regulation can not be im‐

plemented, a currency mismatch risk on the firm level is harder to control and

more difficult to prevent for the authorities than on the bank level – however, it

invokes the same risk at the end.

Furthermore, it should be noted that dollarized public sectors are similarly

vulnerable as non‐tradable firms that are indebted in foreign currency. As the dis‐

cussion about ‘original sin’ (see again section 2.1.2) has already mentioned, emerg‐

ing markets’ public debt is predominantly issued in foreign currency. An external

shock (e.g. a sudden stop35) could give rise to an economic slow down in emerging

markets and trigger a sharp decrease of domestic tax revenues. In such a situation

the domestic currency is likely to depreciate, exacerbating the rise of the real value

of public debt (cf. GALINDO AND LEIDERMAN 2005: 14). Hence, decreasing income and

worsening debt obligations severely increase an emerging market‘s vulnerability

and make it more prone to default.

Lastly, regarding monetary policy and dollarization it is worth briefly men‐

tioning some beneficial effects of dollarization for the domestic financial system.

Earlier research reveals financial deepening, lower borrowing costs, greater on‐

shore intermediation and a reduction of the adverse effects of high inflation as po‐

tential benefits (cf. BALINO ET AL. 1999: 2; DE NICOLO ET AL. 2003: 20‐23). Advocates

of these advantages stress that the positive effects of dollarization should be

weighted against its risks.

34 GALINDO AND LEIDERMAN (2005: 13) explain that derivatives markets in emerging countries are typically underdeveloped. Thus, firms’ foreign currency denominated obligations are often only partially hedged.

35 REINHART AND CALVO (2001: 8) state that emerging market economies are regularly confronted with sudden stops (i.e. reversals of capital inflows) or the drying up of access to world financial markets.


This section has demonstrated that currency mismatches can lead to a cata‐

strophic meltdown of the financial system and the whole economy in the event of a

large depreciation. From the macroeconomic perspective, domestic currency im‐

balances cannot be avoided in dollarized economies and are probably most serious

on the borrowers’ level. The fact that central banks might not be able to act effec‐

tively as a lender of last resort is another grave drawback. Thus, the author con‐

cludes that the risks of dollarization clearly outweigh potential benefits.36 Hence,

there is good reason for monetary policymakers to be concerned about the phe‐

nomenon and closely monitor the economy.

2.3 Measuring dollarization

De facto dollarization may be a widespread phenomenon and its impact on mone‐

tary policy may be deleterious. Measuring its scope, however, is an elusive task.

The distinction between different types of dollarization may be standard in theory

and valuable for a proper analysis. To distinguish these forms empirically, how‐

ever, is particularly challenging. Since a good statistical basis serves as a prerequi‐

site for subsequent analysis, it is crucial to have a close look at the challenges of the

empirical debate. Thus, this section provides a comparison of alternative indica‐

tors (conventional and current ones) and finally describes the use of data in this

paper.

2.3.1 Conventional measures

REINHART ET AL. (2003: 6) provide a helpful overview of assets and liabilities of the

private and public sector in a de facto dollarized economy. All the items in the

boxes of the foreign currency balance sheet (see figure 4) would greatly contribute

to the construction of a comprehensive measure of the degree and nature of dol‐

larization. However, the figure illustrates the severity of the problem and makes

clear that only little data is used.

36 This notion is in line with LEVY YEYATI (2006: 109), who finds no visible gains in terms of domestic financial depth and concludes that the massive risks of dollarization suggest an active de‐dollarization policy.


Figure 4 The foreign currency balance sheet of a de facto dollarized economy

*Dollarization measure used in the study of REINHART ET AL. (2003)

Source: REINHART ET AL. (2003); own illustrations

In fact, the major limitation in measuring de facto dollarization is that foreign

currency in circulation (FCC) is typically unknown. CALVO AND VEGH (1992: 21) de‐

scribe it as follows:

“At an empirical level, the study of currency substitution faces a fundamental problem: there is usually no data available on foreign currency circulating in an economy (i.e, foreign currency being used as a medium of exchange). Therefore, the importance of currency substitution (i.e., using foreign currency as a medium of exchange) is basically unobservable.” (IBID.)

Thus, conventional research on partial dollarization has consistently been

forced to use foreign currency deposits (FCD) as a proxy for dollarization. In terms

of figure 4 this means that private domestic residents’ foreign currency assets are

considered – i.e. the boxes with striped borders. FCD are most typically expressed

as a ratio to broad money (BM) to measure the extent to which a country is dollar‐


ized.37 This paper denotes this measure the broad money dollarization indicator

(DIBM):

(4) DIBM = FCD / BM

Moreover, other empirical studies use the ratio of FCD to total deposits – the

sum of FCD and local currency deposits (LCD) – to assess an economy’s degree of

dollarization (see, for instance, GULDE ET AL. 2004; MONGARDINI AND MUELLER 1999).

This indicator will be denoted deposit dollarization index (DIDD) in the further

course of this paper:

(5) DIDD = FCD / (FCD+LCD)

It is obvious that these measures have some non‐trivial shortcomings. On the

one hand, these limitations are due to the fact that foreign currency in circulation

(FCC) and cross‐border deposits (CBD) are not taken into consideration.38 On the

other hand, these indices consider foreign currency sight and time deposits

equally, although, with respect to whether payments or financial dollarization

dominates the economy, it would be useful to weigh them individually. Moreover,

traditional indices generally ignore nonbank holdings of financial instruments, e.g.

government securities of derivative instruments, which play a significant role in

more developed financial markets (cf. DE NICOLO ET AL. 2003: 5). Said that, conven‐tional dollarization indices cannot be interpreted as comprehensive measures for

the extent and nature of currency substitution.

2.3.2 Current measures

Recently, the discussion about dollarization indices once again increased intensity.

Current literature attempts to overcome the ‘unobservability problem’ and devel‐

ops several more comprehensive indices. FEIGE (1997) and FEIGE ET AL. (2002a) –

one of the main contributors to this strand of academic literature – construct a

new direct measure of foreign currency in circulation.

37 Thereby, the author refers to empirical studies, such as AGENOR AND KAHN (1996), BALINO ET AL. (1999) and SAHAY AND VEGH (1995).

38 Hence, it should be noted that present conventional dollarization indicators generally tend to understate the true degree of dollarization. The actual ratio should be higher in most cases due to foreign cash holdings and deposits held abroad.


Their estimates on the overseas use of the dollar are mainly based on the fact

that the United States Customs Service collects information on cross‐border flows

of US dollars.39 Hence, the data (resulting from so‐called Currency and Monetary

Instrument Reports, CMIRs40) is aggregated in such way that gross inflows and

outflows of US currency to various destinations can be observed. Computing the

accumulation of the net outflows of U.S. currency, FEIGE ET AL. (2002), FEIGE AND

DEAN (2002) and FEIGE (2003) achieve estimates of the amount of dollars in circu‐

lation for a number of transition countries worldwide.

Regarding Eastern European economies, the euro is predominantly employed

as a co‐circulating currency today (see, for instance, section 3.1).41 As CMIR data is

not available for euro currency, the Austrian National Bank (OeNB) conducts a se‐

ries of surveys on fx holdings in eastern Europe (see, for instance, STIX 2008).

However, the obtained data is called into question or at least should be considered

as lower bound estimates, as indirect measures – such as surveys – are known for

suffering from notable underreporting biases (cf. FEIGE 2003: 11).

In 2002, the euro changeover revives the debate of measuring foreign ex‐

change in Eastern Europe. The fact that domestic savers need to convert ‘euro‐in’

money – that is held outside the banking system – to euro notes provides a unique

opportunity to directly estimate FCC. In the case of Croatia, commercial banks fol‐

low an initiative of the Croatian National Bank (CNB) and provide free conversion

via depositing. Thus, enormous amounts of euro legacy banknotes were deposited

onto Croatian bank accounts before the end of 2001 (cf. IBID.). The CNB employs

this data in combination with the survey from the Austrian National Bank, estimat‐

ing the total stock of FCC. As a proposal to the ECB to systematically monitor in‐

flows of euro‐in legacy currency and outflows of euro currency during the intro‐

duction process was rejected. Hence, this certainly more trustworthy information

on euro money in circulation has exclusively been collected in the case of Croatia.

39 Since 1970, the ‘Bank Secrecy Act’ obliges persons or institutions to declare an import or export of currency or other monetary instruments in amounts larger than 10,000 USD.

40 For more details on CMIR data, see particularly FEIGE (1997) and FEIGE ET AL. (2002a). 41 Prior to the euro introduction, residents in CESEE economies also held legacy currencies of some European nations such as Deutschemarks (DM) and Swiss Francs (SF). Estimates by SEITZ (1997) and DOYLE (2000) show that between 30 and 70 percent of the total amount of Deutschemarks is held abroad in the mid‐1990s.


Assuming that reliable data on foreign currency in circulation is available for

various economies, a catalogue of indicators that aim at measuring de facto dollari‐

zation more precisely is presented at this point. The present framework was origi‐

nally developed in FEIGE ET AL. (2002a). Section 2.1.1 has already explained that

foreign currency can displace the local counterpart primarily as a medium of ex‐

change. Hence, when currency substitution is the underlying feature it might be

useful to define a currency substitution index (CSI). With LCC defined as local cur‐

rency cash, this index estimates the fraction of a country’s total currency supply

that is composed of foreign currency:

(6) CSI = FCC / (FCC + LCC)

In contrast, the predominant characteristic of dollarization can be that domes‐

tic residents hold foreign denominated exchange as a store of value. Assuming as‐

set substitution, the degree of dollarization should be measured as the ratio of for‐

eign currency denominated deposits to domestic denominated monetary assets,

excluding (domestic and foreign) cash. This indicator is denoted as the asset substi

tution index (ASI):

(7) ASI = FCD / (LCD + QM), with

quasi money (QM) being the sum of foreign currency deposits and local cur‐

rency time and savings deposits (QM = FCD + LTD). Furthermore, it is conceiv‐

able that foreign banknotes are simply hoarded ‘under the mattress’ but serve

purely as a store of value in some countries. In practice, this amount of money ap‐

pears to be part of FCC. But since saving is the key motive behind these residents’

behavior, this share should be added to ASI in theory – however, identifying the

exact amount is close to impossible.

Finally, when asset and currency substitution occur simultaneously, FEIGE ET

AL. (2002: 51) propose the unofficial dollarization index (UDI) to be the best index.

This measure is broader and basically represents an economy’s fraction of broad

effective money supply that consists of foreign monetary assets. FEIGE ET AL. (IBID.)

consider the UDI to be the most reliable and comprehensive measure of dollariza‐

tion:

(8) UDI = (FCC + FCD) / EBM


In contrast to non‐dollarized economies, effective broad money supply (EBM)

should include foreign currency cash in a dollarized environment (EBM = BM +

FCC). If the amount of foreign currency circulating in partially dollarized econo‐

mies is unknown, the recorded money supply – e.g. M1, M2 or M3 – tends to un‐

derestimate the effective money supply by the amount of foreign currency in circu‐

lation.

The brief outline of dollarization indices has shown that conservative meas‐

ures of dollarization have some major shortcomings, which are mainly due to the

omission of FCC and the fact that CBDs are generally ignored. FEIGE ET AL.’ s (1997;

2002a) contributions bring up new direct estimates on FCC. Finally, this leads to

the development of dollarization indices that are considered to be more suitable to

estimate the extent of different forms of dollarization – in particular, asset and cur‐

rency substitution. One of the main findings of FEIGE ET AL. (2002: 48), however, is

that conventional dollarization measures (DIs) are highly correlated with their

measure of asset substitution (ASI) but appear to be imprecise measures of cur‐

rency substitution. Moreover, FEIGE ET AL. (2000a: 9) find that the conventional in‐

dices can be an adequate proxy of overall dollarization, if foreign currency cash

holdings are of marginal importance. The selection of data for this paper (see next

section) takes into account the insights from dollarization indices.

2.3.3 The use of data in this study

Within the limits of a descriptive paper, the empirical part of this study employs a

variety of data to analyze dollarization and monetary policy. This section briefly

summarizes the origin of the data presented throughout part 3, thereby showing

that in general only three different data sources are applied: dollarization data

from LEVY YEYATI’s (2006)42 empirical study, the statistical databases on the central

banks’ websites43 (BCRP and CNB) and IMF data (World Economic Outlook (WEO)

and International Financial Statistics (IFS)).

Following the discussion on the correct measurement of dollarization, this

study relies on the conventional dollarization indices (DIs). On the one hand, this is 42 The complete dataset can be found in the appendix, table A 1. 43 The websites of the Central Reserve Bank of Peru (BCRP) and the Croatian National Bank (CNB) are: http://www.bcrp.gob.pe/ and http://www.hnb.hr/.


due to the fact that reliable data on FCC, which are necessary for the calculation of

more comprehensive indices, are barely available. On the other hand, employing

traditional indices appears adequate for the purpose of this study: Sections 3.1.2

and 3.1.3 will show that financial dollarization is the main feature in Peru and

Croatia and from the above discussion it is known that conventional indices esti‐

mate the degree of asset substitution fairly well. Hence, assessing the cases of Peru

and Croatia (where currency substitution plays only a subordinate role), the con‐

ventional indicators are an adequate proxy for the countries’ dollarization degrees.

