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Lao People’s Democratic Republic: Selected Issues and Statistical Appendix

Author(s):
International Monetary Fund
Published Date:
March 2002
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I. Dollarization in the Lao P.D.R.1

A. Introduction

1. The domestic use of foreign currencies (“dollarization”)2 has increased remarkably over the recent period in the Lao P.D.R. Foreign currencies now account for the largest component of the domestic money supply. This situation, while encouraging intermediation in a country with poorly developed financial institutions, poses several challenges for the authorities (see Box). In particular, dollarization strengthens the inflationary impact of an excessive expansion of the supply of reserve money, thus increasing the need for a restrained fiscal policy and for the central bank to focus on containing inflation. After discussing the main causes for the surge in dollarization in the Lao P.D.R., this paper explores various strategies that may be adopted to maintain low inflation and thus, indirectly, encourage the use of the national currency.

2. The use of foreign currencies is not a new phenomenon in the Lao P.D.R., a country with porous borders set along major trading routes between relatively large countries. The use of the dollar was prompted by a massive foreign presence in the 1960s and early 1970s, and the cash balances thus acquired were later (illegally) retained by some households as a precautionary store of value.3 With the liberalization of the economy in the late 1980s, residents were allowed to keep deposits denominated in foreign currency, which encouraged the repatriation of balances kept in foreign banks (mainly in Thailand), and of workers’ remittances. By 1995, the amount of foreign currency deposits accounted for about one third of the total stock of broad money. Since 1995, the rate of dollarization (defined here as the ratio of foreign currency deposits to the total stock of broad money) has increased or remained stable, declining only slightly after June 1999 (see attached table and chart below). The sharpest increase occurred between June 1997 and June 1999, when the rate rose from 40 to more than 80 percent. Since then, the rate of dollarization has always remained above 75 percent.4

Box 1.Lao P.D.R.: Effects of Dollarization

Dollarization induces fiscal discipline, contains capital flight, increases bank intermediation, and, in an undermonetized economy, encourages the use of money rather than barter. It also contains the unfair redistribution of resources induced by inflation. However, dollarization reduces the authorities’ control on monetary policy, increases the risk of banking crises, and involves higher “menu” costs (Baliño et al., 1999).

Currency substitution encourages fiscal discipline by raising the inflation rate that is required to collect a given amount of seigniorage. With currency substitution, the demand for real money balances in domestic currency declines, and the amount of seigniorage that can be collected at a given inflation rate thus becomes lower. Indeed, dollarization even reduces the maximum sustainable amount of seigniorage that can be raised, as currency substitution strengthens the “Laffer effect” of an increase in inflation (Calvo and Végh, 1992; Siklar, 1998).1 Monetizing the fiscal deficit thus becomes more costly in terms of inflation, and the authorities have a stronger incentive to maintain the deficit on a sustainable path.

Capital flight is contained (and the repatriation of funds is encouraged) as residents have the opportunity of holding dollar-denominated assets in domestic banks rather than in foreign accounts. These funds, in turn, can be lent to finance domestic projects, thus increasing bank intermediation. In an undermonetized country, dollarization encourages the use of money, by providing a monetary asset whose purchasing power is more stable and reliable than that of the domestic currency—thus facilitating transactions, expanding trade, and encouraging a more efficient allocation of resources.

In a country affected by high inflation rates, dollarization reduces the unfair redistribution effects of inflation, by providing a monetary asset whose purchasing power is relatively unaffected by domestic price increases. It must be remarked, however, that often residents have unequal access to foreign currency, and thus have different opportunities of protecting themselves from the costs of inflation.

Dollarization reduces control over monetary policy. Money supply becomes endogenous as under a fixed exchange rate regime, and money demand becomes unstable, responding to changes in the exchange rate and in the currency composition of the demand for money balances (domestic and foreign currency are not perfect substitutes—each is generally used for a particular type of transactions—but their domains of circulation overlap and change overtime, altering total money demand). Money demand instability is further increased by the possibility of shifting balances between domestic and foreign bank deposits in foreign currency. Changes in the currency composition of money demand render the transmission of monetary impulses to prices and output more unstable and unpredictable.

