Financial Dollarization, Inflation Targeting and Labor Market Responses:

The Case of Eurasian Economic Union

Zhandos Ybrayev*1

University of Massachusetts Amherst

Introduction

There is a growing trend today for central banks across the emerging market

economies to start adopting Inflation Targeting monetary policy. However, despite the

general improvement in controlling price levels over the last two decades, substantial

amount of the population in developing world are still save and borrow in foreign

denominated currency. According to Ize & Yeyati (2003), various Latin American case

studies demonstrate that after experiencing episodes of high and rapid upward

inflationary pressures, a long period of stable macroeconomic environment afterwards

did not contribute to a decrease in share of deposits and financial assets denominated in

foreign currency within the emerging market economies.

Previous literature largely addresses the issue of currency substitution, which

means that foreign currency used as means of payment and unit of account. Therefore,

earlier investigations dealt with network externalities and the costs of switching the

currency of denomination. However, from the prior debates, there were no established

theoretical justifications to expect changes in previous factors affecting the denomination

of financial assets and inflation level dynamics. At the same time, there are reasons to

believe that high degree of financial dollarization might impose difficulties in both the

transmission capacity of monetary policy and the overall functioning of the financial

1 * I am a second year PhD student at University of Massachusetts Amherst. My areas of specialization are monetary economies, international economics, and macroeconomic theory. I am also interested specifically in post-Soviet economies.

sector. Correspondingly, the case of a typical emerging market economy, where external

debts are denominated in foreign currency and domestic firms heavily rely on receipts in

local (national) currency leads to a higher vulnerability in the domestic banking sector

due to currency mismatch issues and large fluctuations in the exchange rates, which is

also one of the features of Inflation Targeting.

The aim of this paper is to investigate the potential challenges of high level of

financial dollarization can have and conducting of Inflation Targeting monetary policy.

Thus, the paper is organized as follows. Next section explains the definitional differences

between various types of dollarization and Section 3 presents the key sources of financial

dollarization phenomenon. Section 4 discuses the main obstacles and modifications in

transmission channels under high dollarization to conducting specifically Inflation

Targeting strategy. Section 5 presents the first stage of empirical attempts to test those

previous hypotheses on the example of Eurasian Economic Union’s member states that

have already adopted Inflation Targeting: Russia, Kazakhstan, and Armenia. Section 6

will be discussing some sectorial job market responses to the exchange rate shocks. Last

section concludes with the distinctive approaches to de-dollarization procedure drawn

from the best practices across the world.

What is Financial Dollarization?

The first general use of term dollarization refers to the currency substitution cases

in Latin America in the 1970s. This was the time of first attempts to analyze the

consequences of abandonment of local currency and adopting the US dollar instead on

effectiveness of domestic monetary policy: cases of Peru, Mexico, Argentina, Chile,

Ecuador and lately Brazil. Since then, dollarization today indicates a broad number of

economic phenomena related to the use of foreign currency within the country.

Therefore, official or full dollarization discusses the original case in which the foreign

currency is given (exclusively) legal tender status. At the same time, unofficial and,

which also known as partial dollarization, is broadly used to indicate the use of a foreign

currency alongside the national currency when the former is not legal tender (Ize &

Yeyati, 2003).

In addition, within the partial dollarization, there is a distinction based on

different functions of money. Thus, currency substitution effect refers to the use of the

foreign currency as medium of exchange, whereas asset substitution effect refers to the

use of the foreign currency as store of value. According to Calvo (2002), definitional

distinctions also reveal behavior differences. Thus, the concept implies that the nominal

interest rate differential of financial assets eventually should bring about no difference in

real returns, and consequently, will lead to the exclusion of any inflation related risks.

Therefore, a measure of dollar share of bank deposits, for instance, reflects the

composition of financial assets, which is primarily an asset substitution case.

While asset substitution stresses main attention on asset side of banks balance

sheets, mainly catching savings of people, the other side of this concept concentrates on

liability dollarization, analyzing the foreign currency denominated debt as a source of

greater financial instability and issues with currency mismatches. As a result, overall term

“financial dollarization” refers specifically to the holdings by the country’s residents of

financial assets and liabilities denominated in the foreign currency. The concept also

involves the fact that observed dollarization reflects both the demand and the supply of

dollar assets, which further conveys an analysis of both sides of banks’ balance sheets. In

addition, there is a growing use of term real dollarization, which describes different

policies of indexing and formally quoting of local prices and wages in the foreign

currency, mainly US dollar. However, real dollarization is not the common practice in

our case study set of countries. Thus, the scope of this paper is to explore all the aspects

specifically related with domestic financial dollarization, its main sources and influence

on conducting Inflation Targeting monetary policy. Also, using available records on

Kazakhstan, Russia, and Armenia, the paper will empirically test whether the

consequences of financial dollarization are verified in the data.

What are the sources of Financial Dollarization?

Previous studies have been proposing a large number of different hypotheses to

analyze the high and also persistent behavior of financial dollarization in developing

markets. One of the early literatures on dollarization tackles the currency substitution

effect, which explores the main propositions of holding of foreign money balances to

hedge against expected risks and returns among different currencies. The general

hypothesis of this model is about monetary policy inefficacy due to perfect

substitutability between local ad foreign currencies, which also means that the elasticity

of this substitution is expected to rise in times of high exchange rate fluctuations. This

directly opposes the notion of adopting floating exchange rate regime and having greater

monetary policy autonomy. Since the countries in Eurasian Economic Union already

have switched to a flexible exchange rate regime, potential problems arise from short-run

money demand instability that currency substitution effect can mainly cause.