In particular, section 3.1.1 requires data for a large number of countries on a

long‐term perspective, as it attempts to give a broad overview of the trends in

worldwide dollarization. Here, the author uses the data from LEVY YEYATI (2006),

which are based on annual average values of the deposit dollarization index

(DIDD).44 An obvious shortcoming of this data is that they only run up to 2004.

However, the analysis of more up‐to‐date data should not differ fundamentally

from the presented facts. Studying dollarization in the cases of Peru and Croatia in

section 3.1.2 and 3.1.3 in‐depth, current data are taken from the statistical data‐

bases on the websites of the BCRP and CNB.45 Here, the dollarization data is annual

and measured consistently by the broad money dollarization ratio – i.e. DIBM. As far

as long‐term inflation data is required, the author refers to the annual inflation

data of the WEO database.

The analysis of monetary policy under the constraints of dollarization and eu‐

roization in section 3.2 starts with the introduction of the current monetary regime

in each country and reaches until September 2009. The monthly data is consis‐

tently taken from the statistical databases on the websites of the BCRP and the

CNB.

As the results are compared and generalized in section 3.3, the employed data

is annual and comprises a number of economies. Besides the WEO database and

the statistical data sources from the BCRP and the CNB, the author relies on the

IMF IFS database in this section.

44 As banks usually avoid currency mismatches in their balance sheets (see section 2.2.2.2), liability dollarization is likely to exhibit a similar level as deposit dollarization. Consequently, this indica‐tor is assumed to reasonably represent the country’s level of financial dollarization.

45 In general, the author does not consider data that goes beyond September 2009.

3 Empirical analysis and case study 36

3 EMPIRICAL ANALYSIS AND CASE STUDY

At the beginning of the theoretical part, dollarization has been defined and the

roots of this phenomenon have been discussed extensively. In addition, the theo‐

retical part has shown that there are good reasons why monetary policymakers

should care about high degrees of domestic de facto dollarization. Thereafter, the

challenges in measuring the degree and type of dollarization have been addressed,

thereby laying the foundations for the empirical analysis.

First of all, the empirical part studies de facto dollarization in section 3.1. An

overview of trends in worldwide de facto dollarization and euroization is provided,

whereupon some particularly noteworthy examples are highlighted. In this re‐

spect, it is found that Peru and Croatia are ranked well within the group of most

dollarized economies. Moreover the Peruvian and Croatian experience with dol‐

larization and euroization is examined carefully in section 3.1.2 and 3.1.3. Subse‐

quently, the analysis turns to monetary policy under the constraints of de facto

dollarization and reviews the recent conduct of monetary policy in Peru and Croa‐

tia (see section 3.2). Thereafter, the chapter concludes with a brief comparison of

the specific country studies and aims to draw some general lessons (section 3.3).

3.1 Analyzing de facto dollarization

3.1.1 Trends in worldwide dollarization: Some stylized facts

This section provides a first glance at the numbers. Table 1 shows a selection of

countries, which are divided into three groups: low, moderate and high dollariza

tion countries.46 According to BALINO ET AL. (1999: 5) dollarization ratios of 15‐20

percent are common in countries where foreign currency accounts are not prohib‐

ited. As the author uses the extensive dataset from LEVY YEYATI (2006), calculations

are based on the ratio of foreign currency deposits to total deposits at domestic

banks (i.e. deposit dollarization). The economies are ranked according to their av‐

46 In order to distinguish between the three groups, this paper follows the threshold values pro‐posed by BALINO ET AL. (1999: 2). Thus, countries exceeding a ratio of 30% are labeled highly dol‐larized and ratios below 30% are defined as moderate degrees of dollarization. In addition, the author introduces a third category (low dollarization) to spot countries with dollarization ratios below 10%.


erage degree of deposit dollarization between 1994 and 2004. The present list re‐

veals a number of interesting facts.

Table 1 Degrees of dollarization in selected countries worldwide (in %)

1994 1996 1998 2000 2001 2002 2003 2004

Average (1994-2004)

High dollarization (>30 percent)

Cambodia 85,7 94,0 92,5 93,2 94,6 94,3 95,5 95,7 93,1

Bolivia 78,5 91,6 91,9 92,4 91,5 91,9 92,6 86,7 89,1

Uruguay 79,6 77,2 79,0 81,6 84,6 88,4 88,8 87,6 82,2

Georgia 66,7 46,4 68,7 77,9 85,6 84,9 86,1 74,3 69,8

Croatia 59,3 67,6 73,8 71,1 71,2 67,7 64,3 61,6 67,8

Peru 66,3 67,7 63,8 68,3 66,0 73,2 70,4 68,3 67,1

Kyrgyz Rep. - 33,0 63,4 66,1 65,1 64,3 66,8 59,0 55,3

Belarus 63,7 31,3 63,9 69,4 66,0 60,5 54,4 48,0 53,1

Slovenia 41,0 39,5 30,2 34,5 36,1 32,5 32,3 34,3 35,2

Moderate dollarization (<30 percent) Honduras 16,9 31,9 27,6 28,7 33,1 34,0 34,8 35,5 29,1

Estonia 16,4 21,5 28,3 34,0 30,1 28,7 26,1 26,6 26,2

Poland 39,0 22,6 18,6 17,5 18,9 16,2 15,9 14,1 21,1

Indonesia 20,1 19,4 22,2 20,8 20,1 17,5 16,2 14,7 19,8

Israel 20,6 18,0 20,5 18,7 18,5 - - 15,0 18,6

Malawi 20,6 11,3 31,2 22,0 14,6 20,4 19,2 20,1 18,3

Slovak Rep. 14,3 11,4 16,4 17,6 17,7 17,2 14,1 14,0 14,9

Kenya - 7,2 9,3 15,5 15,2 16,0 14,8 18,1 12,5

Low dollarization (<10 percent)

Mexico 7,1 7,7 6,2 10,4 10,8 10,6 - - 8,2

China,P.R. - - 7,9 8,9 8,0 6,8 5,6 5,0 7,2

Nigeria 1,2 2,6 3,0 5,4 5,0 9,0 7,8 8,1 5,1

South Africa 0,5 1,5 3,5 4,2 6,2 4,4 2,7 2,7 2,9

Malaysia - 0,9 2,3 3,3 3,7 2,9 3,3 3,3 2,7

Thailand 0,2 0,4 1,1 1,4 1,3 - - - 0,9

Switzerland - - 0,2 0,6 0,1 - - - 0,3

Selected members of the euro area

Netherlands 4,7 - 4,0 4,7 4,1 n.a. n.a. n.a. 4,3

Austria - - 2,1 2,3 1,7 n.a. n.a. n.a. 1,9

Spain - 1,8 1,9 1,8 1,5 n.a n.a n.a. 1,8

n.a.= adoption of the euro

Source: LEVY YEYATI (2006), own calculations


The highest levels of dollarization can be observed in Cambodia and Bolivia,

which show average deposit dollarization ratios of 93 and 89 percent respectively.

Furthermore, Cambodia exhibits the highest value of the whole sample – a deposit

dollarization degree of 95,7 percent in 2004. Peru and Croatia are placed well

within the group of the most dollarized countries, showing average dollarization

ratios of 68 and 67 percent. On the contrary, countries like China, South Africa, Ma‐

laysia and Switzerland are found to be at the lower end of the scale. Switzerland

even exhibits the lowest degree of average deposit dollarization (0,3 percent),

which does not seem surprising due to the good worldwide reputation of the Swiss

franc as a reliable and stable hard currency. In addition, a group of selected mem‐

bers of today’s euro area displayed rather low levels of dollarization before the

adaption of the euro in 2002 (see table 1). Thus, the data also suggests that indus‐

trialized countries are mostly ranked at the bottom of the scale, whereas develop‐

ing and emerging economies are more likely to show high de facto dollarization

levels.

In addition, REINHART ET AL. (2003: 49‐50) analyze the regional variation of the

phenomenon and find that

“dollarization has been consistently high in the Middle East, in the Transition Economies since the 1990s and, especially, in South America, while it has been consistently low in Africa and in most of Asia.” (IBID.)

The results of the calculations in this study support their observation only to a

certain extent. This paper finds that Latin American economies and the transition

countries of Eastern Europe are particularly prominent examples of high de facto

dollarization, with respect to its size and persistence. These findings, which are

based on average deposit dollarization ratios between 2000 and 2004, are illus‐

trated in figure 5.


Figure 5 Regional variation of dollarization ratios (average 20002004, in %)

Country groups are largely based on IMF classifications: Middle East: Bahrain, Jordan, Kuwait, Lebanon, Libya, Oman, Qatar, Saudi Arabia, Syrian Arab Republic, United Arab Emirates, Yemen. Central America and Caribbean: Antigua and Barbuda, Bahamas The, Barbados, Belize, Costa Rica, Dominica, Dominican Republic, El Salvador, Grenada, Guatemala, Haiti, Honduras, Jamaica, Mex‐ico, Nicaragua, Panama, ST. VINCENT & GRENS., St. Kitts and Nevis, St. Lucia, Suriname, TRINIDAD AND TOBAGO. Latin America: Argentina, Bolivia, Chile, Colombia, Ecuador, Para‐guay, Peru, Uruguay, Venezuela. Developing Asia: Bangladesh, Bhutan, Cambodia, CHINA,P.R.: MAINLAND, Fiji, Indonesia, LAO PEOPLE'S DEM.REP, Malaysia, Maldives, Myanmar, Nepal, Paki‐stan, Papua New Guinea, Philippines, Samoa, Sri Lanka, Thailand, Tonga, Vanuatu, Vietnam. Africa: Angola, Cape Verde, CONGO DEM. REP. OF, Comoros, Djibouti, Egypt, Ethiopia, Gambia The, Ghana, Guinea, Guinea‐Bissau, Kenya, Liberia, Malawi, Mauritius, Morocco, Mozambique, Nigeria, Rwanda, SAO TOME & PRINCIPE, Sierra Leone, South Africa, Sudan, Tanzania, Uganda, Zambia, Zimbabwe. Transition Economies: Albania, Armenia, Azerbaijan, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Estonia, Georgia, Hungary, Kazakhstan, Kyrgyz Republic, Latvia, Lithuania, Macedonia FYR, Moldova, Mongolia, Poland, Romania, Russia, Slovak Republic, Slove‐nia, Tajikistan, Turkey, Turkmenistan, Ukraine, Uzbekistan. Advanced Economies: Austria, Cy‐prus, Czech Republic, Denmark Finland, Greece, CHINA,P.R.:HONG KONG, Iceland, Israel, Italy, Japan, Korea, Malta, Netherlands, Netherlands Antilles, New Zealand, Norway, Spain, Sweden, Switzerland, United Kingdom


Although the large majority of countries has experienced relatively stable de‐

grees of dollarization, the share of foreign denominated deposits to total deposits

changes significantly over time in some countries. On the one hand, there are coun‐

tries that have successfully managed to dedollarize – Israel and Poland are among

the most notable examples of market‐driven de‐dollarization.47 Figure 6 illustrates

47 Countries that have abandoned dollarization by legal means (e.g. through forced conversion) are not taken into consideration at this point.


the considerable permanent decline in the dollarization ratio of these countries

over the long term.

Figure 6 Successful dedollarization in Israel and Poland

Source: LEVY YEYATI (2006), own illustrations

On the other hand, there are countries that have chosen to adopt a foreign cur‐

rency as their official legal tender, whereby the deposit dollarization ratio in‐

creases to 100 percent. As figure 7 shows, Ecuador decided to take that path in

2000 and El Salvador followed in 2001. Whereas Ecuador exhibits increasing par‐

tial dollarization ratios before 2000, El Salvador’s de facto dollarization level re‐

mains constantly below 10 percent prior to official dollarization. Hence, de facto

dollarization was probably not the key motivation for opting for the dollar as the

official currency in the case of El Salvador.48

48 For a discussion of the advantages and drawbacks of full dollarization in the face of high de facto dollarization, see section 3.3.2.


Figure 7 Increasing dollarization in Ecuador and El Salvador

Source: LEVY YEYATI (2006), own illustrations

Finally, it is important to note that de facto dollarization has generally in

creased worldwide in the last few decades. Based on data from LEVY YEYATI (2006),

it is found that deposit dollarization amounts only to a worldwide average of 9,4

percent in 1980. As table 2 shows, dollarization of bank deposits increases to a

worldwide average of 19,8 percent in 1990. The ratio continues to rise throughout

the 1990s and partial dollarization reaches 26,7 percent on average in 1999. As

this trend remains unabated, the worldwide deposit dollarization level even ex‐

ceeds 32 percent in 2004. It is important to note that this trend occurs in spite of

the large advances in the process of disinflation that has started in the early 1990s

und continues up to the present day.49 However, regarding the increased relevance

of de facto dollarization worldwide – in particular the rise of financial dollarization

– globalization is supposed to play an important role (cf. DE NICOLO ET AL. 2005:

1718).

