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Chapter 3. Asia’s Most Dollarized Economy: Causes and Consequences

Author(s):
Olaf Unteroberdoerster
Published Date:
February 2014
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Nombulelo DumaAn earlier version of this chapter was published as IMF Working Paper No. 11/49 (Duma, 2011).

Cambodia has made great strides toward macroeconomic and political stability over the past decade. Following decades of civil war and the Khmer Rouge regime, reconstruction efforts began in the mid-1990s. The establishment of peace in 1991 was followed by sizable foreign donor aid and a rebuilding of human capital, physical infrastructure, and institutions (Coe and others, 2006). Significant dollar inflows have contributed to strong economic growth, which during 2000–11 surpassed that of other low-income countries in Asia (Figure 3.1). Per capita income has doubled over the past 10 years; inflation has, on average, been maintained in the single digits; and the incidence of poverty and rates of malnutrition have both fallen.

Figure 3.1

However, dollarization has continued to rise. Measured as the ratio of foreign currency deposits to broad money, dollarization has risen from about 60 percent in the late 1990s to over 80 percent in 2012 (Figure 3.1). Cambodia is classified as partially dollarized, meaning that the U.S. dollar circulates in conjunction with its official national currency—the riel—as opposed to being fully dollarized, as in economies where the dollar is the only legal tender. In contrast with Cambodia, in comparable partially dollarized low-income countries in Asia dollarization has either declined or remained much lower over the same period. In Lao P.D.R., dollarization has declined from around 80 percent in the early 2000s to less than 50 percent in recent years. Dollarization is just above 30 percent in Mongolia and below 20 percent in Vietnam. The increase in dollarization in Cambodia has been contrary to the general belief that macroeconomic and political stability help reduce dollarization.

This chapter explores the factors that have contributed to Cambodia’s dollarization and reviews lessons from international experience to help devise strategies for de-dollarization. After a general discussion of the causes of dollarization, the chapter reviews the Cambodian experience with dollarization, including an econometric analysis of the extent to which changes in the U.S. federal funds rate affect Cambodia’s macroeconomic aggregates. This is followed by lessons from successful dollarization cases. The chapter concludes with suggestions for increasing the use of the riel in Cambodia.

Dollarization in General

The macroeconomic literature identifies several possible causes of dollarization:

  • Large macroeconomic imbalances and hyperinflation: Chile, Colombia, and Peru became dollarized following periods of macroeconomic instability and high inflation that resulted in the substitution of the U.S. dollar for their respective domestic currencies (Galindo and Leiderman, 2005; Herrera and Valdés, 2005; Kokenyne, Ley, and Veyrune, 2010; and Reinhart, Rogoff, and Savastano, 2003).
  • Financial repression and capital controls: Nigeria, Venezuela, and many sub-Saharan African countries became dollarized following the introduction of policies that repressed financial transactions and imposed capital controls (Reinhart, Rogoff, and Savastano, 2003).
  • The appeal of the U.S. dollar as an anchor of macroeconomic stability: Argentina and Ecuador adopted the U.S. dollar as legal tender, in Argentina’s case to help address its long history of problems with monetary and exchange rate policies, and in Ecuador’s case following a deep economic and political crisis (Berg and Borensztein, 2000).

Further, the literature has identified two main motives for the demand for foreign currency assets. The first is currency substitution, which is the use of foreign assets as a means of payment and a unit of account. Currency substitution tends to follow periods of hyperinflation, prompting the public to seek the use of alternative currencies. The second is asset substitution, which results from risk and return considerations between domestic and foreign assets. Price instability and prolonged depressions have prompted the use of foreign-currency-denominated assets as a store of value.

Once entrenched, dollarization is difficult to eliminate. Public memory of macroeconomic instability and hyperinflation tends to remain for a long time, resulting in the maintenance of foreign-currency-denominated assets even during periods of macroeconomic stability. The literature indicates that dollarization remains or does not subside entirely even when both macroeconomic stability and the credibility of government policies have been achieved (Kokenyne, Ley, and Veyrune, 2010).

