The integration of the international financial system, the removal of restrictions on capital mobility and the increasing trade volumes have contributed to the evolution of dollarization. Although it was a phenomenon in different economies for a long time, the word “dollarization” has become a well-known term in the 90’s. In this period, the number of countries that gave foreign currencies the legal tender status increased and the official dollarization has been a widely discussed issue. Alternatively, unofficial dollarization has expanded even more and become a pervasive phenomenon in a wide range of countries. The number of countries where the ratio of foreign exchange deposits to total deposits higher than 30 percent increased from 7 in 1990 to 46 in the year 2000 1 . Similarly unofficial dollarization in Turkey has also evolved during this decade. In this sense, I will focus on unofficial dollarization in the rest of my speech. Distinguished Guests, In general, dollarization occurs in circumstances where residents lose confidence in their own currency. The evidence from countries has also shown that dollarization process advances by certain stages. At the first stage, domestic currency loses its function of being a store of value, which is called “asset substitution”. Following this basic level, dollarization takes the form of “currency substitution” referring to the domestic currency’s loss of functions as being unit of account and means of payment. Apart from this, dollarization can take some other forms like “liability dollarization”, “payments dollarization”, “real dollarization” and “financial dollarization”.

Keeping in mind that the risks for both financial and real sectors are interrelated, the banks that lend in foreign currency to firms, which earn revenues in domestic currency, are also indirectly affected. In such cases, the whole economy becomes more vulnerable to shocks due to amplified risks resulting from dollarization. A recent strand of literature and country cases such as the Asian meltdown of 1997 and the 2000-2001 banking crisis in Turkey, have all emphasized the importance of such vulnerabilities brought about by dollarization. Moreover, firms adjust their prices more frequently in a dollarized economic environment where depreciation of national currency is perceived as permanent. Thus, dollarization leads to higher pass through effect from exchange rates to prices via deteriorating pricing behaviour of firms. Ultimately, from the public sector’s point of view, the issue of debt sustainability is highly influenced by dollarization. In fact, public sector is exposed to problems similar to that of non-trading firms indebted in foreign currency 4 . There is no doubt that dollarized debt adversely affects government’s solvency as its assets are in domestic currency. In this sense, given the high level of dollarization, the fluctuations in real exchange rate might turn an apparently sustainable fiscal situation into an unsustainable one. Furthermore, public sector insolvency can immediately lead to banking sector insolvency if domestic banking system holds large claims against government. Dear Guests, Before continuing with the Turkish experience, I have to add that dollarization deserves a special attention from a central banker’s perspective.