Dollarization: causes and solutions

Mikhail Demidenko

Deputy Director of the Centre for Integration Studies

The National Bank of Belarus has been launching one strike after another against the Belarusian economy’s long-standing problem of extremely high dollarization. However, there are still no serious results to boast. The experts are convinced that the regulator is moving in the correct direction but it needs time and, possibly, even greater decisiveness to eliminate the dollar in Belarus.

Dollar in head

Dollarization is one of the most important challenges for a country’s monetary and financial sphere. Why is it a problem? It’s main drawback is that it reduces the effectiveness of the interest channel since changes in interest rates have almost no influence on the rates of loans and deposits denominated in foreign currencies. This affects the efficiency of monetary policies and limits governments’ capability to manage macroeconomic processes. When a country’s external foreign exchange liabilities exceed its foreign exchange assets, the balance-sheet effect of changes in the exchange rate is opposite to the effect of changes in relative prices, and the cumulative effect of the weakening exchange rate on economic growth can be negative. The systemic risk for the financial system increases, at least for two reasons. First, financial dollarization reduces the central bank’s capacity as the ultimate lender since it increases the probability of foreign exchange liquidity deficit in the financial system in stress situations. Second, since banks extend loans in foreign currencies not only to exporters, financial dollarization causes foreign exchange inconsistencies that increase credit exposure in foreign currencies. Therefore, a more effective monetary policy and greater financial stability cannot be imagined without low dollarization and high trust in the national currency.

Belarus is maintaining one of the highest rates of dollarization among the EAEU member states and European countries (Figure 1). As at 1 October 2016, its economic sectors had foreign currency loans from banks accounting for 57% of their overall borrowings. Among state-owned commercial enterprises, the share of loans in foreign currencies stood at 69% of their total borrowings from banks. Currency deposits accounted for 64% of the broad money. Deposits in foreign currencies made up 72% of all deposits. Among household deposits in banks this figure was 78% and among business deposits 61% (Figure 2).

The extent of dollarization changed significantly in 2009 after the 20 percent devaluation of the Belarusian rouble with respect to the U.S. dollar in response to the negative impacts of the global financial crisis on the Belarusian economy, and in 2011 after the Belarusian rouble impaired by almost three times vis-a-vis the main world currencies. After 2011 and until the beginning of 2016, the share of foreign currencies in deposits and loans continued to go up because of necessary adjustments to the rate of the Belarusian rouble with respect to foreign currencies, including as a result of the depreciation of the Russian rouble in foreign markets due to external shocks.

Reducing dollarization in the financial sector would bring significant economic and political dividends to Belarus. To succeed, however, the root causes of this phenomenon need to be eliminated.

The economists Alain Ize and Eduardo Levy Yeyati believe these causes lie in the monetary and economic turbulence and the weakness of national institutions because dollarization is nothing but a manifestation of the economic subject’s rational desire to insure against hyperinflation [7]. Some economists insist that dollarization should be explained not only by inflation but also uncertainties as to the effective yield of the assets denominated in the national currency arising due to volatile inflation [4]. In addition, the suggestion that different forms of dollarization intensify each other can hardly be disputed [6]. For example, financial dollarization would be higher in an economy with a higher level of “actual dollarization” (where commodity prices are formed in the dollars and euros) and/or a higher level of dollarization in payments. The other important reasons include the public’s low trust in the monetary policy, high inflation and devaluation expectations, and the remembrance of recent high inflation and/or devaluation.

In our opinion, the main causes of the high level of dollarization in the economy are as follows.

1. High inflation and exchange rate targeting (fixation). The fact that dollarization results, to a significant extent, from monetary policies that cannot restrain inflation is illustrated by country comparisons (Figures 3 and 4). Tough control of the exchange rate only strengthens motivation for dollarization. Research and practice in certain countries (for example, Turkey and Poland) suggest that restoring the floating rate and taking measures to reduce and stabilise inflation are the key conditions, without which any other efforts to de-dollarize would most probably be fruitless.

It should be taken into account that these macroeconomic conditions can influence business savings and investment decisions faster than those of households, which need more time to overcome negative remembrances of high inflation [9]. In this connection central banks should, for a significant time, not only send consistent signals to the public about their firm intention to ensure monetary stability and flexibility of the exchange rate and to prevent any steps back in their policies, but also take supporting measures to promote a favourable environment in the financial market and create additional economic stimuli for de-dollarization.

