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Journal of International Economics 59 (2003) 323–347
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Financial dollarization
Alain Ize a , *, Eduardo Levy Yeyati b
a
International Monetary Fund, 700 19 th St. N.W. 20431 Washington, DC, USA
b
UTDT, Minones 2159 (1428), Buenos Aires, Argentina
Received 3 December 1998; received in revised form 1 November 2000; accepted 25 July 2001
Abstract
We present a portfolio model of financial intermediation in which currency choice is
determined by hedging decisions on both sides of a bank’s balance sheet. We show that
minimum variance portfolio (MVP) allocations provide a natural benchmark to estimate the
scope for dollarization of assets and liabilities (financial dollarization) as a function of
macroeconomic uncertainty. Within this benchmark, we find that financial dollarization
displays high persistence whenever the expected volatility of the inflation rate remains high
in relation to that of the real exchange rate, even after price stabilization has been achieved.
The empirical evidence confirms that MVP dollarization approximates financial dollarization closely for a broad sample of countries.
 2002 Elsevier Science B.V. All rights reserved.
Keywords: Dollarization; Financial intermediation; Asset substitution
JEL classification: E52; F36; F41; G11
1. Introduction
While substantial progress has been achieved during the last decade in
controlling inflation throughout the world, financial dollarization, that is, the
holding by residents of a significant share of their assets or liabilities in foreign
currency, remains a common feature of developing economies. In particular, in
several developing countries that have experienced severe inflationary experiences,
*Corresponding author. Tel.: 11-202-623-6533; fax: 11-202-623-7830.
E-mail address: [email protected] (A. Ize).
0022-1996 / 02 / $ – see front matter  2002 Elsevier Science B.V. All rights reserved.
doi:10.1016/S0022-1996(02)00017-X
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such as Argentina, Bolivia, and Peru, financial dollarization remains very high,
notwithstanding several years of stable macroeconomic policies that have gradually improved confidence (Fig. 1).
Although the literature on dollarization is very vast, it leaves some important
issues unaddressed. While there is a general presumption that dollarization restricts
the scope for independent monetary and exchange rate policies, few attempts have
Fig. 1. Dollarization ratios and inflation in selected Latin American economies (in percent).
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
325
been made to systematically estimate dollarization levels across countries based on
macroeconomic conditions, or to explore the scope for altering dollarization
through monetary and exchange rate policies.
Perhaps more importantly, most of the existing literature on the subject is
concerned with currency substitution (i.e., the use of foreign currency as a means
of payment and unit of account).1 This focus is reflected in the emphasis on the
expected nominal returns of holding different currencies (as opposed to the
expected real returns of interest-bearing assets denominated in those currencies) as
a determinant of dollarization and the presumption that dollarization should recede
with price stability. As a result, the literature has typically pointed at the dynamics
of money demand (and, in particular, the link between dollarization and the
inflation level), as well as the network externalities associated with the use of
money for transaction purposes and the costs of switching the currency of
denomination of these transactions as a source of hysteresis.2 However, it is the
dollarization of interest-bearing financial assets that generally accounts for the bulk
of measured dollarization.3 As argued by Calvo and Vegh (1997), in this case there
is no theoretical reason to expect changes in inflation to have any effect on the
choice of portfolio denomination, inasmuch as they are incorporated in nominal
interest rates to leave real interest rates unchanged. Similarly, network externalities
and switching costs are unlikely to play a substantive role in the denomination of
financial assets that can be easily converted to an alternative currency at almost no
cost.
On the other hand, the few papers that specifically address the issue of
dollarization as a portfolio choice problem do not fully recognize the nature of
financial dollarization.4 The fact that the dollarization of bank deposits typically
has as mirror image that of loans is crucial to assess the extent and implications of
dollarization. In particular, the degree of loan dollarization determines the financial
system’s exposure to systemic credit risk in the case of large devaluations.5 The
1
For recent surveys, see Calvo and Vegh (1992, 1997), Giovannini and Turtelboom (1994), and
Savastano (1996).
2
´
´
Examples of the former can be found in the special issue of Revista de Analisis
Economico
(June
1992) on Convertibility and Currency Substitution. For switching cost-based models, see Guidotti and
´
Rodrıguez
(1992), and Sturzenegger (1997).
3
Hence, as noted by many observers, much of the empirical literature is plagued by a definitional
problem, as it uses interest-bearing deposits to estimate money demand equations.
4
See, e.g., Thomas (1985) and Sahay and Vegh (1996). An exception is Ize (1981), on which this
paper draws.
5
This exposure is not eliminated even when, as is usually the case, banks are precluded by
regulations from holding open foreign currency positions. Dollar loans simply transfer the currency risk
to the non-dollar earning borrower, at the cost of greater (exchange rate-related) credit risk to the bank.
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evidence that most of the recent debate regarding dollarization has evolved around
these financial vulnerability issues confirms the relevance of this distinction.6
To address some of these issues, we present a model of financial dollarization
based on a portfolio selection approach, following contributions by Thomas (1985)
and others. However, unlike in the earlier literature, the currency composition of
the portfolio is determined on both sides of a bank’s balance sheet by hedging
against inflation and foreign exchange risk. Thus, deposit and loan dollarization
interact through the loanable funds market. We show that this interaction leads to
financial equilibria that gravitate around interest rate parity and minimum variance
portfolio (MVP) allocations. Hence, the currency composition of MVP, in turn a
simple function of the volatility of inflation and real depreciation rates, provides a
natural benchmark to measure financial dollarization and relate it to macroeconomic stability.
In MVP equilibria, dollarization is explained by the second moments (i.e., the
volatility) of inflation and real exchange rate depreciation, rather than the first
moments (i.e., expected inflation and nominal depreciation) as in the case of
currency substitution models.7 For a given variance of inflation, an increase in the
variance of the rate of depreciation reduces dollarization by limiting the hedging
benefits of dollar assets. Hence, stabilization may fail to reduce dollarization if
accompanied by policies that target the real exchange rate. This provides an
alternative explanation for dollarization hysteresis, without resorting to switching
costs or inflationary memory arguments. In our model, hysteresis can occur even
when the memory of past macroeconomic imbalances has faded away, if the
expected volatility of inflation remains high in relation to that of the real exchange
rate. The evidence seems to support this result as MVP dollarization, measured as
the dollar share of the MVP allocation, generally approximates actual dollarization
closely for a broad sample of countries. The empirical results are confirmed by a
panel regression for five highly dollarized Latin American economies, Argentina,
Bolivia, Mexico, Peru, and Uruguay.
