The Aftermath of High Inflation and Currency Collapses
Countries that experienced a prolonged period of inflation often experience dollarization (heavy use of foreign currency as transaction medium, unit of account, and store of value). Practically, the use of foreign hard currency in trade, or the indexation of bank accounts and bonds is possible.
In many cases, a sustained shift toward dollarization is one of the many long-term costs of episodes of high inflation, one that often persists even if the government strives to prevent it. A government that has grossly abused its monopoly over the currency and payments system will often find this monopoly more difficult to enforce in the aftermath.
The point of a disinflation policy after elevated inflationary period is to reduce dollarization and regain control of monetary policy. But de-dollarization can be extremely difficult. Typically, successful disinflations generally have not been accompanied by large declines in the degree of dollarization.
Parallel market exchange rates and pervasive exchange controls usually occur in countries with histories of high inflation. Few countries with hard pegs have bouts of high inflation. The evidence suggests a link between current levels of dollarization and countries’ past reliance on exchange controls.
Undoing Domestic Dollarization
Inflation reduction is usually not enough to undo domestic dollarization, at least within a 5 year time frame. But some countries have managed to reduce their degree of domestic dollarization.
The few governments that managed to do so followed one of two strategies – either they amortized outstanding debt stock on the original terms and discontinued issuance of those securities, or they changed the currency denomination of the debt – usually using market based approaches. An example is Mexico’s decision to redeem in U.S dollars the dollar linked tesobonos outstanding at the time of its December 1994 crisis (using the loans it was given by the MF and the U.S) and to stop issuing domestic foreign currency bonds thereafter. A recent example of the latter is Argentina’s decision in 2001 to convert to domestic currency the government bonds that it has originally issued in U.S dollars (Under Argentine Law).
Decreases in domestic dollarization caused by declines in the share of foreign currency deposits to broad money are more common. The cases in which the reversal in deposit dollarization was large and lasting, three conditions ought to have been satisfied according to the authors, with regard to the ratio of foreign currency deposits to broad money: 1) experienced a decline of at least 20 percent, (2) settled at a level below 20 percent immediately following the decline, and (3) remained below 20 percent until the end of the sample period.
Only four of the eighty-five countries met the three criteria during the period 1980–2001: Israel, Poland, Mexico, and Pakistan. In sixteen other countries, the ratio of foreign currency deposits to broad money declined by more than 20 percent during some portion of 1980–2001. However, in some of these countries—for instance, in Bulgaria and Lebanon—the deposit dollarization ratio settled at a level considerably higher than 20 percent following the decline.
In most of the other cases (twelve out of sixteen) – the dollarization ratio first fell below the 20 percent mark, but rebounded to levels higher than 20 percent. Some kinds of dollarization are even harder to get rid of.
In the 4 countries that met the three conditions for lasting decline of deposit dollarization ratio, the reversal began when authorities imposed restrictions on the convertibility of dollar deposits. In Israel, in late 1985 the government introduced a one-year mandatory holding period for all deposits in foreign currency, making those deposits much less attractive than other indexed financial instruments.
Whereas in Mexico (1982) and Pakistan (1998), the authorities forcibly converted the dollar deposits into deposits in domestic currency – using an exchange rate that was well below the prevailing market rate. But not all the countries that introduced severe restrictions on the availability of dollar deposits managed to lower the deposit dollarization ratio sustainably. Bolivia and Peru are examples. After periods of severe macroeconomic stability, they allowed foreign deposits once again, and they have since remained highly dollarized.
Currency crashes are more serious when governments explicitly or implicitly try to fix the exchange rate. In a sense, the collapse of a currency is a collapse of a government guarantee on which the private sector might have relied, and therefore it constitutes a default on an important promise.
Large swings in exchange rates can be traumatic for a country with a floating exchange rate, especially if there are high levels of foreign exchange debts and if imported intermediate goods play a large role in production. But the trauma is less, because there is no loss of credibility for the government or central bank.