Georgia started out with a very high initial dollarization level—over 80% in 2009. The National Bank of Georgia (NBG) embarked on the road to larization with a high level of commitment, following a meticulous ‘by the book’ approach. The priority was to achieve macroeconomic stability and establish a proper liquidity management system. Thus, the NBG introduced an inflation targeting regime in 2009. In addition, NBG improved the liquidity management system by introducing one-week refinance loans in 2008, and refinancing loan standing facility and overnight loans in 2010. These measures reduced the volatility of interest rates and made the national currency more attractive.
Price levels and general macroeconomic indicators have indeed stabilized. If the annual inflation rate from 2004-2008 was 8.5%, the same measure from 2009 until February of 2020 averaged just 3.6%1. Yet, despite a steady decline in both deposit and loan real dollarization rates (for deposits from 80% in 2009 to 71% in 2014 and from 84% to 71% for loans during the same period), the progress towards financial dollarization was slow. For example, during tranquil times deposit dollarization showed a declining trend, but the gains were reversed in times of crisis (in particular during the global financial crisis of 2008 and the regional economic crisis of 2014-16). Loan dollarization rates for both businesses and households were also on the decline between 2009-2014, but still hovered above 60%. This could be explained by the fact that lending rates in domestic currency and the interest rate spread between domestic and foreign currency loans were very high and increasing (the gap was on average 6 percentage points between January 2009 and November 2014 and reached 7.8 percentage points by the time the Georgian lari started depreciating rapidly at the end of 2014). In the same time, the Georgian lari did not suffer from a major depreciation episode until 2014. The combination of these factors created incentives for Georgians to borrow in foreign currency.
Regional currency crisis and the “second wave” of larization
The regional currency crisis of 2014-2016 affected nearly all of Georgia’s trading partners and caused a significant lari depreciation, the largest since 2009. For many households who had loans in foreign currency this was a major shock. These events prompted NBG to step up de-dollarization efforts, including introducing administrative measures. The following measures were adopted:
In June of 2016, NBG lowered minimum reserve requirements (MRRs) on national currency from 10% to 7%, and at the same time increased MRRs on foreign currency from 15% to 20%. The main goal of this policy was to make the acquisition of foreign currency resources more expensive for banks, which was expected to lead to a relative increase of interest rates on foreign currency loans, further stimulating the de-dollarization process. Since then, NBG further reduced MRRs on national currency from 7% to 5% in 2018, and increased MRRs on foreign currency twice from 20% to 30% in 2018-19. The asymmetry between foreign currency and national currency MRRs reached its peak in the middle of 2019.
In addition, NBG together with the Georgian government introduced a few other administrative de-dollarization measures:
A voluntary conversion of USD bank loans into lari (with government subsidy);
A lending cap, i.e. banning the issue of loans in foreign currency below a certain threshold (at first the lending cap threshold was 100,000 lari, but it increased to 200,000 lari in 2019) for the majority of lending institutions from the 1st of January, 2017. This regulation affected household loans, but not legal entities.
A regulation obliging legal entities to price any goods and services in a national currency was introduced in July of 2017. This regulation was mainly focused on real estate markets, which were highly dollarized.
How effective were the larization/de-dollarization measures?
Between January 2017 and September 2019, when most of the larization program measures took place, Georgia’s dollarization index went down, with both deposit and loan dollarization decreasing from around 70% to 60% (more precisely: 72% to 64% for deposit dollarization and 65% to 55% for loan dollarization). Both households and businesses saw a decline in deposit and loan dollarization rates (the decline was especially notable for businesses, since legal entities were not directly affected by the new lending caps).
Real loan dollarization of businesses declined from 82% to 70% between June 2016 and December 2019. Deposit dollarization for businesses declined from 79% to 75% during the same period. Deposit dollarization rates for households went down as well, although by much less, from 82% to 75% in the corresponding period2, and the overall dollarization gap (the difference between deposit and loan dollarization rates) increased from 1.5% to 8.6% during the same period.
Part of the story behind the steady, albeit slow de-dollarization process during this period was the country’s improved macroeconomic conditions: annual inflation was stable and close to the target value (the relatively higher inflation rate in 2017 was a result of a one-time increase of excise tax on tobacco and oil), and annual real GDP growth went up to an average of 4.9% during the 2016-19 period. Long-term interest rates have also started to decline in the reference years. However, the USD to GEL exchange rate was relatively volatile during this period. Notably, NBG actively pursued other policy measures, like improved strategic communication with economic agents, sharing and explaining the results of the monetary policy committee meetings, as well as proactive communication with the general public.
The systemic weaknesses threatening this good progress at the time were:
Underdeveloped domestic capital markets in the country left domestic businesses very sensitive to exchange rate swings, as they would still rely on borrowing in foreign currency or on FDI.
The declining, but still high, deposit dollarization generated additional pressure on exchange rates (as discussed in the section below).
The economic effects and side-effects of the larization policy
The combination of improved macroeconomic conditions in the country, NBG’s policy-measures and effective communication strategies helped drive the larization process in the right direction from 2017 to 2019. To some degree, even the administrative measures contributed to removing certain distortions on the lending market, namely shifting the currency mismatch risk from small-time borrowers (who were ill-equipped to recognize and handle such risks) to financial institutions (arguably more prepared to handle the risk of currency mismatch).
Despite all the positive measures from NBG, progress was relatively slow, and it was evident that financial de-dollarization would take considerably more time than one could hope for. Moreover, certain aspects of the de-dollarization process created a number of side-effects which need to be considered more closely.
Challenges in the liquidity management system. The asymmetric minimum reserve requirements in national and foreign currencies and banning foreign currency lending up to 100,000 lari (and then to 200,000 lari) made the liquidity management process more difficult due to the gap between loan and deposit dollarization. On the one hand, the commercial banks had relatively more abundant foreign currency resources (due to high deposit dollarization), but now faced an additional need for national currency to issue new loans.
This, in turn, put additional pressure on the foreign exchange rate. The combination of the above-mentioned asymmetry in minimum reserve requirements, limited lending in foreign currency, and stricter prudential regulation for foreign currency loans can certainly create an additional pressure on the exchange rate. In order for the exchange rate not to be affected, the decreased supply of the foreign currency resulting from these measures should be matched by declining demand for the foreign currency, in particular due to the deposit de-dollarization process. In general, the slower the switching process and the larger the asymmetry in loan and deposit dollarization rates, the higher the pressure on the domestic currency.
In the case of Georgia, the gap between deposit and loan dollarization increased during the reference period. This could have generated further pressure on the exchange rate.
The Georgian lari depreciated several times during the 2017-19 period. The last round of notable depreciation during the reference period started in May 2019 and affected the inflation rate through the end of the year.
One may notice that this round of depreciation started before the June 2019 events which further strained relations with Russia (and included the banning of direct flights from Russia to Georgia). There may have been various factors affecting exchange rate depreciation during that time. Yet, one may observe that the economic fundamentals were generally favorable for the lari exchange rate just before June 20191. Nevertheless, the very fact that depreciation translated into domestic price inflation around this time raised questions on NBG’s policy among businesses, especially those who rely on FDI inflows, as well as among ordinary households who depend on price stability.
De-dollarization policy and the evolution of interest rates
According to the literature, the de-dollarization measures mentioned above tend to increase the spread between domestic and foreign currency deposit rates by increasing domestic and reducing foreign currency deposit rates. This, in turn, incentivizes the switch from foreign to national currency deposits. At the same time, the spread on lending interest rates in national and foreign currency should be getting smaller as a result of de-dollarization measures, making national currency loans more affordable and foreign currency loans more expensive.
In the case of Georgia, the spread between deposit rates in national and foreign currencies notably increased and then remained relatively stable until the end of 2019. Annual weighted average interest rates in national currency deposits increased dramatically by the end of 2015 before starting to decline in line with foreign currency interest rates.
However, contrary to what was expected, the spread between national and foreign currency loan rates did not decline. The spread increased in the beginning of 2016 and then remained unchanged. At the end of 2019, national currency loan rates started to climb again, while the foreign currency lending rate continued its declining trend (hence, the spread increased again). At this point one cannot say with certainty whether these trends were driven by de-dollarization measures per se or by other external factors, but these trends have challenged the market-driven de-dollarization forces in the ways discussed below.
Risks of emergence of shadow banking. The strict administrative measures, such as the lending cap applied to all retail loans, and strict macro-prudential measures could cause the risk of financial disintermediation and the emergence of shadow banking. The risk is high in an environment where capital markets are not sufficiently developed and where interest rate gaps make dollarized loans not less but more attractive to retail borrowers. In Georgia’s case, the potential shadow banking transactions in the retail sector are related to the practice of providing internal installment loans by real estate development companies, as well as electronics and furniture shops. These lending practices are neither efficient (these companies have limited resources) nor based on lending experience (in contrast with financial institutions which specialize in lending). In addition, they are beyond the regulatory framework and, as such, can potentially create instabilities in the financial system.
The effect of limiting foreign currency lending on individuals with income in foreign currency. ‘Blanket’ lending cap measures caused the inability of hedged borrowers to take advantage of lower interest rates in foreign currency, thus creating a market inefficiency. One argument in favor of a blanket lending cap was that the number of such hedged borrowers is relatively small in Georgia, so efficiency costs are not very high. This, however, depends on who we consider a hedged borrower. For example, families that typically receive remittances from the United States or EU countries may be considered hedged (while those who receive remittances from Russia or other countries are not). For instance, in February 2020 around 52% of all remittances came from either the EU or the US. The currency mismatch vulnerability works in the opposite direction for recipients of euro and dollar remittances (e.g. they are vulnerable to lari appreciation episodes).
The effect of the de-dollarization measures on financial stability. In general, de-dollarization programs have a positive impact on the stability of the financial system. The low level of loan dollarization reduces currency mismatch, making individuals less vulnerable to exchange rate shocks (making them more hedged—having income and liabilities in the same currency). On a highly positive note, in Georgia, non-performing loans by commercial banks show a declining trend since the beginning of 2016. However, household debt burden (measured by household debt to household disposable income) and debt service payments to income (measured by household debt and principal payments to income) had an increasing trend in the last couple of years. (see Figure 3). The increase in household indebtedness makes people vulnerable to domestic interest rate fluctuations, rather than exchange rate fluctuations.
Conclusions
Taking stock of the larization policy measures, analyzing the progress and the evidence of its effectiveness, with caveats of risks, it is possible to arrive at the following set of conclusions:
The larization policy of NBG showed solid progress, as it was accompanied by stabilized macroeconomic environment, stable inflation rate within the target, and the policy measures which included considerably improved and effective communication policy and practices of NBG.
Larization measures (such as the initially introduced lending cap of 100,000 GEL and stricter macroprudential requirements) managed to remove some of the market distortions which were related to the currency risk exposure of households with relatively small loans.
On the other hand, the policies such as further increasing asymmetry in minimum reserve requirements between domestic and foreign currencies and the increase of lending cap to 200,000 GEL, were marginally less productive and may have created certain market inefficiencies, including:
Making it more difficult for banks to manage liquidity as their deposits were denominated mostly in foreign currency.
Authors: Davit Keshelava, Yaroslava Babych, Giorgi Mzhavanadze, ISET
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