Our findings suggest that inflation targeting combined with a freely floating
exchange rate should help reduce financial dollarization by increasing real
exchange rate volatility relative to price volatility. However, this conclusion is
6
The recent literature has emphasized the vulnerability to exchange rate fluctuations due to the
currency imbalance associated with financial dollarization, both as a source of financial distress and as
a limitation on monetary and exchange rate policies. Among many others, see Calvo (1999), Burnside
et al. (forthcoming), and Aghion et al. (forthcoming) on the balance sheet channel associated with
domestic foreign-currency lending to producers of non-tradables, and Eichengreen and Haussman
(1999) on the external vulnerability arising from foreign currency-denominated external debt.
7
These conclusions are reminiscent of those reached for Bolivia and Peru by McNelis and
´
Rojas-Suarez
(1996). However, they focus on currency substitution, and therefore on returns on
(domestic and foreign) currency holdings, rather than on interest-bearing deposits. Thus, they find that
devaluation uncertainty promotes dollarization, while in our model dollarization is correlated positively
with inflation volatility but negatively with the variance of the devaluation rate.
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327
conditioned to real dollarization, as defined by the extent to which prices and
wages are denominated in foreign currency and as measured by the pass-through
coefficient of exchange rate changes on prices, being moderate. Otherwise, the
scope for increasing the volatility of the real exchange rate while preserving price
stability is limited. Nonetheless, the paper also shows that while high real
dollarization implies high financial dollarization, the converse is not necessarily
true. Indeed, some preliminary evidence would suggest that many economies with
high financial dollarization exhibit low real dollarization. Such economies may
thus be able to conduct (and benefit from) full fledged inflation targeting.
We also explore how financial dollarization can deviate from MVP dollarization. Based on portfolio interaction between country risk (i.e., confiscation and
banking system risk) and macroeconomic risk (i.e., inflation and foreign exchange
risk), we show how dollarization and the structure of interest rates depend on the
stock of net foreign assets, the volume and currency composition of public
domestic debt (including the central bank’s domestic liabilities), and the taxation
of financial intermediation (e.g., through unremunerated reserve requirements).
The paper is organized as follows. Section 2 presents the model and derives
expressions for the deposit and loan dollarization ratios as a function of MVP
allocations and deviations from interest rate parity. Section 3 introduces some
extensions of the basic model and discusses the linkages between financial and real
dollarization. Section 4 presents empirical evidence of the link between financial
and MVP dollarization ratios. Section 5 explores policy implications. Section 6
summarizes and concludes.
2. The portfolio model
In this section, we develop a simple portfolio model where risk averse
depositors and borrowers choose the currency composition of their deposits and
loans in a bi-monetary economy. We assume that the menu of assets available to
depositors include home currency deposits and foreign currency deposits (at home
and abroad). Borrowers, on the other hand, can borrow either in the home or in the
foreign currency directly from domestic banks. The equilibrium in the market for
loanable funds allows us to characterize the interaction between depositors and
borrowers, its implications in terms of interest rate differentials, and the dollar
portfolio share on both sides of domestic banks’ balance sheets.
2.1. Depositors
Domestic depositors’ portfolios comprise three assets: domestically held home
currency deposits (HCD), domestically held foreign currency deposits (FCD) and
cross-border foreign currency deposits (CBD), with real returns in terms of the
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328
domestic price index denoted as r HD , r FD and r C , respectively. We assume that
depositors are not allowed to short-sell deposits in any currency and, in accordance
with the emphasis of this paper on asset rather than currency substitution, that
agents hold no cash.8
Due to foreign exchange rate risk, dollar deposits or loans (at home or abroad)
are imperfect substitutes for home currency deposits or loans. In addition, deposits
held locally are imperfect substitutes for deposits held abroad, due to the presence
of country risk. The latter is assumed to incorporate all sources of risk that are not
strictly macroeconomic in nature. Thus, it includes confiscation risk, as well as
banking system risk. Although it would be reasonable to expect some correlation
between macroeconomic risk and country risk, these risks are assumed to be
independent for purposes of analytical tractability.
Thus, real returns can be expressed as:
r HD 5
E(r HD ) 2 mp 1 mc
F
E(r D ) 1 ms 1 mc
C
E(r) 1 ms
rD 5
rD 5
F
(1)
where mp , ms and mc are disturbances associated with inflation, the real exchange
rate, and country risk, respectively, assumed to be distributed with zero mean and
variance–covariance matrix [Sxy ], and E is the expectations operator. In addition,
we assume that:
Ssc 5 Sp c 5 0
(2)
Depositors’ preferences are represented by:
UD 5 E(r D ) 2 c D Var(r D ) / 2
(3)
where r D is the average real return of the deposit portfolio, c D . 0 reflects
depositors’ aversion to risk and Var is the variance operator. If lD is the share of
total dollar deposits (including CBD) and g the share of cross-border deposits in
the deposit portfolio, we obtain (see Appendix A for details):
lD 5 l* 2 d DI /(cD V ),
(4)
g 5 1 2 d X /(c D Scc )
(5)
where:
V 5Var(r HD 2 r FD ) 5 Spp 1 Sss 1 2Sp s ,
d DI and d X are the expected internal and external deposit rate differentials:
8
However, the results are identical when cash holdings are introduced. See Thomas (1985).
(6)
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329
d ID 5 E(r HD 2 r FD ),
(7)
d X 5 E(r FD 2 r C ),
(8)
and l* is the dollar share of MVP, which can be written as a simple function of the
volatilities of inflation and the rate of real depreciation: 9
l* 5 (Spp 1 Sp s ) /(Spp 1 Sss 1 2Sp s )
(9)
We denote this share l* as the ‘MVP dollarization’ ratio.10 It can readily be
checked that MVP dollarization increases with inflation volatility, and decreases
with the volatility of real exchange rate depreciation (see Appendix A). Thus, for a
level of country risk such that lD . g,11 the choice of currency (as reflected in the
MVP dollar share of deposits) depends only on inflation and foreign exchange risk,
while the choice of location (as reflected in the cross-border share of deposits)
depends only on country risk.12 Moreover, as country risk favors holding assets
abroad, a positive country risk premium d X is needed to induce depositors to hold
FCD.
2.2. Borrowers
Assume that cross-border loans (CBL) are intermediated by the local banking
system.13 As borrowers only have access to local loans, denominated either in
dollars (FCL) or in the home currency (HCL), there is incomplete arbitrage
between local and foreign rates in the dollar loan market, so that local dollar loan
rates can be above comparable foreign rates adjusted for country risk.
