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Financial Dedollarization: A Carrot and Stick Approach

Financial dollarization (the holding by residents of foreign currency-denominated assets and liabilities) inevitably introduces a currency imbalance for the economy as a whole, amplifying the impact of real shocks. For this reason, it has been placed increasingly at the forefront of the policy debate in emerging economies. This paper argues that a successful strategy to reverse financial dollarization involves a two-way approach that includes: i) the adaptation of the prudential framework to address the externalities that tend to favor financial dollarization through the underpricing of real exchange rate risk, and ii) the development of domestic markets for local-currency substitutes to mitigate the impact of the currency switch on the domestic cost of funds. The paper discusses the main aspects associated with these two components and the menu of policy options in each case.