The Cambodian Experience with Dollarization

The use of dollars in Cambodia has come a long way. During the regime of the Khmer Rouge (1975–79), all barter, private commercial activity, private ownership, means of exchange, and stores of value were prohibited and punishable by death (Prasso, 2001). Savings and property were lost, and cash holdings were made worthless. Between 1975 and 1980, Cambodia was without a monetary system and without money. When the Cambodian riel was reintroduced in 1980, the experience during the Khmer Rouge period contributed to its low acceptance by the public, which instead, preferred other stores of value and means of payment, such as the U.S. dollar, gold, and even rice. Earlier, even the Vietnam dong and Thai baht had been widely used, but their use declined over time and became limited to the border areas with the respective countries.

With the passage of time, the use of the riel increased, and it is widely accepted in rural areas. Banking system riel deposits have grown sixfold since the mid-2000s, and one of the commercial banks engaged in microfinance has the majority of its loan portfolio denominated in riels in rural areas. Nevertheless, although the riel has increased in volume over recent years (Figure 3.2), dollar inflows have been larger. This indicates that the rise in dollarization from 2000 to 2012 has not necessarily come about through a substitution of riels for dollars but through a strong inflow of dollars, as also noted by Menon (2008). Although the ratio of riel deposits to GDP has risen, it remains at only around 1 percent of GDP. This compares with about 70 percent of GDP in Vietnam for dong deposits and about 8½ percent of GDP in Lao P.D.R. for kip deposits. Financial intermediation in riels remains low, partly reflecting constraints on access to finance in rural areas.

Figure 3.2

Sources: Data provided by the Cambodian authorities; and IMF staff estimates.

Growth in Cambodia’s dollar economy has far surpassed that in its riel economy. Cambodia’s economy has two parallel worlds: (i) an urban economy, which is mostly dollar based and has greatly benefited from the buoyant garments sector, tourism, foreign direct investment, and aid; and (ii) a rural economy, which is largely agricultural and is riel based. The contribution of the garment and tourism sectors has surpassed that of the agricultural sector (Figure 3.3). Significant inflows of aid, foreign direct investment, and tourism receipts, along with the growth of the garment export sector, which transacts in dollars—since the mid-1990s—have all contributed to the large amount of dollars.

Figure 3.3

Sources: Data provided by the Cambodian authorities; and IMF staff estimates.

Costs and Risks of Dollarization

Limited influence over domestic monetary conditions. The National Bank of Cambodia (NBC) lacks instruments to influence monetary aggregates and anchor private sector expectations of inflation. Movements in private sector credit tend to be outside the control of the NBC. The extent of dollarization means the NBC effectively delegates its monetary policy to the United States. As illustrated in the next section and in the appendix to this chapter, macroeconomic variables in Cambodia respond significantly to changes in U.S. monetary policy. While the NBC occasionally uses the dollar reserve requirement ratio as a monetary policy tool to control liquidity, its effectiveness has proven to be limited.1 When the reserve requirement ratio was reduced in early 2009 to provide liquidity to banks and to help boost economic activity in the wake of the global financial crisis, banks instead accumulated more reserves at the NBC. Excess reserves rose to their highest levels in history and credit to the private sector contracted.

Loss of seigniorage. Dollarization has resulted in the loss of seigniorage revenue. Seigniorage revenue is the difference between the value of money and the cost to produce it. When the cost of producing money exceeds (or is below) its value, seigniorage is negative (or positive). The cost of seigniorage can be estimated as a one-time stock cost from the amount of new foreign currency that is being acquired, or as a continuing flow cost in terms of seigniorage revenue foregone (Bogetić, 2000). Given the nature of dollarization in Cambodia and the way it occurred—that it was not a conscious official choice to adopt the dollar—the calculation of seigniorage loss using the continuing flow method is more appropriate. Through the creation of base money, the NBC buys real resources for nothing in return—considering the cost of printing money and any remuneration of bank reserves by the monetary authorities. The high level of dollarization means the NBC forgoes this flow of revenue.

Because there is no measure of dollars in circulation in Cambodia, estimates of currency in circulation in comparator low-income countries in Asia (Mongolia, Nepal, and Vietnam)2 are used as a proxy. The measure of the cost of dollarization is the outstanding amount of dollars in circulation multiplied by the dollar market interest rates in annual percent, as quoted in the United States. The interest rates considered are the federal funds rate, the prime lending rate, and the three-month Treasury bill rate; the results derived from using these interest rates are similar. The methodology helps determine lost income that can be recovered if dollars circulating in Cambodia are replaced with the riel to the level found in the comparator countries. Based on this proxy method, the seigniorage loss for Cambodia is estimated at up to 0.6 percent of GDP, based on estimates of currency in circulation for Vietnam as a proxy (Table 3.1). This estimate is significant when compared with Cambodia’s small public revenue base (about 12½ percent of GDP, excluding grants).