9
Nominal interest rates are assumed here to be fixed during the life of the deposit or loan contract
and depositors and borrowers are assumed to reallocate their portfolios optimally at the end of the
contracts. In this case, uncertainty about real rates of return arises only from price or exchange rate
volatility.
10
In what follows, we implicitly assume that lD (alternatively, g )[[0, 1]. Otherwise, under the
no-short-sales condition, the solution would be at one corner, and the ratio would not respond to small
changes in the volatility parameters.
11
For sufficiently high levels of country risk, deposit dollarization may be determined solely by the
location decision, as the optimal share of (foreign currency) deposits abroad exceeds the desired share
of foreign currency deposits (g . lD ). In this case, the existence of small amounts of FCD may be
explained by pure transaction motives, independent of the portfolio selection decision.
12
This follows from the assumption that country risk is uncorrelated with variations in the real
exchange rate and inflation rate. It can readily be shown (proof available from the authors on request)
that an increase in the correlation between country risk and macroeconomic risk induces a decline in
demand for FCD, as the latter lose their hedging benefits relative to HCD and CBD. This can explain,
for example, the large capital outflows that took place in Argentina during the tequila crisis,
notwithstanding the unrestricted availability of FCD.
13
This assumption intends to capture the fact that, in most developing economies, there exists an
asymmetry of access to foreign capital markets between depositors and borrowers.
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The representative borrower uses the loan to invest in a project with a known
return in units of the domestic price index.14 Thus, the real return on the project is
riskless and the borrower’s problem reduces to that of minimizing the risk-adjusted
cost of borrowing. Denote as lL the dollar share of the loan portfolio. The
borrowers’ portfolio preferences are assumed to be similar to that of depositors’,
with the sign of the expected real interest payments inverted:
UL 5 2 E(r L ) 2 c L Var(r L ) / 2
(10)
where r L is the real cost of servicing the loan portfolio. Then, it is easy to show
that the dollar share of the borrowers’ optimal portfolio has the same form as in
(4), with the real interest rate differential now entering with the opposite sign:
lL 5 l* 1 d IL /(cL V ),
(11)
where d IL is the lending rate differential:
d LI 5 E(r LH 2 r LF ).
(12)
2.3. Financial equilibrium
In the absence of differential taxes on financial intermediation, the internal
interest rate differentials on deposits and loans should be the same.15 In this case,
Eqs. (4) and (11) readily imply that deposit and loan dollarization ratios should
always be on opposite sides of MVP, if not at MVP. For example, starting from
MVP, an increase in the domestic interest rate differential in favor of the home
currency should increase the attractiveness of home currency deposits and lower
that of home currency loans, thereby reducing deposit dollarization below MVP
and raising loan dollarization above MVP.
Assume, in addition, that banks maintain balanced open foreign exchange
positions.16 If the economy were closed to capital flows (alternatively, if the
country’s net foreign position is zero), all domestic bank deposits should
necessarily be matched by domestic bank loans. In this case, depositors’ and
borrowers’ portfolios should be identical, and MVP is the only possible financial
14
For simplicity, we implicitly assume a balanced current account so that the share of tradables
(alternatively, dollar-priced goods) in the production basket is the same as in the consumption basket,
and a single representative borrower that produces a mix of tradable and non-tradable goods such that
the price of the mix replicates the consumer price level.
15
The discussion in this section abstracts from the existence of public domestic debt or bank reserves
at the central bank, which may induce deviations from MVP. These issues are discussed in Section 5
below.
16
The assumption of matched open positions is not unreasonable. In addition to being generally
adverse to assuming currency risk directly, banks are typically precluded from running unbalanced
positions by regulators.
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
331
equilibrium. Thus, deviations from MVP can only occur if the supply and demand
of loanable funds do not coincide.17
This can be formalized as follows. Assume that banks can borrow abroad, with
X being their net (dollar) foreign liabilities, and that their balance sheets reflect the
equilibrium between the demand and supply for loanable funds:
(1 2 g )D 1 X 5 L,
(13)
where D and L denote total deposits (including CBD) and total loans, respectively,
from which:
D 2 L 5 g D 2 X,
(14)
In addition, if banks maintain balanced open foreign exchange positions, the home
currency component of their balance sheet may be written as:
(1 2 lD )D 5 (1 2 lL )L
(15)
i
i
Substituting Eqs. (4), (11) and (14) into Eq. (15), setting d D 5 d L 5 d, and
rearranging, we obtain:
d 5 2V(1 2 l*)(g D 2 X)(cD c L ) /(c D D 1 cL L).
(16)
In turn, combining (4) and (11), it can be seen that deviations from l* are
symmetric:
c L ( lL 2 l*) 5 d /V 5 c D ( l* 2 lD ),
(17)
and, from (16), that they depend on the country’s net foreign position, g D 2 X.
3. Some extensions
3.1. Currency pegs
Our model can be applied to the case of a pegged exchange rate with imperfect
credibility (e.g., the case of a ‘peso problem’ such that the peg is expected to
collapse with a positive probability).18 While the expected volatility of the rate of
depreciation can no longer be inferred from backward-looking exchange rate data
during the period of the peg, expectations of a regime change can still affect
dollarization depending on whether the collapse is expected to affect primarily
prices or the real exchange rate. Hence, price stabilization through a fixed
exchange rate arrangement such as a currency board may well deepen dollarization
17
Note that an increase in devaluation expectations does not, by itself, induce more dollarization, as
it should only result in an increase of the internal interest rate differential.
18
Lingering differentials between local currency and foreign currency interest rates in countries such
as Argentina and Estonia suggest that even currency board arrangements lack full credibility.
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A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
rather than reduce it. On the other hand, with a fully credible peg, l* becomes
indeterminate, as Sss 5 Spp 5 2 Sp s . In this case, agents become indifferent in
terms of portfolio choice between the home currency and the foreign currency, and
financial dollarization needs to be explained through other factors.19
3.2. Nominal interest rate volatility
The variability of nominal deposit and lending rates did not affect dollarization
in the model above because rates were assumed to be fixed during the life of the
contract and agents readjusted their portfolios optimally as soon as the contracts
expired. However, if there are transaction costs in recalibrating portfolios
(particularly across currencies) or nominal interest rates are floating rather than
fixed, agents may choose to maintain the same contracts even though the
determinants of underlying dollarization may have changed. In this case, the
expected volatilities of contractual interest rates should also affect the choice of
financial instruments.
