Rising “dollarization” rates across many countries, including Turkey and Peru, are becoming a growing source of concern. The numerous negative consequences associated with the growing use of the US dollar — such as blunting the effectiveness of monetary policy and increasing the potential for liquidity crises — are adding to policymakers’ concerns amid an already challenging global environment. As such, investors operating in, or conducting business with, highly dollarized economies should be aware of the heightened risks to financial stability and the resulting negative implications for payments performance.
What Is Dollarization?
Dollarization is defined by the International Monetary Fund (IMF) as the use of any foreign currency as a medium of exchange, store of value, or unit of account. “Official,” or de jure, dollarization occurs when a country officially adopts another currency (typically the US dollar or another major international currency such as the euro) for all financial transactions. Meanwhile, “unofficial,” or de facto, dollarization (the focus of this report and from here on simply dollarization) is characterized by the widespread holding of assets and liabilities in a foreign currency. It is a common feature of developing economies across many regions.
The Causes of Dollarization
Dollarization is typically a response to the rapidly eroding value of the domestic currency as a result of inflation and exchange-rate depreciation. In these circumstances, domestic actors may seek to mitigate the risk of holding the local currency in order to protect the purchasing power of their savings. A depreciation in the domestic currency increases the expected rate of return on foreign-currency-denominated assets (in terms of their domestic-currency value) and simultaneously increases the burden of servicing foreign-currency liabilities.
These factors then increase the demand for foreign currency. To the extent that inflation is ultimately reflected in the nominal exchange rate, high inflation also drives dollarization. Moreover, high and variable inflation in and of itself can be a factor in encouraging dollarization, as residents may simply prefer to hold and do business in a foreign currency whose value is more stable.
In addition, foreign currency may be used as a hedge against the so-called “inflation tax,” i.e., the penalty for holding cash (in domestic currency) during a period of high inflation. Indeed, given the pass-through effect of a weaker exchange rate to higher imported inflation, foreign-currency assets become a natural hedge to inflation risk. In addition, financial crises and underdeveloped capital markets have also been shown to be factors that drive dollarization.
Current Hot Spots
Dollarization is usually measured as the ratio of foreign-currency deposits to total bank deposits in the domestic banking system. In a 2015 study, the IMF classified high dollarization as the situation where the ratio of foreign-currency deposits to total deposits is above 30% (less than 10% is classed as low dollarization and more than 10% and less than or equal to 30% as moderate dollarization).
Recent data from the IMF shows that countries such as Azerbaijan, Cambodia, Peru, and Turkey are currently classed as countries in which there is a “high” level of dollarization. In the case of Azerbaijan, the global oil price slump resulted in the central bank draining more than half of its foreign reserves last year to support the currency before shifting to a freely floating exchange rate in December. As a result, the manat has plummeted and inflation has soared, prompting an exodus by savers from manat-denominated accounts and pushing up the share of foreign exchange (FX) deposits to an estimated 75%.
Highly dollarized economies can face significantly negative consequences. Dollarization is considered to be both a constraint on monetary policy transmission and a threat to financial stability. Since monetary instruments principally impact the shrinking share of domestic-currency assets and liabilities, high dollarization levels restrain the capacity of central banks to control liquidity. In Cambodia, for example, the IMF has noted that movements in private-sector credit tend to be outside the control of the central bank.
Meanwhile, given that central banks cannot effectively act as lender of last resort in foreign currency (as central banks have only a limited supply of FX), a high level of dollarization also hinders the ability of central banks to stem a liquidity crisis. As such, investors operating in, or conducting business with, highly dollarized economies should be aware of the associated elevated payment risks.
Jaspreet Sehmi is a Senior Economist in Dun & Bradstreet’s Macro Market Insight team. Based in the Marlow/United Kingdom, she covers Eastern Europe and Central Asia. She has an MSc in Economics from University College London.