Table 3.1Seigniorage Loss Estimates Based on Currency in Circulation in Comparator Low-Income Countries in Asia, 2007–11
20072008200920102011Average 2007–11a
(1)Currency in circulation in Asian low-income countries

(In percent of GDP)
Mongolia5.75.04.34.64.74.9
Nepal12.213.513.611.913.412.9
Vietnam19.315.917.717.114.616.9
(2) = ((1)*(8))/100Proxy for Cambodia given its GDP:
Mongolia493.8519.1450.3521.0603.8517.6
Nepal1050.11402.21416.21341.81733.61388.8
Vietnam1665.71651.01841.41920.11886.51792.9
(3) = (2) – (9)Deduct riels in circulation in Cambodiab
Mongolia3.3−46.9−274.8−219.4−328.4−173.3
Nepal559.5836.2691.0601.4801.5697.9
Vietnam1175.11085.01116.21179.7954.31102.1
Seigniorage based on:
(4) = (((3)*((10)/100))/(8))*100U.S. federal funds rate
Mongolia0.00.00.00.00.0−0.1
Nepal0.30.20.00.00.00.3
Vietnam0.70.20.00.00.00.4
(5) = (((3)*((11)/100))/(8))*100U.S. bank prime lending rate
Mongolia0.00.0−0.1−0.1−0.1−0.1
Nepal0.50.40.20.20.20.5
Vietnam1.10.50.30.30.20.8
(6) = (((3)*((12)/100))/(8))*100U.S. 3-month Treasury bills ratec
Mongolia0.00.00.00.00.0−0.1
Nepal0.30.10.00.00.00.3
Vietnam0.60.10.00.00.00.4
(7) = average((4), (5), (6))Seignorage loss estimate
Mongolia0.00.00.00.00.0−0.1
Nepal0.40.20.10.10.10.4
Vietnam0.80.30.10.10.10.6
Memorandum items
(8)Nominal GDP (in millions of U.S. dollars)8639.210351.910414.211255.112890.38594.6
(9)Cambodia riels in circulation (in millions of U.S. dollars)490.5566.0725.1740.4932.2497.0
(In percent of GDP)5.75.57.06.67.25.8
(10)U.S. federal funds rate5.01.90.20.20.13.5
(11)U.S. bank prime lending rate8.15.13.33.33.36.5
(12)U.S. 3-month Treasury bills rate4.41.40.20.10.13.2
Source: U.S. Federal Reserve; author’s calculations; and IMF staff estimates

The average for interest rates is over a longer period of 1991–2011 to make it less biased toward the more recent low interest rates.

During 2009–11, the amount of riels in circulation in Cambodia surpassed the amount of local currency circulating in Mongolia.

A 6-month Treasury bills rate produced similar results.

Source: U.S. Federal Reserve; author’s calculations; and IMF staff estimates

The average for interest rates is over a longer period of 1991–2011 to make it less biased toward the more recent low interest rates.

During 2009–11, the amount of riels in circulation in Cambodia surpassed the amount of local currency circulating in Mongolia.

A 6-month Treasury bills rate produced similar results.

Broader ranges of seigniorage estimates have been found in other countries. Bogetić (2000) estimated seigniorage loss for Latin American countries to range from ½ percent of GDP in Argentina to about 7½ percent of GDP in Ecuador for the period 1991–97. Similarly, Humpage (2002) estimated seigniorage loss for Latin American countries to range from 0.1 percent of GDP in Ecuador to about 5½ percent of GDP in Chile for the period 1990–2000.