49 These findings are broadly consistent with the empirical results of other authors, such as REINHART ET AL. (2003). Figure A 1 (in the appendix) illustrates the evolution of worldwide dol‐larization and inflation, starting in 1980.


Table 2 Increasing dollarization and decreasing inflation worldwide

Degree of dollarization* (in %, average, number of coun-

tries in parentheses)

Inflation (in % change, worldwide

average of consumer prices)

1990 19,8 (52) 26,1

1999 26,7 (132) 5,5

2004 32,6 (108) 3,6 * De jure dollarized economies are excluded

Source: LEVY YEYATI (2006), IMF WEO, own calculations

Using an expression coined by REINHART ET AL. (2003: 13), the most important

trends of “the worldwide spread of the addiction” to foreign currency have been

discussed so far. A large variety of countries has been classified into high, moder‐

ate and low dollarization economies. Some cases of particular relevance have been

discussed in greater detail. Finally, it has been demonstrated that dollarization is

an increasing rather than decreasing phenomenon, which is contrary to the major

disinflation progress in large parts of the developing world since the mid‐1990s.

Hence, it is indicative that the currency substitution view alone cannot explain the

evolution of the phenomenon. The next section focuses on the Peruvian experience

with dollarization.

3.1.2 The Peruvian experience with dollarization

Peru has a very long history of de facto dollarization. Figure 8 depicts the process of

dollarization in Peru from 1970 to 2009. Here, it can be observed that the average

year‐on‐year growth rate of consumer prices first climbs to the double‐digit range

in 1974 and exceeds 20 percent in 1975. The following period of hyperinflation50

and macroeconomic instability gives rise to significant broad money dollarization

ratios by the end of the 1970s, as private agents seek protection from capital losses

and uncertain real returns. In the further course, inflation and dollarization con‐

tinue to rise simultaneously. This development results in a widespread dollariza

tion of the banking system with a first peak of 53 percent on average in 1984.

50 Following CAGAN’s (1956: 25) definition, a hyperinflation period begins in the month when the rise in prices exceeds 50 percent and ends when it falls below this threshold.


Figure 8 Dollarization and inflation in Peru

Source: BCRP, IMF WEO, own illustrations

Consequently, Peruvian authorities enact measures to force conversion of for‐

eign assets into domestic currency in August 1985 (cf. HARDY AND PAZARBASIOGLU

2006: 275). Accordingly, dollarization sharply drops (by almost 80 percent) and

amounts only to 12 percent in 1987. This drastic and interventionist way to de‐

dollarize the economy, however, has opposite effects to those intended by the

authorities. Large nominal devaluations and the introduction of foreign exchange

controls lead to a fall of residents’ income measured in foreign currency. Massive

capital flights and bank dis‐intermediation quickly follow – the deposit‐to‐GDP

ratio falls from 21 percent in 1983 to 10 percent in 1989 (cf. HOELSCHER AND

QUINTYN 2003: 39). After several years of extreme macroeconomic instability, low

intermediation and an enormous loss of credibility (cf. BALINO ET AL. 1999: 26) the

restrictions on the holding of foreign currency are finally lifted in 1988.

Soon after, a rapid redollarization process emerges in the context of persis‐

tent high inflation rates. Deposit dollarization bounces back up to 47 percent in

1990, the year when the Peruvian inflation rate reaches its all‐time high of 7482

percent on annual average. Although inflation is successfully brought down in the

“Forced conversion”


further course,51 dollarization remains at a stable high equilibrium. Even after

achieving single‐digit inflation rates for the first time in 1997, dollarization of the

banking system reaches its highest point of 70 percent in 1999 (see figure 8).

In the last few years (2000 to 2009), dollarization ratios have gradually de‐

creased in Peru. However, the banking system’s broad money dollarization still

shows a very high level of more that 50 percent in 2006 – notably, after ten years

of macroeconomic stability (in particular, stable and low inflation). Moreover, dol‐

larization exhibits a slight upward trend as from September 2008, which is attrib‐

uted to generalized uncertainties in the context of the worsening financial crises52

(cf. BCRP 2009: 75). Dollarization in Peru amounts to an average of 48 percent in

the first nine months of 2009.

With respect to the type of dollarization, it is important to note that domestic

money is the country’s main means of payment. Nearly all current transactions and

non‐durable goods purchases are made in local currency. However, anecdotal evi‐

dence suggests that foreign currency is employed to buy some durable goods or to

effectuate non‐current transactions, such as apartment purchases (cf. QUISPE

MISAICO 2000: 6). Moreover, ARMAS AND GRIPPA (2005: 18) state that prices are nei‐

ther indexed to the exchange rate nor set in foreign currency, which indicates low

real dollarization in Peru (in turn, implying a low pass‐through). Also wages and

salaries are generally paid in nuevo sols53. Interpreting this, the current low infla‐

tion and low‐income environment in Peru should be taken into consideration. As

residents spend most of their income within a short‐term period and as costs of

exchange are high compared to the benefits of using foreign money, it is not sur‐

prising that local currency serves as the predominant means of payment and unit

of account.

51 The dotted vertical line in figure 8 indicates the beginning of the stabilization process in Peru, as inflation begins to fall.

52 The recent financial crisis begins in spring 2007 and hits its peak in fall 2008 with the bankruptcy of Lehman Brothers.

53 The ‘nuevo sol’ (PEN) is the official currency of Peru and is put into use in 1991, replacing the ‘inti’.


Table 3 Composition of bank deposits in Peru (in %)

Local currency Foreign currency

Demand deposits

Savings deposits

Term deposits

Demand deposits

Savings deposits

Term deposits

2004 33,6 31,8 34,6 21,8 25,1 53,1 2005 30,5 32,3 37,1 23,1 24,1 52,8 2006 34,1 31,4 34,5 24,4 24,3 51,3 2007 33,7 29,1 37,3 25,9 21,9 52,2 2008 29,8 30,2 40,1 26,4 22,0 51,6

Source: BCRP, own calculations

Table 3 depicts the composition of bank deposits in Peru, thereby shedding

light on the domestic use of foreign and local currency. Being an indicator for the

predominant form of dollarization, this classification shows clearly that foreign

currency deposits are primarily held in the form of term deposits, whereas foreign

currency demand and saving deposit accounts play only a secondary role. In the

case of local currency, however, demand, savings and time deposits are distributed

more evenly.54 In other words, table 3 reveals that foreign currency has a greater

importance in less liquid deposits, whereas the relative share of the nuevo sol is

higher in more liquid assets. Hence, it is indicative that the overriding motivation

for Peruvians to use the dollar domestically is for the purpose of (long‐term) sav‐

ing – i.e. foreign currency is primarily used as a store of value. In short, it can be

said that asset substitution (in turn, financial dollarization55) is the prevailing

characteristic of the Peruvian economy.

In conclusion, a long period of high inflation and hyperinflation is found to be

the main initial driver of dollarization in Peru. Although there are clear signs of

deceasing dollarization ratios in the last years, the phenomenon must still be clas‐

sified as extremely high and persistent. Furthermore, financial dollarization, rather

than real or payments dollarization, is the underlying feature of the economy –

however, some transactions (particularly purchases of big‐ticket items or durable

54 Earlier studies by DE LA ROCHA (1998: 190) and QUISPE MISAICO (2000: 6) find that domestic cur‐rency is predominantly held in the form of current accounts and savings deposits. However, the more recent data – comprising a time span of 2004 to 2008 – does not confirm this view.

55 As already stated before, it is assumed that asset substitution implies full‐fledged financial dol‐larization, as standard regulation usually obliges banks to match the currency denomination of their assets and liabilities.


goods) are performed in foreign currency. The next section concentrates on the

Croatian experience with euroization.

3.1.3 The Croatian experience with euroization

At first sight, Croatia seems to be an ordinary Southeastern European country that

faces the same economic challenges as other Central, Eastern and Southeastern

European (CESEE) economies. However, the exceptional feature of the Croatian

economy is that it is much more dollarized56. Croatia’s deposit euroization ratio is

the highest of all CESEE emerging and developing economies on a ten‐year average

(see figure 9).

Figure 9 Dollarization in CESEE economies* (average 19942004, in %)

*This group includes all Eastern European emerging and developing economies, as classi-

fied by the IMF. Serbia and Montenegro are not listed due to data omission.


Croatian citizens have experienced a long history of high inflation. Growth of

domestic prices shows rates between 15 and 40 percent in former Yugoslavia

throughout the 1970s and even accelerates in the 1980s (cf. SOSIC AND KRAFT 2006:

494). After a period of war and extreme macroeconomic instability, Croatia be‐

56 It should be clear from above explanations that the term dollarization may also be used when referring to Croatia, although foreign currency is mainly held in the form of euros.


comes independent and introduces its first own currency in 1991.57 In the first few

years after the separation process of Croatia, inflation remains at very high aver‐

age levels of 745 percent in 1992 and 1617 percent in 1993 (cf. IBID.). In addition to

high inflation rates, former Yugoslavia also leaves Croatia a legacy of very high dol‐

larization (cf. KRAFT 2003: 3).58

In October 1993, Croatian authorities introduce a stabilization program that

quickly proves to be effective and successfully brings down hyperinflation (see

figure 1059). In particular, the inflation rate falls to the single‐digit range within two

years and amounts to only an annual average of 1,9 percent in 1995. In the further

course, the annual average year‐on‐year inflation rate remains quite low and sta‐

ble and only once exceeds an upper bound of 5 percent in 1998 and 2008.

Figure 10 Euroization and inflation in Croatia

Source: CNB, IMF WEO, own calculations

57 The first Croatian money is the ‘Croatian dinar’. The ‘Croatian kuna’ (HRK), which is the current official legal tender of the Republic of Croatia, replaces this transitional interim currency in 1994.

58 To be precise, former Yugoslavia is characterized mainly by high ‘D‐markization’ (cf. IBID.). 59 The vertical dotted line indicates the beginning of the stabilization process at the point when inflation rates begin to fall in 1993. The key elements of the Croatian stabilization program are described in section 3.2.2.1.


Despite successful stabilization efforts and major advances in disinflation, eu‐

roization does not decline sustainably in Croatia. On the contrary, measured by the

ratio of FCD to broad money (i.e. M4), dollarization rises to its highest level of 66

percent in 1999 – an increase of about 35 percent compared to only 49 percent in

1994 (see figure 10). The rise of broad money euroization in the second half of the

1990s may be attributed to the successful stabilization of the Croatian economy. As

residents’ confidence in the national banking sector returns, a repatriation process

of domestic savings – that were held abroad or in the form of foreign currency cash

(i.e. ‘under the mattress’), prior to stabilization and during war – develops (cf. LANG

AND KRZNAR 2004: 4).

An additional driver of euroization in Croatia worth mentioning is the resi‐

dents’ experience with expropriation in the 1990s. Having lost the backing of in‐

ternational reserves of the National Bank of Yugoslavia, the Croatian government

converts foreign currency deposits into public debt and freezes them in 1991 (cf.

SOSIC AND KRAFT 2006: 494). Although this very event might stimulate the hoarding

of foreign banknotes outside the domestic banking system rather than deposit dol‐

larization in the first place, it exacerbates the euroization trend when savers return

to foreign currency deposits later, as confidence returns to the banking system.

Moreover, the fact that these deposits are repaid after a while60 may also send a

wrong signal to the citizens, as it implies that foreign currency saving deposits are

secure in the future.

Although the euroization ratio shows a decreasing trend between 2000 and

2007, a sustainable and strong ‘de‐euroization’ cannot be observed. Currently,

broad money euroization even begins to increase again, which may be related to

depreciation pressures and generalized uncertainties in the context of the global

financial crisis – i.e. searching for a safe haven. In short, Croatia has experienced

very low inflation recently, showing an annual average maximum of 6,1 percent in

2008. However, broad money euroization remains at a stable equilibrium of al‐

most 60 percent in the last 15 years. The Croatian experience is briefly summa‐

rized in figure 10, thereby confirming the still‐high level of broad money euroiza‐

tion – i.e. 56 percent in the first nine months of 2009. 60 The authorities start to unfreeze blocked accounts by mid‐1995.


Moreover, Croatia’s persistent dollarization is certainly related to its regional

proximity to the euro area and the EMU. It is easy to understand that financial and

trade‐related links with EU member countries enhance the availability of euros in

Croatia. Additionally, receipts from tourism and remittances from Croatians living

abroad guarantee a constant inflow of foreign currency (cf. SOSIC AND KRAFT 2006:

495), therefore aggravating the persistence of the euroization trend. Employing

survey data, STIX (2008: 17‐20) finds empirical support for the role of remittances

in Croatia, as people that have close relatives working in the euro area are more

likely to hold foreign currency assets. Moreover, the number of foreign banks in

the Croatian financial system is very high – in fact, 80 to 90 percent of all banks are

foreign‐owned (cf. HILBERS ET AL. 2005: 12). Thus, there is an increased access to

foreign funds (from parent banks), which appears to be positively correlated with

liability dollarization (cf. BASSO ET AL. 2007: 5‐6).

