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Dollarization of assets and liabilities in Bolivia

Juan Antonio MoralesPresident of the Central Bank of Bolivia

December, 2003

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Outline.-

1.- Facts and trends

2.- Dollarization: the long-view

3.- Main hypothesis on the causes of dollarization

4.- The costs of dollarization

5.- The measures taken to cope with dollarization

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Dollarized deposits and loans in the domestic system(As percent of totals)

84

86

88

90

92

94

96

98

100

Dic

-90

Jun-9

1

Dic

-91

Jun-9

2

Dic

-92

Jun-9

3

Dic

-93

Jun-9

4

Dic

-94

Jun-9

5

Dic

-95

Jun-9

6

Dic

-96

Jun-9

7

Dic

-97

Jun-9

8

Dic

-98

Jun-9

9

Dic

-99

Jun-0

0

Dic

-00

Jun-0

1

Dic

-01

Jun-0

2

Dic

-02

Jun-0

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LOANS DEPOSITS

FIGURE 1:

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Dollarization: the long view

• Starts in the early 1930’s, coincidental with the abandonment of the gold exchange standard.

• Gets its main impulse with a creeping inflation

• Further impulse to dollarization is given by the renewed access to external savings under its several varieties.

• Until the 1970´s Mainly under the form of real dollarization Payment dollarization for big items

• Bolivia suffered two bouts of hyperinflation between 1950 and 1985

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• Dollarization seems also to be the reflection of a high degree of concentration of wealth and income.

• Deposits and especially, dollarized deposits are very highly concentrated, with 3.4% of the depositors holding 74.9% of the deposits. The Gini coefficient is 0.92

• Also dollarization may have been aided by regulations null or low minimum reserve requirements for bank deposits in

dollars currency blind treatment of deposits in case of the liquidation of a

bank, that in fact favors dollarized deposits (the Broda and Levy Yeyati argument).

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• Real and payments dollarization had a bearing on financial dollarization

real estate, the main collateral for loans has been priced in dollars since 1950´s

the use of dollars as numéraire went beyond the market for goods and non – factor services.

the public became used to “think” in dollars.

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Yet:

• 2 big items of gross national income are set and paid in domestic currency

• wages (with some exceptions)

• taxes (although tax arrears are indexed to the

dollar, as well as the tax base on residential

property)

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A whole monetary system in dollars developed.

claims in dollars were created in Bolivia very extensively

in 1992, banks were allowed to clear and settle their accounts in dollars in the books of the central bank.

money multipliers in dollars however do not seem that large

monetary and financial dollarization reinforce each other

* in fact financial dollarization was made possible to a large

extent because of the payment facilities in dollars

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Why and who demands domestic currency?

Why the labor unions did not demand the dollarization of wages, even during the hyperinflations?

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Two hypothesis:

the monetary system in domestic currency is a shock absorber for fluctuations in income and employment.

it also prevents the interruption of payments, likely with a weak fiscal sector.

• the domestic currency still provides more liquidity services than dollars, for instance,

it is widely used in transactions for wage goods

• in addition, holdings in excess of the demand for domestic money needed to finance the consumption of wage goods can be easily converted into dollars

thus: domestic money is a convenient “stepping stone” to the coveted dollars

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A policy mistake that pushed dollarization

De-dollarization by fiat supreme Decree of 1982

(annulled in 1985)

• all dollar contracts were converted into Bolivian pesos at a rate below the market rate

• all financial operations in dollars were forbidden

• exchange controls were established

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The de-dollarization measures were widely opposed

people suffered from the unfair rate of conversion more important, people resented being left without an

anchor, in the eve of hyperinflation the middle classes, the most affected, were the more

vocal in their opposition the opposition parties blamed on the de-dollarization

measure the hyperinflation that Bolivia suffered these years

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Forced de-dollarization led to capital flight led to financial desintermediation

the ensuing real costs were very high

dollarization if anything increased, although operations with dollars went underground

left a deep scar in the public, the slightest attempt at de-dollarization was to be opposed.

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After the inflation stabilization program of 1985

• dollarization returned with a vengeance

• and this, despite the drastic fall in inflation

• in the past three years the Bolivian inflation has been lower than the US inflation.

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A word on the Bolivian exchange rate system after 1985:

Two pillars:

1) unrestricted freedom to operate in foreign exchange2) a sui generis system

• that started as a dirty float, with an auction mechanism a the central bank (the “bolsín”) for the sale of foreign exchange as instrument of intervention

• that after a few weeks after August 1985 evolved into an incomplete crawling peg.

