CONCLUSIONES Y RECOMENDACIONES

This chapter has covered a brief review of the definitions, types, and measures of dollarization or currency substitution and also presented some theories on the determinants along with the costs and benefits associated with the phenomenon. Under the definition, it was concluded that dollarization and currency substitution have been used interchangeably. There is no single definition that exists for dollarization or currency substitution. The widely held definition has been the adoption of a foreign currency to perform the functions of money. On the issue of how the foreign currency is used, there are two types of dollarization – partial dollarization (where the foreign currency performs some functions of money) and full dollarization (where the foreign currency performs all the functions of money – currency substitution).

The process of dollarization has been described as a continuum with the last stage described as the use of foreign currency as a medium of exchange and known as currency substitution. Several measures or indicators have been used to describe the concept. The most commonly used has been defined as deposit dollarization, which is the ratio of foreign currency deposit to total deposit in the banking sector. On the consequences of dollarization, some key issues emerge – the function of money being performed by the foreign currency, whether the foreign currency has been officially adopted (de jure) or not (de facto), and the extent at which the foreign currency is been used in the domestic economy (full dollarization or partial dollarization).

It is also clear from the review that many of the studies that have been conducted in the emerging market economies, often citing data constraints, have tilted towards Latin American and East Asian countries. However, as a segment of the emerging markets, Africa‘s financial

markets appear not to have received adequate attention by researchers on these issues. The paucity of literature on sub-Saharan African countries like Ghana and the continent in general makes it difficult to establish the exact nature of the relationship between dollarization and macroeconomic fundamentals. This study has made the attempt at filling this significant gap in the literature. The study reported in this thesis focuses on dollarization and macroeconomic instability, with particular focus on Ghana in a collection of essays. The remainder of the chapters are empirical essays which explore different questions connected to the determinants of financial dollarization and the consequences on macroeconomic stability in Ghana.

CHAPTER THREE

DETERMINANTS OF DOLLARIZATION IN GHANA

3.1. Introduction

The rising trend of demand for foreign currency17 _{in recent years presents a major challenge for} policymaking in developing countries. Most of these countries have witnessed the use of other country‘s currency as a store of value, as a unit of account, or as a medium of exchange. In most extreme instances, the foreign currencies replace the local currency or at best used alongside as though it has been given the necessary backing as the legal tender for transactions in the country. The phenomenon has generally been triggered by macroeconomic instability manifesting in high and volatile rates of inflation, strong and intractable depreciation of the domestic currency, undeveloped capital market, market imperfections, and inadequate regulations which lead to loss of confidence in the local currency to serve as a legal tender.

The mounting evidence of dollarization in Ghana has been gathered from, among other things, the increasing demand for and use of foreign currency for transactions, quotation of prices of some domestic goods and services in foreign currency (notably the United States dollar), and statements made by leading government officials and economists alluding to the growing phenomenon in the economy. The theme has attracted the interest of policymakers in recent discourse on the stability of the Ghanaian economy and has been in the spotlight given that the incessant depreciation of the cedi has somewhat been attributed to the mounting dollarizing effect in the Ghanaian economy. The debate was further fuelled when the Bank of Ghana instituted what has been described in some circles as ―draconian‖ measures in February 2014 in its bid to avert the rapid depreciation of the cedi.18

18 _{According to the Bank of Ghana, the attempts to enforce restrictions on foreign exchange transactions were meant to halt the}

Another branch of the literature has focused on the determinants and characteristics of currency substitution and dollarization in developing countries (for example, Ortiz, 1983; Canto, 1985; Ramirez-Rojas, 1985; El-Erian, 1988; Melvin, 1988; Calvo & Vegh, 1992). Several theories have sought to explain the relationship between macroeconomic fundamentals and dollarization. Empirical modelling of dollarization in developing countries has produced nothing but controversial results, with the direction and statistical significance of the effects of macroeconomic variables on dollarization varying from one study to the other (see, inter alia, Savastano 1996; Sahay & Vegh 1996; De Nicolo et al., 2003; Ize & Levy-Yeyati 2003; Rennhack & Nozaki, 2006; Levy-Yeyati, 2006). This makes the subject an interesting empirical adventure that seeks further endeavours to model the evolution of dollarization and the crucial dilemmas it presents to macroeconomic management and policymaking.

In the case of Ghana, there is an on-going debate on the drivers of dollarization. The Central Bank implemented foreign exchange rules based on its belief that the rising dollarization is the cause of exchange rate depreciation. On the other hand, some economists, including a former deputy Governor of the Bank, have questioned the prudence in that attempt. They argue that, it is rather the depreciation of the cedi that brings about dollarization and not the other way. There is little empirical work on the determinants of dollarization. Interestingly, to the best of the author‘s knowledge, there is no empirical study that captures the determinants of dollarization in Ghana despite the heightened controversy. Ghana is one of two countries in Africa that formally adopted inflation targeting framework/regime in the early 2000. It also embarked on a redenomination of its currency in July 2007 by knocking four zeros off the old currency.

reversal had been based on consultations with stakeholders and the general public as well as analysis of the available data and the fact that it has observed some implementation challenges, which indicated that the rules have had limited effect and confirmed the position of those who had argued earlier that the directives were inappropriate.