The risk of banking crises increases, as commercial banks are induced to become exposed in foreign currencies, while the central bank loses its capability of acting as lender of last resort. Banks tend to get exposed to exchange risk, by accepting liabilities in foreign currency and extending loans that are (directly or indirectly) exposed to currency risk. The central bank cannot act as lender of last resort, unless it has access to sufficiently large credit facilities from foreign banks or international institutions.2 Dollarization also increases menu costs, as prices need to be quoted in more than one currency, and adjusted in accordance with changes in the exchange rate.

1 Note, however, that the domestic authorities can recover part of this seigniorage by investing nonremunerated required and excess reserves of banks denominated in foreign currency, into interest-bearing foreign financial assets. This is currently occurring in the Lao P.D.R.2 When the domestic credit sector is highly integrated with the international credit sector, the role of lender of last resort can be effectively played by foreign banks (as occurs in Panama: see Moreno-Villalaz, 1999).

Dollarization and Exchange Rate, 1995–2001

B. Causes of Dollarization in the Lao P.D.R.

3. Aside from the historical factors mentioned above, the use of foreign currencies in the Lao P.D.R. has been encouraged by the close trade links with Thailand (formal and informal) and by the past stability of the baht, and by large inflows of remittances sent by expatriates. These remittances were previously kept in banks in Thailand and informally brought into the country in the form of cash, but more recently have been deposited directly in foreign-currency accounts held at banks in the Lao P.D.R.5

4. The currency composition of this stock of foreign currency is not available. However, the Thai baht is widely used for transactions in major urban centers and in areas close to the border with Thailand, while currencies of neighboring countries (mostly Vietnamese dong and Chinese renminbi) are used in areas close to those borders. The U.S. dollar is also widely used, both to settle major transactions (such as the purchase of vehicles or real estate property) in urban areas, and as a store of value throughout the country. In rural areas far from the border, however, the only currency used is the domestic kip, replaced sometimes, as a store of value, by gold, or livestock.6

5. The main cause of the recent surge in dollarization has been, however, the instability of the domestic currency. In particular, two episodes of sharp devaluation, in 1995 and in 1997-99, have induced residents to reduce their demand for balances in the local currency and increase their demand for foreign currency. The second episode was particularly dramatic. As the exchange rate depreciated from 962 kip to the dollar in January 1997 to 9,430 kip to the dollar in June 1999, and inflation rose from 12 percent to 124 percent, year-on-year, during the same period (peaking at 168 percent in March 1999), the rate of dollarization increased from about 40 percent to more than 80 percent. The process was only slightly reversed when inflation rates fell and the kip stabilized in late 1999—-a typical case of hysteresis normally observed in countries affected by dollarization.7

6. The problem was aggravated by the inflexibility of nominal interest rates. Despite the large actual and expected devaluation, nominal interest rates remained broadly constant, spurring a flight of funds from the domestic currency. Alternative investment opportunities are virtually nonexistent with the financial market still at an early stage of development, and so foreign currencies are a much more attractive stores of value.

C. Implications for Monetary Policy

7. Given the high degree of dollarization, monetary policy should be aimed primarily at preserving the value of the currency by maintaining a low rate of inflation. Owing to the small size of the domestic monetary base, a monetary policy aimed at output stabilization is likely to be highly ineffective, and even a moderate amount of seigniorage may involve high costs in terms of inflation, capital flight, and of a further increase in dollarization. A policy specifically aimed at reducing dollarization to increase the domestic monetary base, through regulations and legal restrictions, is likely to be largely ineffective, inducing capital flight and underground transactions. Instead, encouraging the use of the kip—in the form of incentives rather than regulations—should be pursued through stabilization.

8. Some alternatives for the operation of monetary/exchange rate policy are: “hard” or “soft” exchange rate pegs; inflation targets; monetary targets; and controls on the amount of domestic credit extended by the central bank. All these options involve advantages and disadvantages.8

9. “Hard” pegs, such as full dollarization or a currency board, are most effective at reducing inflation, as they involve legal provisions that are difficult to reverse, and provide additional guarantees for credibility. By reducing or removing currency risk, a hard peg encourages foreign investment and facilitates trade and financial integration with the rest of the world. A hard currency peg however involves a complete loss of control on monetary policy, removing an important instrument to adjust to asymmetric shocks. Moreover, under a hard peg the currency is anchored to (or replaced by) a single foreign currency,9 exposing the country to external shocks deriving from movement in the relative exchange rates of its trading partners. This risk can be particularly relevant in the Lao P.D.R., owing to the diversified pattern of its foreign trade.10 The choice of the appropriate currency for a hard peg may also be problematic, since both the dollar and the Thai baht are widely used in the Lao P.D.R. and would thus be candidates for adoption.11