Hereby, the model suggests that the ratio between national and foreign currency

holdings to be a function of the interest rate differential between domestic and foreign

interest rates. Thus, taking into account perfect capital mobility and interest tare parity to

hold, domestic interest rate depends on the expected rate of depreciation, and thus, in

effect on expected inflation. Therefore, domestic residents have strong preference to

diversify the portfolio composition of their currency funds. However, the persistence of

high level of dollarization in 1990s in Latin America, while the inflation rates were

significantly reduced, contrasts to this view. According to Savastano (1996), existence of

high dollarization and currency substitution effect remains for a long term due to

primarily past inflation memory, which provokes high inflation expectations even after

continuous favorable macroeconomic environment. Therefore, the remedy proposed is to

ensure a long period of appreciation combined with low inflation to revert the system

back, which also reiterates the point that dollarization is mostly a response to past

inflation.

One of the recent additions to the study of currency substitution concept brought

by Freeman & Kydland (2000). Their improvement suggests examining the substitution

not between two types of currencies, but rather between foreign currency and less liquid

component of domestic currency, for instance, time deposits. Following this proposition,

foreign currency performs the role of a financial asset that is prone to future inflationary

pressures, but also less liquid than the domestic currency. This analysis, verified by a

large set of empirical tests, mainly contributes for more realistic modeling of currency

substitution hypothesis, which also helps to formulate stronger results on implications of

welfare economics. The working of the model resonates with the previous researches that

view the use of the foreign currency both as medium of exchange and as store of value.

Therefore, when inflation rate is low, the use of foreign currency is minimal.

Furthermore, some moderate level of inflation leads to incorporation of store of value

function of the foreign exchange, but still limited for the purchase of big-ticket items. At

the time of rapid and high inflation, residents start to use the foreign currency in

transactions for a greater set of goods and services. Overall, the study advocates that high

dollarization enhances the welfare at extremely high level of inflation, but reduces it

when inflation stabilizes at rates lower than some certain kind of minimal threshold.

Another approach to identify the drivers of dollarization is proposed by Ize &

Yeyati (2003) is minimum variance portfolio (MVP) allocation method. The currency

composition comes from both sides of a bank’s balance sheets, and thus, deposit and loan

dollarization highly correlate with key interest rate in the economy. Consequently,

according to MVP rule, the degree of dollarization can be explained by inflation and real

exchange rate depreciation, rather than expected inflation and nominal depreciation as in

the case of currency substitution models. Hence, at any given variance of inflation, an

increase of the rate of depreciation reduces the degree of dollarization through limiting

the hedging benefits of the foreign currency denominated assets. In other words, whereas

the real return of national currency depends on changes in inflation, the real return on

foreign currency depends on changes in real exchange rate, and thus directly proportional

to the coefficient of exchange rate pass-through. As a result, stabilization oriented

monetary policy without the real exchange rate target may contribute for the de-

dollarization processes.

This approach serves as an alternative way to explain the dollarization hysteresis

without indicating of past inflation memory. Accordingly, high level of dollarization may

still occur when the memory of previous macroeconomic discrepancies is not the issue

and volatility of inflation stays high relative to the real exchange rate. Authors measured

the dollar share of the MVP allocation and empirically proved their findings on the

sample of five highly dollarized states in Latin America. Their main conclusion is that

inflation targeting policy combined with free floating exchange rate regime should lead to

a decrease in dollarization level due to an increase in real exchange rate instability in

relation to price volatility. Nevertheless, this observation is subject to moderate degree of

real dollarization, when prices and wages are denominated in foreign currency. In

addition, earlier evidences show that highly financially dollarized economies do not

necessarily demonstrate high level of real dollarization. Thus, fully-fledged inflation

targeting might be successful strategy in such type of countries.

Another important source of dollarization argued by various authors is a set of

institutional factors. There are different ways how the quality of institutions may provoke

the beginning of dollarization processes within the country. For instance, according to De

Nicolo et al. (2003), weak institutions may detract from the credibility of a commitment

not to bail out foreign currency denominated debtors aftermath of sudden devaluation,

which can lead to the mispricing linked to implicit government guarantees. Moreover,

weak institutions may undermine the credibility of domestic monetary policies, as

residents fear that their governments will erode the value of financial assets by generating

unexpected future inflation. Levy Yeyati (2006) include an index for restrictions against

the holding of foreign currency denominated deposits by residents (restrictions against

dollarization) as well as other proxy variables to indicate the quality of institutions. In

general, his results demonstrate negative relationship between the level of dollarization

and restrictions on dollarization. Yet another empirical work by Honig (2009) reports that

the exchange rate does not significantly affect the level of domestic financial

dollarization. Instead dollarization results from the belief that the government will not

adopt policies promoting the currency’s long-term stability, even if the current monetary

policy has successfully controlled inflation and limited fluctuations of the exchange rate.

Thus, the fear that the policy may change in the future leads to dollarization even in low-

inflation setting. As a result, improvement in qualities of institutions is a major

requirement for emerging market economies to reduce their vulnerability to extensive

depreciations.

What are the challenges for conducting monetary policy under high degree of Financial Dollarization?

Standard small open-economy inflation targeting models represent a central role

for the exchange rate in the transmission mechanisms from monetary policy to inflation

(Leiderman et al. 2006). Hence, a rise in domestic key interest rate, with a long-term

purpose of combatting inflation, typically causes of a short-term nominal and real

exchange rate appreciation, which finally helps to reduce initial inflationary pressures

through both direct and indirect transmission channels. The direct effect comes through

the change in tradable goods due to change in exchange rate, and indirect effect works

through the contractionary impact on aggregate demand, output and prices. When

analyzing high financially dollarized economies, it is important to stress the fact that a

substantial share of deposits and loans in the banking sector are denominated in the

foreign currency. (Licandro G. & Licandro J.A., 2003) Therefore, immediately the

exchange rate gains even greater important anchoring role compared to less dollarized

countries, thereby inducing a higher pass through of exchange rate on prices. In addition,

large fluctuations in the foreign exchange may also raise credibility issues. Potentially

adverse effect of exchange rate oscillations is likely to induce fear of floating by the

monetary authorities and require that they closely target the exchange rate stability.