With regard to the underlying form of dollarization in Croatia, it is useful to re‐

view the composition of M4, which is Croatia’s broadest money. Here, it becomes

evident that the share of foreign currency deposits is much larger than the share of

kuna deposits (see figure 11). In fact, the sum of kuna savings and time deposits

amounts to 53 billion HRK, whereas the sum of foreign currency savings and time

deposits reaches 110 billion HRK on average throughout 2008 – this is more than

twice as much. Moreover, 2008 average values reveal that almost 80 percent of all

foreign currency deposits are held in the form of time deposits.61 This is taken as a

clear indication that foreign currency serves for long‐term rather than short‐term

saving purposes. In other words, it is evident from the deposit structure that for‐

eign currency is Croatians’ largely preferred store of value. In turn, assuming that

asset substitution entails liability substitution, this means that the underlying type

of dollarization in Croatia can be denoted best as ‘financial euroization’.

61 A precise description of the methodology is given below the illustration in figure 11.


Figure 11 Composition of broad money in Croatia

Notes on Methodology: Money (M1) comprises currency in circulation outside banks, de-posits by other banking institutions and other domestic sectors with the CNB and banks’ kuna demand deposits. Kuna deposits are savings deposits, and time and notice depos-its in local currency. Foreign currency deposits are foreign currency savings deposits, and time and notice deposits. Savings deposits include all foreign currency sight deposits and foreign currency payment instruments. Households’ blocked foreign currency deposits are those deposits that are regulated by the ‘Act on Converting Households Foreign Exchange Deposits into the Public Debt of the Republic of Croatia’ (cf. CNB 2009 21‐29).

Source: CNB, own calculations

Furthermore, when studying the type of euroization in Croatia, it is important

to consider another fact that mainly refers to payments dollarization:

“By law, transactions in Croatia must be performed in domestic currency and transactions in stores, payment of taxes, and all official payments between firms are in fact performed in Croatian kuna.” (SOSIC AND KRAFT 2006: 495)

At first sight, this legal provision implies that there cannot be any euroization

of payments in Croatia. However, as KRAFT (2003: 5) states, several cash transac‐

tions – especially private transactions such as purchases of used cars and real es‐

tate – are sometimes made in foreign currency. With respect to real dollarization,

anecdotal evidence suggests that Croatian citizens tend to think of prices in terms

of euros (cf. KRAFT 2003: 7). Hence, several prices are informally linked to the

kuna/euro exchange rate, entailing the indication that citizens adjust the domestic


currency counter value respectively. Particularly in the tourism industry, some

prices are even directly quoted in foreign exchange.

In sum, it has been demonstrated that high and persistent financial euroization

is the prevailing type of euroization in Croatia. However, payments and real dol‐

larization cannot be ignored completely either. In particular, foreign currency cash

holdings (outside the banking system) are relevant regarding the Croatian experi‐

ence.62 Employing data from a new OeNB survey on foreign currency holdings,

DVORSKY ET AL (2008: 59) confirm that the main motive of Southeastern European

residents to hold euro cash is the store of value function. On the contrary, they find

that people in Central Eastern European countries accumulate foreign currency

cash for shopping abroad (i.e. ‘payments euroization’). This phenomenon appears

to have its roots in a long high‐inflation history and a deeply rooted lack of confi‐

dence in the banking system and the authorities (e.g. associated with expropria‐

tions). Even the euro changeover did not alter the Croatian agents’ preference for

foreign currency as a store of value.

3.2 Monetary policy under the constraints of dollarization and euroization

The implications of dollarization have been described carefully in section 2.2.2.

The main challenges that dollarization and euroization pose for monetary policy

appear to be lower effectiveness, weaker transmission and most of all, risks re‐

lated to the balance sheet effect and the limited lender of last resort function. In

the empirical part, de facto dollarization – in particular, Peruvian dollarization and

Croatian euroization – have been discussed so far (see section 3.1). Thereby, it has

been shown that both Peru and Croatia are striking examples of extremely high

and persistent dollarization and that policymakers in these countries should be

particularly concerned about financial dollarization.

Based on these results, the conduct of monetary policy under dollarization and

euroization in Peru and Croatia will be examined in the following section. The 62 Measured by a more comprehensive indicator, Croatia’s euroization ratio is found to be higher than that suggested by the results of this study. Estimates by KRAFT (2003:4) show that the cur‐rency substitution index (CSI) exceeds 75 percent at the end of 2001 and FEIGE AND DEAN (2002: 14‐15) find that the true extent of unofficial dollarization – measured by the UDI – scores above 70 percent in 1999.


analysis begins by examining the current monetary policy framework and its in‐

struments and continues by describing the recent monetary experience for both

cases respectively.

3.2.1 Monetary policy in Peru

3.2.1.1 The monetary policy framework and its instruments

The Board of the Central Reserve Bank of Peru approves the adoption of an explicit

inflation targeting (IT) framework on 24 January 2002. Having an annual inflation

target of 2,5 percent and a tolerated margin of one percentage point on each side,

Peru becomes the first known highly dollarized economy that adopts inflation tar‐

geting (cf. ARMAS AND GRIPPA 2005: 5). Above all, the BCRP is mandated to preserve

monetary stability, whereupon its overall key role is to maintain price stability (cf.

BCRP 2008: 121‐122). In addition, the Constitution stipulates the central bank’s

autonomy and operational independence – accordingly, the BCRP is prohibited

from implementing measures against its main objective and must not grant direct

loans to the treasury.

During the disinflation process from 1991 to 2001, the Peruvian monetary

policy follows a monetary targeting framework without any commitment to the

exchange rate or interest rate level. At the same time, the BCRP makes a number of

adjustments in its monetary targeting policy design that attempt to create the con‐

ditions necessary for the introduction of the IT regime in 2002.63 The decision to

adopt an inflation targeting scheme in 2002 is mainly associated with the chal‐

lenges of operating in a new low‐inflation environment (see section 3.1.2) and

thereby attempts to support the BCRP’s key role – to maintain price stability.

At the beginning of 2007, the BCRP reduces its numerical inflation target to 2

percent with a tolerance of plus or minus one percentage point (i.e. 1 to 3 percent).

The rationale behind the reduction of the inflation target is “to continue reinforc‐

ing confidence in the domestic currency and reducing the vulnerability of the Pe‐

ruvian economy associated with dollarization” (BCRP 2007: 20). At first sight, the

63 For instance, the BCRP begins to announce one‐year inflation targets in 1994. Moreover, the monetary base is replaced by banking reserves as the central bank’s operational target in 2000. ROSSINI AND VEGA (2008: 395‐397) provide more details on this point.


Peruvian IT scheme seems to contain the typical characteristics of any inflation

targeting framework. However, opting for inflation targeting was a very conscious

decision for Peruvian monetary policymakers, as they are fairly aware of the dan‐

gers associated with operating in a highly dollarized environment. Figure 12 gives a

short overview of the BCRP’s monetary policy framework, which is referred to as

‘adjusted inflation targeting’, as several features are particularly relevant to the

high dollarization degree of the economy – these characteristics will be highlighted

in the following.

Figure 12 Adjusted inflation targeting in Peru

Source: BCRP, own illustrations

Firstly, the Peruvian numerical inflation target is among the lowest in Latin

America (cf. ARMAS AND GRIPPA 2005: 7‐9). A very low inflation target puts the local

currency in a better position to compete against other currencies internationally.

Moreover, if domestic prices in Peru rise at the same rate as prices of main indus‐

trialized economies, a depreciation of the nuevo sol should be avoided (cf. BCRP

2007: 20). In a nutshell, the BCRP’s strict commitment to price stability aims at


strengthening the purchasing power of the domestic currency and attempts to an‐

chor inflation expectations64 – it consequently fights dollarization.

Secondly, when choosing the interbank overnight interest rate as an opera

tional target65, the short‐term interest rates should become more stable and fore‐

seeable. Table 4 provides some evidence that the level and variability of the inter‐

bank interest rate in domestic currency now are much lower than before the in‐

troduction of inflation targeting. The volatility, calculated as the standard deviation

of monthly average interbank interest rates, decreases from 7,7 percentage points

in 1998 to only 1 percentage point in 2002. Thereafter, interest rate volatility con‐

stantly remains below the levels prior to IT66 – it appears to be high (2,2 percent‐

age points) only in 2009. This high figure, however, is attributed to the large cuts

in the central bank’s reference interest rate – in fact, there was a reduction of 525

basis points (bps) in only 8 months (see section 3.2.1.2).

Table 4 Decreasing interbank interest level and volatility in Peru

Interbank interest rate (average, in percent)

Standard deviation (in percentage points)

1998 19,0 7,7 1999 15,1 5,1 2000 12,7 2,4 2001 8,7 4,1 2002 3,2 1,0 2003 3,3 0,5 2004 2,6 0,2 2005 3,0 0,1 2006 4,3 0,3 2007 4,7 0,2 2008 5,8 0,7 2009* 4,1 2,2

*January - September Source: BCRP, own calculations

An important implication of stable and predictable interest rates in domestic

currency is that a yield curve of interest rates for different maturities becomes eas‐

ier to develop (cf. ARMAS AND GRIPPA 2005: 10). Thus, long‐term operations in local 64 ROSSINI AND VEGA (2008: 401) illustrate that one‐year‐ahead inflation expectations have been reduced significantly since 1995 in Peru. Moreover, they show that expectations remain well in line with the announced inflation targets.

65 An operational target of monetary policy is the target level that is announced and directly influ‐enced by the central bank.

66 VELARDE’ s (2005: 236) results also support these findings.


currency become more foreseeable, whereby financial dollarization should de‐

crease further.

Thirdly, dollarization has an impact on the design of the Peruvian inflation

forecasting67 system. The projection model generally consists of four main ele‐

ments: a Phillips curve, a monetary policy rule, an investment‐savings curve and

an exchange rate equation (cf. LUQUE AND VEGA 2003: 3‐13). Most noteworthy, the

model’s IS curve includes a dollar interest rate component with regard to dollari‐

zation – thereby, it directly takes into account the fact that foreign interest rate

changes affect domestic consumption and investment decisions. Moreover, an iner‐

tia term that reflects the central bank’s policy of exchange rate intervention (see

below) is integrated in the exchange rate equation of the forecasting model (cf.

ARMAS AND GRIPPA 2005: 17‐24).

Fourthly, although several particularities of inflation targeting in Peru have

been described so far, the differences from non‐dollarized economies’ IT regimes

still seem to be small. However, besides inflation targeting (which maintains price

stability and countercyclical monetary policy), the central bank’s role is linked to

financial stability, which is addressed by two auxiliary functions (see figure 12). The

first pillar is predominantly concerned with liquidity management and does not

require any further explanations, as it is a primary task of central banks.68

Indeed, the second auxiliary function – dollarization risk control – plays a more

prominent role and is supposed to be the chief reason for including the financial

stability pillar into the Peruvian monetary policy framework. On the one hand, the

BCRP obliges commercial banks to hold higher reserve requirements on foreign

currency and aims to accumulate a high level of net international reserves (NIR),

which makes funds in foreign currency more readily available. At the same time,

commercial banks are forced to internalize dollarization risks properly, thereby

preventing moral hazard dollarization. On the other hand, the central bank inter‐

venes in the foreign exchange market to reduce extreme exchange rate changes

67 Inflation forecasting is a key ingredient of any IT system. In order to make its monetary policy transparent and to communicate closely with the public, the BCRP publishes its inflation forecast in so‐called ‘inflation reports’ every four months.

68 Central banks’ role to guarantee liquidity to the financial system, to assure the normal function‐ing of the money market and payment system as well as the lender of last resort function are widely accepted in literature (see, for instance, section 2.2.1).


without announcing a predetermined level or path (cf. BCRP 2008: 121‐122). The

inclusion of a managed floating exchange rate regime reduces the risks that large

exchange rate variability poses for a dollarized economy and simultaneously pro‐

motes de‐dollarization, as the public cannot rely on a fixed or stable exchange rate

but has to internalize currency risks.69 Lastly, the Peruvian monetary policy

framework includes an escape clause that allows for a transitory increase in the

interbank interest rate (cf. VELARDE 2005: 235). In monetary targeting schemes, the

effect of a large shock can usually be separated between the interest rate and the

exchange rate and partly be absorbed by interventions. Under inflation targeting in

dollarized Peru, the escape clause is needed in order to fight extreme exchange

rate depreciation (e.g. in the event of a strong negative shock or speculative attack)

by allowing the interbank interest rate to depart from the typically predetermined

band (cf. ARMAS AND GRIPPA 2005: 15). The right pillar in figure 12 summarizes the

dollarization risk control measures of the BCRP.

Finally, the author provides a brief summary of the main instruments that the

Central Reserve Bank of Peru uses within its inflation targeting framework. As

with any IT system, the BCRP primarily carries out monetary policy changes

through variations of its reference shortterm interest rate (i.e. a benchmark for the

overnight interbank lending market). In order to get the money market’s interbank

interest rate to align with the reference level, the central bank conducts direct re‐

pos and rediscounts (i.e. a discount window) and provides an overnight deposit fa

cility. In addition, the BCRP can conduct open market operations through purchases

or sales of Certificates of Deposit (CDBCRPs) or Treasury Bonds (BTPs) on the sec‐

ondary market, thereby injecting or withdrawing liquidity. Moreover, the central

bank introduces a swap in foreign currency in 2007, which is used to inject domes‐

tic currency to the financial system and withdraw the foreign exchange (especially

dollars), as a complement to traditional measures (cf. BCRP 2009: 73). It is impor‐

tant to note that this instrument can have a temporary effect on de‐dollarization.