10. A “soft” peg allows more scope for flexibility, allowing the possibility of a devaluation of the parity, and can contain the risk of external shocks (by anchoring to a basket of currencies reflecting the composition of foreign trade),12but is less credible and may not be trusted by the public, particularly at an early stage, when the monetary authorities have not yet established a reputation for credibility. In the Lao P.D.R., owing to the memory of large and rapid depreciation, the risk of a lack of confidence inducing speculative attacks may be particularly high. Under these conditions a soft peg may even result in an increase in dollarization, and expectations of a devaluation (or even of an abandonment of the peg) may turn out to be self-fulfilling. A soft currency peg may be more easily enforced at a later stage in the stabilization process, when the monetary authorities have acquired the trust of the public.13

11. By targeting inflation, the authorities make explicit their aim of stabilizing the value of the currency, undertaking a commitment that is easily understood and verified by the public. At the same time, the authorities maintain control on monetary policy and thus the possibility of reacting to unforeseen or asymmetric shocks. The disadvantages of inflation targeting derive from the fact that inflation is not directly controlled by the authorities. Targeting inflation thus requires an accurate understanding of the relation between the instruments at the disposal of the monetary authorities (credit, interest rates, money supply) and inflation; in addition, it requires prompt and reliable information and forecasts of the relevant variables, and efficient financial institutions that allow an accurate transmission of monetary impulses on prices.14 In the Lao P.D.R., owing to the scarce development of financial institutions, and to the instability of money demand (deriving, in turn, from dollarization), neither of these requirements might be satisfied under present conditions.

12. Monetary targets are more directly controlled by the authorities and thus allow them to acquire more quickly the confidence of the public, reducing actual inflation by inducing favorable expectations. Monetary targeting, however, requires a stable—and known—money demand function. In a highly dollarized country, money demand is unstable, owing to the high elasticity of substitution between domestic and foreign currency,15 and to the possibility of large movements of funds between foreign currency deposits held at domestic and foreign banks, and (unrecorded) foreign cash holdings. Such shifts may occur even with minor variations in the relevant parameters, and thus hamper the capacity to accurately estimate a money demand function. Owing to the high degree of dollarization, moreover, money supply in the Lao P.D.R. may be largely endogenous and thus escape the control of the authorities.

13. Controlling the amount of domestic credit of the central bank would tackle the root of inflationary money expansion—the monetization of the deficit of the government and of state-owned enterprises—laying the ground for an effective stabilization of the currency. Domestic credit is directly controlled by the authorities even in the absence of developed financial institutions. The disadvantage of this type of policy is that domestic credit is only indirectly linked with inflation. However, with a ceiling on domestic credit, a sustained expansion of broad money could only derive from an inflow of foreign currency, that would be demand-driven and thus have a lower impact on inflation. While not allowing for a fine-tuned control on the actual inflation rate, a monetary policy focused on domestic credit would allow an effective reduction of inflation over time.

D. Conclusions

14. The domestic use of foreign currency in the Lao P.D.R. has increased remarkably over the past few years, and now accounts for about three-quarters of broad money. The main cause of the recent surge in the degree of dollarization appears to be the recent severe nominal devaluation of the currency and very high inflation.

15. Aside from positive effects, such as enhancing fiscal discipline and encouraging bank intermediation, this phenomenon poses several challenges to monetary policy, reducing the authorities’ capacity to control money supply and increasing the vulnerability of the banking system. It also reduces the government’s capacity to raise seigniorage, and may induce an unfair redistribution of resources in favor of those residents who have better access to foreign currency.

16. The high degree of dollarization increases the need to stabilize the value of the currency. A policy aimed at stabilizing output may be ineffective and highly costly in terms of inflation. At the same time, measures directly aimed at encouraging a wider use of the domestic currency should only be used as a complement to a wider stabilization strategy, and should be based on incentives and confidence rather than legal restrictions.

17. Among various policy options that may be used to increase the stability of the currency, containing the amount of domestic credit extended by the central bank has important advantages. A ceiling on the expansion of domestic credit would directly address the main cause of instability, namely, the monetization of the deficit of the public sector, and, being under the direct control of the monetary authorities and thus easily achievable, would allow the central bank to establish a reputation for credibility that would facilitate the subsequent maintenance of stable economic conditions.