Implementation of foreign exchange interventions might help to maintain such policy,

and also can be successful for inflation targeting economies since large oscillations of the

exchange rate prevents utilization of a store of value function of the dollar.

One of the main characteristics of Inflation Targeting monetary policy is an actual

free floating of the exchange rate, which principally sets the domestic inflation level a

role of a “nominal anchor” for the real economy. If economic agents will not have

sufficient information about the average price level and its most likely future dynamic

patterns, there is a greater risk that they would misallocate resources due to incorrect

observation of changes in relative prices. Thus, having well recognized and easily

understandable anchor provides better communication with the public. In a system of fiat

money, it is essential to put an additional constraint on monetary policy to limit the price

level to a particular level at a specific period of time. For instance, there are traditional

practices of designing some other forms of nominal anchors such as quantity and price

constraints. Quantity limit option is considered as a control of the money supply that can

be added into circulation, while, the price limit form is essentially fixing the value of

paper money expressed in terms of foreign goods, i.e., the level of exchange rate. Thus,

without any potential money constrains, public would be vulnerable to fluctuations in

inflation expectations driven by various set of factors (Laurens et al. 2015). As a result,

an institutional commitment to long-run price stability is also an effective way to launch a

nominal anchor, and thus, Inflation Targeting stands as one of the potential choices. In

addition, according to Mishkin, emerging market economies are often subject to

disruptive effects of exchange rate fluctuations (2011). Too frequent and substantial

interventions in the foreign exchange market might pose greater risks of switching the

exchange rate into a nominal anchor. Therefore, it is very important to run a transparent

monetary policy that would allow smoothing of short-run exchange rate volatility, but

also making possible for the exchange rate to reach its market determined equilibrium

level. Thus, a high level of financial dollarization will affect the monetary policy through

the exchange rate and would imply three aspects: pass-through, currency substitution, and

balance sheet effects of banks.

There is a general principle that the highly dollarized economies should bear

higher levels of pass-through. It is important to note that the real dollarization (indexation

of prices and wages within a country in the foreign currency) becomes a real issue. In

addition to high share of imports, domestic residents often compare and adjust the overall

price levels to the nominal exchange rate. For example, in Kazakhstan, state law prohibits

actual quoting of prices on real estate and big-ticket items in dollars, which might be a

useful precedent in other EEU countries. Thus, actual central bank’s intervention into FX

market to smooth some sharp fluctuations in order to manage inflationary expectations

would disrupt potential empirical evidences of testing our hypothesis of high exchange

rate pass-through. Moreover, there are a lot of evidences of asymmetric pass-through

response due to sticky prices, such that producers always willing to increase price due to

depreciation, but not to decrease them in case of the exchange rate appreciation.

Therefore, it is unclear to argue that the pass-through would automatically higher in

highly dollarized economies, or that monetary regime focusing on the exchange rate

stability will bring about overall low inflation level. Thus, the next section considers the

empirical investigation of the above hypotheses based on date of EEU countries.

The actual circulation of a foreign currency alongside the local currency in a

given economy certainly affects the conduct of domestic monetary policy, and its

ultimate goal, level of inflation. Therefore, the earlier literature on this subject reiterated

the fact that dollarization, by reducing the costs of switching to the foreign currency to

mitigate the negative effects of rapid inflationary pressures, may increase the volatility of

domestic money demand, impacting on the capacity of the central bank to conduct

monetary policy. While the very roots of this argument come from the currency

substitution case of dollarization, it is still useful to link that type of reasoning regarding

the dollarization of domestic savings accounts phenomenon (Cowan K. & Do Q., 2003).

In particular, since the flight to easily available foreign-currency denominated assets

becomes less costly, the demand for reserve money in a moderate to highly dollarized

economies should be more perceptive to a monetary expansion or to fluctuations in the

exchange rate.

An additional fundamental concern related with financial dollarization is a

deleterious influence on the vulnerability to default in the financial sector, in other words,

financial fragility. For instance, De Nicolo et al. (2003) recently empirically

demonstrated that dollarized banking sector is characterized by higher insolvency risk

and higher deposit volatility. Currency mismatches can affect bank’s balance sheets

directly, or indirectly by undermining the quality of bank’s dollar loan portfolio. Banks

with massive domestic dollar liabilities must balance their foreign exchange positions by

either extending dollar lending to local currency earners or holding dollar assets abroad.

To maintain their profitability and satisfy demand for loans, banks end up on-lending

domestically a large share of their dollar deposits, effectively transferring their exchange

rate risks to their unhedged clients and also retaining the resulting credit risk. Thus,

currency mismatches in the event of large depreciation can have devastating effect, and in

general, acquire broad macro-systemic ripple effects, particularly regarding output losses.

As a result, high degree of financial dollarization certainly affects conducting of sound

inflation targeting monetary policy, which implies one nominal anchor, which is a price

stability.

