Dollarization in Georgia
THE DOLLARIZATION OF THE FINANCIAL SECTOR, which is reflected in lending and attracting deposits in a foreign currency instead of the national currency, is one of the most significant challenges for many developing countries in the world. Unfortunately, Georgia is no exception. In general, the origins of dollarization have historically been linked to macroeconomic instability and periods of hyperinflation. Over such periods, due to high uncertainty, financial intermediation using the local currency becomes more difficult. Hence, the local currency is often replaced by a more stable currency.
The origins of dollarization in Georgia are also linked to the experience of the macroeconomic and political instability in the 1990s.In addition, in the early 2000s, Georgian commercial banks’ access to the international financial markets increased. Resultantly, commercial banks started attracting foreign currency funding from non-resident banks and international financial institutions, thus contributing to the growth of foreign currency lending in the country. In small open economies like Georgia, high dollarization is a source of various problems. Given the free capital mobility, which is necessary to achieve productivity growth in the country, and consequently, economic growth in the long run, the existence of a floating exchange rate regime is the optimal choice.
A small open economy, integrated with the global economy, is affected by any change in external conditions. The flexibility of the exchange rate allows a country to reduce negative impact of the so-called external shocks on the real economy. Hence, the floating exchange rate serves as a shock absorber and helps the economy to recover with the lowest social costs. However, under a floating exchange rate regime, local borrowers who have a loan in foreign currency are subject to currency risk. Most of these borrowers, especially borrowers with smaller loans, do not have the ability to manage this risk, which in turn increases the overall credit risk in the banking sector. In addition, the high dollarization of corporate loans also results in higher volatility of inflation. As a result, during external or domestic shocks followed by currency depreciation, the economy is hit by an additional shock, which requires tighter monetary and fiscal policy stances. Thus, due to dollarization, the shock is amplified further, and we get the so-called “double shock” effect that is translated into lower growth of income and higher unemployment than it would have been under lower dollarization. Therefore, high dollarization significantly increases the risks of macroeconomic instability to an economy.
Along with currency (and induced credit) risk, dollarization also increases liquidity risks. The central bank’s ability to play the role of a lender of last resort is limited by high dollarization. In particular, the central bank can provide unlimited liquidity to commercial banks in local currency, but foreign currency financing is limited by the amount of foreign exchange reserves. In response to this challenge, banks are forced to maintain high buffers of liquidity in foreign currencies. Unlike the national currency, the creation of foreign currency liquidity buffers is costly, making the country’s long-term financial resources more expensive. At the same time, dollarization reduces the efficiency of the monetary policy.
In case of high dollarization, the central bank must increase/decrease the interest rate by more than it would otherwise. Due to dollarization, the sharp rise in interest rates is causing higher economic volatility and, as a result, reduces long-term growth. Moreover, dollarization is also hindering the improvement of Georgia’s sovereign credit rating. Credit ratings directly affect the price of resources attracted from international markets. The higher the risk of the country, the higher the price of credit attracted by the private and public sectors and the lower the volume of foreign direct investment.
Consequently, long-term potential economic growth is lower. Considering the reasons discussed above, under high dollarization, the economy is characterized by high volatility and macroeconomic instability, which is eventually reflected in lower incomes and high unemployment. Hence, we can say that the high dollarization of the financial sector, first and foremost, causes problems for borrowers, and at the same time, has a negative impact on the whole economy. As a result, everybody is affected, including those who do not have loans in foreign currency. Due to these high and fundamental risks, it is important to resolve the dollarization issue to improve the economic outlook of Georgia. Different countries have had various experiences of dealing with dollarization.
Many countries have either avoided the dollarization of the financial sector from the outset or eliminated it through consistent market reforms. Several countries, however, have solved the problem of dollarization by using administrative measures after a crisis. Nevertheless, there are still many countries where, despite reforms and administrative measures, the dollarization of the financial sector remains high. At the same time, the experiences of different countries clearly reveal that to solve the problem of dollarization, it is necessary to have a stable macroeconomic environment, developed financial markets, and, in case of market failure, use administrative measures. In Georgia, larization measures include increasing the availability of long-term GEL resources, adequate distribution of foreign exchange risks, and measures to promote pricing in lari.
Price stability is critical to boosting the confidence of the national currency and increasing larization. SinceGeorgia introduced inflation targeting framework in 2010, inflation has fallen sharply, averaging 3.6% over the past ten years, which is quite low. Over the same period, the National Bank of Georgia, together with the Government of Georgia, supported the creation of long-term GEL instruments in the financial sector. Throughout this period the dollarization of the financial sector declined. The renewal in issuance of treasury securitiesin2009 and the gradual increase in their maturity and volume is of particular importance, as it is essential for the development of the securities market.
In 2016, NBG together with the government developed a joint strategy for the development of capital markets, which was being gradually implemented over the several years and currently it is almost complete. At the same time, NBG provides commercial banks with liquidity risk management tools that allows them to offer long-term GEL loans to consumers. Hence, banks are managing GEL liquidity more efficiently. These steps have had a positive effect on the de-dollarization trend, reducing the dollarization of both total loans and deposits. Meanwhile, the de-dollarization of loans to individuals is of particular importance, as individuals are most vulnerable to currency risks.
The dollarization of loans to individuals has decreased by 40% when compared to 2010 (excluding the exchange rate effect, this figure has been halved), and since the end of 2016, it has decreased by 18%. The downward trend in dollarization is somewhat volatile, as declining dollarization will lead to a reduction in macroeconomic risks, and consequently, a decrease in interest rates on resources attracted in foreign currency, resulting in banks having excess foreign currency. Meanwhile, excess foreign currency reserves lead to an intensification of foreign currency lending for some time and a slowdown in the dedollarization of loans, which is often the basis for criticism of the de-dollarization policy.
Despite these fluctuations, it is important to continue the downward trend of dollarization in the long run. Of course, dollarization will never be reduced to zero, nor is this the goal. However, it is necessary to reduce the share of foreign currency loans to the extent that during external shocks macroeconomic instruments can mitigate external shocks as much as possible.