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Understanding Dollarization

Book Description

A very commonly observed phenomenon in developing and emerging market economies is the use of another country’s currency (whether the US dollar or another currency) in lieu or in addition to the local currency. The most common type of this financial phenomenon is partial (de facto) dollarization where foreign currencies are used side by side with local currency for saving and borrowing purposes in addition to serving as medium of exchange.


Governments in these countries have been encouraging dollarization for years by allowing their citizens to save and borrow from local banks in foreign currency. Yet the existence of multiple currencies on banks' balance sheets on both the asset and liability side poses risks to the health and stability of the banking system.


This book evaluates the practical aspects of partial dollarization in countries such as Turkey, South Korea, Peru, and Cambodia among others. Starting with the origins of the phenomenon, the impact on banking systems and financial depth of the credit markets are discussed along with risks to the banking systems. Challenges faced by Central Banks and banking regulators are evaluated using recent country studies.

Table of Contents

  1. Halftitle Page
  2. Title Page
  3. Copyright
  4. Dedication
  5. Foreword
  6. Contents
  7. 1 A Primer on Dollarization
    1. 1.1 Introduction
    2. 1.2 Asset vs Currency Substitution
    3. 1.3 Official and Partial Dollarization
    4. 1.4 Measuring the Degree of Partial Dollarization
    5. 1.5 Causes of Dollarization
    6. 1.6 Dollarization and Banking Dollarization
    7. 1.7 A Brief History of Dollarization Around the Globe
      1. 1.7.1 Latin America
      2. 1.7.2 Transition Economies
      3. 1.7.3 Asia
      4. 1.7.4 Sub-Saharan Africa
    8. 1.8 Exchange Rate Regimes and Dollarization
  8. 2 Pros and Cons of Dollarization
    1. 2.1 Introduction
    2. 2.2 Arguments in Favor of Dollarization
      1. 2.2.1 Inflation Reduction
      2. 2.2.2 Fiscal Discipline
      3. 2.2.3 Reduction in the Cost of Borrowing
      4. 2.2.4 Lower Transaction Costs
    3. 2.3 Benefits of Partial Dollarization
      1. 2.3.1 Encourages Saving
      2. 2.3.2 Promotes Financial Deepening
    4. 2.4 Arguments Against Dollarization
      1. 2.4.1 Costs of Dollarization under Full Dollarization
        1. 2.4.1.1 Loss of Monetary Policy
        2. 2.4.1.2 Inability to Act as a Lender of Last Resort
      2. 2.4.2 Costs of Dollarization under Partial Dollarization
        1. 2.4.2.1 Increased Foreign Exchange Rate Risk for the Banking System
        2. 2.4.2.2 Mismatch of Foreign Currency Assets and Liabilities
        3. 2.4.2.3 Increased Default Risk
        4. 2.4.2.4 Monetary Policy Challenges
  9. 3 What Causes Dollarization?
    1. 3.1 Introduction
    2. 3.2 Inflation and Dollarization
    3. 3.3 Transmission Mechanisms
      1. 3.3.1 The Trade Channel
      2. 3.3.2 The Credit Channel
      3. 3.3.3 Liability Channel
      4. 3.3.4 Evidence on Currency Substitution Theory
    4. 3.4 De-Dollarization Hysteresis
    5. 3.5 New Ideas
      1. 3.5.1 Inflation in Collective Memory
      2. 3.5.2 Minimum Variance Portfolio (MVP) Theory
        1. 3.5.2.1 The MVP Model
        2. 3.5.2.2 Evidence that Supports the MVP Theory
      3. 3.5.3 Institutions Argument
  10. 4 The Impact of Dollarization on Banking Systems
    1. 4.1 Introduction
    2. 4.2 Why Do Governments Allow Foreign Currency Accounts and Foreign Currency Lending in the Banking System?
    3. 4.3 Banking Risks in a Partially Dollarized Economy
      1. 4.3.1 Currency Mismatch Risk
      2. 4.3.2 From Currency Mismatch Risk to Default Risk
    4. 4.4 Empirical Evidence
  11. 5 Dollarization, Financial Deepening and Financial Inclusion
    1. 5.1 Introduction
    2. 5.2 What We Know about Financial Depth and Dollarization: A Review
    3. 5.3 Financial Inclusion
    4. 5.4 Bitcoin: The New Future Form of Dollarization?
  12. 6 Policy Interventions in Dollarized Economies
    1. 6.1 Introduction
    2. 6.2 Monetary Policy in Partially Dollarized Economies
    3. 6.3 Regulatory Attitudes Toward Dollarization in the Aftermath of the Financial Crisis
    4. 6.4 Case Study: Turkey
  13. 7 Conclusions
  14. References
  15. Index
  16. Footnotes