Eurasian Economic Union

After dissolution of the Soviet Union, newly created independent states have

started integration processes to strengthen their former economic ties. Among different

attempts to build effective international body, the one between Kazakhstan, Russia, and

Belorussia experienced a long way to become the most advanced and economically

diverse organization today. In 2012 the three countries transformed the customs union

into a Single Economic Space. Later they signed an agreement about creation of Eurasian

Economic Union, and on January 1st 2015 the EEU came into force. Armenia and

Kyrgyz Republic joined the Union later that year. Eurasian Economic Union is an

international organization for regional economic integration with international legal

personality, established by the treaty on the EEU. It provides free movement of goods

and services, capital and labor, pursues coordinated, harmonized and single policy in the

sectors determined by the Treaty and international agreements within the Union. The

Eurasian Economic Union has an integrated single market of 183 million people and a

combined gross domestic product of over 4 trillion US dollars. (Blockmans, Vorobiev, &

Kostanyan, 2012) The Union operates through supranational and intergovernmental

institutions. In addition, provisions for an optimal currency space and greater

macroeconomic policy cooperation are envisioned in future. As a result, current official

implementation of Inflation Targeting by most of its member states is considered as

harmonization phase of their monetary policies. Therefore, this paper focuses on

Armenia, Russia, and Kazakhstan as they already run Inflation Targeting monetary

policy, but also are characterized by obtaining a high degree of financial dollarization.

Hence, an empirical testing is based on macroeconomic variables derived from above

mentioned countries, and is considered to be main contribution to the study of highly

dollarized economies and their monetary policy efficacy. Table 1 demonstrates the annual

inflation growth rates for our target states. The series run from the January of 2007 up

until the end of 2016. All the data is derived from central banks of those countries and all

the additional information is provided in Data Appendix. From the graph, we can identify

two major inflationary episodes. One of them occurred aftermath the global financial

crisis of 2008, and the second one after free floating of their exchange rates and a

simultaneous sharp decline in world oil prices in 2015, affecting both of oil exporting

countries of region. This graph generally shows a high vulnerability of these states for the

externally generated shocks. It is worth mentioning that Armenia is recently experiencing

an actual disinflation period.

Table 1. Annual inflation rates in Kazakhstan, Russia, and Armenia.

Source: CBA, CBR, NBK.

Following, Table 2 and Table 3 indicates corresponding foreign currency

denominated deposits ratio in Armenia, Russia and Kazakhstan. Table 2 shows overall

dynamics of the dollarized deposits to total deposits and the time series of those

fluctuations in their respective domestic currencies. As I mentioned above, our best

technique to estimate the level of financial dollarization at least to this part of the world is

to measure the foreign currency deposits over all deposits within the country. Thus, in

Table 3 we, you can observe that the highest level of financial dollarization belongs to

Armenia, which is consistently around seventy percent. At the same time, the lowest level

is in Russia that is also steadily around twenty five percent. Also, Kazakhstan is

experiencing a surge in foreign currency deposits ratio for the past several years, settling

the ratio of dollarization from fifty to sixty percent recently.

Table 2. Dynamics of Total Deposits versus FX Deposits.

Source: CBA, CBR, NBK.

Table 3. Foreign currency denominated deposits ratio in Kazakhstan, Russia, and Armenia.

Source: CBA, CBR, NBK.

Empirical tests.

First, I will try to test the hypotheses suggested in third section and identify what

are the causes of higher financial dollarization based on data from three Eurasian

Economic Union. I model the dependent variable, which is a foreign currency deposit

ratio (Δdep) as a function of the set of independent variables, which are the CPI annual

inflation rates (Δ π), logged difference of money supply (ΔM2), first difference of

monthly-adjusted key interest rate (Δi), annual growth rate of industrial production index

(Δgdp) that will serve us as proxy of real gdp, first difference of nominal exchange rate

(Δer), and the dollar share of the minimum variance portfolio (mvp) to test the portfolio

model, and additionally will include various spurious and interaction terms:

Δdep = α0 + β1Δ π + β2ΔM2 + β3Δi +β4Δgdp + β5Δer + β6ΔMVP + ε, (1)

mvp = (var(π)+cov(π, er))/(var(π) +var(er) +2cov(π,er)), (2)

MVP = var (π)/cov(π, er) (3)

Assuming that the investment menu of risk-averse resident investors consists from

two options: dollar and national interest bearing bank deposits, with real returns equal to

Rn = E(Rn) – η(π) – η(er), and Rd = E(Rd) – η(er), respectively where η(π) and η(er)

are zero-mean disturbances to the local inflation and real devaluation rates, and E(Rn)

and E(Rd) indicate the expected return on the assets. Assume further that investors will

maximize their following utility functions:

Max (n,d) U =E(R) - Var (R)/2, where “n” and “d” are the national currency and dollar

shares, and R=sum of shares * R is the return on the portfolio. Therefore, we can derive

that if uncovered interest parity condition holds, the dollar share of optimal investment

portfolio will be the previous MVP expression. Furthermore, replacing η(er) = η(nominal

er) - η(π), we can further simply our relationship and get: MVP = var (π)/cov(π, er).

Table 4. “Dollarization and Inflation”

Dollar Deposit Kazakhstan Armenia Russia

Inflation .005136(.0017211)*

-.004019(.0026953)

-.0011347(.0010572)

M2 growth rate .0919658(.2296075)

.0756153(.1989101)

.1086366(.11539)

Real GDP -.0146532(0020424)

-.0042247(.0012162)*

-.0077708(.0006821)*

Exchange Rate .0035805(.0011655)*

.0018907(.0011062)

.0005679(.0016261)

Interest rate .0058564(.0115354)

-.000108(.0290901)

-.0047949(.0046577)

Constant .3982009(.0178322)

.6923978(.0158684)

.2310614(.0108452)

R-squared 0.4514 0.1809 0.5740

Table 4.1 “Dollarization and Inflation”: some extensions

Dollar Deposit Kazakhstan Armenia Russia

Inflation -.0031588(.0046503)

.0069463(.0058036)

-.0004459(.0037165)

Inflation (t-1) .0030997(.0044241)

.0008756(.0061444)

-.0015414(.0035709)

M2 growth rate

-.1553421(.0276638*)

-.0661317(.0489587)

