Dollar Dependence

Author:Luis A.V. Catão and Marco E. Terrones

The move away from domestic dollar use ended in most emerging markets after the global crisis, but not in Peru


Dollar Dependence Finance & Development, September 2016, Vol. 53, No. 3

Luis A.V. Catão and Marco E. Terrones

The move away from domestic dollar use ended in most emerging markets after the global crisis, but not in Peru

Dollarization, the partial or full replacement of a country’s domestic currency with a foreign currency, spread widely in the 1970s in Latin America, when high and hyperinflation robbed national currencies of their traditional roles as a stable medium of exchange and store of value. Households and firms in these countries began to use foreign currencies—typically the dollar—to save and to buy and sell big items like real estate.

The phenomenon eventually spread far beyond Latin America to become a generalized feature of financial sectors in many emerging market economies. By the early 1990s, the banking systems in Turkey and several economies in Africa, Asia, and eastern Europe routinely accumulated substantial dollar-denominated assets and liabilities. The possibility of dollar-denominated bank liabilities substantially exceeding dollar-denominated bank assets presented a serious risk to financial systems in the event of a large and sudden exchange rate devaluation or depreciation. Regulators and policymakers worried, rightly it turned out, that because dollars would be much more expensive after a devaluation or depreciation, the imbalance between banks’ dollar-denominated liabilities and assets could trigger large losses and cause systemic financial instability. This asset-liability mismatch was behind some of the gravest financial crises in emerging market economies during the mid-1990s and early 2000s—including Turkey in 1994, Argentina in 1995, Russia in 1998, and Argentina again in 2001.

Dollarization began to subside in the early years of this century as economic conditions improved in many emerging market economies. Favorable terms of trade, more flexible exchange rates, and better economic policies—including the adoption of inflation targeting and greater fiscal discipline—helped keep inflation low and reduced the risk of abrupt currency devaluations in many of these economies. In recent years, however, large currency depreciations coupled with less-well-anchored inflation expectations and companies’ greater exposure to dollar-denominated debt made it less likely that the move away from the dollar would continue, which appears to be what is happening. A broad look at international data since the global financial crisis shows that dedollarization has halted and even reversed in many emerging market countries. But notable exceptions are found precisely in the birthplace of modern financial dollarization—Latin America, where movement away from the dollar has continued. We look at the Peruvian experience in detail and find some key policy lessons that may be relevant for many other countries.

A global look An examination of 28 emerging market economies over the past 15 years found moderately high financial...

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