However, no study has considered whether the turn of events has contributed to the trend of dollarization in the economy. The subject has become more imperative, especially with the difficulty in proving whether weak macroeconomic fundamentals is the precursor to dollarization as argued by Bawumia (2014) or otherwise.

The rise in demand for foreign currency in Ghana has been described as a remarkable attribute of the financial sector reforms and liberalization that started in the 1980s (Adenutsi & Yartey, 2007). With the aim of integrating domestic financial markets with the rest of the world, capital account controls/restrictions have been relaxed and to some extent have paved way for the conduct of transactions in both domestic and foreign currencies, albeit within some restrictions. This has seen astronomical growth in the share of foreign currency denominated assets and liabilities in the financial system. Despite some significant improvement in the macroeconomic fundamentals in the last few years, the Ghanaian economy continues to be characterised by relatively high and persistent inflation rates, continuous depreciation of its currency, unbridled recurrent budget deficits, and rising stock of public debt (Bawumia, 2014). The inflation rate which declined from 18.1 percent in 2008 to 12.5 percent in 2011 has increased steadily to 17.4 percent in October 2015 (Ghana Statistical Service, 2015). Fiscal deficit and stock of public debt have seen dramatic increases reaching 10.8 and 55.5 percent of GDP respectively at the end of 2013 (Terkper, 2014). According to the Finance Minister, the stock of public debt stood at 60.8 percent of GDP at the end of September 2014. Also, despite all the policies embarked upon by the Bank of Ghana and other policymaking agencies, the cumulative depreciation of the cedi against the major trading currencies reached almost 30 percent in the first half of 2014 (Bank of Ghana, 2014). Both the World Bank and the International Monetary Fund (IMF) expressed a worrying response about the deteriorating macroeconomic fundamentals and the challenges

engulfing the lower middle income country.19 _{It has been argued that macroeconomic stability} and fiscal discipline are necessary for curbing dollarization as against direct measures such as compulsory conversion of foreign currency earnings to the domestic currency as it substantially diminishes the government‘s credibility and hypes the risk perceived by domestic residents (Berg & Borensztein, 2000b). However, the success or failure of such attempts would be based on understanding the true drivers of the process in both the short and long-run. To the best of our knowledge, despite the debate and controversy surrounding the evolution of dollarization of the Ghanaian economy no study has attempted to establish its driving forces empirically.

This study strengthens the frontiers of the existing literature on the determinants of dollarization in emerging markets. The purpose is to present further evidence on dollarization in Ghana by exploring the long-run determinants of the process. The study makes use of most updated data. The fact that we make use of monthly data up to March 2015 is a novelty because most previous studies have at best used quarterly data. Besides, our study does not include the fixed exchange rate regime. Some of the landmark activities during the period are the implementation of HIPC, adoption of inflation targeting monetary policy, major reforms in the financial sector, redenomination of the domestic currency, among others have been captured in this present study. Due to these developments, the study makes another contribution to the literature by including proxies for financial development and economic activity. We include a proxy for economic activity to encompass potential market failures and fluctuations in aggregate demand not captured by the other measures, such as economic and institutional factors that influence the development of local currency markets (Levy-Yeyati, 2006). It is expected that a well-developed financial system would be associated with better management and investment opportunities in domestic currency. We capture the credibility of macroeconomic policies by including a proxy

19 _{Ghana reached a US$1bn bailout agreement with the IMF in February 2015 to shore up the economy and bring about fiscal}

for inflation targeting. This is because the adoption of explicit (fully-fledged) inflation targeting monetary policy in May 2007 was expected to boost the credibility of macroeconomic policies, and therefore the regime is expected to reduce the extent of dollarization in the economy. This would shed light on the pattern of the phenomenon, extract the possible implications for policymaking, and prescribe options to contend with the situation. The empirical evidence suggests that financial dollarization shares a common stochastic trend with exchange rates, inflation, interest rate differential, real output, and financial development. The long and short run analysis points to the important role of exchange rates depreciation and financial development in the dollarization process in Ghana. Whereas the depreciation of the cedi induces a switch to the use of foreign currency, financial development diminishes the trend.

The remaining sections of the chapter are structured as follows: Section 3.2 relates the behaviour of dollarization to the movements of exchange rates, interest rates, inflation, and the other variables under consideration. The properties of the data, data sources, descriptive statistics, and correlation are presented. We do this to present a preliminary evidence of possible association of the variables. Section 3.3 is an empirical model for the evolution of dollarization and an overview of the econometric methodology. Section 3.4 presents the results and analysis, indicating a long- run relationship between the variables within the ARDL bounds testing framework. Section 3.5 is the conclusion and policy recommendations.