In addition, the Peruvian central bank frequently uses foreign exchange interven

tions as a monetary policy instrument. In order to smooth exchange rate move‐

69 By contrast, Peru would loose its monetary autonomy under a fixed exchange rate regime (as there are no capital controls), which would be inconsistent with the IT framework.


ments, the BCRP directly purchases or sales foreign exchange but can also issue

exchange rate indexed securities (CDRs), which aim to provide the market with a

hedging asset (cf. ARMAS AND GRIPPA 2005: 46). Finally, an important instrument of

the BCRP is the reserve requirement that obliges banks to hold a certain amount of

liquid assets with the central bank. The BCRP distinguishes between legal reserve

requirements and marginal reserve requirements, whereby only the latter is re‐

munerated. Today, the reserve requirement for commercial banks’ domestic cur‐

rency obligations is 6 percent, whereas there is a 30 percent reserve requirement

on banks’ foreign currency liabilities (cf. BCRP 2009a: 4; BCRP 2009b: 2). Monetary

policy decisions are released on the first Thursday of every month.

In conclusion, Peruvian authorities deliberately opt for IT as the appropriate

monetary policy framework in 2002. This section has described several particu‐

larities of the Peruvian inflation targeting framework that have to do with the in‐

flation target, the operational target and the inflation forecasting system. Above all,

monetary policymakers add a dollarization risk control component to the mone‐

tary policy framework that aims at smoothing exchange rate changes through a

managed floating system, fosters internalization of financial dollarization risks and

makes foreign currency liquid funds largely available. This auxiliary function

seems to be the major difference to classical inflation targeting frameworks and

can be interpreted as a major threat at the same time:

“For the inflation target to be credible, it should be perceived as the central bank’s most important target. No other variable, such as the exchange rate, should overshadow it.” (ARMAS AND GRIPPA 2005: 30)

It could be argued that the inclusion of a managed floating into the Peruvian

framework may weaken inflation targeting. In order to shed further light on this

question and to assess the monetary policy track record of the BCRP, the next sec‐

tion will study the Peruvian monetary experience in‐depth.

3.2.1.2 The recent monetary experience in Peru

Having established that Peruvian monetary policymakers have adopted an infla‐

tion targeting framework, this section analyzes the use of the most important

monetary policy instruments. The analysis begins with an illustration of the inter‐

est rate policy of the Central Reserve Bank of Peru (see figure 13).


Figure 13 Interest rate policy and interbank interest rate in Peru


After the adoption of the interest rate operational target in 2002, the level of

the interbank interest rate decreases and remains within the BCRP’s reference cor‐

ridor (i.e. the band between the overnight deposit rate and the discount rate).

However, in September 2002, Brazilian presidential elections trigger a large nega‐

tive shock in Latin America that is expected to create strong depreciatory pres‐

sures. In order to prevent excessive depreciation of the nuevo sol, the ‘escape

clause’ is used to spread this effect between the exchange rate and the interbank

interest rate (cf. ARMAS AND GRIPPA 2005: 15; VELARDE 2005: 235). As figure 13 illus‐

trates, the interbank interest rate is allowed to depart the benchmark channel.

Subsequently, the interbank interest rate remains close to the target rate.70

Regarding the recent experience, it is particularly striking that the BCRP

steadily tightens its monetary policy stance until early 2009 – in fact, the BCRP

raises the reference interest rate from 4,5 percent in mid‐2007 to 6,5 percent in

January 2009 (see figure 13). Notably, monetary tightening is applied in a period of

70 In addition to the ceiling and floor of the target range, in 2003 the BCRP begins to announce an explicit reference interest rate that is the center of the target range.

“Escape clause”

“All-time low”


high uncertainty about the development of the world economy due to the financial

crisis. The main reasons for this hike, however, are robust growth of domestic de‐

mand and significant price rises on the international food and fuel markets that

lead to an (imported) upward trend of the inflation rate (see figure 15). The BCRP

repeatedly states that it aims at steering inflation to return to the target range,

since the domestic price increase accelerates and reaches its peak of almost 7 per‐

cent only in November 2008 (cf. BCRP 2007: 19; BCRP 2008: 118). In that context,

the BCRP significantly raises the marginal rate of reserve requirements – in par‐

ticular, the rate for local currency reserve requirements increases from 6 to 25

percent, whereas foreign currency reserve requirements raise from 30 to 49 per‐

cent in February 2008 (cf. BCRP 2008: 119). This action is in line with the gradual

process of interest rate tightening and primarily attempts to support sterilization

mechanisms that are applied in a context of large capital inflows and purchases of

foreign exchange (see figure 14).

In February 2009, the Board of the Central Reserve Bank of Peru finally de‐

cides to reduce the policy reference interest rate by 25 basis points, thereby directly

reacting to the challenges of the financial turmoil.

“This decision is based on the fact that lower inflationary pressures have been observed in a context of lower global economic growth and a drop in the interna‐tional prices of food and fuels.” (BCRP 2009c: 1)

In the following six months, the BCRP continues to ease its monetary policy

stance, reaching a policy rate all‐time low at 1,25 percent in August 2009 (see fig‐

ure 13). Put differently, the Peruvian reference rate has been cut by 525 bps since

February 2009 as reduced international commodity prices and the persistence of

the financial and economic crises steer inflation (and inflation expectations) to

return to the target range (see figure 15). As early as fall 2008, the central bank also

cuts the rates of reserve requirement to its original level in response to the spill

over of global financial turbulences – thereby it aims to prevent the financial sys‐

tem from drying out. In line with this, the Central Reserve Bank of Peru also im‐

plements (new) liquidity injection mechanisms. In an attempt to prevent a strong

depreciation of the nuevo sol and the disruption of credit, the BCRP has injected

liquidity for more than 35 billion PEN since 2008 – an amount that equals about 9

percent of GDP (cf. BCRP 2009: 82). Accordingly, the central bank provides liquidity


through open market operations, mainly using 1‐year repos, repurchases of

CDBCRPs and currency swaps. When monetary policy easing translates into ap‐

propriate levels of liquidity, the BCRP re‐orients its monetary stance from a liquid‐

ity injection strategy and begins to carry out sterilization operations in June 2009.

Furthermore, figure 14 provides a close look at foreign exchange rate interven

tions, as it is another frequently applied policy instrument.

Figure 14 Foreign exchange interventions and exchange rate in Peru


The evolution of the exchange rate shows that a depreciation arises in fall

2002, shortly after the introduction of IT. This transitory effect, caused by the un‐

certainty about Brazilian presidential elections quickly abates and a sustainable

longterm appreciatory trend develops. In the second half of 2004, capital inflows

lead to an acceleration of this movement (cf. LEIDERMAN ET AL. 2006: 7). Although

the BCRP intervenes with foreign exchange purchases amounting to 1950 million

USD between August 2004 and February 2005, the appreciation trend of the nuevo

sol does not reverse sustainably. Upward pressures sharply increase in the second

half of 2007, pushing the dollar to only 2,75 nuevo sols in April 2008. The weaken‐

ing of the dollar in the international financial market, which is due to enhanced

fears of an US recession, appears to have played a key role in this development (cf.

“Net purchases”

“Net sales”


BCRP 2007a: 39). In an attempt to ‘lean against the wind’, the Peruvian central bank

repeatedly intervenes in the exchange market – in particular, it buys a sum of more

than 7000 million dollar during 2007.

From April 2008 onwards, the Peruvian national currency faces strong depre

ciatory pressures. Here, major reasons are the deepening of the financial crisis and

a decline of global demand that, in turn, trigger a re‐composition of both foreign

investors’ and national entities’ portfolios (cf. BCRP 2008: 125‐127). The BCRP at‐

tempts to alleviate this trend by means of consistent foreign exchange interven‐

tions – more precisely, the central bank sells foreign exchange amounting to 8370

million USD from May 2008 until July 2009 (see figure 14). Finally, abrupt deprecia‐

tion can be stopped and negative effects on the economy (e.g. through the deterio‐

ration of dollarized balances of firms and households) are prevented. It is impor‐

tant to note that this heavy intervention could only be conducted because of the

purchases of foreign exchange in previous years. In February 2009, the nuevo sol

begins to appreciate again.

In general, it should be mentioned that overall exchange rate volatility is rela‐

tively low in Peru. The range between the most depreciated level of the exchange

rate (3,61 PEN/USD) and the most appreciated value (2,74 PEN/USD) is only about

30 percent.71 This development, not least, reflects that the BCRP’s efforts to reduce

excessive volatility by interventions in the exchange market are successful. Moreo‐

ver, the PEN/USD‐exchange rate exhibits a clear and stable appreciatory trend of

the nuevo sol since 2002. Firstly, this may be attributed to steady portfolio shifts

towards the local currency – in other words, the dollarization ratio decreases by

28 percentage points between 2002 and 2008 (see again section 3.1.2). Secondly,

capital inflows (partly based on interest rate hikes) are found to be a common

phenomenon in Peru and can bee seen as another driver to the persistent appre‐

ciatory trend of the nuevo sol.

71 In comparison, the EUR/USD‐exchange independently floats within a range of about 80 percent between the weakest level of the euro in early 2002 and the most appreciated one in mid‐2008 (see appendix, figure A 2).


Finally, figure 15 illustrates the evolution of the Peruvian inflation and imported

inflation72 on a monthly basis. Here, it is apparent that the inflation rate escapes

the target range several times in the observation period.

Figure 15 Inflation and imported inflation in Peru

Source: BCRP, own calculations

It appears most noteworthy that the annual rate of change of the consumer

price index (CPI) reaches a peak of 4,61 in July 2004 and hits its highest point since

the introduction of inflation targeting at a rate of 6,75 percent in November 2008.

In both events, strong external supply shocks are identified to be the main driver.

More precisely, in response to increases in the prices of oil and imported foodstuff,

imported inflation levels reach about 12 percent in November 2004 and April

2008 (cf. BCRP 2004: 33; BCRP 2009: 84). In the context of a weak economic envi‐

ronment and the resurgence of international commodity prices, inflation returns to

the target range in July 2009 and is expected to fall below the lower bound of the

target range in early 2010 (cf. BCRP 2009: 87).

72 The imported inflation indicator mainly comprises food, fuel and medicine as prices of these goods are most affected by the exchange rate and international price movements (cf. BCRP 2004: 35).

“Supply shocks in prices

of foodstuffs and fuels”

“Inflation target range”


In conclusion, the conduct of monetary policy in Peru exhibits typical charac‐

teristics of inflation targeting similar to that in any other non‐dollarized economy.

The decisions of the central bank to change the reference interest rate are based

on the development of the recent inflation and inflation forecasts. Interest rate

adjustments are implemented in a gradual and continuous way. At the same time,

the central bank intensively intervenes in the foreign exchange market to smooth

strong exchange rate fluctuations – i.e. leans against the wind. In order to sterilize

created liquidity, the BCRP changes in reserve requirements once in a while. Al‐

though fx interventions are necessary to reduce the risks of large exchange rate

fluctuations in a dollarized economy, a managed floating system is supposed to

contrast with IT frameworks (see again section 3.2.1.1). As the BCRP has main‐

tained a low average inflation level of 2,9 percent since the introduction of the IT

framework, this paper does not find signs that prevent a combination of inflation

targeting and managed floating. All in all, the monetary analysis clearly shows that

the Central Reserve Bank of Peru conducts a monetary policy that is quite conven‐

ient and succeeds in maintaining low and stable inflation and promoting financial

stability in a highly dollarized environment.

3.2.2 Monetary policy in Croatia

3.2.2.1 The monetary policy framework and its instruments

The monetary policy framework in Croatia differs substantially from the Peruvian

one. At the same time, the Act on the Croatian National Bank illustrates that the

central banks’ main goals are fairly similar:

“The objective of the Croatian National Bank shall be to maintain price stability. Without prejudice to the achievement of its objective, the Croatian National Bank shall support the economic policy of the Republic of Croatia (…).” (CNB 2008: 3)

A major difference regarding the goal of price stability, however, is that the

Croatian National Bank does not announce a specific target range for the year‐on‐

year growth rate of consumer prices. Moreover, the legal framework stipulates

that the CNB is independent within the Constitution and law – more precisely, the

central bank is autonomous in adopting measures and instruments to fulfill its

main task, i.e. to formulate and execute monetary and foreign exchange policies (cf.


CNB 2008: 4). As another basic institutional feature, the central bank is prohibited

from lending to the public sector (cf. CNB 2008: 40).

After a long period of hyperinflation and instability, the CNB introduces a sta

bilization program in 1993 (see section 3.1.3), which successfully ends deprecia‐

tion and brings down inflation. Rather than direct price controls, one of the main

elements of the stabilization program is a nominal exchange rate anchor, which is

initially set to the Deutschemark (cf. LANG AND KRZNAR 2004: 3). By allowing banks

to set exchange rates freely, further financial market liberalization is promoted.

