Unraveling Dollarization

The financial crises of the 1990s in Asia, Argentina, and Russia sparked interest in the phenomenon of dollarization—the use of a foreign currency to perform national currency functions.¹ Dollarization has a long history dating back to the nineteenth history. More recently, a growing body of work has outlined how dollarization limits the independence of monetary policy in host countries and restrains local central banks from acting as lenders of last resort. This research has revealed dollarization’s far-reaching impacts: it causes higher financial fragility, leading to crises during currency depreciation; it eliminates the use of the exchange rate as a policy tool to increase international competitiveness of exports goods and services;² and it hinders economic growth.³ These tendencies have only been aggravated in the aftermath of Covid-19, with rising debt levels and deepening asymmetries between the global North and South.

Neoclassical approaches to dollarization depict it as a consequence of financial and macroeconomic instability. But despite improved financial indicators, dollarization rates across the developing world remain high, a phenomenon referred to as dollarization hysteresis.⁴ Understanding this persistence and ubiquity, I argue, requires a deep and qualitative investigation of government decision-making, examining the interests of state actors, domestic and foreign capital owners, and civil societal groups. Though states tend to be excluded from theories of dollarization, they are essential to understanding it both analytically and historically. Currencies are embedded within broader hegemonic struggles of state formation, between domestic and international, state and non-state actors. 

The experience of Georgia can shed light on how dollarization is embedded into processes of state-building, development, accumulation, and governance. Georgia represents a classical example of dollarization hysteresis: in 2021, its rate of deposit dollarization reached 60 percent, corporate loan dollarization 70 percent, and household loan dollarization 41 percent. Household borrowers have been most exposed to the risks of foreign currency debt, earning 90 percent of their money in the national currency. Consumer loans and mortgages have long become an inseparable part of daily life, with credit repayment issues leading to foreclosure in most instances. Moreover, 80 percent of the public debt is denominated in foreign currency. These trends have only worsened with the pandemic—with sharp increases in the ratio of government debt to GDP and government debt service to budget revenues, increased unemployment, and rising poverty levels, non-performing retail loans in foreign currency more than doubled. In what follows, I examine the political foundations of this pernicious monetary arrangement.

Dollarization & state formation

Dollarization first appeared in the colonial context of the nineteenth century, across countries like Egypt, Ghana, Liberia, and Tunisia.⁵ In the twentieth century, it expanded throughout Latin America, as American policymakers sought to solidify their military and economic expansion.⁶ Throughout the 1990s, it was revived in post-Soviet economies.⁷

Following the First World War, “dollar diplomacy” was used to secure American economic and political dominance and the currency’s international role. The 1940s would see a momentary pause in dollarization efforts, as the Federal Reserve, under the leadership of Robert Triffin, advocated capital controls, adjustable exchange rates, and an activist monetary policy.⁸ With the breakup of Bretton Woods and the transition to floating exchange rates in 1971, however, the dollar reemerged as a cornerstone of the global economy. Susan Strange referred to this change as the “progression from exorbitant privilege to super-exorbitant privilege”⁹ for the United States. The liberalization of currency regimes and capital accounts in the 1970s, as well as the shift to price stability in monetary policy tightened the policy space for dollarized countries, who were forced to choose between currency and price stability. 

Thus, the expansion and use of the dollar have always been entangled in a web of geopolitical and economic interests. These interests, however, were not always externally imposed. Understanding the reasoning of dollarized countries is crucial to characterizing the persistence of dollarization and conceptualizing alternatives. Peripheral states seek to strengthen their weak currencies in order to avoid domestic economic outcomes from exchange rate volatilities, expand their capacity for monetary and countercyclical fiscal policies, and strengthen the tools they have for engaging with local interest groups.¹⁰ In each of these ways, states act both as vessels for competing interests, and political agents in their own right. 

Currencies have been essential to the political calculations of modern nation states since their founding.¹¹ By controlling a country’s currency, central banks mediate between states and domestic business interests—both financial and industrial. Central bank policies which alter between price and currency stability have distributional implications for foreign investors, local producers, workers, and households. While export industries can profit from currency devaluations which cheapen their products in the international market, households indebted in foreign currency experience greater difficulty servicing their loans. Likewise, prioritizing price stability through interest rate hikes will slows down economic activity in the real economy. 

Mediating between these groups, central banks themselves become contested power players. These tensions are even more pronounced in the periphery, where central bank policies must navigate among the expectations of the IMF, foreign investors, local producers, and governments. Currency policies thus always reflect the outcome of political negotiations. The hegemony of a foreign currency, and especially its use as a primary means of payment, furthermore reflect a consensus among key fractions of the ruling elite, whose interests may deviate from those of society as a whole. 

Georgia’s dollarized economy

The development of Georgian dollarization parallels its national independence. The ruble and dollar have dominated the country’s domestic economy since 1991, with the dollarization rate reaching 67 percent in 1994, preceding the issue of the national currency, the lari, in 1995.¹² Dollar domination originated in post-Soviet transition policies, which opened the doors of the Georgian economy to the world market. In the opaque, patrimonial, and bureaucratic Georgian state, the dollar was used as a primary means of payment—serving the interests of rent-seeking political, economic, and financial elites who used it towards bribery and corruption, as well as speculative commercial banks who profited from FX conversions and encouraged dollar deposits via high interest rates. Given the public preoccupation with questions of democracy and human rights, dollarization proceeded largely unnoticed. Even as it recognized the outcomes of dollarization, the IMF denied its relationship to liberalization and placed the burden with the inadequacies of the Georgian state. 