-.075701(.0127762)*

Real GDP -.0054135(.0014182)

-.004337(.0009343)*

-.0067017(.0005722)

Exchange Rate .004584(.0006962)

.002161(.0007882)

.0022912(.0011689)

Exchange Rate (t-1)

-.0023601(.0006627)

-.0007785(.0007739)

.0012348(.0011711)

Interest rate -.0158296(.0042575)

.0052459(.0067727)

-.0076428(.0029335)

Constant 2.614391(.4270072)

.9171516(.6042469)

.9344041(.1325842)

R-squared 0.7996 0.5477 0.7821

According to Table 4, in cases of Armenia and Russia, we find that there is a negative

interrelationship between dollarization level and corresponding inflation rates. Also, the

coefficients are small, showing unexpected negative signs, and also are statistically

insignificant. In the meantime, this evidence of Kazakhstani data only, supports the view

that the higher inflation leads to a greater increase in financial dollarization. Also, we

largely have the correct positive signs for interest rates, exchange rate, money supply

growth, and negative for real production. However, a positive association between

financial dollarization and inflation (the correlation between foreign currency deposits

and inflation rates) cannot be taken as a symbol of monetary policy independence under

high degree of financial dollarization. It is important to notice that this model is intended

to examine short-run elasticity of the inflation rate, and further specification are needed to

reach the reliable interpretations and conclusions. For instance, addition of the first lags

of inflation and the exchanger rate slightly improves sign restrictions. Thus, in case of

Armenia and Russia, one period past inflation corresponds to a positive and near positive

relationship of the deposits dollarization. In addition, the first lag of the exchange rate

also lead to a better sign response, but which are also statistically insignificant. These

results also predict that higher inflation and higher inflation volatility lead to reallocation

in portfolio’s agents. Correspondingly, we can conclude that in a high and moderate-

inflation background financial dollarization result from a lack of trust to the national

currency, which come from the belief that monetary authorities will not necessarily

follow policies that will ensure long-run currency stability. As a result, improving central

bank’s accountability and transparency along with it consistency in providing main

policy goals proven to bring down the dollarization level, since the public will no longer

need to protect its wealth through the tools of financial dollarization. Until then, should

we refer to this phenomenon as a “necessary evil”?

De-dollarization agenda for Eurasian Economic Union.

Since, this paper argues that the high level of dollarization is a serious obstacle to

conduct efficient monetary policy, in this section we will provide measures to overcome

this issue. In order to answer that question, the best procedure would be to turn to

successful examples around the world and draw a set of tools that during the time proved

their effectiveness. Still, some general policy implications include the following

propositions. For instance, prudential requirements have to be stricter when financial

system lends to an agent who receives its income in domestic currency. Liquidity

requirements also have to higher in foreign currency transactions, reflecting the inability

of central banks to perform their lender of last resort role in foreign currency. Generally,

the road to reducing dollarization should be based on discouraging the use of dollar and

enhances the attractiveness of the domestic currency as medium of exchange. Therefore,

measures are needed to ensure that hidden externalities are properly internalized through

enhanced prudential settings. One of the major preconditions is a credible commitment to

price stability and sound monetary policy to finally gain a stable market share for

domestic currency.

Reinhart et al. (2003) state that only a small number of countries managed to

successfully dedollarize their locally issued foreign currency obligations, either by

amortizing the debt stock at the initial terms or by changing the currency denomination of

the debt. In addition, authors searched for scenarios where the ratio of foreign deposits to

broad money declined by 20 percent, then moved to the level below 20 percent

immediately after the decline, and remained below 20 percent until the end of the sample

period. As a result, they have identified only four countries out of eighty-five that met

those requirements during the period between 1980-2001. It is worth mentioning that

when transition economies experienced a sharp decline of foreign deposits ratio below

than 20 percent, including Russia, they usually followed up by the rebound of the same

size and increased even larger. However, in three of the four cases mentioned above, as

soon as the monetary authorities imposed restrictions on the convertibility of dollar

deposits, the reversal of a decline in dollarization have taken place. The authors conclude

that only Israel and Poland appear to be countries with an experience of large and lasting

dedollarization process, which also was supplemented by a successful disinflation

program based around a strong exchange rate anchor and introduction of various financial

assets with alternative forms of returns.

At the same time Galindo & Leiderman (2005) analyze dedollarization attempts

conducting a survey among central banks in Latin America. They report that one of the

most useful strategies was developing CPI-indexed domestic financial instruments during

the time of high and volatile inflation. In addition, an author suggests that the latest trend

is to develop independent and fully competitive market for domestic financial assets,

where Chile and Peru are the best examples. Furthermore, Moron & Castro (2003) in case

of Peru, argues that the detrimental effect of financial dollarization are experienced

through balance sheet effects that intensify the effect of external shocks on real

macroeconomic variables. Authors find that regulatory tools that are based on

encouraging residents toward the use of local currency denominated assets may also lead

to capital flight. Thus, inflation targeting regime is considered as a useful strategy to

combat dollarization. The experience of Uruguay in dedollarization can be summarized in

two main channels: development of market in national currency to generate a credible

alternative to foreign currency and strengthening of the safety net through the regulatory

identification of non-marketable risks. Finally, the unique example of Chile refers to the

policy measures, such as strict capital controls, prudent fiscal policy, improved

institutional design, and a combination of private and fully funded pension system.

The Role of the Dollar.