Rate of Dollarization
Quarter EndingDollarization1/Exchange rate2/Devaluation3/ (percent)Inflation 4/ (percent)
Dec-9435.6719
Mar-9529.27646.36.2
Jun-9534.784210.210.3
Sep-9540.892910.310.3
Dec-9542.2925-0.4-0.4
Mar-9644.99381.45.7
Jun-9642.09481.14.1
Sep-9638.99570.93.5
Dec-9640.5954-0.3-1.0
Mar-9741.11,0065.55.3
Jun-9743.81,0383.27.3
Sep-9748.01,34429.514.1
Dec-9756.62,15260.1-1.9
Mar-9860.32,43113.021.1
Jun-9865.63,43041.148.6
Sep-9865.44,15521.116.8
Dec-9867.14,2742.915.1
Mar-9971.85,36525.533.7
Jun-9983.79,43075.825.1
Sep-9976.76,810-27.815.7
Dec-9979.57,60011.6-3.5
Mar-0079.37,560-0.54.2
Jun-0078.77,8353.64.4
Sep-0078.18,0853.24.4
Dec-0076.08,2171.6-2.8
Source: Data provided by the Lao P.D.R. authorities.

Foreign currency deposits on broad money, in percent, end-of-period.

Kip per U.S. dollar, official rate, end-of-period.

Quarter-on-quarter change of the end-of-period nominal exchange rate, in percent.

Quarter-on-quarter change in the end-of-period CPI, in percent.

Source: Data provided by the Lao P.D.R. authorities.

Foreign currency deposits on broad money, in percent, end-of-period.

Kip per U.S. dollar, official rate, end-of-period.

Quarter-on-quarter change of the end-of-period nominal exchange rate, in percent.

Quarter-on-quarter change in the end-of-period CPI, in percent.

References

Prepared by Marco Pani (APD).

The word “dollarization” is used to describe the domestic use of foreign currencies-not necessarily the U.S. dollar-both as a store of value (“asset substitution”) and for transaction purposes (“currency substitution”). For a discussion of the different nature and economic implications of these two phenomena, see Baliño et al. (1999). In particular, the authors note that, unlike with currency substitution, with asset substitution the amount of domestic foreign currency deposits “is unlikely to be […] related to domestic demand” (p. 34), and the relevant definition of money thus only includes assets denominated in the local currency. In the Lao P.D.R., however, “there is ample anecdotal evidence of currency substitution” (ibid), although foreign currencies are also used for speculative purposes (“asset substitution”).

The exact stock of foreign currency held by residents in the Lao P.D.R. is not known, as it includes an unmeasured amount of foreign cash. In February 2001, foreign currency deposits amounted to 84.5 percent of total deposits held in Lao banks, and to 75 percent of “broad money,” (defined, in the Lao P.D.R., as the sum of bank deposits and the stock of domestic cash circulating outside banks).

Melvin and Peiris (1996) underline that dollarization in some Latin American countries has also been encouraged by the illegal drug trade.

The Lao economy is poorly monetized, and barter trade and in-kind payments are still quite common in rural areas. Even credit is often awarded in kind, with complex conventions regulating the repayment of principal and “interest.” Bank branches are rare in rural areas-apart from those of the state-owned Agricultural Development Bank-and intermediation is very low. Financial markets are also scarcely developed, and a secondary market for Treasury bills has not yet been established.

For a more detailed discussion of the advantages and drawbacks of various targets of monetary policy see Mishkin and Savastano (2000).

In principle, a currency board could be designed in a way that removes the risk of external shocks by pegging to multiple currencies (Oppers, 2000) or to a currency basket. At present, however, such arrangements are mere academic hypotheses.

While about 70 percent of Lao imports come from Thailand, some of these imports originate in third countries; Lao exports, in turn, are purchased by a variety of countries belonging to different currency areas.

For a discussion of the “pros and cons” of full dollarization see Berg and Borensztein (2000).

Since the trade pattern changes over time, the currency basket would need to be periodically adjusted.

In order to be effective, an exchange rate peg needs to be transparent. When a peg is adopted, the authorities should thus take care at informing the public about the composition of the currency basket, the criteria used for its periodic revision, and the technical details of the pegging rule that is adopted.

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