Measurement of Co-Circulation of Currencies and Dollarization in the Republic of Armenia, The

European Journal of Comparative Economics, The, 2005 by Zoryan, Hakob

B. Comparison with other FSU Countries

Armenia is one of the most highly dollarized economies in the former Soviet Union As Table 3 shows, dollarization is highest in the Caucasus region (Armenia, Azerbaijan, Georgia) and the lowest in the Baltic States (Estonia, Latvia, Lithuania) and Russia and the Ukraine.

According to Balino (1999) "highly dollarized" countries are those where DI is higher than 30%. Thus, most FSU countries fit into this definition. For all three countries in the Caucasus regon, the difference between DI and percentage of foreign currency deposits in total deposit is high, for these are cash economies with proportionately high levels of DCC. Given these conditions, high deposit dollarization suggests that the ratio of foreign currency in total currency in circulation may also be high in Armenia. Therefore, estimation of FCC is very important in evaluating overall monetary conditions and economic activity.

C. Reasons for Persistence of Dollarization

While investigating the factors contributing to high levels of dollarization in Armenia is beyond the scope of this paper, it is useful to review arguments for why dollarization tends to persist so the level of present dollarization in Armenia can be better understood. .

Persistence has been attributed to the "hysteresis" effect. (Oomes, 2003; Havrylyshyn and Beddies, 2003). Hysteresis refers to the fact that dollarization remains high even in the face of declining inflation. Hysteresis occurs because some costs associated with currency substitution make dollarization costly to reverse. Once people have adjusted to macroeconomic instability by switching to a foreign currency and reduce the demand for real domestic money balances, they lack confidence in the domestic currency for a long time even if macroeconomic fundamentals improve sharply.

Apart from the hysteresis effect, several other factors exist in Armenia that contributes to high level of dollarization.

1. Small size and openness f t h e Armenian economy. Armenia is highly dependent on foreign trade. On the average, imports of goods and services were about half of GDP over 1996-2002, exports about a quarter. Openness increases the demand for foreign currency.

2. Dependence onpm'vate transfen from abroad. Armenia has traditionally been dependent on remittances from abroad from the large Armenian Diaspora. This has increased the economy's bias toward dollarization. Private transfers more than doubled over 1998-2002 (Table 4). The volume and percentage of private transfers in GDP have been growing steadily since 1998. Private transfers are about a fifth of the country's GDP and have a sizable effect on the economy.

3. Small size ofthe banking ystem. The Armenian banking system is small and its role in financial intermediation is modest. This reflects the low confidence in the banking system, following the loss of savings in the 1993-94 hyperinflation and the expansion of the informal economy which operates outside official banking channels. While the Armenian economy has been growing since 1994, the banking system is still very weak and is unable to generate sufficient savings for profitable lending opportunities to the formal economy. In 2002, GDP grew by 12.954, but bank lending grew by only 7.7%. At the end of 2002, banking system assets were only 15 %, and bank capital only 4% of GDP. Lack of trust in the banking system creates large volumes of cash savings, which are held mainly in foreign currency as most people are concerned about the stability of the Armenian dram.