DOES DOLLARIZATION ALLEVIATE OR AGGRAVATE EXCHANGE RATE VOLATILITY?

Abstract

Relying on hard currency or dollarizing an economy has been a common practice of many developing countries taking the form of dollarizing bank deposits and loans, settling transactions in dollars and the indexation of wages and prices in dollars. The relationship between dollarization and exchange rate volatility is both theoretically and empirically unresolved. While the effect of such practices has been the focus of numerous investigations, such studies have concentrated on the Latin American and Asian economies. This paper contributes to the limited research on the African economies by specifically investigating the consequences of dollarization on Eritrean exchange rate volatility. Using quarterly official and black market exchange rate data for the study period 1996-2008, E-GARCH analysis suggests that dollarization has a positive impact on real exchange rate volatility.Keywords: Dollarization, Exchange Rate Volatility, Eritrea, Official and Black MarketJEL classification: F3, O2, O5(ProQuest: ... denotes formulae omitted.)1. INTRODUCTIONThe dollarization of the developing countries has been an inspiring field of research for many scholars. Despite a number of studies that address the measurement and consequences of dollarization, this literature concentrates on the Latin American and Asian economies with very limited focus on African economies. In this paper, we investigate whether dollarization alleviates or aggravates exchange rate volatility in the case of Eritrea. The existing literature suggests that the impact of dollarization can depend on the form of dollarization that exists in a given economy. For example, Akofio-Sowah (2009), Savvides (1996), Schnabl, (2007) and Barrell et al. (2009) among others show that if dollarization is full, then dollarization minimises exchange rate volatility. Similarly, Fielding and Shields (2003) argue that full monetary union leads to lower real exchange rate volatility than is the case under a fixed exchange rate system. However, if dollarization takes a partial form, then the evidence is less clear-cut. The theoretical work of Girton and Roper (1981), Akcay et al. (1997) and Corrado (2008) demonstrate that exchange rate instability increases with the increase of the degree of currency substitution. Empirical studies by Calvo and Vegh (1992, 1996), Yinusa (2008) and Akcay et al. (1997) suggest that an increase in dollarization increases the exchange rate volatility. In contrast to these studies, Devereux and Lane (2003) find that financial dollarization in the form of acquiring dollar loans alleviates exchange rate volatility.In addition to an African focus, our contribution to the literature is further enhanced through the construction and utilisation of a new hard currency index based on a holistic approach towards its measurement. This approach suits the nature of the Eritrean economy and addresses the shortcomings of alternative measures of dollarization adopted by earlier studies. In further contrast to the existing literature, we analyse both the official and black market exchange rate in both nominal and real form.The paper is organized as follows. In the following section, we briefly review the relevant literature. The third section discusses the data and methodology. Quarterly time series data for Eritrea are employed for the study period 1996Q1-2008Q4. Estimation is based on extending the Exponential Generalised Autoregressive Conditionally Heteroscedasticity (E-GARCH) model originally proposed by Nelson (1991). The fourth section offers a discussion of the econometric findings. We find that dollarization has a positive impact on exchange rate volatility. The final section offers a summary and conclusion.2. LITERATURE REVIEWDollarization, which refers to the use of US dollars or any other foreign currency within the domestic economy, has become a contemporary economic feature of many countries from the developing world. …