2. Macroeconomic volatility. Inflation volatility – if it is higher than the volatility of the nominal depreciation of the exchange rate – is one of the causes of dollarization. In particular, the policy of disinflation (aimed at reducing and stabilising inflation) by means of controlling the exchange rate when it stabilises faster than inflation – tend to stimulate dollarization. Here’s the example of Armenia: on the one hand, it had stably low inflation rates for a long time but the banking sector had one of the highest asset and liability dollarization rates in the EAEU. This is because the Armenian monetary policy has many peculiarities, not typical of net inflation targeting. Therefore, a stable exchange rate, in combination with other factors, create preconditions for high dollarization.

Expectations and trust among market participants are also important. If economic players do not believe that the recent good results of a macroeconomic policy would be reversed the medium term, dollarization may not go down even if the policy has been changed fundamentally.

3. The fear of the floating exchange rate induced by the gap in positions (having significant open foreign exchange positions). In a highly dollarized economy the central bank may want to fix or control rigidly the exchange rate in order to protect economy players against devaluation effects. However, when international reserves are insufficient and the economy is affected by significant adverse external shocks such exchange policy becomes a hostage to “the fear of the floating exchange rate.”

4. Credit risk undervaluation by unhedged borrowers. Borrowers and lenders may undervalue the credit exposure associated with extending foreign currency loans to unhedged borrowers. The inability to foresee a sharp and significant impairment of the exchange rate makes borrowers accept extreme foreign exchange risks, on the one hand, and induces lenders to provide loans in foreign currencies, on the other hand. In addition, the significant gap between interest rates, which favours foreign currencies, can result – through adverse selection – in that riskier projects will concentrate in the segment of unhedged borrowers.

An efficient deep and liquid foreign exchange market (spot and forward markets) equipped with reliable pricing mechanisms reduces the need for foreign currency as an “insurance” as it provides its participants with unrestricted access to financial resources and foreign exchange hedges. Without an efficient foreign exchange market businesses will try to attract finance in alternative currencies, exposing themselves to foreign exchange risks. The best hedging policy for importers, in the absence of a developed hedging mechanism, is to fix prices in foreign currencies.

In view of the above, it seems advisable to divide de-dollarization measures into three levels: the top priority measures should be aimed at changing the macroeconomic environment; the second level should be passive measures aimed at creating a favourable financial market environment; and the third level should be active measures intended to influence the stimuli for transaction expansion in a certain market segment and the pricing of certain goods. As shown by an empirical analysis by the IMF, central banks use active measures to stimulate and support de-dollarization [10].

The top priority measures aimed at changing the macroeconomic reality include inflation reduction and stabilisation by switching to a floating exchange rate. This stage is intended to remove the main obstacle – high inflation and the insufficient flexibility of the exchange rate, failing which all other measures and actions, or most of them, will fail.

The second-level (passive) measures are aimed at forming a favourable environment in the financial market. Their objective is to create conditions minimising negative effects in the economy if the strategic measures included in the first group aren’t implemented in full. In particular, these measures should help banks to expand their balance sheets by promoting instruments denominated in the national currency, developing domestic financial markets, and eliminating uncertainties relating to long-term interest rates.

The passive measures should focus largely on changing the structure of future flows, not the current dollar positions. As international experience suggests, if the de-dollarization of flows is successful the positions will begin to adjust approximately in two to four years (depending on the duration of the average bank portfolio) [5].

The passive measures include:

• avoiding actions that are conducive to the use of foreign currencies instead of the national currency and promoting government borrowings and savings predominantly in the national currency; extending subsidies for loan repayments also denominated in the national currency; and using a system of the differentiated taxation of income from savings, deposit insurance, etc.;
• placing on a regular basis significant amounts of fungible benchmark notes and bonds to form an yield curve, which would be trusted by investors and can be used to price long-term lending instruments in the national currency, as well as hedging transactions;
• developing secondary markets in bonds and other instruments denominated in the national currency to create products, which would allow pricing long-term lending instruments denominated in the national currency, which will also help to improve the pricing of forward rates;
• promoting foreign exchange hedges by improving accounting, tax regulation and hedging mechanisms;
• reporting transactions with derivative instruments and ensuring corporate risk management;
• improving the infrastructure of the foreign exchange market (developing trading systems, expanding the use of remote trading terminals);
• liberalising gradually capital flows and advancing the domestic foreign exchange market in order to stimulate an increase in the market of the number of, and opportunities for, risk takers, which would be ready to take forward foreign exchange positions; developing the market in government securities derivatives (options, futures) as they promote the development of foreign exchange options and futures;
• developing and improving a system to monitor foreign exchange risks, and informing market participants about foreign exchange risks and advantages of transactions in the national currency;
• providing banks with guaranteed access to liquidity in the national currency in the event of a liquidity deficit in the banking system.

