Prudential Responses to de facto Dollarization

Abstract

We present a model that encompasses three distinct motives for dollarization (price volatility, credit risk, and moral hazard) and discuss when risk‐based prudential policy responses are called for and the form they should take. We argue that the overall policy response must be tailored to the nature of the dollarization the economy is facing. However, prudential policies should be formulated irrespective of the roots of dollarization. Their aim should be to enhance financial stability by ensuring that banks internalize credit risk within acceptable risk tolerance levels, taking dollarization and the current monetary policy environment as given.

Key Words:

• Dollarization
• prudential regulation
• monetary policy

JEL Classification Numbers:

• E52
• G21
• G28

Acknowledgements

We should like to thank Giovanni Majnoni, Eduardo Levy Yeyati, Eduardo Fernandez Arias, participants and discussants at the pre‐conference and conference on de‐dollarization held at the InterAmerican Development Bank in October and December 2003, and participants in an internal International Monetary Fund seminar in January 2004 for valuable comments. Andrew Powell would like to thank the InterAmerican Development Bank for Financial Support.

Notes

1. For a recent review of dollarization trends and risks, see De Nicolo et al. (2005).

2. In a more complete model, the range of exchange rate shocks would include values of d* below or in the negative range, reflecting the fact that the distribution of shocks should be broadly symmetric (it should also include undervaluation shocks). However, as long as the exchange rate peg is maintained under undervaluation shocks (with adjustments towards the equilibrium exchange rate taking place through price adjustments rather than nominal appreciations), the returns on all currencies would be equally affected over that range. Hence, making the distribution of shocks symmetric would complicate the model without affecting currency choice. For simplicity, we will thus exclusively focus on overvaluation shocks. Notice however that the asymmetric monetary policy response to overvaluations and undervaluations is a key feature underlying the competitiveness of the dollar relative to the peso (we come back to this point later in the paper).

3. The MVP has some of the characteristics of a price‐indexed peso but is not equivalent to one. It only protects against inflation to the extent that the expected pass through equals the actual pass through, but does not protect against undervaluation‐induced inflation.

4. The expected pass through can be expressed as a ‘beta’ coefficient, e.g. as the ratio of the covariance of the price level and the nominal exchange rate over the variance of the exchange rate. (Ize and Levy Yeyati, 1998). This assumes that investors are domestic residents, their consumption basket is linked to the domestic CPI).

5. That agents can prefer the dollar to the MVP (i.e., a fully credible peso) under high fear of floating is the basic result in Jeanne (2002).

6. Contingent contracts that fully tie the returns on the loan to that of the project would dominate dollar contracts if they were available.

7. That agents prefer the dollar to the peso under low monetary credibility is reminiscent of Calvo and Guidotti’s (1989) finding in the context of public debt that the viability of nominal contracting in local currency shrinks drastically under expectations of severe inflation. The result extends here to the case of private contracts.

8. This can be easily checked from (26) and (23) in Appendix I after setting = δ^R in (26) and λ_i = ν in (23).

9. Recent papers that emphasize government intervention as a source of free insurance against currency risk include Dooley (2000) and Burnside et al. (2001).

Additional information

Notes on contributors

Alain Ize

This paper does not necessarily represent the view of the International Monetary Fund or any other institution.