Wednesday, May 13, 2009

Measures of Financial Dollarization

Domestic financial dollarization, defined as the use of a foreign currency to denominate the assets and liabilities of a country’s residents, has been both a trigger for financial crisis and a reason why currency crises have different impacts on emerging countries than on industrial countries. Financial dollarization constrains monetary policy choices and, most prominently, assures that anexchange rate depreciation will have a deleterious impact on the solvency of dollar debtors (the balance sheet effect). ). An important analytical study by Cavallo, Kisselev, Perri and Roubini shows that the depth of an output contraction in a currency crisis depends on the degree of external dollarization of the country.

Despite the vast analytical literature on these issues, very little empirical work has confirmed that financially dollarized economies are more prone to suffer financial and currency crisis. Levy-Yeyati’s new paper fills this gap. The author builds a comprehensive database on deposit dollarization, revisits the evidence on the determinants of financial dollarization and tests the impact of deposit dollarization on monetary and financial stability, and economic performance. In brief, he finds that financially dollarized economies have a greater propensity to suffer banking crises after a depreciation of the local currency without gaining domestic financial depth and have slower and more volatile output growth.

In a similar vein, Bebczuk, Galindo and Panizza use a panel of 57 countries across the world to test if the impact of exchange rate depreciations on the growth rate of output. An innovative feature of the paper is their measures of dollarization – external and domestic – and their distinct impacts on output. One of their major findings depreciation leads to decrease in output in countries with external dollarization greater than 0.84 (countries that have dollar denominated external debt greater than 84 percent of GDP). Likewise, in countries with domestic liability dollarization (bank loans/GDP) higher than 0.5 depreciations have a negative impact on output.

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