The Causes and Consequences of Domestic Liability Dollarization

Domestic liability dollarization is a phenomenon where companies and individuals in a country opt to settle their debts in a foreign currency, such as the US dollar, rather than the local currency. This can lead to a loss of control over monetary policy and a decline in the value of the local currency.

The main cause of domestic liability dollarization is the lack of confidence in the local currency, often due to high inflation or economic instability. As a result, businesses and individuals prefer to borrow in a currency they perceive as more stable.

High inflation rates, such as those experienced in Argentina and Brazil, can lead to a significant decline in the value of the local currency, making it more expensive to repay debts in domestic currency. This can create a vicious cycle of dollarization, where more and more debts are denominated in foreign currencies.

In countries with a history of high inflation, such as Peru, dollarization can be a way to avoid the risk of currency devaluation and protect against inflation.

Dollarization can be caused by a lack of confidence in a country's own currency, often due to a history of high inflation, currency devaluation, or political instability.

In countries with a history of high inflation, people may lose trust in their local currency and turn to a more stable foreign currency like the US dollar.

The government may not be able to control inflation, leading to a decrease in the purchasing power of the local currency.

Hyperinflation, like in Zimbabwe, can be a major factor in dollarization.

A country's economic instability, such as a banking crisis or a large trade deficit, can also lead to dollarization.

In some cases, dollarization can be a result of a country's economic dependence on a foreign power, such as the United States.

The US dollar is often used as a store of value in countries with weak financial systems, as it is seen as a safe-haven asset.

Domestic liability dollarization can be a complex issue, but effective risk management is key to mitigating its effects.

Dollarization can increase the risk of foreign exchange losses for businesses operating in dollarized economies.

To minimize this risk, companies can implement hedging strategies, such as forward contracts or options, to lock in exchange rates.

In some cases, dollarization can also lead to a decrease in credit availability, as lenders may be less willing to extend credit in a foreign currency.

Businesses can mitigate this risk by diversifying their funding sources and maintaining a cash reserve in the local currency.

Dollarization can also impact the overall stability of a country's financial system, particularly if it leads to a large increase in foreign currency-denominated debt.

To manage this risk, governments can implement policies to regulate the use of foreign currencies in domestic transactions.

To tackle domestic liability dollarization, it's essential to develop a sustainable de-dollarization approach in Ukraine. This involves creating market-friendly operations and nurturing local financial markets to slow down the dollarization of the local debt market.

A key step is to shift the local debt markets and household orientation from an FX-based orientation to a local currency orientation, even if the initial costs are higher. This requires structural changes in the composition of total public debt, local corporate debt, and local household debt.

The government and Central Bank must work together to develop alternative investment instruments for institutional investors and long-term corporate entities, such as indexed derivatives and instruments attached to the Consumer Price Index.

The National Bank of Ukraine needs to accept full accountability and responsibility for pursuing price stability through its inflation targeting monetary policy. This includes clear and objective public communication of targets and anchors.

Here are the key policy recommendations for Ukraine: