1. 1 COMMENTS ON DEDOLLARIZATION December, 2003

2. 2 Dollarization is a term which has been used loosely in the academic literature  Currency Substitution: Agenor and Khan (1992), Guidotti and Rodriguez (1992), Dornbusch and Reynoso (1989), Ortiz (1983).  Effectiveness of monetary policy and long run effects of inflation on money demand.  Balance Sheets Mismatches : Krugman (1999), Céspedes, Chang and Velasco (2002), Calvo, Izquierdo and Mejía (2003), Hausmann et al. (2001).  Vulnerabilities generated by balance sheet mismatches, and endogenous decision to hedge foreign exchange exposures.

3. 3 Dedollarization: What does it mean?  In a currency substitution framework the use of dollars in the payment system should be reduced through macroeconomic stability, credibility gains, and prudential regulation.  In a balance sheet framework it means that the economy is being capable of reducing currency mismatches.  As domestic financial markets deepen and foreigners are willing to buy local currency risk, either through outright purchases of local currency bonds or through derivatives.  As a result of prudential regulation which does not allow some financial institutions and/or private corporations to acquire debt in foreign currency.

4. 4 Dedollarization in Mexico  Currency substitution has not been an issue in Mexico for many years.  Balance sheet mismatches have been an issue, but one that is loosing importance as the financial system develops and the credibility of the macroeconomic stability increases. Mexico: Foreign Currency (% of Broad Money) (%) Mexico: Bank Credit in Foreign Currency (% of Broad Money) Source: Banco de México

5. 5 Dedollarization: What drives it in the Mexican case? Mexico is dealing with its balance sheet currency mismatches through the development of domestic financial markets. A prudent fiscal policy has decreased public sector crowding out, a long-term yield curve for domestic public debt has been created. Public and Private Sector Absorption Of Domestic Financial Savings (%) Domestic Public Debt Yield Curves (% Rates) Source: Banco de México and SHCPSource: Banco de México and SHCP estimates

6. 6 Dedollarization: What drives it in the Mexican case? The lengthening of the yield curve has been possible as inflation targeting by the central bank has reduced observed and expected inflation. Inflation: Headline and Core and inflation Targets (%) Expected Inflation: Next 12 Months (%) Source: Banco de MéxicoSource: Banco de México and Infosel

7. 7 The pension reform has increased long-term savings and this has contributed significantly to the growth of domestic financial savings. Dedollarization: What drives it in the Mexican case? Institutional Savings: Pension and Housing Funds (% of GDP) Growth of Domestic Financial Savings And the % from Siefores (Millions of Pesos) Source: Banco de México

8. 8 Institutional savings growth and a reduction in public sector crowding out have resulted in an expansion of credit to the private sector. Dedollarization: What drives it in the Mexican case? Bank Credit to Non-Financial Private Sector (Annual % Real Growth) Non-Bank Credit to Non-Financial Private Sector (Annual % Real Growth) Source: Banco de México

9. 9 Foreign currency bank credits have been falling as a percentage of the total since 1998 and debt issuance in domestic markets has increased sharply. Dedollarization: What drives it in the Mexican case? Bank Credit in Foreign Currency (As a % of Bank Credit) Securities Issued by the Private Sector (millions of Pesos) Source: Banco de MéxicoSource: Banco de México and BMV

10. 10 Total credit from foreign sources received by corporations continues increasing and its share of the total bank and non-bank credit maintains a positive trend. However, there is evidence that points that the corporations which are using external debt are exporters and, therefore, they are not generating a currency mismatch. Dedollarization: What drives it in the Mexican case? Bank and Non Bank Credit from Foreign Sources (As a % of Total Bank and Non-Bank Credit 4q/4q ma) 4q/4q ma) Survey Responses to: Is your Main Source of Financing a Foreign Bank (Positive Responses % of Total) Source: Banco de México

11. 11 Derivative markets have been expanding, increasing the opportunities to hedge risks in Mexican markets. The Mexican experience shows that financial market development is possible if the credibility of prudent macroeconomic policies is increased and a fully-funded pension system reform generates a captive source of long-term domestic financial savings. Dedollarization: What drives it in the Mexican case? Derivative Contracts Traded (12 mo average) Source: MexDer