Dollarization of assets and liabilities in Bolivia

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• Dollarization of assets and liabilities in
  Bolivia
• Juan Antonio Morales
• President of the Central Bank of Bolivia
• December, 2003

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Outline.-

• 1.- Facts and trends
• 2.- Dollarization the long-view
• 3.- Main hypothesis on the causes of
  dollarization
• 4.- The costs of dollarization
• 5.- The measures taken to cope with dollarization

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FIGURE 1
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Dollarization the long view

• Starts in the early 1930s, coincidental with the
  abandonment of the gold exchange standard.
• Gets its main impulse with a creeping inflation
• Further impulse to dollarization is given by the
  renewed access to external savings under its
  several varieties.
• Until the 1970s
• Mainly under the form of real dollarization
• Payment dollarization for big items
• Bolivia suffered two bouts of hyperinflation
  between 1950 and 1985

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• Dollarization seems also to be the reflection of
  a high degree of concentration of wealth and
  income.
• Deposits and especially, dollarized deposits are
  very highly concentrated, with 3.4 of the
  depositors holding 74.9 of the deposits. The
  Gini coefficient is 0.92
• Also dollarization may have been aided by
  regulations
• null or low minimum reserve requirements for bank
  deposits in dollars
• currency blind treatment of deposits in case of
  the liquidation of a bank, that in fact favors
  dollarized deposits (the Broda and Levy Yeyati
  argument).

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• Real and payments dollarization had a bearing on
  financial dollarization
• real estate, the main collateral for loans has
  been priced in dollars since 1950s
• the use of dollars as numéraire went beyond the
  market for goods and non factor services.
• the public became used to think in dollars.

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• Yet
• 2 big items of gross national income are set and
  paid in domestic currency
• wages (with some exceptions)
• taxes (although tax arrears are indexed to
  the
• dollar, as well as the tax base on
  residential
• property)

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• A whole monetary system in dollars developed.
• claims in dollars were created in Bolivia very
  extensively
• in 1992, banks were allowed to clear and settle
  their accounts in dollars in the books of the
  central bank.
• money multipliers in dollars however do not seem
  that large
• monetary and financial dollarization reinforce
  each other
• in fact financial dollarization was made
  possible to a large
• extent because of the payment facilities in
  dollars

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• Why and who demands domestic currency?
• Why the labor unions did not demand the
  dollarization of wages, even during the
  hyperinflations?

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• Two hypothesis
• the monetary system in domestic currency is a
  shock absorber for fluctuations in income and
  employment.
• it also prevents the interruption of payments,
  likely with a weak fiscal sector.
• the domestic currency still provides more
  liquidity services than dollars, for instance,
• it is widely used in transactions
• for wage goods
• in addition, holdings in excess of the demand for
  domestic money needed to finance the consumption
  of wage goods can be easily converted into
  dollars
• thus domestic money is a convenient stepping
  stone to the coveted dollars

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• A policy mistake that pushed dollarization
• De-dollarization by fiat
• supreme Decree of 1982 (annulled in 1985)
• all dollar contracts were converted into Bolivian
  pesos at a rate below the market rate
• all financial operations in dollars were
  forbidden
• exchange controls were established

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• The de-dollarization measures were widely
  opposed
• people suffered from the unfair rate of
  conversion
• more important, people resented being left
  without an anchor, in the eve of hyperinflation
• the middle classes, the most affected, were the
  more vocal in their opposition
• the opposition parties blamed on the
  de-dollarization measure the hyperinflation that
  Bolivia suffered these years

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• Forced de-dollarization
• led to capital flight
• led to financial desintermediation
• the ensuing real costs were very high
• dollarization if anything increased, although
  operations with dollars went underground
• left a deep scar in the public, the slightest
  attempt at de-dollarization was to be opposed.

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After the inflation stabilization program of
1985

• dollarization returned with a vengeance
• and this, despite the drastic fall in inflation
• in the past three years the Bolivian inflation
  has been lower than the US inflation.