Moreover, current account convertibility is introduced, guaranteeing residents the

opportunity to convert foreign exchange into domestic money and/or back later

(cf. KRAFT 2003: 2). These elements are regarded as crucial for the success of the

stabilization program.73

Up until now, Croatian monetary policy is strongly concerned with the ex‐

change rate (see section 3.2.2.2). In other words, it could be said that Croatia’s cur‐

rent monetary policy is determined by a nominal exchange rate targeting frame

work – today, the exchange rate anchor is set to the euro. LANG AND KRZNAR (2004:

3) correctly state that the reason for pursuing exchange rate stability after success‐

ful stabilization in Croatia is the high and widespread euroization degree of the

economy. At the same time, it is important to note that the CNB does not pre‐

commit to a specific path or band for the exchange rate.

A closer look at Croatian monetary policy reveals several interesting facts. Fig‐

ure 16 helps to shed further light on the monetary framework, as it clearly shows

that the Croatian National Bank’s international reserves exceed the domestic

money supply at all times since the introduction of the stability program in 1993

(i.e. the launch of the current monetary policy framework). Admittedly, monthly

data reveals that money supply was higher than the amount of international re‐

serves for a transitory period of three months in 1994.

73 For a detailed description of the Croatian stabilization program, see e.g. SONJE AND SKREB (1997).


Figure 16 International reserves and money supply in Croatia


In addition to these results, figure 17 provides important empirical evidence. In

September 2009, foreign assets comprise 99,97 percent of total assets of the CNB.

Moreover, employing monthly data, it becomes evident that the share of foreign

assets relative to CNB’s total assets amounts to an average of 98 percent in 2008.74

The findings illustrated by figure 16 and 17 clearly indicate that the composition

of the balance sheet of the Croatian National Bank is similar to the typical balance

sheet structure of a currency board.75 Above all, however, a pure currency board

arrangement requires a clear legal mandate, which obliges the central bank

through its Constitution to fix the international value of the domestic currency.

Moreover, monetary policy instruments to control domestic liquidity would not be

available and the money supply process would be exclusively determined by

changes in the central bank’s foreign exchange account under a pure currency

74 SOSIC AND KRAFT (2006: 502) find similar results for the year 2005. 75 Under a pure currency board arrangement, the monetary authority is obliged to fully cover do‐mestic money supply (e.g. monetary base) by foreign currency reserves. Moreover, a currency board is prohibited from lending in any form domestically (cf. BOFINGER 2001: 171‐172). Hence, the asset‐side column of the monetary authority’s balance sheet exclusively comprises net foreign reserves. In addition, a typical currency board is prevented from acting effectively as a lender of last resort, as it cannot engage in fine‐tuning operations or buy and sell domestic assets (cf. HANKE 2002: 89‐92).


board. Although the balance sheet structure of the Croatian National Bank indi‐

cates a currency board regime, the central bank has never declared such a system

to be its monetary policy framework.

Figure 17 Assets of the CNB in September 2009

Source: CNB, own illustrations

In 2005, the CNB introduces a number of new monetary policy instruments that

indicate that the conduct of monetary policy in Croatia differs from a standard cur‐

rency board regime. Since then, aside from CNB bills, the central bank’s most im‐

portant instruments are open market operations, standing facilities, reserve

requirements and foreign currency auctions.

Open market operations constitute the main instrument to manage liquidity in

Croatia. In turn, regular reverse repo auctions are the standard means for funding

the financial sector (cf. CNB 2005: 88‐89). With the aim of increasing the banking

system’s liquidity, they are conducted every week and have a maturity of one

week. Furthermore, fine‐tuning operations are used to temporarily reduce or in‐

crease liquidity in the financial system. They are performed by means of repo and

reverse repo auctions and are not standardized in frequency of maturity (i.e. they

are performed ad hoc). In an attempt to control the long‐term structural liquidity

position of the banking system, the CNB’s open market operations also entail struc‐


tural operations. Here, the central bank conducts repo and reverse repo opera‐

tions, and carries out outright purchases or sales of securities in either regular or

irregular intervals, without committing to a predetermined maturity.

In addition, the Croatian monetary framework provides for standing facilities.

In particular, standing facilities offer deposits with the central bank (i.e. a deposit

facility) and make funds available in the form of Lombard loans. Having an over‐

night maturity, these measures aim at stabilizing unexpected changes in bank

liquidity and establish an interest rate corridor on the short‐term money market

(cf. CNB 2009a: 2). The deposit facility sets the floor of the band (currently 0,5

percent) and the Lombard loan interest rate offers the ceiling (currently 9 per‐

cent). Another frequently used instrument of the Croatian National Bank is reserve

requirements. The calculation base consists of both a kuna and a foreign exchange

component, whereby remuneration is paid at different rates on both components.

The current overall mandatory reserve requirement rate is 14 percent and the cal‐

culation period is set to one month. As the CNB has changed both rate and base of

reserve requirements several times, the exact calculation of this monetary policy

instrument appears to be fairly complex today.76 In general, changes in this in‐

strument are used for monetary tightening or loosing and will turn out to be a pre‐

dominant instrument to sterilize the financial system’s surplus liquidity in section

3.2.2.2 (cf. CNB 2005: 90).

Without doubt, the Croatian central bank regularly intervenes in the foreign

exchange market. Foreign exchange interventions are held to “protect the stability

of the domestic currency and maintain liquidity of payments in the country and

abroad” (cf. CNB 2009a: 3). In other words, the central bank frequently performs

foreign currency auctions that aim at smoothing exchange rate fluctuations on the

one hand and create liquidity on the other one. The central bank can implemented

one‐sided or two‐sided fx auctions, depending on whether the CNB buys or sells, or

buys and sells foreign exchange. Foreign exchange interventions are generally

based on a discretionary decision of the CNB (cf. IBID.). As a result, the euro/kuna

76 A detailed description goes beyond the scope of this brief summary. Nevertheless, more informa‐tion on reserve requirements can be found in CNB (2009a).


exchange rate has fluctuated within a very narrow exchange rate band in the last

decade, as the analysis in section 3.2.2.2 will show.

In conclusion, the structure of the CNB’s balance sheet, the evolution of the

CNB’s international reserves relative to M1 and a strong commitment to exchange

rate stability are the typical characteristics of the Croatian monetary framework.

These features suggest that policymakers follow a currency board regime. The lack

of a clear legal framework and the existence of domestic monetary policy instru‐

ments (e.g. open market operations as a means to control liquidity and reserve

requirements to sterilize interventions) indicate that the monetary framework of

the Croatian National Bank differs substantially from a pure currency board.

Therefore, the Croatian monetary policy framework might best be denoted a quasi

currency board (cf. VUJCIC 2003: 83). Such a regime attempts to allow a certain de‐

gree of flexibility of the exchange rate and to provide important credibility (by the

means of the exchange rate anchor) at the same time. Moreover, the fact that in‐

ternational reserves exceed the monetary base by far (see again figure 16) permits

the CNB to react adequately to large exchange rate swings and serves as a means of

precaution at the same time (e.g. to effectively act as a lender of last resort). As

high exchange rate variation (in particular, large depreciation) is clearly not an

option to Croatian monetary policymakers, the chief reason for adopting such a

framework appears to be the high euroization level of the economy. At the same

time, Croatian policymakers might have felt that it is worth preserving a certain

degree of monetary policy autonomy instead of introducing a fixed exchange rate

regime. Examining the use of monetary policy instruments in Croatia in more de‐

tail, the author continues to clarify the functioning of this unusual framework.

3.2.2.2 The recent monetary experience in Croatia

This section discusses the use of monetary policy instruments in a chronological

order. Starting with the post‐stabilization period (i.e. after the introduction of the

current monetary policy framework in 1993), it takes into account important

monetary events and ends with the monetary challenges related to the recent fi‐

nancial crisis.

The 1993 stabilization program (see section 3.2.2.1) entails, among other

measures, banking sector liberalization and thereby creates attractive deposit in‐


terest rates due to increased bank competition. Furthermore, enhanced confidence

in the banking sector and successful stabilization contribute to large capital in‐

flows in the poststabilization period (19941998). To avert a strong appreciation of

the kuna, monetary authorities intervene in the foreign exchange market. In an

attempt to manage the liquidity, created by fx purchases, the CNB sterilizes inter‐

ventions mainly by means of reserve requirements and by issuing voluntary and

obligatory CNB bills (cf. LANG AND KRZNAR 2004: 4).

In 1998, several newly established and fast growing banks with aggressive in‐

terest rate policies fail, which is regarded as a long‐term consequence of financial

market liberalization (cf. JANKOV 2000: 11‐14). Currency portfolio redistributions,

deposit withdrawals, recession and strong depreciation pressures are associated

with the mounting banking crisis (19982000).77 Accordingly, the central bank

modifies its conduct of monetary policy and reinforces several (new) instruments.

In particular, the CNB increases credits to commercial banks through the introduc‐

tion of pre‐rehabilitation loan or interventive loan instruments in 1998. In addi‐

tion, the national bank intensifies repo operations and continues to issue CNB bills

(cf. CNB 1998: 64‐67). At that point, the CNB gives up the currency board policy for

the first time. In order to stabilize the financial system, the Croatian National Bank

injects 1,5 billion kuna into those banks that face liquidity problems (cf. VUJCIC

2003: 91‐92). Serving a lender of last resort function, these major actions maintain

liquidity and the normal functioning of payments in the financial system. In addi‐

tion, the CNB heavily intervenes in the foreign exchange market to thwart the

strong depreciation pressures in that period. Although the central bank sells large

amounts of foreign exchange, the kuna devalues by almost 13 percent between

January 1998 and March 2000 – this is by far the largest devaluation of the Croa‐

tian currency (see figure 18). The Croatian National Bank is faced with a very seri‐

ous situation in that period as a vicious circle could arise: if further devaluations of

the kuna accelerate currency substitution and cause further bank runs (even on

healthy banks), the number of bank failures would rise and consequently push the

kuna further down and so on. VUJCIC (IBID.) associates such a situation with the

77 The banking crisis begins in early 1998, when the Dubrovacka Bank – the fifth largest bank in Croatia at that time – stops to meet its obligations (cf. IBID.).


term “lukewarm capital”, as enormous risks can arise from the herd behavior of

domestic residents.

Figure 18 Foreign exchange interventions and exchange rate in Croatia


Having overcome the adverse effects of the banking crisis in the year 2000, a

period of economic and monetary expansion develops. This is related to reductions

in the reserve requirement rate (see figure 19) and the fact that the government

pays its arrears (cf. LANG AND KRZNAR 2004: 5). Moreover, having lifted restrictions

on the purchase and holding of foreign currency in June 2001, a speculative attack

threatens the kuna. Thus, the CNB conducts the largest fx intervention in a single

month (see figure 18) and sells foreign currency amounting to more than 414 mil‐

lion EUR in August 2001 – these strong sales are sterilized by further reductions in

the reserve requirements. In the end, the attack is not successful and the exchange

rate settles around a new stable equilibrium of 7,5 HRK/EUR.

“Net purchases”

“Net sales”


Figure 19 Reserve requirements in Croatia

Source: CNB, own illustrations

As Croatian commercial banks provide conversion via depositing (see section

2.3.2), large sums of euro‐in currency flow into the domestic banking system dur‐

ing the euro changeover. Numerous depositors do not withdraw their deposits

thereafter, which leads to a credit and lending boom in Croatia. As a result, the CNB

begins to tighten its monetary policy stance in 2003. They predominantly employ

passive operations (such as CNB bills) to gather excess liquidity, as liquidity is high

and because an increase of the interest rate level might lead to additional capital

inflows (cf. LANG AND KRZNAR 2004: 6). Among other measures, the central bank also

penalizes commercial banks whose loan portfolio rises faster than 4 percent (cf.

CNB 2003: 11).

The kuna/euro exchange rate touches an upper bound of 7,7 kuna per euro in

January 2004, but quickly returns below this level (see figure 18). Although the cen‐

tral bank generally abstains from announcing specific exchange rate targets, since

2002 the governor of the CNB has occasionally stated that the central bank would

defend an upper level of 7,7 HRK/EUR (cf. SOSIC AND KRAFT 2006: 502). The CNB is

mainly confronted with appreciation pressures between 2005 to 2008, which pri‐

marily result from sustained inflows of capital from abroad (in particular through

direct investments, enhanced external borrowing, remittances and seasonal capital

inflows from tourism) and mounting appreciation expectations of market partici‐


pants due to growing EU accession prospects (cf. CNB 2005: 38; CNB 2006: 11).78 In

an attempt to buffer nominal appreciation, the CNB repeatedly intervenes in the

foreign exchange market, thereby accumulating large amounts of foreign exchange

(see figure 18). In order to actively manage banking sector liquidity in the short‐

term, the CNB begins to conduct open market operations – hence, regular reverse

repo operations and foreign exchange interventions are the central bank’s main

instruments of money creation in 2006 and 2007 (cf. CNB 2006: 83; CNB 2007: 11‐

12).

The Croatian National Bank has to deal with two different challenges in 2008.

