Undoing and Avoiding Dollarization Comments by Ilan Goldfajn

How to undo dollarization? At first glance the answers are depressing.. Galindo and Leiderman (GL) find that dollarization has been growing in spite of a major reduction of inflation and a shift toward central bank independence. GL say dedollarization can be very difficult and very costly. Herrera and Valdes (HV) say that the Chilean case is not easily implemented elsewhere. Caballero, Cowan and Kearns (CCK) say that removing external vulnerability requires “trust” that is bound to take a significant time (e.g. even Chile is not there yet).

At second glance they remain depressing.. Dedollarization does not happen by decree: imposing forced restrictions on dollarization leads to off-shore deposits and financial intermediation declines in the economy (GL) Main pre-requisite: Keep sound monetary and fiscal policies for decades (GL) Dedollarization is a side effect of a persistent and long process of disinflation and stabilization (GL, CCK for Australia) But do we have this patience (discount rates) in Latin America? Moreover, the pre-requisite (necessary condition) may not be sufficient. Dedollarization does not happen automatically. Need to develop markets.

So, is there any lesson for a poor policy maker that wants to do the right thing? The answer is plenty, if you keep reading the papers. My summary is the following: 1.Policy makers should be active in developing markets when international conditions permit and fundamentals are improving. Surf the wave, don’t surf if there is a hurricane. 2.Reversing public sector dollarization is more rapid than private sector dedollarization (CCK about Australia, GL about Israel). Check the costs though. 3.Issue domestic currency debt to locals first (CCK about Australia, GL about Israel, HV about Chile). 4.Foreigners will come later when trust is there. Australia: 100 years of clean inflation and default record (CCK).

More Lessons 5.Float your currency to create incentives for dedollarization (HV). Avoid spurious intervention (CCK – for the case of Chile). 6.Don’t be too ambitious. While increasing nominalization (fixed, long, in domestic currency) of public debt is a final goal, in the meantime, CPI indexing reduces external vulnerability (HV, AL) 7.Develop foreign exchange derivatives markets (forwards, swaps) to redistribute currency risk (Australia, Israel). 8.Prudential regulations should be in place to make sure FX risks are rightly assessed by banks. Systematic guidelines to banks is optimal but limits on mismatching and exposure are good initial steps.

The Case of Brazil: Public Debt % Dollar linked debt/ Total Debt Nominal Debt/ Total Debt set 03 26,5% jan 02abr 02jul 02out 02jan 03abr 03jul 03 set 03 9,0% jan 02abr 02jul 02out 02jan 03abr 03jul 03 % 26

The Case of Brazil: External Debt US$ bilhões S2003 jun 03 US$ 189,0 bi