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Dollarization has been a widespread phenomenon in CIS countries since
independence, but recently its nature has changed considerably, especially in oil
exporting ones. In the early years of transition, the introduction of national currency
in CIS countries led to severe confidence crisis which reflected the worsening of the
economic and financial environments in almost all newly independent states. High
inflation volatility and fragile economic stability in the early phase of transition
induced dollarization as people attempted to avoid rapid devaluation in their assets.
Now, after more than twenty years passed over their independence, the institutional
transformation in the organization and structure of the markets has completed and
the situation seems to be stabilized in almost all countries. It is highly probable that
in parallel to the improvements in the economy, people's confidence in their
national currency has been restored and dollarization has reversed its direction.
Though almost all previous studies document the prevalence of currency
substitution in those countries, some recent studies reveal the reverse trend of
currency substitution process, especially in the oil-exporting countries.
Studying the period during and after hyperinflation years of 1992-1996 in Russia,
Tullio and Ivanova (1998) documented currency substitution between ruble and
dollar assets by estimating demand functions for different monetary aggregates. In
their model, the significant exchange rate depreciation was interpreted as an
evidence for dollarization. Oomes (2003) developed a model to explain
dollarization hysteresis observed in Russia during 1992-1998 when dollarization
ratio exhibited persistence despite declining inflation and exchange rate
stabilization. Ohnsorge and Oomes (2005) estimated money demand functions
covering the period of 1996-2003 in Russia and demonstrated that the money
demand was rather stable in the case of effective broad money which also included
an estimate of cash dollars in the economy. They claimed that the reason for lower
inflation (“missing inflation”) despite rapid money growth was in fact due to the de-
dollarization took place in the country. Harrison and Vymyatnina (2007) addressed
the issue of the currency substitution in Russia after the crisis period, 1999 -2005
and shed light on the phenomenon of the decline in currency substitution. That is,
although currency substitution was rather prevalent phenomenon in the early years
of transition in Russia, it has reversed its direction, more probably due to
stabilization of the economy and windfall of petrodollars.
Similar to the Russian case, Yılmaz et.al (2009) found evidence on the reversal of
the currency substitution in Kazakhstan during the years of 2000 - 2007 in contrary
to the high dollarization years of 90s. Although they attribute the de-dollarization to
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the implementation of stable monetary policy in the country, it seems that stable
economic environment and significant accumulation of petrodollars contributed to
the stable monetary policy and increase in the confidence to the national currency.
Though currency substitution has long history in Azerbaijan, there was little interest
in the country to study the phenomenon at the empirical level. One known study
conducted to determine the level of dollarization in the country is due to Fiege and
Dean (2004) who reported the approximate volume of dollars in circulation.
However, any other studies providing empirical documentation of currency
substitution in the country using econometric tools are rare, if exist.
In general, high dollarization level in a national economy poses several risks to
policy makers. First of all, central banks lose the effective control of the domestic
money supply and interest rate in the presence of high dollarization. Secondly, high
dollarization makes domestic agents susceptible to exchange rate shocks and
restricts the maneuvers of policy makers aiming to use exchange rate policy to
stabilize the economy. That is, a sharp depreciation of the national currency in the
case of high dollarization may lead to financial turmoil if a country is a net debtor
from the external world. The case of Azerbaijan is a proper example showing
restrictive characteristics of high dollarization in the country. Here, policy makers
always pay special attention to the probable consequences of moving from the peg
regime to a more flexible one. As the presence of currency substitution has serious
implications for policy makers and the choice of nominal anchor, we empirically
verify the existence and the degree of it in the economy.
In the literature, most of the empirical studies use one equation money demand
function in the estimation of the currency substitution, which is subject to Lucas
(1976) critique. Those models ignore the dynamics of decision making process of
economic agents and their expectation formation mechanism. To avoid those
problems we follow the dynamic money-in-the-utility-function approach
(Imrohoroglu (1994)) to study the currency substitution in Azerbaijan.
Friedman and Verbetsky (2001) also follow the same methodology developed by
Imrohoroglu (1994) to investigate the currency substitution in Russia during 1995-
2000. The model incorporates the decision making process of economic agents, and
the system equations for econometric estimation are derived from optimization
problem of households. In the model, agents decide on the monetary and non-
monetary asset mix and then allocate currencies in their currency portfolio.