Estimates of seigniorage loss should be interpreted with caution. The costs of dollarization in terms of seigniorage loss are very relevant when the government in question has or would have implemented optimal macroeconomic policies. Chang (2000) argues that, in cases where policy credibility has been a problem, interpreting seigniorage becomes more complicated. In countries in which dollarization has increased, the credibility of policies had been an issue. In these cases, the increase in dollarization could, in fact, have been associated with an increase in social welfare provided, which would otherwise not have occurred. Chang (2000) further argues that computed seigniorage loss can only be unambiguously interpreted as “real loss” to the economy if policy credibility problems are assumed away. In this light, dollarization has benefits, which have been evident in the stability of the Cambodian macroeconomy and in the containment of inflation. These benefits—while not necessarily quantifiable—have to be weighed against the costs.

Liquidity risk and limited lender of last resort. Sudden changes in investors’ and depositors’ perceptions of the health of the banking system, which result in a run on deposits, could compromise the NBC’s international reserves. Therefore, high dollarization requires that the NBC maintain an adequate level of dollar liquidity both at the macro level (Figure 3.4) and at the individual financial institution level. However, although international reserves serve as the main backstop in the event of a severe banking system liquidity shortage in Cambodia, the coverage of foreign currency deposits by gross official reserves has declined over time.

Figure 3.4

Bank balance sheet risks. Balance sheet risks tend to arise in cases of partial dollarization. Dollarization tends to add to the banking sector vulnerabilities that arise from currency mismatches, exchange rate and credit risks, and dollar-denominated nonperforming loans (Unteroberdoerster, 2002). These vulnerabilities may be heightened because of direct exchange rate risks that result from currency mismatches in banks’ balance sheets. Indirect credit risk may arise in the case of devaluations in the presence of substantial dollar lending to nonhedged borrowers (Kokenyne, Ley, and Veyrune, 2010).

Monetary Policy in Dollarized Cambodia

The extent of dollarization makes Cambodia susceptible to changes in U.S. monetary policy. This poses constraints on the domestically available tools with which to respond to external shocks. Monetary expansion in the United States tends to result in economic booms in other countries (Kim, 2001), including in dollarized economies (Goux and Cordahi, 2007). During late 2007 and early 2008, Cambodia experienced an increase in inflationary pressures as commodity prices and foreign inflows rose. Coincidentally, U.S. monetary policy had become loose following the Federal Reserve’s attempt to increase liquidity as the subprime crisis hit. The federal funds rate had declined from about 5.26 percent in July 2007 to 1.98 percent by May 2008.

The high degree of dollarization raises the question of the extent to which Cambodia imports U.S. monetary policy. The fact that about 60 percent of Cambodia’s garment exports go to the United States indicates strong real linkages between the Cambodian economy and the U.S. economy in addition to the financial linkages caused by dollarization. The appendix to this chapter provides an analysis of the extent to which changes in the federal funds rate influence macroeconomic variables in Cambodia. The analysis finds that financial sector variables (including domestic interest rates) and real economy variables (including trade) respond greatly to changes in the federal funds rate within the first few months. A one standard deviation shock to the federal funds rate (an increase of about 0.3 percent) results in an increase in the lending rates of about 0.4 percent and in the deposit rates of about 0.5 percent as local banks attempt to minimize the spread between domestic and foreign interest rates. This illustrates the extent to which monetary conditions are beyond the control of the NBC.

Structural Challenges that Instill Dollarization

While Cambodia’s economic growth track record has been impressive, several structural weaknesses inhibit faster economic development and private sector performance. Rennhack and Nozaki (2006) argue that weak institutions undermine policy credibility as they create doubt about the enforceability of contracts, thereby inducing residents to hold foreign currency as security. The institutional environment in Cambodia, based on indicators of governance, remains a challenge to private sector and rural development, which are critical economic sectors that use the riel (Figure 3.5). The adoption of an anticorruption law by the Cambodian government in 2010 has been a good step toward improving the institutional environment. However, the country still lags behind other low-income peers in Asia in enforcement of regulations and in rule of law. There is also a need to build the infrastructure—especially electricity, telecommunications, and access to land—in order to support private sector and rural development.

Figure 3.5*

Source: World Bank, World Governance Indicators.

* Percentile rank indicates the percentage of countries worldwide that rate below the selected country. Higher values indicate better governance ratings.