According to Krugman (1984), in addition to the three basic functions of money,

international money has additional three functions, which nevertheless are based on very

similar roles: settling of international payments, fixing up prices, and holding of a liquid

asset for international transactions. Differentiating between private agents and central

bank allows us to systemize those dimensions. Thus, a medium of exchange function in

private transactions can be mirrored in the same selling and buying actions of central

banks, a unit of account function makes it an “invoice” currency and the par values of the

exchange rate stating in dollars, and finally a store of value function leads to the private

economic agents’ holdings of liquid dollar-denominated assets and central banks’ dollar

reserves. Practically and historically all of those functions are separable from each other,

but also they are not independent in a sense that the more the dollar is used in one role,

the more incentive to use it in the others.

Also, the role of the dollar as a “vehicle” (a universal medium of exchange)

currency largely reflects the economies of scale in foreign exchange markets. At the same

time, it comes form the fact that international acceptance makes it easier to use US dollar

than any other pair of foreign currencies of trading countries. Thus, when considering n-

country models, a process of “snowballing” might lead to a situation when a currency of

a country, which is not dominant in international payments to emerge as vehicle and

possibility of evolving of multipolar world with several vehicle currencies. Snowballing

example works when there are several large economies with one of them slightly larger

than others and a number of small ones. The concept predicts that the transactions

between large economies will be through direct exchange, whereas trading among small

countries will be predominantly through the medium of exchange of the largest country’s

currency. That will expand those markets and will motivate other large countries to use

the same medium of exchange in trading with small economies. Consequently all of this

can swell all the markets in the largest country’s currency, which ideally might eliminate

any bilateral markets. Thus, on the other hand, that could lead to a multiple centers of

gravitation world, when large countries divide up the blocks of small countries’ markets.

That actually happened in the interwar period when dollar and sterling coexisted in one

system for a substantial period of time.

As a result, if a currency successfully establishes itself as a medium of exchange,

then it will encourages other functions of international money to follow, which also

means that the first one is a sort of fundamental and superior relative to a unit of account

and a store of value functions. Therefore, one of the key reasons for central banks to hold

dollar reserves because it is an intervention currency. In other words, central banks must

accumulate first reserves in dollars in order to be able to convert in other foreign

currencies and diversify, and convert back to dollars to make any foreign exchange

interventions. However, unlike in the era of the UK pound sterling, today we have a

global system of the floating exchange rate regimes. Diversification against exchange rate

risks however is the cost central banks pay against the advantage of full reserves

dollarization, and also poses real threats to the future dominance of dollar. The possibility

of a dollar’s international role decline might come form the temporary disruption of

financial markets that will permanently damage the dollar’s effectiveness. Historically,

the World War I was a major disruption, which led to the constant sterling’s decline.

Thus, any imaginary world conflict with the imposition of exchange controls in different

regions might as well break the system of dollar’s dominance. As Krugman (1984)

concludes, that a more likely scenario in the future is to have a multipolar system with

several world currencies, but at the expense of a loss of economies of scale and higher

transaction costs.

In other paper, Eichengreen and Flandreau (2010) consider the role of central

banking and monetary policy in overall design of international financial structures and

building financial markets. Authors argue that the recent developments of Asian and

Latin American countries to create various debt instruments denominated in their

respected domestic currencies to effectively avoid the problems of currency mismatches

are very limited, but the same strategies adopted by the US back then fostered today’s

global currency composition. Also, they argue that there is a room for more than one

international currency in the global system of tomorrow. Based on historical perspective

of interwar period and claiming that network effects are actually weaker than any other

functions, Eichengreen and Flandreau predict that the invoicing and settlement currency

in Asia will be largely dominated by renminbi, where China’s finance trade is growing

very rapidly, and pinpoint the overall regional dimension of international financial

infrastructure.

Drawing from the extensive historical data, authors found evidences that the

rivalry between dollar and sterling has started much earlier than interwar period and that

the US Fed actions meticulously led to the rise of New York as a new financial capital of

the world. The arguments they suggest tell us that the growth of US trade and their

foreign branches allowed American banks, which were freed from regulations, to enter

the global credit market expansively. Another Fed’s contribution focused on creation of a

liquid secondary market of private and institutional investors, where various securities

originated by US banks could be resold. But before the creation of this market, the Fed

itself emerged as a secondary market-maker of last resort. Authors believe that this

mechanism would allow countries such as China to increase international use of their

domestic currency. Finally, they state that since the world already have seen both dollar

and sterling at the same time as international currencies in the interwar period, thus the

there is always a room for a multiple international currencies world in the 21st century.

Labor Market Responses.

In this section we discuss the effects of macroeconomic shocks such as exchange

rate shocks (oil price shocks) on the creation and the destruction of employment in labor

markets of Eurasian Economic Union countries. The relation itself comes form the

macroeconomic policies adopted by the monetary authorities of the countries in the

region, and therefore, are the consequences of Inflation Targeting regime and to some

extent of high degree of financial dollarization. These phenomena are not necessarily

associated with each other, but nevertheless strongly linked and interdependent from each

other. This paper’s focus on sectoral employment in the job markets will allow us to

better evaluate the role of macroeconomic shocks, and thus, avoid some misleading

aggregative approaches that have been used before in standard literature and research

approaches. At the same time, this kind of decomposition will also provide some insights

of how the economy truly responds to such kind of external macroeconomic shocks and

helps to identify the most vulnerable sides exposed to that risk. In our study, the paper

will be considering the domestic exchange rate depreciation (appreciation) and GDP

shocks as principal sources of shocks that can be caused by various global scenarios.

Particularly, in our case countries, I can refer to the recent oil price fluctuations as a main

contributor to the exchange rate depreciation, but also, taking into account that any future

external disbalances will be primarily absorbed through the exchange rate, and thus the

focus on the exchange rate will be the key to sectoral job market responses.