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A word on the Bolivian exchange rate system after
1985

• Two pillars
• unrestricted freedom to operate in foreign
  exchange
• a sui generis system
• that started as a dirty float, with an auction
  mechanism a the central bank (the bolsín) for
  the sale of foreign exchange as instrument of
  intervention
• that after a few weeks after August 1985 evolved
  into an incomplete crawling peg.
• The stated policy of the central bank to
  maintain a stable RER, subject to a low inflation.

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Why financial dollarization persisted and even
increased? We shall remember that by end
2002 - almost 100 of the loans were
dollarized - over 90 of the deposits were
dollarized N.B. The microfinance institutions
are the most dollarized
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Main hypothesis on the causes of
dollarization My favorite explanation A non
zero probability of catastrophic devaluation and
ensuing inflation continues to affect portfolio
decisions of depositors and banks the
probability increases with the large
deficits - in the current account of the
BOP - in the fiscal accounts
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• The above hypothesis can be modeled as
• a peso problem

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Figure 2 Interest rate spreads and depreciation

jul-02
jul-03
ene-02
ene-03
depreciation of exchange rate interest
rate spread (lagged 12 months)
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The peso problem
 
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• The econometric evidence however is not wholly
  conclusive because the banks decided around 1998
  to discourage deposits in Bolivianos. An easy way
  to do this was to offer very low interests for
  deposits in domestic currency

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• Alternative explanation (the Levy Yeyati Ize
  model)
• Minimum Variance Portafolio (MVP)
• Derived from a CAPM model
• ? is the underlying dollarization coefficient
  based on relative volatilities of inflation and
  of the RER
• Unfortunately ? is bounded from above by ? but
  it not bounded by zero from below.

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• The Bolivian results ?
• full sample 1988.01 2003.07 0.8788
• truncated sample 1992.02 2003.07 - 0.0379
• Up to 1994 inflation and its variance were still
  relatively large. The variance of inflation was
  larger than the variance of the RER.
• Since the start of the crisis (around 1999) the
  variance of RER has been larger than the variance
  of inflation.

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• The costs of dollarization
• The most obvious the currency mismatch creates
• fragility to the banking system
• Note however, that this fragility became apparent
  only after
• the regional crisis of 1999. Until then, the
  co-existence of 2 monies did not seem to
  cause problems.
• Even with partial dollarization the central
  bank is left, by and large,
• without monetary policy.
• The channels of transmission of monetary policy
  are very weak.
• By the way the standard monetary programming
  of the IMF becomes
• largely irrelevant, both the demand for
  domestic money and the
• demand for dollarized bank reserves are very
  unstable.

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• Main consequence for the central bank
• the central bank is reduced to the role of
  liquidity insurer in dollars of the banking
  system,
• to perform this duty it has to hold very large
  international reserves,
• the large international reserves induce in turn
  further dollarization.
• But also
• the banks are obliged to remain very liquid
  substantial excess reserves.

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• The measures taken to cope with dollarization
• Preliminary the bipolar option
• full dollarization
• relatively little transition costs, because the
  economy is already very dollarized.
• however
• the country has to be ready
• with healthy fiscal accounts
• a strong financial sector
• a reasonable growth of productivity in its
  tradable
• sector
• none of these conditions is currently met

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• fully flexible exchange rate
• unrealistic
• backtracking the road followed during many
• years
• unwarranted effects on the financial sector
• little political support, not even of
  exporters

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• What is left?
• keep the current bi-monetary system
• keep an intermediate exchange rate-regime
• i.e managed but with some flexibility to cope
• with real shocks
• in fact, keep the crawling peg but leaning
  more to the initial auction aspect
• try to de-dollarize through market mechanisms and
  gradual changes in prudential regulations

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• The de-dollarization menu
• First and foremost keep inflation low and have
  a
• credible commitment on low
• future inflation
• Give some advantages to deposits in domestic
  currency in terms of
• minimum reserve requirements
• taxation of interest
• Develop financial instruments indexed to
  inflation instead of dollars
• Operations of the government, to the extent
  possible, are to be conducted and even announced,
  in domestic currency.
• Increase the credibility of the central bank to
  anchor expectations.

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The End