Partly reflecting these structural weaknesses, the interest rate differential between Cambodian and U.S. interest rates has remained high (Figure 3.6). The spread between deposit and lending rates in Cambodia and the United States has been wide, with rates in Cambodia significantly higher. The high interest rate spread reflects several factors, including high country risk, the high cost of banking (including legal uncertainty, litigation costs, and default rates), and low financial intermediation (de Zamaróczy and Sa, 2002). The high interest rate spread is also consistent with findings by Powell and Sturzenegger (2000), who argue that the abolishment of currency risk is offset by an increased default (country) risk premium and that interest rate levels stay significantly higher than in the United States (usually the benchmark).

Figure 3.6

Sources: Data provided by the Cambodian authorities; the Federal Reserve Economic Data; and IMF staff estimates.

Lessons from International Experience

Several countries have successfully dedollarized. Reinhart, Rogoff, and Savastano (2003) separate countries into two categories: (i) those that dedollarized their locally issued foreign currency obligations (examples are Mexico and Argentina); and (ii) those that reduced the share of foreign currency deposits to broad money (examples are Israel, Mexico, Pakistan, and Poland). The latter category is more relevant for Cambodia, given that the country has a high share of foreign currency deposits in broad money and that there are currently no locally issued government securities in foreign currency. In the cases of Israel, Mexico, Pakistan, and Poland, the share of foreign currency deposits in broad money fell by at least 20 percent and settled at a level below that amount.

The following lessons can be drawn from international experiences with dedollarization:

  • Gradual and market-driven policies have been more successful. Countries in which supportive policies aimed at lowering inflation and deepening financial markets helped reduce dollarization include Chile, Egypt, Israel, and Poland. In these cases, a combination of policies were implemented including: (i) creating markets for local-currency-denominated bonds; (ii) introducing differential remuneration rates on reserve requirements on foreign currency deposits to create a wedge in bank intermediation spreads; and (iii) actively supervising banks to ensure that they fully covered their foreign currency loan positions (Erasmus, Leichter, and Menkulasi, 2009). Further, in the cases of Chile and Israel, indexation was also used successfully to promote local currencies.
  • Forced dedollarization has had macroeconomic costs (Reinhart, Rogoff, and Savastano, 2003). Forced conversion of dollar deposits into domestic currency was imposed in 1982 and 1998 in Mexico and Pakistan, respectively. Conversion was done using an exchange rate that was substantially lower than the prevailing market rate. While Mexico and Pakistan successfully dedollarized, there were costs. In the case of Mexico, there was substantial capital flight, and private sector bank credit was almost halved in two years; growth suffered significantly and inflation shot up. In the cases of Bolivia and Peru, forced conversion of dollar deposits was subsequently followed by macroeconomic instability that resulted in hyperinflation and led these countries to later allow foreign currency deposits. A similar restriction was introduced in Israel in 1985; however, there it was gradual and market oriented. In Israel’s case, a mandatory one-year holding period for all foreign currency deposits was introduced, which made those deposits less attractive than other indexed financial instruments.
  • Reversing dollarization is not easy and is mainly a gradual process. According to Baliño, Bennett, and Borensztein (1999), dedollarization tends to be difficult, since it depends on institutional changes and occurs when significant benefits can be gained by switching currencies. Dedollarization requires persistence in reducing inflation and stabilizing macroeconomic policy (Erasmus, Leichter, and Menkulasi, 2009). Establishing the credibility of macroeconomic policy is essential.

Cambodia could also draw lessons from the experience of Lao P.D.R. In an attempt to dedollarize, Lao P.D.R. tried to enforce an increased use of the local currency (the kip) by passing a decree (in June 1997) stipulating that only the kip could be used as a medium of exchange in all domestic transactions. This was followed by a depreciation of the kip against the U.S. dollar and the Thai baht (both significant foreign currencies used) as a result of loss of confidence in the kip following the announcement of the measure (Menon, 2008). The share of kip in the money stock fell from about 50 percent to 30 percent, partly due to the valuation effect. Lao P.D.R.’s experience therefore stands as another example of how forced dedollarization could have unintended consequences and thus should be avoided.

Policy Options for Cambodia

In pursuing the goal of promoting greater use of the riel, the Cambodian authorities should consider market-based policies. There is no single silver bullet for encouraging the use of local currency over foreign currency. Rather, a combination of supportive and market-oriented policies is needed. Forced and rapid de-dollarization should be avoided, given that it has been unsuccessful elsewhere. Recommended policies for Cambodia are discussed next.

