In the past several months the world has been rocked by profound economic and social turbulence. The COVID-19 epidemic has forced many countries around the world into widespread emergency lockdowns. Economic activity plunged dramatically in February-March 2020, with rapid indicators showing strong contractions in retail, restaurant business, and passenger transport. The scale of the imminent economic fallout is not yet known, but early expert opinions suggest that the economic shock may be even more dramatic than during the 2008 global financial crisis. Under these circumstances, it seems impossible to think of any kind of economic policies except those related to the epidemic and the means of combatting its fallout. Yet, some policies, particularly those that have long-term economic consequences for the country, deserve our attention even in these turbulent times. Among them are the larization policy measures initiated by the National Bank of Georgia in June 2016.
One of the reasons for paying attention to the larization policy is that it has a direct bearing on the health of the financial system, the sustainability of the private sector, and the stability of key economic variables such as inflation, interest rates, exchange rates, and growth. In this policy note we examine the larization policy in Georgia in the context of international experience with de-dollarization. We discuss how the larization measures have impacted the economy so far, which market distortions may have been corrected, and which may have been created inadvertently. Finally, we suggest the direction of policy actions that may be taken in the future.
Taking stock of international experience
It is a truth universally acknowledged that persistent high levels of financial dollarization can inflict considerable economic damage. Among the unpleasant consequences highlighted in the economic literature are: creating foreign currency risks for unhedged borrowers; reducing the efficiency of monetary policy since the central bank can only influence national currency interest rates; creating liquidity risks, since the central bank cannot act as a lender of last resort of foreign currency; limited ability of the central bank to collect “seigniorage revenues” from lending in domestic currency; and finally, with high dollarization, the exchange rate cannot act as an absorber of external shocks. Given these risks, many countries seek to reduce or revert dollarization.
Potential de-dollarization measures
There is, however, a consensus in the economic literature that financial dollarization is difficult to revert, and the de-dollarization process needs three main ingredients: time, consistent stabilization efforts, and policy-maker credibility.
Drawing on international experience, one can distinguish three broad groups of policy activities that can lead to de-dollarization:
a) Macroeconomic Stabilization –these activities require considerable time and consistency from policy makers. The literature suggests that achieving macroeconomic stability is a necessary, but (on many occasions) not a sufficient condition to reach sustainable de-dollarization. Macroeconomic stabilization involves:
achieving fiscal consolidation by cutting the fiscal deficit. This reduces the government’s need to borrow in foreign currency;
reducing inflation under an inflation-targeting regime to build confidence in the national currency and reduce the volatility of local currency interest rates;
maintaining a two-sided flexible exchange rate to avoid speculation on the exchange rate, reduce pass-through from exchange rate to inflation, and overcome the “fear of floating”2;
strengthening the macroeconomic environment addressing macroeconomic imbalances, especially external ones (e.g. a persistent current account deficit, growing negative net foreign asset position, etc.);
improving the credibility of the central bank (having independent monetary policy). This helps control inflationary expectations and builds confidence in the local currency.
b) Market-Driven Activities and Prudential Measures – these activities also take time and effort to establish. Moreover, they need to be used with caution in order to minimize potential market distortions. These measures include:
deepening the capital market i.e. supporting the issuance of local currency and/or inflation-indexed securities. This contributes to the de-dollarization process by creating long-term debt instruments in national currency, improving the local currency liquidity management process. If capital markets are underdeveloped (as is still the case in Georgia) there will be few opportunities for domestic firms to borrow long-term in national currency. This will necessitate foreign currency borrowing. Moreover, the existing domestic debt instruments will not be liquid enough, which would further incentivize dollarization.
developing hedging instruments including forward exchange contracts for currencies, derivative products;
introducing asymmetric reserve requirements (higher minimum reserve requirements for foreign currency than for domestic currency), which makes foreign currency lending relatively more expensive. This and similar measures need to be used with caution, as we will discuss later on in the text.
limiting open foreign currency positions to reduce possible risks resulting from foreign exchange transactions, in the case of possible exchange rate movements;
demanding higher liquidity requirements on foreign currency deposits;
raising capital requirements on foreign currency loans;
introducing strict credit coefficients on foreign currency loans. The latter three prudential measures aim to internalize the negative externality for commercial banks of giving foreign currency loans to unhedged borrowers;
announcing deposit insurance only on domestic currency deposits, which makes domestic currency deposits more attractive for risk-averse retail bank clients.
c) Administrative Forces (Forced De-dollarization) – These are “quick fix” measures designed to achieve some of the de-dollarization goals in the shortest possible time. Among them:
Forcible conversion of foreign currency deposits to local currency;
Mandatory conversion of foreign currency loans to local currency;
Limiting (banning in extreme cases) foreign currency deposits;
Limiting (or even banning) foreign currency lending.
The forced de-dollarization measures are, however, mostly supplementary tools in the wider de-dollarization plan. One would be hard pressed to find empirical evidence of the effectiveness of these measures. On the contrary, according to the empirical literature, these measures (especially mandatory conversion of deposits) fail to achieve a de-dollarization plan and even create problems of financial disintermediation and macroeconomic instability.
Many try but few succeed
The causes and consequences of financial dollarization have been studied widely in both the theoretical and the empirical literature. In general, while many countries try to de-dollarize their economies, only a few of them have managed to succeed in this effort. Mecagni et al. (2015) studied 42 cases of initially dollarized countries1 (including Georgia) between 2002 and 2012. Out of these, only 11 countries managed to successfully de-dollarize, while the other 31 countries failed to meet the criteria for success. The authors have identified several key factors that distinguished the successful cases of de-dollarization from the unsuccessful ones.