The stated policy of the central bank: to maintain a stable RER, subject to a low inflation.

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Why financial dollarization persisted and even increased?

We shall remember that by end 2002- almost 100% of the loans were dollarized- over 90% of the deposits were dollarized

N.B. The microfinance institutions are the most dollarized

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Main hypothesis on the causes of dollarization

My favorite explanation

A non – zero probability of catastrophic devaluation and ensuing inflation continues to affect portfolio decisions of depositors and banks

the probability increases with thelarge deficits:

- in the current account of the BOP- in the fiscal accounts

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The above hypothesis can be modeled as

“a peso problem”

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Figure 2: Interest rate spreads and depreciation

0

5

10

15

20

25

en

e-8

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jul-

89

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jul-

92

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jul-

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—•— depreciation of exchange rate—— interest rate spread (lagged 12 months)

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The peso problem

 

t

tt

t

t dCiCC

i

1

1ln)3()1ln()2()1(

1

1ln *

1212

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Method: Least squares Date: 09/05/03 Time: 19.10

Sample (adjusted) 1990:01 2003:07 Included observations: 163 after adjusting endpoints.

Coefficient Std. deviation t-statistic Prob. C(1) 0.06 0.01 5.79 0.00 C(2) 0.24 0.11 2.26 0.03 C(3) 0.40 0.07 5.58 0.00

R-squared 0.17 Mean dependent var 0.08 Adjusted R-squared 0.16 S.D dependent var 0.04 Log likelihood 322.74 F-statistic 16.22 Durbin-Watson 0.40 Prob. 0.00

Wald test H0: C(1)=0 C(2)=1 C(3)=1

Test statistic Value df Prob. F-statistic 29.89605 (3,1609) 0.0000 Chi-square 89.68816 3 0.0000

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The econometric evidence however is not wholly conclusive because the banks decided around 1998 to discourage deposits in Bolivianos. An easy way to do this was to offer very low interests for deposits in domestic currency

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Alternative explanation (the Levy Yeyati – Ize model)

Minimum Variance Portafolio (MVP) Derived from a CAPM model

λ* is the “underlying dollarization coefficient based on relative volatilities of inflation and of the RER

Unfortunately λ* is bounded from above by but it not bounded by zero from below.

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The Bolivian results λ*

full sample 1988.01 – 2003.07 0.8788truncated sample 1992.02 – 2003.07 - 0.0379

Up to 1994 inflation and its variance were still relatively large. The variance of inflation was larger than the variance of the RER.

Since the start of the crisis (around 1999) the variance of RER has been larger than the variance of inflation.

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The costs of dollarization

The most obvious: the currency mismatch creates fragility to the banking system

Note however, that this fragility became apparent only afterthe regional crisis of 1999. Until then, the co-existence of 2 monies did not seem to cause problems.

Even with partial dollarization the central bank is left, by and large, without monetary policy. The channels of transmission of monetary policy are very weak. By the way: the standard monetary programming of the IMF becomes largely irrelevant, both the demand for domestic money and the demand for dollarized bank reserves are very unstable.

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Main consequence for the central bank:

• the central bank is reduced to the role of liquidity insurer in dollars of the banking system,

• to perform this duty it has to hold very large international reserves,

• the large international reserves induce in turn further dollarization.

But also:

• the banks are obliged to remain very liquid substantial excess reserves.

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The measures taken to cope with dollarization

Preliminary: the bipolar option

full dollarization* relatively little transition costs, because the economy is

already very dollarized.

however:the country has to be ready

* with healthy fiscal accounts * a strong financial sector * a reasonable growth of productivity in its tradable sector

none of these conditions is currently met

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fully flexible exchange rate

unrealistic

* backtracking the road followed during many

years

* unwarranted effects on the financial sector

* little political support, not even of exporters

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What is left?

keep the current bi-monetary system keep an intermediate exchange rate-regime

i.e managed but with some flexibility to cope

with real shocks

in fact, keep the crawling peg but leaning more to the initial auction aspect

try to de-dollarize through market mechanisms and gradual changes in prudential regulations

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The de-dollarization menu

First and foremost: keep inflation low and have a credible commitment on low future inflation

Give some advantages to deposits in domestic currency in terms of» minimum reserve requirements» taxation of interest

Develop financial instruments indexed to inflation instead of dollars

Operations of the government, to the extent possible, are to be conducted and even announced, in domestic currency.

Increase the credibility of the central bank to anchor expectations.

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The End