Dollarization has been a feature of banking systems of many Latin American countries. Financial dollarization—the process in which a large share of residents’ assets and liabilities are denominated in U.S. dollars—has been a distinguishing feature of the banking sector of many countries in Latin America, making it one of the most dollarized regions in the world. Although it was largely a consequence of past episodes of severe economic crises and high inflation, financial dollarization has remained stubbornly high even after a prolonged period of economic stability and low inflation.
Financial dollarization is a source of concern for policy makers since it contributes to the vulnerability of the banking system. Banks in dollarized economies are vulnerable to sharp exchange rate movements as banks usually lend in foreign currency to borrowers with little or no foreign currency earnings, creating currency mismatches in the balance sheet of corporates and households. Also, dollarization increases the liquidity risk that is common to banking systems as the central bank in dollarized economies does not issue foreign currency.
In the last decade, Bolivia, Paraguay, Peru, and to a lesser extent Uruguay experienced a gradual, yet sustained decline in financial dollarization. On average, deposit dollarization declined by 27 percentage points during 2001-2010, with somewhat smaller declines, amounting to 26 percent, in the case of credit dollarization.
Declines in dollarization have been similar across all types of deposits and loans. Despite the differences in dollarization across deposits of different maturities (dollarization is higher for time than sight deposits), dollarization declined for all types of deposits. Similarly, all credit sectors exhibited a decline in dollarization during the past decade, although dollarization continues to be higher for loans with longer maturities (i.e., mortgages and commercial credit).
What explains de-dollarization? Our recent work explores the short-term drivers of both credit and deposit de‐dollarization in Bolivia, Paraguay, Peru and Uruguay. The main results of this paper are as follows:
- Drivers of deposit de-dollarization are different from those of credit de-dollarization.
- The appreciation trends experienced during the last decade have been key for deposit de-dollarization in these countries.
- The introduction of prudential measures to create incentives to internalize the risks of dollarization has fostered credit de-dollarization. Examples of the measures implemented by these countries have been active management of the spread between reserve requirement on foreign currency deposits and domestic currency deposits, higher provision requirements for foreign currency loans, and tighter limits on the banks’ net open position.
- The development of the capital market in local currency (for example, through the issuance of long-term treasuries in local currency) has been one of the drivers of credit de-dollarization as it has facilitated bank funding and pricing of long-term loans in domestic currency.
- De-dollarization of deposits has also contributed to credit de-dollarization reflecting banks’ behavior of maintaining a matched foreign currency position.
- Once macroeconomic stability and strong fundamentals, which are pre-conditions for de-dollarization, are achieved, marginal changes in macroeconomic variables—such as inflation rates—do not appear to have any impact on financial de-dollarization.
What are the main policy lessons? Experience shows that market-based de-dollarization is a long-term process, given the high persistence of financial dollarization. While the steady decline in financial dollarization in recent years observed in Bolivia, Paraguay, Peru, and Uruguay has been remarkable, dollarization levels remain high, and efforts to lower them should continue. Policies that maintain strong fundamentals and macroeconomic stability (for instance, keeping a low and stable inflation) while at the same time ensure that the prudential regulation framework of the financial sector (including an active management of reserve requirements) provides incentives for an appropriate internalization of currency risks by agents will foster de-dollarization. Further developing local currency capital markets—which are still narrow in these countries—would also help enhance de-dollarization.
All rights reserved. Opinions and comments on RGE EconoMonitors do not necessarily reflect the views of Roubini Global Economics, LLC, which encourages a free-ranging debate among its own analysts and our EconoMonitor community. RGE takes no responsibility for verifying the accuracy of any opinions expressed by outside contributors. We encourage cross-linking but must insist that no forwarding, reprinting, republication or any other redistribution of RGE content is permissible without expressed consent of RGE.