To see this, suppose that the home currency nominal interest rate follows a
Fisher-type interest parity condition such as:
R H 5 (1 2 u)p 1 v,
(18)
where u measures the degree to which the Fisher parity condition is satisfied and v
is a stochastic ‘excess volatility’ term (i.e., a volatility in excess of that needed to
offset inflationary shocks) which is assumed to be uncorrelated with the other
sources of shocks. The derivation of the MVP portfolio, following the same
procedures as above, now leads to the following expression:
l* 5 (Svv 1 u 2 Spp 1 uSp s ) /(Svv 1 u 2 Spp 1 Sss 1 2uSp s )
(19)
which reduces to (9) when u51, Svv 50. This expression shows that the volatility
of nominal interest rates may either accentuate or diminish the impact on currency
choice of inflation and real exchange rate volatility, depending on whether it
increases or reduces the volatility of real ex-post returns. Dollarization falls if the
volatility of local currency interest rates mainly reflects the need to accommodate
inflationary shocks (Svv and u are both close to zero). However, it rises if local
currency rates exhibit a high excess volatility (due, for example, to the use of a
monetary aggregate as the operational target, instead of the interest rate) while
19
The comparative depth of the money and bond markets and the volatility of nominal interest rates
in each currency could be an important residual determinant of currency choice (see below). Currency
substitution could also affect asset substitution, as funds invested in term deposits or other financial
instruments will eventually be spent. Hence, to limit the need for currency conversion, agents may
allocate the currency of denomination of their investments in accordance with their future spending
plans.
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
333
dollar rates remain stable (due to arbitrage with foreign rates). The lack of
longer-term fixed-rate financial instruments in local currency, by exposing
investors to interest rate uncertainty, can similarly contribute to financial dollarization.
3.3. Real dollarization
While a full discussion of the factors underlying real dollarization falls largely
outside the scope of this paper, the model developed in Section 2 is useful to
illustrate the linkages between real and financial dollarization. Suppose that
inflation, p, the rate of change of the nominal exchange rate, e, and the rate of
change of the real exchange rate, s, evolve according to:
p 5 a e 1 (1 2 a )m,
(20)
s 5 e 2 p 5 (1 2 a )(e 2 m),
(21)
where m represents nominal, monetary-induced price shocks and a represents the
pass-through from the exchange rate to the price level (alternatively, the foreign
currency component of the consumption basket). A high pass-through could result
from an open economy (i.e., a large tradable sector) or directly from dollar pricing
of non tradable goods. From (20) and (21), the inflation rate and the rate of
nominal depreciation can be expressed as functions of the underlying nominal and
real shocks:
p 5 m 1 [a /(1 2 a )]s
(22)
e 5 m 1 [1 /(1 2 a )]s
(21)
Assuming that the underlying shocks are uncorrelated (i.e., cov(s, m)50),20 it can
easily be shown, replacing (22) into (9), that:
l* 5 a 1 (1 2 a )Smm / [Smm 1 Sss /(1 2 a )2 ]
(24)
The equation shows that, although real and financial dollarization (as determined
by a and l*) are linked, there is no simple correspondence between the two. The
former clearly sets a floor for the latter ( l* . a ). As prices and wages become
increasingly dollarized, the pass-through increases, which raises the volatility of
inflation relative to that of the real exchange rate and, hence, reduces the hedging
attractiveness of the home currency. When price and wage contracts are fully
dollarized (a 5 1), the demand for financial instruments in domestic currency
20
In the short run, real and nominal shocks could be positively correlated (e.g., a real depreciation
induced by a monetary expansion), or negatively correlated (e.g., a ‘leaning against the wind’ policy by
which an exogenously-induced real depreciation is partially offset by a monetary contraction). Thus, the
assumption of orthogonality provides a reasonable middle-ground.
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should vanish as they lose all their hedging benefits. However, the converse is not
necessarily true. A low pass-through coefficient does not necessarily imply a low
financial dollarization. Indeed, for a 5 0, l* may be close to one if Smm is high
relative to Sss .21
4. Empirical evidence
The previous model suggests that actual dollarization can be largely explained
in terms of MVP dollarization. To test this hypothesis empirically, we compared
actual and MVP dollarization ratios for a broad sample that includes all countries
for which data on domestic deposits in foreign currency is available.22 MVP
dollarization was measured as the dollar share of the MVP ( l* in Eq. (9)). In the
absence of forward-looking data on inflation and exchange rate expectations,
variances and covariances were obtained from quarterly CPI and exchange rate
data over the period 1990–1995, or the longest period for which meaningful data
exists. Actual dollarization was computed as the ratio of total foreign currency
deposits over total domestic and cross-border deposits at the end of the period
(year 1995), or the latest observation available, to reduce potential endogeneity
problems.23
A first glance at the data confirms the analytical findings. Fig. 2 plots MVP
dollarization ratios against actual dollarization. As the figure shows, the fit is
highly satisfactory. The relevance of MVP dollarization as a key explanatory
factor of dollarization is further confirmed by the regressions in Table 3. In
particular, the table shows how the explanatory power of the inflation rate,
significant when taken alone, is substantially reduced when the MVP dollarization
ratio is also included in the regression.24 The importance of net foreign assets in
21
One could argue that the presence of loan dollarization would in principle call for dollar pricing in
the non-tradable sector to reduce the borrower’s exposure to currency risk, thus making a a function of
l*. However, as argued by Calvo (2000), indexing to the dollar would make individual firms
uncompetitive in the event of a large devaluation if competing firms set their prices in the domestic
currency.
22
For the sake of comparison, we deliberately excluded countries where foreign currency deposits are
not permitted. Similarly, we excluded countries that run a fixed exchange rate regime for the whole
period for which data on foreign currency deposits were available, since this precluded a reliable
measure of devaluation expectations. The list of countries and the period coverage are shown in Table
1. Table 2 provides a definition of the variables used in the empirical estimates.
23
With the exception of data on domestic foreign currency deposits, which are from IMF Staff
Reports (www.imf.org), the source is the International Financial Statistics (IFS) of the IMF.
24
The coefficient of inflation is still significant when combined with l*, but has negative sign.