The data on sectoral job markets come from the respective state statistics agencies

of our countries for the period between 2007 till 2015. The data available by sectors is

annual, and thus, the cubic extrapolation was applied to obtain monthly frequency, which

is a standard technique for time series analysis. Manufacturing and constructing sectors

jobs represent two groups of employment that are used as proxies for tradables and non-

tradables sectors respectively. Therefore, for producers of tradable goods, the

depreciation of the exchange rate increases prices, which then allows them to increase

labor in those sectors. At the same time, for producers of non-tradables, the response

depends on how much of the decline in aggregate demand is switched towards non-

tradables. In general, empolyers in contracting sectors will have three tools to respond:

cutting wages, employment, or hours worked. When inflation surges following a wave of

depreciation, nominal wages very rapidly undercut. Stickiness in wages therefore may

provide some employment after shocks occurrence. Also, employers are reluctant to lay

off a group of high-skilled workers during the contraction period. In addition, there are

maybe different reasons why expanding sectors cannot hire additional workers. There are

maybe some constraints on capacity expansion that might be linked with credit obtaining

difficulty due to banking crises and high interest rate, which follow surges in inflation.

Overall, the ability of labor to move and allocate between across sectors is crucial and to

some extend migration is a large factor impacting that adjustment process.

As a result, based on those stylized facts, we can now observe the actual numbers from

Russia and Kazakhstan.

Table 5. Sectoral employment composition in Russia and Kazakhstan.

Source: Russian Statistics Agency.

Source: Kazakhstan Statistics Agency.

Of these two tables, we can clearly identify that after the 2008 financial crises, the

employment in manufacturing sector fell gradually in Russia, whereas it remained

stagnated with a little upraising slope in Kazakhstan. At the same time, both countries

sharply differ in their response of non-tradables sectors, which is construction sector

employment, with Kazakhstan having a surge in this sector over the last decade, and the

Russian segment showing a stable stagnation stage. Since, both the fluctuations in

employment can respond to different structural changes in the economy, therefore we test

them based on GDP and the exchange rate shocks. To perform our investigation I will be

estimating constructed structural VAR models with two different sectors. Thus, I

consider five variable linear stochastic system for each sector: Yt = [Exch, GDP, Inf, Int,

Man, and Con], where “Exch” is the nominal exchange rate, “GDP” is the index for

industrial production index, “Inf” is the inflation levels, “Int” is the domestic short term

interest rate, and “Man” and “Con” is the employment in Manufacturing and

Construction sectors respectively. The VAR model will be specified such that monetary

shocks are identical across the sectors, but the response variable will be vary freely across

the sectors. An ordinary VAR model demonstrates the dynamic movement of endogenous

variables by their own past values:

yt =c + B1yt-1 + B2yt-2 + … + Bpyt-p + ut, (1)

yt = c + B(L)yt + ut,

where t = 1, …., T, yt is a (n x 1) vector of endogenous variables at a time t, c is a (n x 1)

vector of constants, B’s are (n x n) matrices of coefficients with lag-length i = 1, …, p, u t

~i.i.d, is a vector of disturbances with E(utut’)=Σu, and L is the lag operator. A general

structural VAR can be expressed as:

A0y(t)= c + B(L)yt-1 + εt (2)

where the structure of the simultaneous determination in the economy is now

expressed on A0. Thus, each equation now is assumed to characterize specific monetary

relations, and the innovation in ε represents an exogenous shock in it. Thus, our model

inspects various macroeconomic shocks to our countries case of a small open economy

and primarily examines the dynamic responses of labor market sectors over time. Also,

since our assumption that ε’s are exogenous, and then they are orthogonal to each other,

so the variance matrix D is a diagonal matrix. Thus, zero restriction on upper diagonal

matrix is applied to prevent sectoral employment response variables to affect common

variables. Therefore, all common disturbances to contemporaneously affect sectoral job

creation and destruction. The ultimate goal is not to argue that the exchange rate directly

affects the sectoral employment in manufacturing or constriction industries, but rather

interpreting estimated shock response function of having symmetric effects on industries

and whether or not they likely to increase the employment in both sectors sectors.

Estimated sectoral VAR system on monthly data from 2007M1 to 2015M12 with two

lags in each variables and 12-steps ahead forecast error for sectoral rates of employment

growth. Since, the labor market is considered to respond slowly than any other economic

sectors, a large responding time period is chosen to reflect those characteristics. As a

result, impulse response functions on one standard deviation positive shocks for each

sector in both countries are reported in Table 6.

Table6. Impulse Response Functions on Sectoral Employment growth.

Russian case:

Kazakhstani case:

Above graphs represent generation of positive one standard deviation shock to the

exchange rate and GDP variables and then trace out the impulse response function

implied by the MA representation of our structural VAR system. Thus, as you can see

from Russian case graphs, there are strong expected responses on one time exchange rate

positive shock (depreciation), which have resulted in spike in manufacturing sector and

downturn in construction sector. At the same time, a one time positive GDP shock results

in an increase in manufacturing sector, whereas leads to some decrease in construction

industry. This is rather a puzzling result and will requiring further investigation. it is

important to note, that responses in all cases occur towards the end of 12th period, which

means that the labor sector is responding with a large lag market, and the structural

changes take time to occur. Increasing of response steps in our case will only bring a

further increase in large uncertainty areas that should be kept in check. In case with

Kazakhstani data, the exchange rate channel is stronger in manufacturing sector, whereas

construction sector’s response is very weak. In other two cases, positive GDP shock

produces a small increase in manufacturing sector, and overall negative trend in

construction sector, which I find very unusual for both countries. At the same time, GDP

shock responses are taking place earlier compared to exchange rate shocks. In addition,

only exchange rate variable estimated coefficients are statistically significant. Overall, the

exchange rate channel demonstrates parameters responses that are broadly consistent with

our hypothesis. All of our impulse response functions point to the fact of asymmetric

sectorial employment fluctuations following the exchange rate changes, ensure stable

macroeconomic environment.