Macroeconomic Environment

A stable macroeconomic environment is critical. Cambodia has achieved macroeconomic stability over the past decade with low inflation, high growth, and a credible fiscal position. The authorities should aim to build upon these achievements. Given the limited tools for conducting monetary policy, continuous buy-in by the fiscal authorities through a prudent fiscal stance is essential. In parallel, it is necessary to establish a credible monetary policy. Since attaining such credibility takes time, the monetary policy authorities should constantly be seen as taking appropriate policy decisions, given economic developments, should be accountable, and should be independent.

A strategy to reduce dollarization should be aligned with an appropriate exchange rate policy. Once dollarization has taken hold, maintaining an independent monetary policy is difficult and therefore exchange rate stabilization becomes a viable option. The NBC has maintained a relatively fixed exchange rate vis-à-vis the U.S. dollar, which has been the effective nominal anchor for three decades in the absence of a formal monetary framework. However, the achievement of low inflation has not halted or reversed the trend of increasing dollarization.3Ize and Yeyati (2005) find that dollarization hysteresis (the persistence of dollarization after years of subdued inflation) can be the result of exchange-rate-based stabilization efforts. Monetary policy that closely targets the real exchange rate stimulates dollarization. They further find that if the real exchange rate is stable relative to inflation, the dollar becomes the preferred currency. Therefore, exchange-rate-based stabilization can enforce dollarization and not be well aligned with a dedollarization strategy. Ize and Yeyati (2005) further argue that allowing the exchange rate to be more flexible alters relative risks in favor of the local currency. Kokenyne, Ley, and Veyrune (2010) also find that maintaining trends in the exchange rate could enforce dollarization by entrenching the expectation of a continuous appreciation or depreciation. They argue that a move in the currency in either direction, with less bias toward currency depreciation, helps make foreign exchange risk more apparent and could provide a disincentive to financial dollarization. Given the endogeneity of exchange rate policy, the policy alone is not sufficient for dedollarizing and needs to be put into context with other measures aimed at promoting the use of the local currency.

Domestic Financial Market

The money market needs to be further developed in Cambodia to help reduce risks associated with the dollarization of credit to nontradable sectors and to strengthen the interest rate channel of monetary policy transmission. Developing the money market’s ability to forecast and target short-term liquidity is one of the main priorities. There is currently no interbank market in Cambodia; its development should be a priority for the monetary transmission mechanism and for liquidity management.

Several steps are needed to create the interbank market, including establishing the ability of the NBC’s Monetary Policy Committee to define a corridor of interest rates for standing facilities. A collateralized rediscount facility could establish a ceiling for the interbank money market, while an overnight deposit facility in the central bank could provide a floor to the interbank rate. Other steps would include developing the NBC’s expertise to forecast daily outstanding balances on current accounts of banks that would be used to introduce open market operations; and introducing auctions of NBC certificates to help regulate excess liquidity. How best to sequence the issuance of NBC securities (denominated both in riels and in U.S. dollars) to help develop the interbank market and make further progress in dedollarization is discussed in Part II of this book.

Financial Policy and Prudential Regulation

Several measures could help raise intermediation in the domestic currency and help build a liquidity line of defense.

  • First, through the reserve requirement. Having a higher reserve requirement on foreign currency liabilities helps make such liabilities more costly. At the same time, this helps mitigate a liquidity risk of dollarization (such as deposit runs) that is related to such deposits. A lower reserve requirement on local currency simultaneously creates an incentive to intermediate in Cambodian riels. The NBC currently maintains a higher reserve requirement on foreign currency than on the riel, helping to promote use of the latter. However, this on its own is not enough to ensure a significant shift toward riel use.
  • Second, introducing a deposit insurance system. This could foster confidence in the financial system. Insurance coverage should be made higher for the domestic currency than for the foreign currency.
  • Third, maintaining a sufficient level of international reserves. International reserves play an important role in a dollarized economy as they serve the purpose of liquidity support to banks in case of bank-runs. High coverage of international reserves helps reduce the perception of a weak currency.