In early 2008, the CNB needs to tighten monetary policy in the face of an inflation‐

ary environment. It reacts by reducing reverse repo auctions (cf. CNB 2008a: 11),

which leads to an increase in interest rates and an acceleration of the appreciatory

exchange rate trend. In that context, the CNB abstains from fx interventions and

allows the euro to drop in value to a minimum of 7,13 HRK/EUR in September (see

figure 18). In the fourth quarter of 2008, however, the turbulences of the global fi

nancial and economic crisis spill over to the Croatian economy and force the CNB to

relax its monetary policy stance. The kuna/euro exchange rate comes under strong

depreciation pressure at that time, which is directly associated with slower eco‐

nomic growth and lower capital inflows. Moreover, increased withdrawals of

household foreign currency deposits from banks (after the bankruptcy of Lehman

Brothers) increase the domestic demand for foreign currency (as a means of pre‐

caution) and push the kuna further down (cf. CNB 2008a: 32). In fact, the Croatian

kuna devalues by 4 percent between October 2008 and February 2009, whereupon

the CNB releases foreign currency reserves amounting to 600 million EUR to alle‐

viate further depreciation (see figure 18). This, in turn, justifies the accumulation of

reserves in the previous years, as they give the central bank more flexibility.

As the global financial crisis intensifies, the Croatian National Bank enacts

measures to ensure sufficient liquidity to the domestic financial system. In the first

step, the CNB increases the volumes of liquidity created at regular reverse repo

78 Taking into consideration the steady appreciatory trend of the real effective exchange rate of the kuna during the same span of time (cf. CNB 2008a: 32), the exchange rate trend may also be attrib‐uted to the Ricardo‐Balassa‐Samuelson effect. For further information on the implications of this effect see BALASSA (1964), SAMUELSON (1964) and BOFINGER (2001: 406‐409).


auctions and injects additional short‐term liquidity to banks by providing Lombard

loans. In addition, it abolishes the marginal reserve requirement in October 2008

(cf. CNB 2008a: 65). In December 2008, the CNB also cuts the general reserve

requirement rate by 3 percentage points to 14 percent (see figure 19), which

directly releases 1151 million euros of immobilized liquidity into commercial

banks (cf. ROHATINSKI 2009: 3). In short, the various measures used by the CNB

throughout the financial crisis aim to deal with two major challenges: to safeguard

the exchange rate through interventions and to maintain financial stability through

liquidity injections.

Having discussed the conduct of monetary policy in a chronological order, it is

now possible to summarize the use of monetary policy instruments. Foreign ex

change interventions are among the most important instruments of monetary pol‐

icy in Croatia – the CNB intervenes 94 times between January 2000 and September

2009, averaging nearly one intervention per month. In this period, purchases of

foreign currency exceed sales by 24 billion HRK, whereby the central bank sells

foreign exchange on only 25 occasions. This instrument mainly serves two pur‐

poses: on the one hand, the CNB aims to reduce strong exchange rate fluctuations,

but permits small variations (i.e. a managed floating), which is certainly related to

the risks of large exchange rate changes in a highly euroized economy. In conse‐

quence, the exchange rate fluctuates within a very narrow ‘ex post range’ of about

9 percent throughout the last decade or, in other words, within a gap of 7,10

HRK/EUR and 7,74 HRK/EUR (see again figure 18). On the other hand, as far as in‐

terventions are not fully sterilized, they perform a money creation function. With

respect to the introduction of regular reverse repo auctions, the Croatian National

Bank puts it as follows:

“While this instrument [foreign exchange auctions] remains necessary to man‐age the exchange rate, it is does not allow for the possibility of liquidity fine‐tuning and is less flexible compared to reverse repo operations.” (CNB 2005: 11)

As the above quotation suggests, open market operations are the CNB’s major

instrument to promote monetary management today and to attempt to stabilize

interest rate fluctuations in the money market. Moreover, the central bank fre‐

quently issues CNB bills (voluntary and obligatory ones) or changes reserve re‐


quirements (in both rates and base) in order to sterilize excess liquidity or as an

instrument for monetary tightening or easing.

All in all, the discussion of the recent monetary experience in Croatia has

shown that the CNB employs a variety of different measures that aim at achieving

the main objective (i.e. price stability). Inflation has remained fairly low in the last

decade (see section 3.1.3) and the CNB has proven its ability to managed the

threats of recent banking and financial crises (1998‐2000 and 2008‐2009). Thus, it

can be concluded that Croatian monetary policymakers are successful in promot‐

ing stable domestic prices and financial stability in a highly euroized economy.

3.3 Policy issues from both cases – lessons and options

3.3.1 Comparison and general lessons

So far, section 3.2 has examined monetary policy in two economies with high dol‐

larization or euroization – Peru and Croatia. It has become evident that these two

countries pursue different monetary policy strategies. The Central Reserve Bank of

Peru operates within an inflation targeting framework that is adjusted at several

points with respect to dollarization – most notably, a second pillar that monitors

financial stability and a managed floating exchange rate regime are included. In

comparison, the Croatian National Bank employs a quasi‐currency board frame‐

work: on the one hand, it is characterized by an amount of international reserves

that exceeds domestic money supply by far, an almost 100 percent share of central

bank’s foreign assets relative to its total assets and a close management of the ex‐

change rate. On the other hand, the CNB employs liquidity management and ster‐

ilization instruments (such as CNB bills, minimum reserve requirements and open

market operations) and is found to act as a lender of last resort. Despite these ma‐

jor differences in the framework and conduct of monetary policy, this section at‐

tempts to draw some general lessons for monetary policy in highly dollarized

economies to be abstracted from a comparison of both cases.

First and foremost, the empirical analysis has clearly demonstrated that

monetary authorities in both countries manage the exchange rate by foreign ex

change interventions. As they persistently ‘lean against the wind’, the nuevo

sol/dollar and the kuna/euro exchange rates remain within a very narrow ‘ex post


band’. The range between the most depreciated and the most appreciated level of

the domestic currency is 30 percent in the case of Peru and only 8 percent in the

case of Croatia in this decade.79 In other words, it can be said that both countries

show clear symptoms of what CALVO AND REINHART (2002) term “fear of floating”. At

the same time, both countries are found to use instruments (such as changes in the

reserve requirements) to sterilize liquidity created through interventions – how‐

ever, neither Croatian nor Peruvian monetary policymakers follow a predeter‐

mined path of the exchange rate. Thus, exchange rate regimes in both Peru and

Croatia are characterized best as managed floating strategies that entail a certain

degree of flexibility on the one hand, and a considerable intensity of foreign ex‐

change interventions on the other hand (see again section 2.2.1). An independently

floating exchange rate regime is clearly not an option for a highly dollarized or eu‐

roized economy, as it would include high systemic risks due to balance sheet mis‐

matches. In contrast, a fixed exchange rate regime, which is at the other end of

FISCHER’s (2001) “bipolar view”, is not advisable either, as it would increase the

probability of speculative behavior and would reduce the incentives for domestic

residents to internalize the risks from dollarized balance sheets. In other words,

strong variations must be prevented in order to reduce balance sheet risks, while

small exchange rate fluctuations should be tolerated – particularly, to promote de‐

dollarization. BOFINGER AND WOLLMERHAEUSER (2001: 62) argue that a managed float

is perfectly feasible under the pressure of strong capital inflows (i.e. appreciatory

trends) by means of sterilization. Since capital inflows and high dollarization are

among the key challenges of monetary policy, this study suggests that a managed

float is an adequate exchange rate strategy in both Peru and Croatia.

The central banks’ high level of international liquidity is another common fea‐

ture of both cases that undoubtedly is related to their interventionary behavior.

The accumulation of international reserves is regarded as a precautionary meas‐

ure in dollarized emerging economies as they can reduce several policy concerns:

high levels of international liquidity can help to stabilize banking and currency

crises, counter speculative attacks and put the central bank in the position to act

79 OZSOZ ET AL. (2008: 8) argue that, in general, exchange rate variation in highly dollarized econo‐mies is smaller than in countries without dollarization, once inflation has been controlled.


effectively as a lender of last resort (e.g. a bank run on foreign currency). Most im‐

portantly, the Peruvian and Croatian monetary experiences have demonstrated

that only an adequate level of international reserves gives the central bank enough

leeway to management of the exchange rate effectively. Figure 20 illustrates the ra‐

tio of total international reserves minus gold to broad money for a variety of

emerging market economies in 2008.

Figure 20 High levels of international liquidity in 2008 (in %)

Source: IMF IFS, own calculations

This broad comparison criterion confirms that dollarized countries tend to

hold a larger‐than‐normal level of international liquidity. Peru exhibits the highest

ratio in the present sample (84,1 percent) and is directly followed by Cambodia

and Bolivia, which are famous for their high degree of dollarization (see again sec‐

tion 3.1.1). It should be noted that amassing international reserves is a key objec‐

tive of the Peruvian monetary framework (see again section 3.2.1.1). In Croatia, the

share of total reserves minus gold to broad money amounts to a relatively high

level of 29,4 percent (see figure 20). The fact that this share is lower compared to

other highly dollarized economies may be attributed to Croatia’s excessive domes‐


tic credit growth in recent years (cf. ZDZIENICKA‐DURAND 2009: 23).80 Chile, Brazil

and Turkey are ranked at the bottom of the scale, showing international liquidity

fractions of only about 20 percent – in fact, their levels of dollarization or euroiza‐

tion are rather low. In the words of a word CALVO AND MISHKIN (2003: 112), it can be

said that dollarized emerging market economies generally tend to “float with a

large life jacket”.

In this context, it is also advisable for central banks to create the conditions for

an adequate quantity of foreign currency liquidity on the bank‐level. In general,

this can be achieved by obliging domestic banks to hold a higher reserve require

ment rate for deposits denominated in foreign currency – it has been shown that

both the Croatian National Bank and the Peruvian Central Bank follow this advice.

In addition, the analysis of the monetary policy framework has demonstrated

that financial stability is a key concern to the Peruvian authorities (see again sec‐

tion 3.2.1.1). The second pillar is concerned solely with financial stability and at‐

tempts to reduce the extreme economic risks of dollarization. Thus, the author

suggests that financial stability should be placed at the same level as a clear com‐

mitment to stable domestic prices in the monetary policy framework of a heavily

dollarized country. In this regard, MISHKIN (1996: 45) even argues that financial

stabilization should be a primary concern and output stabilization only secondary:

“Thus, before engaging in an anti‐inflation stabilization program, developing countries need to pay particular attention to the health of their financial system, making sure that the regulatory/supervisory process has been effective in pro‐moting strong balance sheets for financial institutions.” (IBID.)

This quotation directly leads to the question of effective supervision and regu‐

lation of dollarized financial systems. It has been explained in section 2.2.2.2 that

financially dollarized banking systems are exposed to greater liquidity and sol‐

vency risk. As prudential norms generally oblige banks to internalize risks prop‐

erly, the design of a prudential regulatory and supervisory framework (such as the

Basel II guidelines) is certainly another key issue to monetary authorities. To men‐

tion only one aspect of this field of research, prudential regulation can help to re‐

80 Computing the ratio of total reserves minus gold to M1 for the same sample, values are generally greater than one for highly dollarized economies. In Croatia, for instance, reserves represent about 1,3 times M1 in 2008 (see also section 3.2.2.1).


duce moral hazard and fear of floating in a dollarized environment (cf. IZE AND

POWELL 2005: 34). A comprehensive discussion of prudential supervisory and

regulatory measures, however, would go beyond the scope of this paper, as it fo‐

cuses primarily on monetary policy.81

Finally, it has become evident that both countries have successfully main‐

tained low levels of inflation over the medium‐term in the present decade. In fact,

Peru achieves an average inflation of 2,6 percent (which is well within its target

range) compared to an average of 3,2 percent in Croatia. Table 5 compares the an

nual average inflation levels of Croatia and Peru with average rates from emerging

and developing economies, the euro area and the US. In general, it is indicative that

both an inflation targeting framework82 as well as a quasi‐currency board regime

are feasible under high de facto dollarization.

Table 5 Low inflation in Peru and Croatia (annual average CPI, in % change)

Croatia Peru

Emerging and developing economies

Euro area United States

2000 4,6 3,9 8,6 2,2 3,4 2001 3,8 2,0 7,9 2,4 2,8 2002 1,7 0,2 6,9 2,3 1,6 2003 1,8 2,3 6,7 2,1 2,3 2004 2,0 3,7 5,9 2,2 2,7 2005 3,3 1,6 5,9 2,2 3,4 2006 3,2 2,0 5,6 2,2 3,2 2007 2,9 1,8 6,4 2,1 2,9 2008 6,1 5,8 9,3 3,3 3,8 2009* 2,8 3,2 5,5 0,3 -0,4

*IMF WEO staff estimates Average 3,2 2,6 6,9 2,1 2,6

Source: CNB, BCRP, IMF WEO, own calculations Taking into consideration that average inflation in Croatia exceeds the Peru‐

vian average value by 0,4 percentage points between 2000 and 2009, it could be

argued that the Peruvian framework is more successful. However, Croatian mone‐

tary policymakers may never be designated to be less successful than Peruvian

ones, as an average inflation rate of 3,2 is still much lower than the emerging mar‐

kets’ average. Inflation in both countries is much closer to the growth of prices in

the industrialized world than to the emerging economies’ average (see table 5). 81 For further information on this issue see, for instance, CAYAZZO ET AL. (2008). 82 It should be noted that IT was introduced after successful disinflation.


