Dollarization:%20step%20by%20step

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Dollarization step by step

• Manuel Hinds
• August 23, 2007

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Agenda

1. Currency and globalization
2. The essence of dollarization
3. Questions
4. The steps
5. The impact

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1. Currency and globalization
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Assumed outcomes and reality of the local
currencies in small economies
Assumed Reality
Financial Autonomous interest rates International rates country risk currency risk
Plentiful credit Credit rather scarce, short maturities
Avoid financial crises Dollars needed to resolve crises
Access to lender of last resort Dollars needed to overcome crises
Trade Devalue your way to become a successful exporter Negative correlation between devaluation and exports performance
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There are two ways to cope with globalization

• The conventional one split monetarily from the
  rest of the world
• And hope that you will have in place optimal
  monetary policies throughout
• And accept that you will have to
• Be out of financial and monetary globalization
• In a system that makes sense only if floating,
  you will be prey to the fear of floating
• Which in turn will limit what you can do with
  your freedom to conduct monetary policy

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The other way

• Get into the area of an international currency,
  which is a truly optimal area
• Rely on substitution effects for adjustments
• Avoid contradictions between trade and financial
  integration
• Have access to deep financial services and
  hedging against other currencies
• Forget about the non-linearities introduced by
  the possibility of devaluation against the
  standard of value
• Forget about currency crises, which have been at
  the root of all the financial crises in
  developing countries

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2. THE ESSENCE OF DOLLARIZATION
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Assume that the country was born using the euro

• People would have cash in euros
• The deposit banks together would multiply this
  money
• People deposit their cash with the banks
• Banks deposit a Legal Reserve Requirement in the
  Central Bank and lend the remainder
• The borrowers deposit it back in the banks
• Banks deposit a Legal Reserve Requirement in the
  Central Bank and lend the remainderand so on

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Now assume that the government wanted to create
the ISK

• The Central Bank would buy the euros, paying for
  them with ISK
• Now the Central Bank would have the eurosand
• People would have their cash in ISK
• The deposit banks together multiply this money
• People deposit their cash with the banks
• Banks deposit a Legal Reserve Requirement in the
  Central Bank and lend the remainder
• The borrowers deposit it back in the banks
• Banks deposit a Legal Reserve Requirement in the
  Central Bank and lend the remainderand so on

This would be the only action needed
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Why not buying all the deposits of the banks?

• The deposits are not held in cash
• Their counterpart is loans
• Which will become liquid only in due time
• You just specify that, when due, they will be
  paid in ISK

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The opposite procedure is needed if you want to
euroize

• The central bank uses its international reserves
  to buy its monetary liabilities (reserve money),
  paying with euros at a given exchange rate.
  Reserve money is
• The cash with the public
• The deposits of the banks in the central bank
• Convert all the assets and liabilities of the
  banks to euros by dividing them by the said
  exchange rate
• Convert all other assets and liabilities and
  contracts in ISK to euros

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3. QUESTIONS
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A. What would be the exchange rate?

• The government must set an exchange rate for the
  conversion
• In El Salvador, it was easy the choice was the
  exchange rate that had prevailed during the
  previous 9 years, since 1992
• The choice with a floating currency is more
  difficult
• If it is set too high (too depreciated), the
  result would be rapid inflation right after the
  conversion

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B. Who should manage the liquidity reserves?

• International reserves to defend the currency are
  no longer needed
• Instead, what is needed is liquidity reserves for
  the banking system
• When the Central Bank buys the deposits of the
  banks in the Central Bank, the ownership of the
  resources previously used as international
  reserves is transferred to the banks
• The Central Bank could keep on managing the
  liquidity reserves of the banks
• Or the banks themselves could manage them, under
  strict rules and supervision

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C. What would be the role of the Central Bank?

• Potential functions
• Manage the governments financial operations
• Manage the liquidity reserves of the banks
• Manage payments
• Be the originator of banking policy and
  legislation

This can be managed privately or outsourced
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D. What to do with the remainder of the reserves?
Funds for last resort? Govt liquidity?
SOURCE International Financial Statistics,IMF
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E. Will you have a sunset clause for the ISK
bills?

• In Ecuador, the old currency bills became
  valueless after a certain date
• In El Salvador, the old colones bills and coins
  do not have a sunset clause. They can always be
  exchanged for dollars

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4. THE STEPS
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Before eurization

• Tell the European Central Bank what you intend to
  do
• Ask to have a representative reviewing the
  euroization law and process
• Arrange for the supply of bills and coins (in the
  case of El Salvador, it is a private bank (the
  Bank of New York)
• Tell the IMF

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The euroization

• Establish one midnight for the change in the
  accounts of the banks (in El Salvador this date
  was January 1st, 2001, at 000 hours)
• This starts the process of euroization
• All banking operations would be denominated in
  euros from that day on
• Begin to exchange euros for ISK through the banks
• Announce that the banks will exchange checks in
  ISK only up to a certain date (three months in El
  Salvador)
• The commission charged to exchange ISK to euros
  and back should be set to zero
• All prices should be announced in both currencies
  for six months
• Banks should be given 3 months to adjust their
  lending interest rates to the cost of their new
  euro deposits

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5. THE IMPACT
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A. The rounding

• In all cases of dollarization (the introduction
  of the euro in Europe and t the dollarization of
  Ecuador and El Salvador), there was a rounding
  effect in prices
• The effect was not objectively large, but had a
  strong psychological effect

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B. The collapse of interest rates
SOURCE International Financial Statistics,IMF
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Interest rates are very high in Iceland
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The inverted yield curve in Iceland
SOURCE Central Bank of Iceland
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C. The collapse of the intermediation spread
SOURCE International Financial Statistics,IMF
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The spread is very large in Iceland
SOURCE Central Bank of Iceland
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D. The maturity and size of loans

• Increased from 3-5 years maximum to 30 years
  maximum today
• Long-term loans is the portion of credit that is
  increasing faster in the country
• In terms of size, the smaller loans are the ones
  that are growing faster

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In most developing countries, the maturity of
most loans is not longer than one year
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In most developing countries, the government has
to subsidize loans to small borrowers
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D. The banks in El Salvador

• Are the largest, most profitable in Central
  America
• Were all sold to large international banks
• At very good prices

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In summary

• El Salvador is connected financially with the
  rest of the world
• People have access to all the sophisticated
  services of the dollar area
• There is no danger of currency crises
• Long-term credit, credit to the small enterprise
  and retail banking in general have prospered fast