Abstract
In this paper, we study the drivers of permanent and transitory deposit dollarization for a sample of CESE countries using panel cointegration techniques. The results suggest that a positive cointegration relationship exists between permanent dollarization and Minimum Variance Portfolio (MVP) share. This provides an additional empirical validation of the MVP method as the standard tool for analyzing financial dollarization. In the long run, agents make savings decisions based on the relative volatilities of inflation and nominal depreciation rates and do not take into account the interest rate spread. Somewhat different factors affect dollarization in the short rather than in the long run. Namely, apart from MVP share, transitory deposit dollarization is driven, also, by the real interest rate spread. Our results suggest that affecting dollarization through changes in the interest rate spread may have a short term impact. In the long run, however, for dedollarization it is critical to reduce the volatility of inflation compared to the volatility of exchange rate depreciation.
Highlights
We find that permanent dollarization is largely determined by Minimum Variance Portfolio (MVP) share, while the interest rate spread and exchange rate movements play a substantial role in explaining the transitory component
In order to test for the presence of a long-run relationship between permanent dollarization and MVP, we applied Westerlund panel cointegration tests
When uncovered interest parity (UIP) holds, agents make their optimization decisions based on MVP
Summary
The determinants of dollarization have been discussed in numerous theoretical and empirical studies. Ize and Levy Yeyati (2003) empirically tested the relationship between financial dollarization and MVP share using a panel data set of five Latin American countries applying a fixed effect panel methodology. They confirmed that crosscountry deviations of financial dollarization are positively affected by MVP share using a sample of 46 highly dollarized economies. We find that permanent dollarization is largely determined by MVP share, while the interest rate spread and exchange rate movements play a substantial role in explaining the transitory component In this way, we have combined and extended the above-mentioned two strains of literature. The rationale for using a panel error-correction methodology (ECM) is that it is designed for panels with larger T dimension and enables us to estimate the relationship between variables and the speed of convergence towards the longrun equilibrium
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