These inadequacies were precisely what the Rose Revolution of 2003 was meant to address. Through rolling back the public sector, promoting economic growth, and establishing liberal democratic elections, Georgia was meant to embrace Europe and leave its Soviet past behind.¹³ The revolution was successful in many of these efforts—it generally eliminated corruption in everyday life, provided a favorable legal framework for investors, shrunk the bureaucracy, and pursued radical deregulation of economic activity across the board. Under the façade of democratization, however, the post-revolutionary government continued to suppress civil society groups and social movements. Moreover, distributional politics were excluded from the discourse on democracy—GDP grew through foreign direct investment, resulting in lower taxes, a more flexible labor market, and a deregulated financial sector. As finance became one of the fastest growing sectors of the Georgian economy, urban unemployment, poverty, and income inequality persisted and worsened.¹⁴ 

Moreover, despite the economic recovery which followed the Rose Revolution, dollarization rates remained at 70 percent. Under the guidance of the IMF, most Georgian banks came under foreign ownership (more than 50 percent of shares were owned by non-residents). By 2013, nineteen out of the country’s twenty banks were foreign owned. Institutions like the European Bank for Reconstruction and Development, International Financial Corporation, Dutch Entrepreneurial Development Bank, and Deutsche Investitions und Entwicklungsgesellschaft were among the major shareholders in Georgian banks. 

The post-revolutionary deregulation of banking activities, development of the judicial system, and improvement of collateral lending practices encouraged commercial banks to issue loans to households in addition to select corporations. With no development banks and foreign currency denominated loans, commercial banks generated rising household debt, import dependence, and vulnerability to exchange-rate fluctuations. Easy access to foreign money encouraged Georgian banks to issue foreign currency loans, where the exchange-rate risk was mostly borne by the borrowers (especially in retail lending). Thus, foreign capital was largely behind the Georgian credit boom of 2005. The credit boom was also enabled by the absence of regulations on foreign currency lending. The abolition of the interest rate ceiling and personal insolvency law, a lack of guidelines around the income-interest rate ratio for borrowers, and uncomplicated procedures for seizing collateral together made it easier for banks to issue loans. 

During the credit boom, household debt (consumer loans and mortgages) rose, directly contributing to dollarization persistence. Loan dollarization reached 72 percent, while deposit dollarization was 65 percent in 2011. Loan dollarization was largely driven by retail loans, which presented more than 30 percent of total loans in 2010. Consumer loans were mostly used for financing imports that further worsened the Georgian trade balance. Mortgages in foreign currency also encouraged price dollarization on the real estate market. The real estate and construction sectors emerged as the foremost winners of the post-revolutionary accumulation regime, in which the rate of price dollarization for buying or renting real estate remains very high.

The Georgian state government played a crucial role in constructing favorable legal conditions for foreign capital, empowering commercial banks, and cutting back key public functions. Mortgage loans and credit increased in order to compensate for this public sector withdrawal. 

By embracing an inflation targeting monetary policy, Georgia’s central bank was also systematically weakened. Before the 2008-2009 crisis, the National Bank of Georgia (NBG) had to tackle the impacts of foreign capital inflow and currency appreciation through sterilization, but under inflation targeting its policy choices were constrained by price stability aims and exchange rate stability. Its major instrument—the interest rate—was ineffective not only due to dollarization, but also because of foreign bank ownership. Given that most banks in Georgia had access to foreign capital, they were not interested in lending from the central bank. 

The changing nature of elite interests over the past decades helps explain the  trajectory of Georgian economic policy. Prior to the revolution, dollarization benefited the shadow economy, which relied on foreign currency for bribes and black market transactions. It also benefited the financial sector, when banks promoted currency conversions and encouraged savings in foreign currencies. In the aftermath of the revolution, the Georgian government actively sought to weaken the NBG, even considering its abolition, in order to protect an accumulation regime constructed around foreign capital inflow.

Even after the government gave up its attempts to control the central bank, the NBG still served the interests of foreign investors. Its inflation targeting regime subordinated strong currency to price stability aims. Local financial elites, alongside foreign owners, profited from dollarization. Commercial banks had excess liquidity in foreign currency and were allowed to lend in foreign currency without restrictions. A highly dollarized real estate market also meant that foreign capital inflow and dollarization served the interests of economic elites from the construction and real estate sectors. Easy access to dollar loans with low interest rates appeared to be beneficial opportunities for the public, as long as the national currency was stable. In the meantime, civil society organizations—NGOs, academia, think tanks, and the media—neglected to approach economic policy as an arena of struggle, focusing instead on democracy and civil rights. Some of the nation’s leading universities as well as foreign think tanks supported the economic development policies of the post-revolution government.

The consequences

The currency crisis of 2015–2016 unraveled the structural socio-economic issues brought on by dollarization over the course of decades. By 2016, more than 50 percent of retail loans were denominated in foreign currency, and one-third of household borrowers spent more than half of their income on servicing their loans. Dollarization was thus politicized as a result of increased poverty and household over-indebtedness.

The currency crisis soon prompted a political legitimacy crisis. Public pressure, as well as the recommendations of the IMF and the World Bank, pushed the Georgian government and the NBG towards formal de-dollarization. The reforms restricted the volume of loans denominated in foreign currency, introduced payment to income and loan to value indicators for retail loans, encouraged real estate transactions in the national currency, and reintroduced a ceiling for the annual interest rate on all loans. 

Despite these new regulations, the root causes of dollarization remain unresolved. Strong currencies cannot exist without strong state institutions, public trust towards the government, and a well-developed economy. De-dollarization measures cannot solely address monetary and fiscal policies or commercial banks alone; they instead must reflect more deeply on the role of the state in society, public participation in economic policymaking, and the impact of the international monetary system on the policymaking capacity of local governments. This requires substantial reform to the mandate of central banks and the architecture of the global financial system. 

This article is adapted from the recently published book Unravelling the Persistence of Dollarization: The Case of Georgia.