Regulation to encourage the use of the riel as a unit of account could help. This could include requiring that all prices in the market be listed in the riel, and that the riel be used for all accounting, financial reporting, and official purposes. The experience of a riel-listing requirement for the newly created stock market shows that such a measure can be effective. Although regulations allow settlement of stock market transactions in U.S. dollars for a transition period of three years, reportedly all transactions have so far been settled in riels, in part reflecting conversion risks. Moreover, the riel is already being used for tax purposes, which is a step in the right direction.

Policies that promote the use of the riel for payments through more convenient and lower-cost services than for foreign currency could be pursued. Peru, for example, introduced a 2 percent tax on checks denominated in foreign currency to discourage the use of foreign currency for payments (Erasmus, Leichter, and Menkulasi, 2009). Also, the riel could be promoted by making it continuously available in larger denominations that are convenient for the public or by introducing a clearance tax for checks denominated in foreign currency.

Conclusion

Dollarization in Cambodia has risen in the presence of a stable macroeconomic and political environment. Dollarization appears not to be a problem of currency substitution, given that the volume of riels being used has risen significantly over time. There are several costs associated with dollarization, including a loss of monetary policy and the loss of seigniorage. Also, liquidity and balance sheet risks become heightened. A strategy to reduce dollarization will require making the dollar less attractive compared with the riel. There is no silver bullet, but a comprehensive set of market-driven measures, supported by the continuation of a stable macroeconomic environment, is essential.

Appendix: Effects of Changes in the U.S. Federal Funds Rate on Macroeconomic Variables in Cambodia

The macroeconomic literature identifies two main channels through which monetary policy shocks could be transmitted between countries. The first channel is the trade channel. In this channel, monetary policy tightening in a trading partner country (country A) can result in dampened economic activity in that country, leading to lower demand for imports that translates to lower exports in the trading partner country (country B). The second channel is the financial channel. When capital is mobile between two countries, the financial channel tends to be important. Monetary policy tightening in country A relative to country B can attract capital to country A given the higher rate of return owing to higher interest rates. The importance of these channels to Cambodia is explored below using a vector autoregression model (VAR).

Vector Autoregression Model

The VAR approach has gained popularity in the economic literature since its introduction by Sims (1980) as a tool to assess the transmission mechanism. In a general form, the VAR(p) model is as follows:

where c is an n × 1 vector of constants, βi is an n × n matrix of betas for i = 1, 2, . . . p and εt is an n × 1 vector of error terms. The error terms are serially uncorrelated and the mean of each error vector is the zero vector; the covariance matrix between the error terms for a given point in time is positive definite; and the correlation between the error vectors is zero across time (i.e., there is no serial correlation among the error vectors).

The VAR model is estimated using quarterly data for Cambodia for the period 1995:Q1 to 2009:Q2. The choice of variables in the model is motivated by various theories of the transmission mechanism. While the traditional Mundell-Fleming-Dornbusch model (see Dornbusch, 1980) establishes macroeconomic aspects of transmission in small open economies providing the basis for the trade channel, the model itself has been found in empirical work to be insufficient to explain the full transmission. Therefore, there have been extensions in the literature, including that by Obstfeld and Rogoff (1995), by incorporating the microeconomic aspects of transmission, especially the incorporation of monetary shocks and therefore the important role of interest rates, which help to provide the basis for the financial channel. The variables incorporated in the VAR model are the federal funds rate (for U.S. monetary policy shock); the bilateral nominal exchange rate; the trade balance, which helps to capture the impact on and significance of the trade channel, broad money, domestic lending and deposit interest rates (to help test the significance of the financial channel); inflation; and the output gap (for real economy impact). The output gap is measured as the deviation of real GDP from the historical trend (measured through the Hodrick-Prescott filter). A positive output gap implies that real GDP is above its potential and therefore can have inflationary effects and would warrant domestic tightening.

Tests on Variables and the Model

All variables were found to be integrated of order 1 (I(1)) except the output gap variable, which was found to be integrated of order 0. This means that I(1) variables need to be differenced once to make them stationary. The residuals from the VAR are found to be stationary (Appendix Figure A3.1). The VAR was estimated with two lags given that this number of lags minimizes the Akaike information criterion, which helps measure the goodness of fit of the model.

Figure A3.1Residuals

Source: IMF staff estimates.

Note: See text for explanation of abbreviations.