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
Table 1
List of countries
Armenia
Bolivia
Bulgaria
Cambodia
Canada
Chile
Costa Rica
Croatia
Czech Republic
Ecuador
Egypt
El Salvador
Germany
Greece
Guinea-Bissau
Haiti
Honduras
Hungary
Israel
Jamaica
Japan
Jordan
Kazakhastan
Laos PDR
Macedonia
Malawi
Mexico
Mongolia
Netherlands
Nicaragua
Pakistan
Paraguay
Peru
Philippines
Poland
Romania
Sierra Leone
Slovak Republic
Trinidad y Tobago
Turkey
Uganda
Ukraine
United Kingdom
Uruguay
Venezuela
Zambia
Table 2
Definition of variables and sources
CBD5Cross border deposits (IFS).
CBL5Cross-border loans (IFS).
FCD5Foreign currency domestic deposits (IMF, 1998; Central Bank Bulletins, and IFS).
HCD5Local currency domestic deposits (Central Bank Bulletins, and IFS).
Financial dollarization ratio ( lD )5(FCD1CBD) /(FCD1CBD1HCD).
FA (FL)5Foreign assets (liabilities) of commercial banks (IFS).
CR5Total claims of deposit money banks (IFS).
D5FCD1HCD1CBD.
L5CR1CBL.
NFA5(FA2FL1CBD2CBL) /(D1L).
rxy 5Correlation between variables x and y computed based on quarterly data covering
the previous 6 years
(latest 24 observations).
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336
Fig. 2. MVP and actual dollarization ratios (in percent).
Table 3
Cross-country regressions
p
(1)
(2)
(3)
(4)
(5)
0.006*
(0.002)
20.002
(0.002)
20. 002
(0.002)
20. 002
(0.002)
0. 003
(0.003)
l*
NFA
Sp
Ss
rps
INDEX
R2
0.104
0.794**
(0.106)
0.770**
(0.102)
0.761**
(0.103)
0.563
0.235**
(0.067)
0.226**
(0.066)
0.309**
(0.079)
0.660
0.010**
(0.002)
20.013**
(0.004)
20.070
(0.119)
20.110*
(0.051)
20.202**
(0.052)
0.667
0.510
Number of observations: 45. White heteroskedastic-consistent standard errors in parentheses. * and
** represent 95 and 99% significance. Actual dollarization and net foreign assets (NFA) are end-1995
values. All other variables computed from quarterly CPI and exchange rate data, and averaged over the
period 1990 to 1995, or the longest period for which there is available data.
explaining deviations from MVP was tested by including the variable NFA.25 As
predicted by the model, the coefficient is significantly positive.
25
Net foreign assets (NFA) were computed as net external assets of the banking system plus
cross-border deposits (CBD) minus cross-border loans (CBL), over the sum of total deposits and loans,
(gD 2 X) /(D 1 L). This measure is consistent with Eq. (17) for the case in which the coefficients of
risk aversion of depositors and borrowers are the same (c D 5 c L ). Tests using an alternative proxy for
the country’s net foreign position, (g D 2 X) /L, which is broadly consistent with the case in which
c D < c L , yielded similar results.
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
337
It is also interesting to test the model’s predictions for countries that have
developed alternative instruments to limit foreign macroeconomic risk, particularly
price-indexed or interest rate-indexed instruments. Abstracting from lags and other
measurement problems, price-indexed assets are free from inflation and currency
risk. Thus, as long as indices can be found that follow purchasing power closely,
such instruments should dominate local dollar-indexed instruments. The data
supports this conclusion: the indexed deposits dummy (INDEX) displays a
significant and negative sign, as expected (Eq. (4)).26 Alternatively, Table 4
compares MVP dollarization with actual dollarization and with the use of
alternative indexing instruments for countries in which price or interest rate
indexation have been broadly used, such as Chile, Israel and Brazil.27 Again, as
expected, predicted dollarization, as measured by l*, generally exceeds actual
dollarization by a large margin. Finally, as a robustness check, we repeated
regression 4 this time replacing the MVP dollarization ratio by its components
(Eq. (5) of Table 3). The coefficients are significant and of the predicted sign in all
cases.28
Unfortunately, longer series for many of the dollarized economies in the sample
are inexistent or unreliable, so that the results obtained from the cross country
Table 4
Deviations from MVP in the presence of indexation
Chile
Brazil b
Israel
a
b
Period
MVP
Actual a
1975:1–1985:3
1985:4–1996:3
1980:1–1996:3
1980:1–1985:4
1986:1–1996:4
57.6
32.0
99.0
86.4
10.4
36.2
14.2
11.6
26.1
18.2
End of last year of corresponding period.
CBD only. FCD are not allowed in Brazil.
26
Our sample includes only two countries (Chile and Israel) in which both dollar and indexed
deposits are allowed domestically. Brazil, another example of widespread use of price-indexed assets,
does not allow dollar deposits in the domestic banking sector and was therefore excluded for
consistency.
27
In Brazil, both price indexation and interest rate indexation have been broadly used. In particular,
the indexation of deposits to the overnight interest rate protected the purchasing power of HCD
throughout the turbulent period of the 1980s. In Chile, indexation has been facilitated by the
introduction in 1967 of a unit of account, the UF, that is published by the central bank daily on the
basis of the consumer price index. In Israel, a broad menu of indexed assets has been available to the
public, including CPI-indexed assets, dollar-indexed assets (PATZAM), and dollar deposits (PATAM).
However, the use of CPI-indexed assets has been mainly restricted to long-term time deposits and
saving deposits.
28
The lack of significance of the re p term is consistent with the fact that the sign of dl* / dre p cannot
be unambiguously determined. See Appendix A.
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
338
Table 5
Latin America-panel regressions (1982–1995)
p
(1)
0.028
(0.015)
(4)
Sp
Ss
rp s
R2
0.690
0.155**
(0.023)
0.151**
(0.023)
0.071**
(0.021)
(5)
(6)
NFA
0.036*
(0.015)
(2)
(3)
l*
0.036
(0.027)
0.728
0.733
0.346**
(0.044)
0.260**
(0.039)
0.269**
(0.036)
0.778
0.670**
(0.064)
0.680**
(0.067)
20.825**
(0.152)
20.888**
(0.168)
22.413
(0.2.175)
22.436
(2.210)
0.807
0.808
Number of observations: 280. White heteroskedastic-consistent standard errors in parentheses.
Includes dummies to control for country specific effects. * and ** represent 95 and 99% significance.