One of the first lessons is: sound macroeconomic policies matter. While on the de-dollarization path, successful countries managed to reach higher real GDP growth (on average 2.5 ppts higher), improve the current account balance (on average, from a deficit of 5.0% to a surplus of 0.3%1), and reduce fiscal balance (on average, from a deficit of 2.8% to a small surplus of 1.4%), while unsuccessful countries have not made significant progress in these areas. In addition, the successful countries have had a prolonged appreciation of their national currencies during the de-dollarization period. There is, however, not much evidence that these variables caused the success in de-dollarization. It is more likely that sound macroeconomic policies influence both de-dollarization and also result in higher economic growth, improved current account position and lower budget deficit.
The second important lesson: initial conditions matter. Successful countries usually started out with a higher average initial level of dollarization (67.4% for successful and 48.4% for unsuccessful countries). The higher the initial dollarization, the more likely that a country will achieve the de-dollarization target. Similarly, successful countries had higher initial inflation rates and managed to reduce inflation considerably during the process of de-dollarization. This may be due to the fact that the de-dollarization process requires significant patience and commitment on the part of the authorities, and countries with higher dollarization and higher inflation levels may have been more committed to achieving results.
Yet, as the body of research on de-dollarization makes clear, there is no universal recipe for a successful de-dollarization policy. Some conclusions, however, can be drawn on the basis of country case studies. For example, the cases of Israel and Poland tell a story of successful de-dollarization coupled with prudential regulations. Both countries started reducing dollarization by achieving macroeconomic stability.
Poland’s dollarization problem in the 1980s was nearly as severe as Georgia’s. Deposit dollarization was about 80%. By 1993, Poland’s dollarization level reached 35%, and 4.5% by 1999. Improved macroeconomic stability seems to be one of the most important components in the country’s fight against dollarization. Poland managed to strengthen its macroeconomic environment, stabilize the inflation rate, deepen the local bond market (e.g. in 1991, the Polish government started to issue local currency treasury bills, which were considered an alternative form of savings, reducing demand for foreign currency deposits. T-bills were seen as a safe investment). The supervision of foreign currency loans was strengthened. Poland also used some administrative measures on the deposit side (requiring special permission for depositing money in foreign currency, which made foreign currency deposits less convenient/attractive). The efficacy of this regulation was questioned, however, and it lasted only 3 years before being abolished in 1999.
Israel started out with 39% dollar-denominated deposits in 1984, and reached 17% in 2002.
From 1985 through the 1990s, Israel cut its fiscal deficit from 19% of GDP to 10%; reduced inflation under an inflation-targeting regime; gradually increased exchange rate flexibility; and managed to restore confidence in the national currency. On the prudential side, the country introduced higher remuneration of reserve requirements in foreign currency and introduced stronger requirements for collateral on foreign currency loans to borrowers with income in domestic currency. Furthermore, Israel developed hedging instruments, managed to deepen the local bonds market (issuing bonds indexed to inflation), and started to finance government debt in local currency. In addition, the country employed some administrative measures. For example, they banned short-term (less than 1 year) dollar deposits and prohibited local transactions in foreign currency (notably, however, these administrative measures were not the main drivers of the de-dollarization process, according to studies).
Among the unsuccessful cases one may single out the experience of Bolivia and Peru in the 1980s. These countries attempted to de-dollarize by following strict administrative measures,
among them: mandatory conversion of foreign currency deposits into domestic currency; and imposing capital controls, price controls, and interest rate caps (in Bolivia’s case). These strict administrative measures led to financial disintermediation, capital flight, and macroeconomic instability in both countries. Ultimately these measures had to be abandoned.
The international experience with de-dollarization offers valuable lessons for Georgia on its own path. These lessons are summarized here and will be discussed in more detail in Part 2 of this policy note.
Administrative measures such as prohibiting or restricting deposits in USD, or imposing capital controls generally do not work. Luckily, Georgia did not embrace capital controls and does not regulate USD deposits. However, the country does have a blanket restriction on lending to individuals in foreign currency. At first the cap was 100,000 GEL, later raised further to 200,000 GEL. The potential consequences of such restrictions, pros and cons, are discussed in more detail in the next sections.
Macroeconomic stability is the crucial factor, but it does not guarantee successful de-dollarization. Thus, even achieving stable growth, low inflation, and a low budget deficit, which was a case in Israel and Poland, and as Georgia has done in the past, may not automatically solve the dollarization problem.
De-dollarization takes a long time and may sometimes be derailed by external events. Thus, consistency, patience, and commitment are key to success in this process.
A well-functioning domestic capital market is an important component in successful de-dollarization. This process takes time and patience as well. Georgia’s newly established pension fund may help contribute to the creation of a viable domestic capital market. Now, however, there is no clear mechanism how the pension fund will contribute to capital market development.
Two-way exchange rate flexibility is important (i.e. the national currency sometimes depreciates, and sometimes appreciates, making returns on savings in foreign currency more risky). Trust in the national currency is the key, and if the public perceives that the domestic currency is much more likely to depreciate than appreciate, then deposit dollarization will live on.
Finally, the adopted de-dollarization policies, should be market-sensitive, i.e. there should not be a large gap between the regulations and the market-driven incentives. Otherwise, there is a risk of derailing the de-dollarization process and pushing it into the shadows.