The third-level (active) measures stimulate the use of the national currency by regulating the degree of differentiation of the standards and requirements for financial transactions in different currencies and different segments of financial markets, as well as pricing rules.

The authors believe that the third-level measures in respect of financial transactions should be focused predominantly on the banks’ lending transactions and not deposits, because the dynamics of individual deposits is shaped by motives and conditions often unrelated to interest rates (for example, devaluation expectations). In addition, the shortage of deposits in the national currency may be, to a significant extent, an endogenous response to the lack of loans in it.

The experience of other countries suggests that commercial banks view retail and short-term lending as the most promising segments for de-dollarization and are ready to cooperate in introducing restrictions, which are necessary to this end [8]. It should be noted that de-dollarization of the transactions of small and medium-sized businesses may begin at a later stage. It is also important to note that large corporate clients and households usually resist switching from the foreign currency to the national one more than other market players and this should be taken into account when respective measures are being devised and implemented.

In view of the above, the third-level measures include:

• greater differentiation of reserve requirements, including the differentiated approach to their softening;
• greater differentiation of prudential supervision requirements (for example, introducing differentiated collateral ratios and debt service coverage ratios, especially in the most vulnerable segments such as consumer and short-term lending; restricting the provision of foreign currency loans in the most vulnerable segments). International experience (that of Poland, Serbia and Turkey, for example) demonstrates that extending foreign currency loans to the population is associated with high foreign exchange and repayment risks if repayments increase to exceed borrowers’ incomes;
• promoting the conversion of currency loans into the national currency;
• subsidising interest rates on currency loans converted into the national currency;
• arranging a large-scale campaign to promote the national currency as the means of payment, including by prohibiting the establishment of prices (tariffs, tax rates and other payments) in a foreign currency.

The third-level measures are believed to be the least valuable in a situation when the measures envisioned at the preceding two levels have not been fulfilled. They will be useless at best, or, at worst, provoke unfavourable consequences, for example when clients are forced to get disadvantageous loans in the national currency or banks bear additional credit risks they cannot internalise2. The third-level measures are intended to, in the first place, protect the most vulnerable segments against foreign exchange risks and, in the second place, make the mechanical transfer of foreign exchange risks onto clients unacceptable for banks. It is also necessary to ensure that such measures are not too restrictive in the context of the current phase of a business cycle.

Experience of Belarus

Understanding the impacts of high dollarization on its monetary sphere and financial stability, as well as that it is impossible to eliminate this problem alone, the National Bank and the Government of Belarus launched a range of measures to reduce dollarization and solve related problems such as the population’s low trust in the Belarusian rouble, the use of different currencies for asset and liability denomination, a restricted access to currency liquidity, and the country’s significant gross demand for external finance, which require a continuous search for compromises and weighted decisions. In this connection, the de-dollarization strategy is fundamental and forms the basis not only for the monetary, prudential and financial market development strategies in Belarus, but the entire economic policy.

The fundamental, first-level measures that have already been taken include:
1) the National Bank and Government’s work pursued since 2011 to gradually abolish directed lending;
2) the National Bank’s transition in 2012 to the maintenance of positive real interest rates in order to promote savings in the national currency;
3) the use since 2015 of a new monetary policy of monetary targeting, which helped to focus the National Bank’s efforts on the achievement of its most important goal – to reduce and stabilise inflation;
4) the National Bank’s transition since the beginning of 2015 to more flexible exchange rate formation principles that envision that the National Bank will gradually reduce its interventions in the foreign exchange market and that the role of market factors in exchange rate formation will be strengthened;
5) the toughening of the tax and fiscal policy, including the salary policy, which helped to alleviate external and internal imbalances in the economy and foreign exchange risks.