Actual dollarization and net foreign assets (NFA) computed from annual data. All other variables
computed from quarterly CPI and exchange rate data.
comparisons cannot be tested using panel data covering a longer period of time.29
However, the dynamic behavior of dollarization can be tested using panel data for
a sub-sample of highly dollarized Latin American countries during the past two
decades. Table 5 presents the results of panel regressions for a sample including
Argentina, Bolivia, Mexico, Peru and Uruguay.30 The results closely resemble
those in Table 3. The inflation rate, measured as the average quarterly inflation
over the past year, largely loses its explanatory power once MVP dollarization is
introduced. Net foreign assets are positively correlated with dollarization, and the
individual components of l* display the correct sign and are highly significant.31
5. Policy implications
From the discussion in Section 2, it follows that policy can affect dollarization
by acting on either the second moments or the first moments of the distribution of
expected returns. Through the choice of the macroeconomic policy regime, the
monetary authorities can change macroeconomic uncertainty and, hence, the
29
A particularly important obstacle is the fact that in most cases, official data aggregate foreign
currency deposits with time and saving deposits denominated in the home currency.
30
These five countries are the Latin American examples most often cited in the literature. Dummy
variables were used to control for country-specific fixed effects.
31
Note that the coefficients are substantially lower than in the cross-section tests, reflecting both the
limits of measuring expectations from past data, as well as the fact that in reality agents do not adjust
their portfolios on a continuous basis.
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
339
volatility structure underlying the MVP allocations. Alternatively, they can affect,
through monetary, public debt or tax policies, the interest rate differentials,
causing actual dollarization to deviate from MVP allocations. This section
discusses each of these options in turn.
5.1. Affecting volatilities through the exchange rate regime and inflation
targeting
Since l* increases with inflation volatility, and decreases with the volatility of
real exchange rate depreciation, stable inflation and a fluctuating real exchange rate
should be associated with low dollarization. In particular, the combination of
inflation targeting (to the extent that it reduces inflation volatility) with a floating
exchange rate (to the extent that it increases real exchange rate volatility) should
foster the use of the local currency and discourage that of the foreign currency.
Instead, a stabilization policy that gradually reduces inflation volatility may fail
to reverse dollarization if it is accompanied by an increasingly more stable real
exchange rate. Where losses of monetary control have been accompanied by
currency crises, inflation and real exchange rate stabilization would be expected to
occur simultaneously once the monetary authorities recover control. Furthermore,
by adopting the exchange rate as an anchor or out of concern for the potentially
destabilizing impact of exchange rate volatility, the monetary authorities may have
followed policies that limit exchange rate fluctuations, such as following a
crawling peg or using monetary policy to target the nominal exchange rate.
Latin American economies provide good examples where the decline of
inflation volatility in the post-stabilization period was offset by a fall in the
volatility of real exchange rate changes. Table 6 illustrates this idea by comparing
Table 6
Exchange rate-based stabilization and financial dollarization
Argentina
Bolivia
Mexico
Peru
Uruguay
Hungary
Period
Inflation rate
l*
Dollarization ratio
1986–1990
1991–1995
1985–1989
1990–1995
1983–1987
1988–1995
1986–1990
1991–1995
1986–1990
1991–1995
1988–1992
1993–1995
88.75
5.20
58.45
2.94
17.45
5.95
110.29
11.24
16.16
11.58
5.67
5.44
89.15
78.48
94.88
89.90
49.46
28.72
91.99
78.94
91.86
89.46
37.67
43.21
78.37
71.65
88.02
90.81
44.62
33.30
84.79
80.48
90.99
86.33
23.96
39.95
Inflation rate computed as the average of quarterly inflation during the period. Dollarization ratios are
measured at the end of the period.
340
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
periods before and after exchange rate-based stabilizations.32 While inflation fell
significantly in most cases, financial dollarization continued to be high, reflecting
the evolution of MVP dollarization. This account of dollarization hysteresis
contrasts with the currency substitution view that typically emphasizes the
beneficial effect of low inflation on dollarization.33
The linkage between real and financial dollarization raises an important caveat
to the finding that dollarization may be reduced by targeting inflation exclusively
and abstaining from intervening in the money or foreign exchange markets for the
sole purpose of stabilizing the exchange rate. Indeed, in an economy with a
floating exchange rate where both financial and real dollarization are high, a
volatile nominal exchange rate would result in a more volatile rate of inflation and,
yet, would not necessarily translate into a more volatile real exchange rate.34
Indeed, when all prices are denominated in dollars and the pass-through is total,
the real exchange rate becomes fixed and stabilizing the nominal exchange rate
may become the only practical means to stabilize inflation. Hence, in economies
with high real dollarization, the scope for affecting l* through the adoption of a
flexible exchange rate regime could be limited and the benefits of a decline in
dollarization would need to be weighed against the costs associated with a more
volatile inflation.
However, a scenario with low real dollarization and high financial dollarization
appears to be consistent with anecdotal evidence of a moderate real (and
particularly, wage) dollarization in countries with very high financial dollarization.
Moreover, recent empirical evidence indicates that the exchange rate pass-through
depends negatively on the degree of price variability and can be moderate even in
highly dollarized economies.35 Subject to possible caveats on the effectiveness of
32
The former were computed using data from the five-year period preceding the beginning of the
stabilization plan.
33
Bolivia and Peru provide particularly interesting examples. Bolivia is the only country for which
dollarization has actually increased after stabilization. In this case, MVP dollarization was bolstered by
a de-facto crawling peg policy that corrected for past inflation. Instead, Peru has followed a flexible
exchange rate regime. However, it de facto limited the volatility of the nominal exchange rate by using
banks’ excess reserves at the central bank (rather than the interest rate) as the monetary operating
target, thereby channeling most of the underlying volatility into the interest rate rather than the
exchange rate. As noted in Section 3, both the reduction in the volatility of the exchange rate and the
concomitant increase in the volatility of local currency interest rates are likely to have contributed to
the dollarization process.
34
The high elasticity and instability of money demand in an economy with high currency substitution
may exacerbate the volatility of the nominal exchange rate. This factor has been used to argue in favor
of a pegged system when currency substitution is extensive. See Girton and Roper (1981) and
Giovannini and Turtelboom (1994).
35
Taylor (2000) shows that the degree of price adjustment to exchange rate fluctuations should
decline with inflation expectations. Empirical evidence on a positive link between inflation and the
exchange rate pass-through is provided by Goldfajn and Werlang (2000). Recent estimates of strikingly
low pass-throughs in highly dollarized economies are provided by Rossini (2001) for Peru and
Choudhri and Hakura (2001) for a broad sample of (dollarized and non-dollarized) countries.
