University of Mannheim: Dollarization in emerging markets is not associated with higher financial market risks

Dollarization refers to the introduction of the US dollar in parallel with or instead of the local currency and is widespread in developing and emerging countries. The dollarization of deposits can be viewed as an insurance arrangement that occurs more often within the country concerned than across the borders of the country.

On average, the cross-border capital flows amount to around half of the domestic capital flows, write the authors, who evaluated various data sets from up to 16 countries in the period between 2000 and 2018.

The idea of ​​’insurance’ for dollar deposits goes back to the fact that the US dollar tends to appreciate if the economy of the dollarized country slides into a recession. “For many people – especially in the US – deposits seem like a trivial instrument, but in most countries, especially in emerging markets, such investments are the main instrument of saving,” the researchers explain.

Households that denominate their investments in dollars are buying a kind of insurance policy about the business cycle, argue the economists Lawrence Christiano from Northwestern University, Husnu Dalgic from the University of Mannheim and Armen Nurbekyan from the Central Bank of Armenia.

The ‘price’ for this insurance for the investor is the difference in interest rates compared to investments in local currency. The ‘return’ of the insurance is the increase in the return in dollars that arises when the local currency depreciates against the dollar in a recession.

The results of the study painted a “relatively harmless picture of the dollarization of deposits,” the scientists write. “Still, the view persists that dollarization is dangerous and makes banks more vulnerable to a systemic crisis.”

In contrast, the study’s data suggested that dollarization “does not increase the risk of a financial crisis because the resulting currency mismatch is in the hands of low-debt companies that can handle exchange rate fluctuations,” said Christiano, Dalgic and Nurbekyan.

‘Currency Mismatch’ describes the situation where a loan is denominated in a foreign currency, so that the costs fluctuate with the exchange rate of the domestic currency.

Dollarization alone is not a driver of unemployment or a cause of crisis
At the same time, the results of the study show that the majority of such dollarized contracts are offered by non-financial companies, but not by banks. This is thanks to prudent regulation and supervision that help avoid direct negative effects on the banking system.

The study also does not support the view that dollarization leads to lower investment and falling employment in the event of a recession, the researchers said. “Revenue and gross domestic product seem to be the main drivers of non-financial corporate investment, not exchange rate fluctuations.”

Furthermore, economists could not find any empirical evidence that dollarization leads to an overreaction to exchange rate fluctuations. Rather, the data suggested that dollarization’s contribution to volatility was “minimal”.

After all, the dollarization of deposits does not lead to better predictability of financial crises or the severity of a crisis. “While our results confirm previous research that excessive borrowing increases the risk of a crisis, denominating the credit does not per se increase its likelihood,” the authors say.

More information about the study

The discussion paper presented is a publication of the Collaborative Research Center (SFB) Transregio 224 EPoS. The full study can be found here . A list of all discussion papers of this project group of the SFB can be found here .

Authors
Husnu Dalgic, Ph.D., member of the Collaborative Research Center Transregio 224 EPoS and postdoc at the University of Mannheim
Professor Lawrence Christiano, Ph.D., Department of Economics, Northwestern University, USA
Armen Nurbekyan, Ph.D., Macroeconomic Directorate, Central Bank of the Republic of Armenia

The Collaborative Research Center Transregio 224 EPoS
The Collaborative Research Center Transregio 224 EPoS , established in 2018 , a cooperation between the University of Bonn and the University of Mannheim, is a long-term research facility funded by the German Research Association (DFG). EPoS deals with three central societal challenges: How can equal opportunities be promoted? How can markets be regulated in view of the internationalization and digitization of economic activity? And how can the stability of the financial system be ensured?

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