Impulse Response Functions

The responses of variables to the shock in the federal funds rate are identified in the VAR using the Cholesky decomposition (Figure A3.2). The Cholesky method requires identifying the chain of reaction (or the ordering of variables) starting from the exogenous variable to the most endogenous. The ordering used is from the federal funds rate (DFEDFUNDSR), to the exchange rate (DLREXCHR), to the trade balance (DTRADEB), to broad money (DLBM), to deposit rates (DRDEPR), to lending rates (DRLENDR), to the output gap (YGAP), and lastly to inflation (DLCPI). Oil prices enter exogenously in the model to help capture the effect of commodity prices. In the acronyms of the variables, d stands for the differencing and l means that the variable has been logged.

Figure A3.2Impulse Responses

Source: IMF staff estimates.

Note: The dotted lines are response standard errors. See text for explanation of abbreviations.

It appears that financial sector variables (specifically the lending and deposit rates) have a stronger reaction to shocks in the federal funds rate compared to the trade balance (Figure A3.3). The results can be summarized as follows:

  • A one standard deviation shock to the federal funds rate (an increase of about 0.3 percent) results in an increase in the lending rates of about 0.4 percent and a 0.5 percent increase in deposit rates as local banks attempt to minimize the spread between domestic and foreign interest rates. The impact on domestic interest rates occurs within the first quarter of the shock to the federal funds rate, with a larger impact occurring in the second quarter. However, as the lag of the impact increases, domestic interest rates decline (between five and seven months following the shock) probably reacting at this point to lower demand for loans as the Cambodian economy contracts.
  • A shock to the federal funds rate appears to result in an increase in the Cambodian trade balance (by about 0.1 percent following a 0.3 percent shock in the federal funds rate) within a quarter and a negative effect in two quarters. The immediate positive impact may reflect a stronger contractionary impact on imports in Cambodia, since as domestic interest rates also respond with an increase, they contribute to an overall contraction. However, the trade balance worsens in the third quarter, indicating the contractionary effect on exports as U.S. demand has had time to respond to the initial federal funds rate shock.
  • The response of the exchange rate is small, with the riel depreciating against the U.S. dollar. This is not surprising owing to the high dollarization in Cambodia, which implies a loss of flexibility in exchange rate policy. Some economists have contended that highly dollarized economies tend to adjust through goods and factor markets, as well as financial markets, and not necessarily through the exchange rate (de Zamaróczy and Sa, 2003).
  • A shock to the federal funds rate results in a decline in output and inflation in Cambodia, reflecting a contractionary effect of U.S. monetary policy (and therefore lower liquidity into Cambodia) as well as the contractionary effect of domestic interest rates within the first quarter. However, as domestic interest rates decline in the following months, domestic output picks up and inflation rises a quarter later.

Figure A3.3Cumulative Pass-Through Coefficients of the Federal Funds Rate

Source: IMF staff estimates.

Note: See text for explanation of abbreviations.

Variance Decompositions

Another way to analyze the dynamics of the VAR is through forecast error variance decompositions. The variance decompositions help to determine the relative importance of the shock variable to fluctuations in the response variables in the model (Figure A3.4). Shocks to the federal funds rate contribute about 25 percent of variation in the financial variables, whereas they contribute about 5 percent of the variation in the trade balance. On real economy variables, the federal funds rate contributes to about 15 percent of variation in the output gap and about 23 percent of variation in Cambodian inflation. The higher impact on the real economy compared to the trade channel likely reflects the double impact of the financial and the trade channels on overall economic activity.

Figure A3.4Variance Decompositions

Source: IMF staff estimates.

Note: See text for explanation of abbreviations.

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1Banks are required to hold reserves in U.S. dollars (for foreign currency deposits) and in riels (for riel deposits). As of end-2012, the required reserve ratio on foreign currency was 12.5 percent, while that on riel deposits was 8 percent. Required reserves are remunerated at one-half the Singapore interbank offered rate (SIBOR).
2Bangladesh and Lao P.D.R. were also assessed, but this produced insignificant results given that both countries have low levels of currency in circulation.
3Moreover, the relatively fixed exchange rate conflicts with the need to facilitate adjustment to asymmetric shocks as well as to protect official reserves, given the limited lender-of-last resort capability under dollarization.

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