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
341
monetary transmission, this would suggest that inflation targeting may be viable
even in highly dollarized economies and, when used, could help limit or reverse
financial dollarization.
On the other hand, in a financially dollarized economy, the financial system
must be able to withstand the strains exerted on banks’ borrowers by the
potentially large exchange rate fluctuations associated with a more flexible
exchange rate regime.36 Indeed, it is precisely when real dollarization is low while
financial dollarization is high that borrowing firms are more exposed to currency
risk. However, large and permanent exchange rate adjustments of the type
experienced during the late 1990s by some Asian countries in the wake of the
collapse of their fixed exchange rate regime are much less likely to occur under a
successful inflation targeting regime. Instead, prudential strains are more likely to
arise during the phase of transition towards a fully floating exchange rate regime,
i.e., when the currency exposure of debtors arises from large unanticipated
exchange rate volatility. Such strains should relax once agents adjust to the new
environment by changing the currency composition of their debt portfolio to
minimize their (ex-ante) risk exposure.
5.2. Affecting return differentials through monetary, public debt or tax policies
To allow for policy-induced changes in the differential between domestic and
foreign currency interest rates, we need to introduce a public sector in our
framework. For simplicity, assume that public sector liabilities take the form of
required reserves on domestic and foreign currency deposits held by banks at the
central bank in the same currency as the deposits. Denoting as R and lR bank
reserves and their foreign currency share, respectively, Eq. (15) may now be
expressed, as:
(1 2 lD )D 5 (1 2 lL )L 1 (1 2 lR )R
(25)
which indicates that the dollarization of deposits is obtained as a weighted average
of that of loans and reserves.
Since reserves may not be remunerated equally, the internal deposit and loan
rate differentials can differ. To see this, denote as e H and e F the shares of reserves
that are not remunerated. If banks are competitive with zero intermediation costs,
intermediation spreads may be expressed as:
E(r iL 2 r iD ) 5 r i e i E(r di ) 5 t i
36
(26)
This point has been highlighted by the recent literature on exchange rate regimes (see references in
footnote 7). In particular, the argument has been used to make a case against exchange rate flexibility in
the presence of financial dollarization (Calvo and Reinhart, 1999). However, Cespedes et al. (2000)
stress that, even under a heavily dollarized environment, flexible exchange rates may be better shock
absorbers of real foreign shocks than fixed rates.
342
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
where t i , i 5 H, F, are the implicit tax rates on financial intermediation that derive
from unremunerated reserve requirements, and r H and r F are the ratios of bank
reserves to bank loans in each currency, i.e.:
r H 5 lR R /lL L,
r F 5 (1 2 lR )R /(1 2 lL )L.
From (26):
t F 2 t H 5 d IL 2 d DI .
(27)
Substituting Eqs. (4) and (12) into (25), using (27), and rearranging, deviations
from MVP dollarization can now be written as:
lD 2 l* 5 (c L /M)[(1 2 l*)(g D 2 X) 1 ( lR 2 l*)R 2 (t F 2 t H )L]
(28)
lL 2 l* 5 (c D /M)[2(1 2 l*)(g D 2 X) 2 ( lR 2 l*)R 2 (t F 2 t H )D]
(29)
M 5 cD L 1 cL D
(30)
with:
These expressions show that deviations from MVP can occur through three types
of wedges: (i) an external wedge, when exogenous or endogenous (i.e., monetary
policy-induced) capital flows lead to an unbalanced net external creditor position
for the country (g D 2 X ± 0); (ii) a public debt wedge, when the currency
composition of government liabilities differs from MVP ( lR 2 l* ± 0); and (iii) a
tax wedge, when financial intermediation in domestic currency and foreign
currency are not taxed at the same rates (t F 2 t H ± 0).
Consider first the impact of an external wedge taken in isolation (i.e., assuming
an MVP currency composition of bank reserves and no tax wedge) and take, as a
benchmark, the case of autonomous capital inflows (i.e., an increase in banks’
external borrowing). Rather unsurprisingly, the inflow of dollar funds boosts loan
dollarization. At the same time, however, it reduces deposit dollarization as the
relative affluence of dollar loanable funds tilts domestic interest rates against the
dollar. Thus, a reduction in (deposit) dollarization may not necessarily reflect
changes in risk perceptions. Instead, it may simply be the result of an endogenous
realignment in interest rates taking place in a context of capital inflows.37
Similarly, a monetary policy induced increase in domestic interest rates would
increase the external spread and induce a shift from CBD to FCD, i.e. a fall of g D
and a worsening of the country’s net creditor position. As before, the inflow would
give rise to an excess supply of local dollars which depresses dollar rates relative
37
Indeed, there is evidence that phases of strong capital inflows in heavily dollarized economies such
as Bolivia or Peru have led to a decline in the external spread and an increase in the internal spread
(Ize and Yeyati, 1998).
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
343
to local currency rates, thereby reducing deposit dollarization but raising loan
dollarization. Hence, if aimed at reducing dollarization, a tight monetary policy is
unlikely to be successful. Besides being difficult to sustain on macroeconomic
grounds, it has a mixed impact on dollarization.38
Consider next the impact of a public debt wedge. Attempts to reduce
dollarization by shifting the currency composition of public debt in favor of the
local currency are similarly bound to fail due to their symmetric impact on either
side of a bank’s balance sheet. As interest rates on the local currency rise relative
to the foreign currency, deposit dollarization declines while loan dollarization
rises.
Consider, finally, the case of a tax wedge. When a tax wedge is introduced, the
deposit and loan internal interest rate differentials deviate from each other and
move in opposite directions. Thus, a positive tax wedge (i.e., in favor of home
currency intermediation) reduces dollarization on both sides of a bank’s balance
sheet. However, by depressing the domestic foreign currency interest rate and, in
turn, the external interest rate differential, it stimulates capital flight and financial
disintermediation.
A similar outcome would be expected when FCD or FCL are prohibited. By
forcing depositors to hedge exchange risk through CBD rather than FCD, forced
conversions of FCD into HCD, as occurred in Mexico (1982), Bolivia (1982), and
Peru (1985), can reduce dollarization but at the cost of provoking capital flight and
disintermediation.39 In contrast, the removal of a ceiling on local currency deposit
rates, whose impact should be broadly equivalent to that of the removal of a tax
wedge, can reduce deposit and loan dollarization while stimulating financial
intermediation.40
6. Concluding remarks
We presented a portfolio model of dollarization in which agents hedge against
macroeconomic risk on both sides of a bank’s balance sheet. Due to the symmetry
38
If a tight monetary policy is aimed at limiting the macroeconomic impact of capital inflows, the
impact on loan dollarization may be particularly acute as both effects combine. As illustrated by recent
events in several Asian countries, the prudential implications of such large loan dollarizations can be
particularly severe once the exchange rate collapses.
