1. Dollarization: step by step Manuel Hinds August 23, 2007

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

3. 1. Currency and globalization

4. 4 Assumed outcomes and reality of the local currencies in small economies AssumedReality FinancialAutonomous interest ratesInternational rates + country risk + currency risk Plentiful creditCredit rather scarce, short maturities Avoid financial crisesDollars needed to resolve crises Access to lender of last resort Dollars needed to overcome crises TradeDevalue your way to become a successful exporter Negative correlation between devaluation and exports performance

5. 5 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

6. 6 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

7. 2. THE ESSENCE OF DOLLARIZATION

8. 8 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 remainder…and so on

9. 9 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 euros…and –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 remainder…and so on This would be the only action needed

10. 10 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

11. 11 The opposite procedure is needed if you want to euroize… 1.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 2.Convert all the assets and liabilities of the banks to euros by dividing them by the said exchange rate 3.Convert all other assets and liabilities and contracts in ISK to euros

12. 3. QUESTIONS

13. 13 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

14. 14 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

15. 15 C. What would be the role of the Central Bank? Potential functions –Manage the government’s 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

16. 16 D. What to do with the remainder of the reserves? Funds for last resort? Gov’t liquidity? SOURCE: International Financial Statistics,IMF

17. 17 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

18. 4. THE STEPS

19. 19 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

20. 20 The euroization 1.Establish one midnight for the change in the accounts of the banks (in El Salvador this date was January 1st, 2001, at 0:00 hours) This starts the process of euroization All banking operations would be denominated in euros from that day on 2.Begin to exchange euros for ISK through the banks 3.Announce that the banks will exchange checks in ISK only up to a certain date (three months in El Salvador) 4.The commission charged to exchange ISK to euros and back should be set to zero 5.All prices should be announced in both currencies for six months 6.Banks should be given 3 months to adjust their lending interest rates to the cost of their new euro deposits

21. 5. THE IMPACT

22. 22 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

23. 23 B. The collapse of interest rates SOURCE: International Financial Statistics,IMF

24. 24 Interest rates are very high in Iceland

25. 25 The inverted yield curve in Iceland SOURCE: Central Bank of Iceland

26. 26 C. The collapse of the intermediation spread SOURCE: International Financial Statistics,IMF

27. 27 The spread is very large in Iceland SOURCE: Central Bank of Iceland

28. 28 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

29. 29 In most developing countries, the maturity of most loans is not longer than one year

30. 30 In most developing countries, the government has to subsidize loans to small borrowers

31. 31 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

32. 32 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