Notably, Peru has even achieved the same average inflation as the United States in

this decade, which can certainly be attributed to the BCRP’s strict commitment to

its numerical inflation targets. In turn, it is indicative that dollarization does not

pose an additional challenge to the maintenance of stable prices in both Peru and

Croatia (i.e. to reach the central banks’ main goals). MORON AND WINKELRIED (2003:

27) find that monetary policy in the face of liability dollarization should follow a

non‐linear policy approach that allows for some exchange rate fluctuations, but

prevents large ones (i.e. defends the real exchange rate), rather than an IT frame‐

work. They argue that the latter system encourages domestic agents to take on

greater risk (i.e. to underinsure against balance sheet risks), if the central bank

implicitly defends the exchange rate within its IT framework. However, this study

does not find any indications that the fragility of the Peruvian economy has in‐

creased since 2002 – on the contrary, a decreasing dollarization trend has been

detected in section 3.1.2, which rather implies lower financial vulnerability.

At this point, it can be concluded that both an inflation targeting and a quasi‐

currency board regime are perfectly able to produce low and stable inflation rates

and adequately promote financial stability in dollarized economies. In fact, a man‐

aged floating exchange rate regime is found to be the key for a stability‐oriented

and successful monetary policy.

3.3.2 Further policy options: Full dollarization or de‐dollarization?

The wide spectrum of ideas about what monetary policy should do to deal with the

challenge of operating in a highly dollarized environment is bounded by full dol‐

larization at one end and de‐dollarization at the other.

On the one hand, a high level of de facto dollarization may be considered to be

a reason for monetary policymakers to abolish their own currency and to opt for a

foreign one instead. An obvious benefit of this strategy is that economic crises due

to currency mismatches cannot happen under full dollarization, as all assets and

liabilities are denominated in the same (foreign) currency (cf. REINHART AND CALVO

2001: 1). Hence, balance sheet vulnerabilities could be eliminated entirely with a

single blow. Moreover, monetary authorities are credibly constrained and there is

no way for the government to inflate away public debt (cf. CALVO AND VEGH 1997:


168), which should generally increase the residents’ confidence in the financial

system. Empirical studies by ROSE (1999), ROSE AND WINCOOP (2001) and FRANKEL

AND ROSE (2002) also suggest that the adoption of a common currency raises the

volume of trade between these countries substantially. However, full dollarization

also implies considerable disadvantages: among the most notable ones, the trans‐

fer of revenues from seigniorage to the foreign country’s government and the fact

that the home country gives up its monetary policy autonomy can be found in

literature. BERG AND BORENSZTEIN (2000: 18‐21) find it particularly problematic that

the country loses the possibility to depreciate in light of major shocks. The most

serious concern, however, is the fact that the central bank of a fully dollarized

economy loses its ability to effectively act as a lender of last resort by printing

money (cf. BOFINGER 2001a: 26). Considering an increased mistrust in authorities, a

bank‐run (and the fatal consequences for the economy) can unfold easily in dollar‐

ized emerging markets, with the central bank unable to restore confidence. The

costs from losing seigniorage or monetary policy autonomy may be lower in coun‐

tries that have faced partial dollarization before. However, the risks of giving up

the lender of last resort function still appear so grave that they clearly outweigh

the benefits of full dollarization.

On the other hand, the high risks of de facto dollarization could make a case

for an effective dedollarization program, whereby a distinction between a pro‐

active ‘hands‐on’ and a marked‐driven ‘hands‐off’ approach should be made. At

first sight, it seems plausible that an extreme way is needed to de‐dollarize the

economy – a handson approach is needed, if a sound macroeconomic policy and

better institutions do not lower dollarization persistence sufficiently. However,

attempts to enforce de‐dollarization have failed in several countries such as Bolivia

and Mexico – besides the Peruvian case (see section 3.1.2). These examples suggest

that forcing domestic agents to use a currency that they consider untrustworthy

(e.g. by the imposition of direct restrictions, taxes on intermediation in foreign cur‐

rency or forced conversion) often results in financial disintermediation, capital

flight and large devaluations, finally driving authorities to lift the restrictions again

(cf. BALINO ET AL. 1999: 26‐28). Thus, an attempt to implement policy measures that

frontally fight dollarization can only be successful, if there is wide consensus and


backing from a large proportion of domestic agents. Ideally, such support should

be created by enhanced credibility in monetary policy prior to the introduction of

drastic de‐dollarization measures and, in turn, confidence in the stability of the

domestic currency. In reality, IZE AND LEVY YEYATI (2005: 21‐22) state that a crisis

may be needed to create these conditions.

In contrast, it seems more promising to gradually de‐dollarize the economy by

indirect means. In order to uncover the key elements of a marketdriven de

dollarization agenda, it is useful to explore the Israeli de‐dollarization process.

GALINDO AND LEIDERMAN (2005: 23) argue that Israel’s de‐dollarization has been a

side effect of persistent stabilization and disinflation rather than an outcome of a

comprehensive policy plan. As partial dollarization is often initiated by macroeco‐

nomic instability, one should always keep in mind that a prerequisite to reduce

dollarization is a good quality of macroeconomic policy – i.e. a sustainable fiscal

policy and a credible monetary policy framework. IZE AND LEVY YEYATI (2005: 7) use

the expression “only ‘good’ products sell” to summarize this natural policy recom‐

mendation. Another important element is seen in Israel’s sustained effort to

change the composition of public sector issuance. Hence, the market for domestic

currency‐denominated government bonds has deepened significantly and the ma‐

turity of these bonds has increased gradually (cf. GALINDO AND LEIDERMAN 2005: 24‐

26). In addition, the Bank of Israel actively promotes the use of CPI‐indexed in‐

struments and financial derivatives during de‐dollarization and thereby aims to

deal with domestic residents’ inflation and exchange rate risks. Hence, the intro‐

duction of alternative financial instruments appears to make an important contri‐

bution to market‐driven de‐dollarization.

In conclusion, full dollarization is clearly not an advisable option for partially

dollarized economies – most particular, due to the lender of last resort issue. En‐

forcing de‐dollarization by legal means also appears to be highly problematic. Al‐

though taking the market‐driven route to de‐dollarization costs more time, it is

found to be the most promising alternative. In this context, a policy mix that com‐

prises a number of different measures appears most helpful. Part 4 aims to sum‐

marize the key elements of such a policy mix and attempts to give an outlook of the

cases of Peru and Croatia.

4 Conclusions and future prospects 82

4 CONCLUSIONS AND FUTURE PROSPECTS

This paper has analyzed monetary policy under high de facto dollarization and has

approached the topic from a case study perspective. The outlined issue has in‐

creased relevance (particularly to emerging and developing economies) and it has

been pointed out that there is good reason why monetary policymakers should be

concerned with high dollarization: as the degrees of dollarization or euroization in

assets and liabilities do not match on the macroeconomic level, increased eco‐

nomic vulnerability appears to be the most severe policy concern. Although this

study does not support the view that dollarization inhibits efficient monetary pol‐

icy per se (i.e. both countries under observation achieve their main policy goals

fairly well), it has become evident that it may complicate the conduct of monetary

policy at various points. Using a nautical metaphor coined by SOSIC AND KRAFT

(2006: 499), it can be said that “dollarization reduces the stability of one’s boat.”

By assessing two particularly striking examples – Peru and Croatia – in great

detail, the author has attempted to find some general advice for monetary policy‐

makers in partially dollarized and euroized economies. Above all, section 3.3 has

revealed several measures that help to deal with the dollarization risks and may

contribute to reduce its extent over the long run. This study proposes a policy

agenda that comprises the following elements: (1) an exchange rate that is allowed

to fluctuate to a certain degree, but is prevented from excessive volatility at the

same time, (2) an adequate level of international liquidity that serves as a precau‐

tionary measure (i.e. ‘a large life jacket’) and allows effective ‘leaning against the

wind’, (3) a sufficient depth of the domestic financial market that provides for al‐

ternative financial instruments (e.g. long‐term local currency bonds, CPI‐indexed

assets or derivatives) to hedge against inflation and exchange rate risk and (4) a

prudential regulatory and supervisory framework that encourages intermediation

in local currency and requires the public and banks to internalize the risks of dol‐

larized balance sheets. The underlying macroeconomic situation and the public’s

confidence in the domestic currency, however, remain the crux of the matter and

can only be improved by (5) a sound macroeconomic policy. With respect to mone‐

tary policy, a strong commitment to stable domestic prices as well as a high level of


independence would be particularly relevant to provide the authorities with the

necessary degree of credibility.

In this regard, Peruvian authorities deliberately opt for an inflation targeting

framework and adjust it by including a managed floating exchange rate regime and

a financial stability pillar. GOLDSTEIN (2002: 43‐47) considers a “managed floating

plus” (where the plus serves as shorthand for an inflation targeting framework and

a set of measures to reduce currency mismatches) the best regime choice for

emerging market economies.83 The present study has confirmed that such a

framework is perfectly able to align Peruvian inflation with US long‐run inflation

(see section 3.3.2), which puts the nuevo sol in an excellent position to compete

against the dollar and helps to reduce de facto dollarization. Moreover, it has been

illustrated that the active promotion of alternative financial instruments (i.e. the

deepening of the domestic financial market) is a helpful feature. Thus, it should be

recommended to the BCRP to gradually introduce more aggressive measures to

accelerate market‐driven de‐dollarization. All in all, it appears that the Peruvian

monetary policy framework is almost perfectly suited to deal with the challenges

of a low‐inflation‐but‐highly‐dollarized environment. Yet, as the example of Croatia

has demonstrated, this framework cannot serve as a general recommendation for

all dollarized or euroized economies.

With respect to monetary policy in Croatia, which has been determined to be a

quasicurrency board policy, switching to inflation targeting might have some at‐

traction: above all, the introduction of a numerical inflation target would

strengthen the CNB’s commitment to price stability and might help to reduce do‐

mestic agents’ focus on exchange rate changes (cf. KRAFT 2003: 17‐19). Moreover,

inflation targeting is closer to the ECB’s framework and has become viable, since

inflation has been low for more than a decade now. At the same time, regional par‐

ticularities must be taken into consideration. Croatia has been a candidate country

for EU membership since June 2004 and accession negotiations might even be con‐

cluded in 2010 (cf. EC 2009; EP 2009). Since there is no ‘opt‐out clause’ for new

member states, the growing prospects of joining the European Union directly im‐ 83 Moreover, BOFINGER AND WOLLMERSHAEUSER (2001: 52) argue that the most obvious solution to provide a managed floating exchange rate system with the necessary anchor for the public’s ex‐pectations is inflation targeting.


ply that Croatia will introduce the euro in the medium term, which would solve the

problems of high de facto euroization in Croatia at one go. Thus, it appears more

advisable for Croatia to maintain the current monetary framework and pursue the

objective of becoming a full member of the EMU than to take the long way via infla‐

tion targeting and market‐driven de‐euroization. However, an improvement of

monetary policy transparency should certainly be recommended to Croatian

monetary policymakers – more precisely, a well‐defined monetary framework and

a better communication with the public might increase the efficiency of monetary

policy.

In conclusion, it is obvious that the current monetary policy of Peru should be

continued and intensified with regard to active de‐dollarization policies – finally,

enhancing confidence in the domestic currency and reducing the degree of dollari‐

zation. Likewise, it is most useful for Croatian authorities to maintain its monetary

policy for the moment as the country is expected to enter the EU and become a full

member of the euro area soon. All in all, the challenges of de facto dollarization and

euroization appear too complex to find simple solutions. Thus, there is certainly no

panacea that is able to prepare the ground for de‐dollarization. In fact, this study

calls for a comprehensive policy agenda that pays attention to the various points

listed at the beginning of this section, takes into consideration the roots of the

phenomenon and does not ignore the regional context.

Appendix 85

Appendix

Table A 1 Deposit dollarization degrees of 136 countries*

Appendix 86

Appendix 87

Appendix 88

Appendix 89

Appendix 90

Appendix 91

Appendix 92

*The original file is available on the attached DataCD and

can be downloaded from http://profesores.utdt.edu/~ely/papers.html Source: LEVY YEYATI (2006), own illustrations

Appendix 93

Figure A 2 EUR/USD exchange rate


Figure A 1 Persistent dollarization and decreasing inflation worldwide

Source: LEVY YEYATI (2006), IMF WEO, own calculations

References 94

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Erklärung

Hiermit erkläre ich, dass ich die Arbeit selbstständig verfasst, keine anderen als die

angegebenen Quellen und Hilfsmittel benutzt und die diesen Quellen und Hilfsmit‐

teln wörtlich oder sinngemäß entnommenen Ausführungen als solche kenntlich

gemacht habe. Die Arbeit wurde auch keiner anderen Prüfungsbehörde vorgelegt.

Würzburg, 23. Dezember 2009

(Christian Schaub)

monetary policy under de facto dollarization: the cases of ...€¦ · 2 by dollarization the...

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