39
The financial disintermediation was amplified in all three cases by expansionary fiscal and
monetary policies which resulted in sharply negative real local currency interest rates. For a more
complete description of these events and their impact, see Savastano (1992).
40
The main difference between a regulatory ceiling on deposit rates and unremunerated reserve
requirements is that, in the former case, banks, rather than the central bank, appropriate the benefits of
the higher intermediation margin.
344
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
of portfolio decisions, this interaction leads to MVP portfolio allocations in the
absence of external, public debt or tax wedges. Thus, MVP dollarization provides
an important benchmark to estimate the scope for financial dollarization and its
relation with macroeconomic policies, a finding strongly supported by the
empirical evidence. In contrast with the traditional dollarization literature, our
results suggest that financial dollarization is likely to persist as long as inflation
volatility remains high in relation to real exchange rate volatility, even in low
inflation environments.
We derived several important policy implications from the model. In particular,
we argued that, whereas a tight monetary policy that attempts to reduce
dollarization by tilting the domestic interest rate differential in favor of home
deposits is bound to increase loan dollarization, tax-based or regulatory policies,
while more effective to reduce dollarization, are likely to have substantial costs in
terms of capital flight and financial disintermediation.
In contrast, a credible, full-fledged inflation targeting regime in which the
exchange rate is allowed to fluctuate freely within the limits set by the inflation
target should gradually reduce financial dollarization. While the scope for
implementing such a regime would be limited in economies where dollarization
has spread to the real sector, preliminary evidence would suggest that this may not
be the case even in economies with very high financial dollarization. The
co-existence of low real dollarization and high financial dollarization, while not
inconsistent with the simple macroeconomic framework presented in this paper, is
nonetheless puzzling as the same factors that induce a preference for the dollar as
unit of account in financial contracts should also affect the choice of currency in
which to denominate price and wage contracts. This, combined with the close
linkage between real and financial dollarization revealed by the model, highlight
the importance of exploring the determinants of real dollarization in order to gain a
better understanding of how financial dollarization may be reversed and to what
extent. The modeling of such linkages within a general equilibrium framework
with fully specified microeconomic foundations is an important issue for future
research.
Acknowledgements
˜ Mario Blejer, Guillermo Calvo, Tito
´ J.T. Balino,
We are indebted to Tomas
Cordella, Peter Garber, Esteban Jadresic, Malcolm Knight, Carlos Vegh, seminar
participants at the IMF, Universidad Torcuato Di Tella, and the 1998 Latin
American Meeting of the Econometric Society, two anonymous referees and our
´ Velasco, for their helpful comments and suggestions, and to Kiran
editor, Andres
Sastry for his research assistance.
A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
345
Appendix A
Depositors’ portfolio
Defining x F , x C , and x H as the portfolio shares of FCD, CBD and HCD,
respectively, the reader can readily check that, from (1)–(2), the first and second
moments of the probability distribution of portfolio real returns can be expressed,
after substituting x H 5 1 2 x F 2 x C , as E(r)5w91r H , and Var(r)5x9Bx12Cx1
Var(r H ), where: 41
x5
SD
S D
xF
,
xC
w5E
B5
rF 2 rH
,
rC 2 rH
S
S
C5
Var(r F 2 r H )
Cov(r F 2 r H , r C 2 r H )
Cov(r F 2 r H , r C 2 r H )
Var(r C 2 r H )
D
D
Cov(r F 2 r H , r H
,
Cov(r C 2 r H , r H
and E is the expectations operator. Assuming that depositors’ preferences are
represented by U 5 E(r) 2 c D Var(r) / 2, with c D . 0, the first order condition for a
solution to the portfolio selection problem can be expressed as 2w /c D 1Bx1C5
0, from which we obtain the optimal portfolio shares:
x 5 B 21 [2C 1 (1 /c D )w] 5 l* 1 (1 /c D )B 21 w
(A.1)
where:
S
1 V 1 Scc 2V
B 21 5 ]
uBu 2V
V
D
(A.7)
with V 5Var(r F 2 r H ) 5 (Sss 1 2Ss p 1 Spp ), and uBu5SccV. Note that l*5 2B 21 C
characterizes the currency composition of the minimum variance portfolio (MVP).
Then, it is easy to check that C 1 5Cov(r H , r F ) 2Var(r H ), and (C 1 2C 2 )5Scc , from
which l *2 5 (C 1 2C 2 )V/ uBu 5 1, l 1* 5 2 l 2* 2 C1 Scc / uBu, and l* 5 l* 1 1 l* 2 5
H
H
F
2 C1 Scc / uBu 5 [Var(r ) 2 Cov(r , r )] /V, from which we obtain Eq. (9). Finally,
the CBD share and the dollarization ratio follow from x C 5 l *2 1 (V/c D uBu)(r C 2
r F ) 5 1 2 (1 /c D Scc )d XD , and lD 5 x F 1 x C 5 l* 2 (Scc /c D uBu)(r H 2 r F ) 5 l* 2 (1 /
c DV ) d DI .
41
We drop the subscript for notational simplicity.
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A. Ize, E.L. Yeyati / Journal of International Economics 59 (2003) 323–347
Determinants of MVP dollarization
Expressing (9) as l* 5 (Spp 1 rp s Sp Ss ) /(Spp 1 Sss 1 2rp s Sp Ss ), and multiplying
the numerator by Sp /Ss and Ss /Sp , respectively, we have that, for l*, [0, 1],
Sp Ss 1 rp s Sss . 0, and Ss Sp 1 rp s Spp . 0. In turn, differentiating l*, we obtain
≠l* / ≠Sp 5 Ss [ rp s (Sss 1 Sp s ) 1 2Ss Sp ] /(Spp 1 Sss 1 2rp s Sp Ss )2 . 0, and ≠l* / ≠Ss 5
2 (Sp /Ss )≠l* / ≠Sp , 0. Finally, ≠l* / ≠rp s 5 Ss Sp (Sss 2 Spp ) /(Spp 1 Sss 1 2Sp s )2 ,
so that sign(≠l* / ≠rp s ) 5 sign(Sss 2 Spp ).
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