As a result of stabilisation of the national currency, the share of currency deposits in the broad money began to decline since March 2016.

In this connection the National Bank’s use of monetary targeting exclusively as a temporary strategy and its plans to switch to inflation targeting, which is considered more effective as regards the improvement of economic agents’ trust in the monetary policy as a whole and the national currency in particular, seem absolutely reasonable.

At the same time, the level of dollarization is still high. The issue of liquidity and the lack of foreign exchange reserves to neutralise significant external shocks, as well as the issue of the economy’s overall low efficiency remain acute [1]. All these factors require that further active actions be taken as well as other passive and active supports be involved.

As for the passive measures aimed at creating a favourable market environment and conditions, we would like to note the following.

The National Bank’s transition to a more flexible exchange rate, as well as external shocks associated with the significant fluctuations of world oil prices and global currencies in recent years have induced non-financial institutions that make currency payments in export and import transactions and on bank loans to hedge foreign exchange risks. At the same time, the volumes of transactions entered into by banks with businesses in order for the latter to insure their foreign exchange exposure were insignificant and the main reasons for this were as follows: the lack of regulations governing and clarifying the procedure for the conduct by non-financial institutions of hedging transactions and accounting for them, as well as for the taxation of income derived from foreign exchange hedges and having the respective expenses accounted for the taxation purposes; the low quality of corporate risk management at businesses; the lack of risk takers in the foreign exchange market, which would be ready to take forward currency positions; the lack of yield benchmarks for long-term debt instruments, and other factors. The National Bank’s efforts in 2015-2016 to popularise hedging [2] did not help to reverse this trend. For this reason, the top priority measures in this case should be those aimed at improving regulation of foreign exchange hedges as regards accounting, taxation and execution, as well as creating yield benchmarks for financial instruments denominated in the Belarusian roubles. Whether these issues can be solved as soon as possible will depend on when the Belarusian Ministry of Finance introduces the national accounting and reporting standard for financial instruments. This document should set forth the rules for businesses’ accounting for transactions with financial instruments, including hedges, and the placement of benchmark issues of government bonds with respective maturities to form the yield curve for the Belarusian rouble.

As for improving the foreign currency liquidity, it would be reasonable to ensure a wider use of foreign direct investments (FDI) and not foreign borrowings which tend to increase the risk that high dollarization will continue to persist. Therefore, the initiated Government’s institutional and structural reforms aimed at improving the investment attractiveness of the Belarusian economy, reducing macrofinance exposure, and building economic capacity, seem very important and should be fulfilled as soon as possible. In addition, to improve the conditions for FDI attraction, it is extremely important that the National Bank fulfils its plans to liberalise foreign exchange relationships and reduce the amount of foreign exchange proceeds subject to compulsory sale. We should note that on 1 September 2016 the National Bank did already reduce this rate from 30% to 20% of foreign exchange proceeds.

As for the indirect regulation of the attractiveness of rouble and currency deposits, in order to stimulate extensions in term deposit periods, Presidential Decree 7 passed on 11 November 2015 resolved that from 1 April 2016 interest on irrevocable individual deposits would be exempt from income tax provided that the period of deposits in the Belarusian roubles and foreign currencies exceeded one and two years respectively. In view of the current low international reserves of the National Bank and other banks, changing this procedure in the nearest time in order to improve the attractiveness of long-term savings in the national currency compared to currency savings does not seem reasonable. However, as the National Bank and other banks accumulate highly liquid foreign currency assets, the abolishment of preferences for foreign currency deposits should stimulate financial de-dollarization.

In addition, to ensure the attractiveness of the national banking system and to stimulate and protect individual savings, in 2008 Belarus introduced a system of 100% insurance for individual deposits3. In this case it would be reasonable, in a manner similar to the one stated above, to switch gradually, in proportion to financial stabilisation, to a system of limited guaranteed repayment of deposits covering deposits in the national currency only.

It should be also said that Belarus makes a limited use of third-level instruments (measures), the effectiveness of which, as it was stated above, depends on:
1. the internalisation of dollarization risks;
2. the prevention of negative effects of the exchange rate shocks on the economy; and
3. the strengthening of the financial system’s capacity and ability to absorb shocks.