Conclusion.

The aim of this paper was to search for the links between financial dollarization

and its effect on conduct of monetary policy, and specifically of inflation targeting as a

main policy strategy in countries of Eurasian Economic Union. Therefore, key drivers of

dollarization were identified first, and then a number of consequences were provided in

relation to macroeconomic and financial variables. From the above analysis, it is clear

that there is no general approach to explain this phenomenon, and greater regional

specifications are necessary to draw a better picture. However, our preliminary empirical

tests have shown that financial dollarization tends to lead to higher inflation rates, for a

greater financial fragility in the banking sector, and a lower output growth.

In this paper, we also have tested our hypotheses of labor market responses to the

exchange rate and GDP fluctuations, based on available Russian and Kazakhstani data for

the past decade. In this exercise particularly, labor market is represented with both

tradable and non-tradable sectors, which will help to understand the overall picture in

more structural and systematical way. Following our experiment, we found that the

exchange rate does correspond to a positive employment growth in manufacturing in both

countries, whereas destroying a portion in construction sector. At the same time, GDP

shocks did not produce significant results, in addition to rather puzzling responses in both

sectors, which might be due to other structural unrecognized reasons. However, a clear

asymmetric responses in both sectors in both countries lead us to the importance of the

exchange rate as important macroeconomic stability tool, which central bank denies

under the current monetary regime.

Overall, a persistently high level of dollarization suggests that sound monetary

policy and macro-stability institutions might be greatly weakened, and thus not be

efficient. Furthermore, credibility and trust take time to build, and even more time is

necessary in already highly dollarized economies to rebuild those necessary

arrangements. Thus, successful way of combating long run dollarization will be

consisting of macro prudential regulation, taking into account considerations that the long

run costs of reducing the dollarization are rather minimal. The modeling of linkages

within a general equilibrium framework with fully specified macro linkages is the next

step of the research.

BibliographyBlockmans, S., Vorobiev, I., & Kostanyan, H. (2012). "Towards a Eurasian Economic Union: The challenge of integration and unity.". CEPS Special Report.

Calvo, G. (2002). On dollarization. Economics of Transition , 10 (2), 393-403.

Cowan K., & Do Q. (2003). Financial Dollarization and Central Bank Credibilty . Inter-American Development Bank.

De Nicolo, G., Batholomew, P., Zaman, J., & Zephirin, M. (2003). Bank consolidation, Conglomeration, and Inernationalization: Trends and Implications for Financial Risk. IMF Working Paper 03/158.

De Nicolo, G., Honohan, P., & Ize.A. (2003). Dollarization of the banking system: good or bad? IMF Working paper WP/03/146.Eichengreen , B., & Flandreau, M. (2010). The Federal Reserve, the Bank of England and the rise of the dollar as a international currency, 1914-39. BIS Working Papers No 328.

Freeman, S., & Kydland , F. (2000). Monetary aggregates and output. The American Economic Review , 90 (5), 1125–1135 .

Galindo A., & Leiderman L. Living with dollarization and the route to dedollarization . Inter-American Development Bank. 2005: Working Paper No.526.

Honig, A. (2009). Dollarization, Exchange rate regimes, and government quality. Journal of International Money and Finance , 28, 198-214.

Ize , A., & Yeyati, E. (2003). Financial Dollarization. Journal of International Economics , 59, 323-347.

Krugman, P. (1984). The International Role of the Dollar: Theory and Prospect. NBER. University of Chicago Press.

Laurens, B., Eckhold, K., Darryl, K., Nasser, N., & Durre , A. (2015). The Journey to Inflation Targeting: Easier said than done. The case for transitional arrangements along the road. IMF Working paper WP/15/136.

Leiderman, L., Maino, R., & Parrado, E. (2006). Inflatoin Targeting in Dollarized Economies. IMF Working Paper WP/06/157.

Licandro G., & Licandro J.A. (2003). Building the dedollarization agenda: lessons from the Uruguayan case. Central Bank of Uruguay.

Mishkin, F. (2011). Inflation Targeting in emerging economies. NBER Working papers No.7618.

Moron E., & Castro J.F. (2003). De-dollarizing the Peruvan economy: a portfolio approach. Universidad del Pacifico, Mimeo.

Ozcan K., & Us V. (2007). Dedollarization in Turkey after decades of dollarization: A Myth of Reality? Elseveier.

Reinhart C.M., Rogoff K.S., & Savastano M. (2003). Addicted to dollars. NBER Working Papers Series No.10015.

Savastano, M. (1996). Dollarization in Latin America: Recent evidence and some policy issues. IMF. Washington: IMF Working Paper 96/4.

Yeyati, L. (2006). Financial Dollarization: evaluating the consequences . Economic policy , 61-118.

Data Appendix.

Variable name Source MeasurementForeign Currency Deposit

Dollarization ratioCentral Bank of Armenia;Central Bank of the Russia Federation; National bank

of Kazakhstan.

Foreign currency deposits/Total Deposits

Inflation rate Central Bank of Armenia;Central Bank of the Russia Federation; National bank

of Kazakhstan.

Annual growth rate

Interest rate Central Bank of Armenia;Central Bank of the Russia Federation; National bank

of Kazakhstan.

First difference of monthly average key policy interest

rates

Money supply (M2) Central Bank of Armenia;Central Bank of the Russia Federation; National bank

of Kazakhstan.

Logged first difference

Real GDP National statistics service of Armenia; Russian

Federation federal statistics services; Committee of

Statistics of Kazakhstan.

Annual growth rate of industrial production index

Exchange rate Central Bank of Armenia;Central Bank of the Russia Federation; National bank

of Kazakhstan.

First difference of nominal exchange rate.