Banking integration and dollarisation

Martin Brown, Ralph De Haas, Vladimir Sokolow 14 March 2015

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Inflation and financial dollarisation

Policymakers who advocate credible monetary policy as a remedy for dollarisation in emerging markets, find broad support in cross-country empirical studies. A growing body of evidence documents that countries with low and stable inflation are characterised by lower levels of financial dollarisation (De Nicolό et al. 2005, Lin and Ye 2013). While countries with low and stable inflation may make wider use of the domestic currency, it is far from clear that monetary policy is actually responsible for low dollarisation. Differences in fiscal policy, financial sector structure, and institutions may confound the cross-country relationship between monetary conditions and dollarisation.

In a new working paper (Brown et al. 2015), we exploit variation in consumer price inflation across Russian regions to examine the relationship between the perceived stability of the domestic currency and dollarisation. Our within-country data allow us to ease concerns about heterogeneity in other economic policies and institutions.

Regional inflation and dollarisation across Russia

Our analysis is based on quarterly data on local consumer price inflation for 71 Russian regions over the period 2005-2014. We match these data with information on the currency composition of bank deposits and loans, again at the regional level. The Russian Federation is one of the world’s largest currency blocks and displays substantial regional variation in both inflation and dollarisation. Figure 1 shows a ‘heat map’ of average consumer-price inflation across Russian regions during 2005-2014. The substantial cross-regional variation is immediately apparent. Behind these averages also lies substantial variation over time. For instance, in Q2 2014 consumer price inflation in the Kurk region was 2.3 percentage points higher than in Q2 2004, while it declined by 28.9 percentage points in Kamchatka over the same decade. This variation makes Russia an ideal setting to analyse the relationship between the stability of the domestic currency and dollarisation in a context with common macroeconomic policies and institutional frameworks.

Figure 1. Regional inflation across Russia

Note: This heat map of Russia shows average consumer price inflation over the period Q2 2005-Q2 2014. Source: Central Bank of the Russian Federation.

But how can regional inflation impact regional dollarisation? Theory predicts that the currency composition of assets and liabilities of households and firms is determined by expected real interest rate differentials as well as the volatility of inflation and of the real exchange rate (Ize and Levy Yeyati 2003). In such a framework, high regional inflation will increase FX deposits if households interpret the region-specific inflation they experience as a private signal of imminent exchange-rate deprecation. Analogously, higher regional inflation may lead to a reduction in the demand for FX loans among those households (and firms) that base their monetary expectations on locally observed inflation.

In line with these predictions, our results show that regions with high inflation experience a higher dollarisation of household bank deposits. Higher regional inflation is also associated with a lower dollarisation of bank loans to households and firms in non-tradable sectors. These results suggests that locally observed consumer-price inflation serves as a private signal for the stability of the local currency vis-à-vis foreign currencies and thus affects the currency composition of households’ and firms’ portfolios.

The role of banking integration

Russia is not only characterised by substantial regional variation in inflation and dollarisation but also in the extent to which the local banking sector is integrated with the rest of the country. There are large regional differences in the share of banks that operate locally versus those that operate nation-wide as well as large regional differences in the proportion of bank liabilities held by such local versus national banks.

How ‘open’ or ‘closed’ a regional banking sector is may influence the relationship between inflation and dollarisation. In a closed region, banks cannot easily allocate FX deposits to other regions, neither via external markets nor through internal capital markets. If these banks want to avoid currency mismatches on their balance sheet, they need to match the currency structure of their loans to that of their local deposits (see Brown and De Haas 2012 and Brown et al. 2014 for empirical evidence on such matching). When inflation increases and FX deposits rise, these banks will therefore try to offload this increase in FX deposits in the form of new FX loans (even when the demand for such loans actually goes down at the same time). In contrast, when banks are regionally integrated, the local supply and demand of FX funds need not coincide and this may allow firms and households to better adjust their currency portfolios.

Our results confirm that the impact of inflation on credit dollarisation depends strongly on whether a region is financially integrated with the rest of the Russian Federation. In regions with closed banking sectors – where most banks are local and depend on local funding – the negative impact of inflation on the demand for foreign currency loans is partially offset by banks’ efforts to locally intermediate the increased supply of foreign currency deposits. The asset-liability management of banks constrains the currency-portfolio choices of firms and households in less-integrated banking markets. In contrast, in regions with more nationwide banks and banks that are not locally funded, an inflation-driven influx of foreign currency deposits can be more easily distributed to other regions. This reduces the need to offload them locally. Such integrated banking markets therefore allow households and firms to respond to inflation shocks by adjusting both their assets and liabilities.

Conclusions

Within-country evidence supports the view that a stable monetary policy is a key ingredient of any de-dollarisation policy. In the Russian Federation, a large currency block with uniform macroeconomic policies, regions with higher inflation exhibit more dollarisation of household deposits and less dollarisation of credit. The impact of (perceived) monetary instability on credit dollarisation, and therefore on financial stability, depends strongly on the integration of the banking sector. While inflation stimulates households to save in a foreign currency, it simultaneously leads firms and households to borrow in the domestic currency. Price instability thus creates currency mismatches on banks’ balance sheets. Banks that want to avoid such mismatches can take two courses of action. Firstly, they can try to offload the FX deposits in the form of FX loans. Secondly, banks can reallocate the FX deposits elsewhere, either abroad or to branches in other regions where the demand for FX loans may be higher. Our results suggest that regionally integrated banks are better able to take this second course of action compared to local banks. Regional banking integration may therefore not only prevent banks from accumulating currency mismatches on their balance sheet, but it also reduces the offloading of currency risks on unhedged borrowers and helps them to rebalance the currency composition of their financial portfolio.

References

Brown, M, and R De Haas (2012), “Foreign Banks and Foreign Currency Lending in Emerging Europe”, Economic Policy 27, 57-98.

Brown, M, R De Haas, and V Sokolov (2015), “Regional Inflation, Financial Integration, and Dollarisation”, European Banking Center Discussion Paper Series No. 2015-002, Tilburg University.

Brown, M, K Kirschenmann, and S Ongena (2014), “Bank Funding, Securitization, and Loan Terms: Evidence from Foreign Currency Lending”, Journal of Money, Credit, and Banking 46(7), 1501-34.

De Nicolό, G, P Honohan, and A Ize (2005), “Deposit Dollarisation: Causes and Consequences”, Journal of Banking & Finance 29, 1697-1727.

Ize, A, and E Levy-Yeyati (2003), “Financial Dollarisation”, Journal of International Economics 59, 323-47.

Lin, S and H Ye (2013), “Does Inflation Targeting Help Reduce Financial Dollarisation?”, Journal of Money, Credit and Banking 45, 1253-74.

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Topics:  Financial markets International finance

Tags:  dollarisation, Russia, inflation, domestic currency

Professor of Banking, University of St. Gallen

Director of Research, EBRD

Assistant Professor at the International College of Economics and Finance, Higher School of Economics, Moscow

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