The main measure at this level is the prohibition to extend individual loans in foreign currencies, which has been in effect in Belarus since 20094. To reduce potential risks for the financial system, Belarusian banks should be provided with incentives to reduce the share of foreign currency loans in their assets, however without losing possibility to extend foreign currency loans for foreign trade. Since the level of dollarization in the economy has not declined but increased over 2011-2016, it seems that the current prohibition to provide foreign currency loans to individuals should be preserved.

Another important measure aimed at de-dollarizing the economy, as viewed by the National Bank and Government, is the abandonment of foreign currency payments between Belarusian residents. To this end, the sides approved a joint action plan in mid-2016 envisioning that by 2019 the use of foreign currencies in payments between residents would be reduced significantly and that taxes, customs duties, rents, tariffs and other payments would be untied from the U.S. dollar or set exclusively in the Belarusian roubles.

The third measure was to differentiate reserve requirements. Although in the past the reserve requirements for different currencies and types of depositors differed, in order to ensure financial stability and improve the liquidity of banks, in June 2015 the National Bank set a single reserve requirement of 7.5% for all deposits (Figure 5). It is believed that setting the same requirements for deposits in the national and foreign currencies instead of a higher rate for foreign currency deposits suggests that the liquidity risks for national and foreign currency deposits are considered to be the same. At the same time, while access to finance in foreign currencies remains limited, as in Belarus, the liquidity risk for foreign currency deposits is higher. Therefore, it seems advisable to restore the differentiation of the reserve requirements and set higher rates for foreign currency deposits than for rouble ones. The higher rate for foreign currency deposits will be somewhat of a tax on financial intermediation in the foreign currency and will, therefore, help to reduce dollarization in the financial system. Interest rates will go down for foreign currency deposits and up for foreign currency loans and this will help to reduce their attractiveness compared to deposits and loans in the Belarusian roubles.

The third group of measures are macroprudential initiatives aimed at limiting foreign exchange risks and stabilising the financial sector. Research by the World Bank and the International Monetary Fund conducted in 2016 has shown that certain Belarusian banks had significant indirect credit exposure associated with foreign currency loans extended to unhedged borrowers [1]. If to consider positive international experience in using macroprudential measures to reduce dollarization risks5, it seems advisable that capital requirements for such banks be raised by increasing capital risk weights for foreign currency loans, which have a greater credit risk associated with exchange rate fluctuations, in order to induce banks to increase interest rates on foreign currency loans, which will decrease demand for them.

Belarus has still a lot to do to achieve sustainably high economic growth and high dollarization creates a number of systemic risks that may complicate these efforts significantly. At present, economic agents, business partners, investors, lenders and all other players need to have negative expectations as to the future of the Belarusian economy and Belarusian rouble alleviated. Therefore, the problems associated with dollarization, devaluation and inflation should be solved in a comprehensive and fundamental manner. This means not only aiming to maintain price stability and ensure exchange rate flexibility, but fulfilling an entire range of interlinked measures to stimulate a structural shift in financial assets and liabilities towards the national currency. Without due trust to the Belarusian rouble, the country won’t be able to restore sustainably positive macrodynamics in the economy.

The initiated Government’s institutional and structural reforms aimed at improving the investment attractiveness of the Belarusian economy, reducing macrofinance exposure, and building economic capacity, seem very important and should be fulfilled as soon as possible. This task is difficult because of the country’s limited foreign exchange reserves, as well as the need to repay its liabilities denominated in foreign currencies and increase international reserves.

Creating a fully-functioning hedging mechanism is also extremely important to form a favourable financial market environment and conditions conducive to the reduction of potential foreign exchange risks, and to increase the use of the national currency by foreign investors, exporters and domestic borrowers.

The triggers and important catalysers of de-dollarization can be specific macroprudential measures aimed at restricting the foreign exchange exposure of unhedged borrowers, prohibiting the most risky types of foreign currency lending, reducing the use of foreign currencies in payments between residents, untying tax rates (customs duties, rents, tariffs and other payments) from the U.S. dollar and euro, returning to differentiated reserve requirements, and ensuring indirect regulation of the attractiveness of rouble and foreign currency deposits. These measures should not be ignored because they help to reduce the foreign exchange risk and its impact on the economy. This, in turn, helps to improve financial stability since it creates space for enhancing the flexibility of the exchange rate and economy as a whole and, at the same time, conditions to maintain stabilised prices and inflation expectations and improve trust in the national currency and monetary policy.