Liability Dollarization Research Articles

Bankruptcy costs, liability dollarization, and vulnerability to sudden stops

Countries with intermediate levels of institutional quality suffer larger output contractions following sudden stops of capital inflows than less developed nations. However, countries with strong institutions seldom experience significant falls in output after capital flow reversals. We reconcile these two observations using a calibrated DSGE model that extends the financial accelerator framework developed in Bernanke, Gertler and Gilchrist (1999). The model captures financial market institutional quality with creditors' ability to recover assets from bankrupt firms. Bankruptcy costs affect vulnerability to sudden stops directly but also indirectly by affecting the degree of liability dollarization. Simulations reveal an inverted U-shaped relationship between bankruptcy costs and the output loss following sudden stops.

Firms’ Financing, Contract Enforcement, and Liability Dollarization

Firms’ Financing, Contract Enforcement, and Liability Dollarization

Systemic Sudden Stops: The Relevance of Balance-Sheet Effects and Financial Integration

Using a sample of 110 developed and developing countries for the period 1990-2004 we analyze the empirical characteristics of systemic sudden stops (3S) in capital flows --understood as large and largely unexpected capital account contractions that occur in periods of systemic turmoil -- and the relevance of balance sheet effects in the likelihood of their materialization. We conjecture that large real exchange rate (RER) fluctuations come hand in hand with 3S. A small supply of tradable goods relative to their domestic absorption -- a proxy for potential changes in the real exchange rate -- and large foreign-exchange denominated debts towards the domestic banking system, denoted Domestic Liability Dollarization, DLD, are claimed to be key determinants of the probability of 3S, conforming a balance-sheet effect that impacts on the probability of 3S in non-linear fashion. Regarding financial integration, the larger is the latter, the larger is likely to be the probability of Sudden Stop; however, beyond a critical point the relationship gets a sign reversion.

Sudden stops and liability dollarization: Evidence from Asia's financial intermediaries

Before the currency crisis of 1997–1998, East Asian financial intermediaries borrowed heavily in international markets. During the crisis, the intermediaries' stock market value declined sharply, and a sizable fraction of the institutions were closed or nationalized. We investigate how the short-term and the foreign-currency nature of the intermediaries' international borrowing contributed to these outcomes. From the impact of long-term international debt on the stock returns of surviving intermediaries, we observe the negative effects of the foreign-currency nature of international debt (liability dollarization). From the impact of short-term international debt on the likelihood of firm failure and on the size of surviving intermediaries' assets and liabilities, we observe the negative effects of the short-term nature of international debt (sudden stops).

Sudden Stops and Liability Dollarization: Evidence from Asia's Financial Intermediaries

Before the currency crisis of 1997-1998, East Asian financial intermediaries borrowed heavily in international markets. During the crisis, the intermediaries' stock market value declined sharply, and a sizable fraction of the institutions were closed or nationalized. We investigate how the short-term and the foreign-currency nature of the intermediaries' international borrowing contributed to these outcomes. From the impact of long-term international debt on the stock returns of surviving intermediaries, we observe the negative effects of the foreign-currency nature of international debt (liability dollarization). From the impact of short-term international debt on the likelihood of firm failure and on the size of surviving intermediaries' assets and liabilities, we observe the negative effects of the short-term nature of international debt (sudden stops).

Misalignment, Liabilities Dollarization and Exchange Rate Adjustment in Latin America

Exchange rates in Latin America display a large volatility, constitute a central element of the policy strategies and their evolution have an important impact on financial stability due to the dollarization of liabilities which most countries exhibit. However, assessments on equilibrium exchange rates are scarce in the region. This paper aims at both filling this gap and analysing the impact of the adjustment of the exchange rates to equilibrium on financial stability. Building on the methodology of Alberola et al (1999-2002), we show that the stock of net foreign assets and the evolution of productivity are the fundamentals underlying the behavior of the real exchange rate. Using an unobserved components methodology in a cointegration framework, a time varying equilibrium real exchange rate is derived, and deviations from this equilibrium provide an estimate of the degree of multilateral misalignment. The results uncover among other things the large overvaluation of the Argentinean peso in 2001, which was only partially explained by the estimated dollar overvaluation. The adjustment of exchange rates in 2002 corrected this and, to a lesser extent, other misalignments. The final part of the paper addresses the impact of liability dollarization on the adjustment of exchange rates. It is argued that the real exchange rate will tend to overshoot its equilibrium level, due to the need to foster higher current account surplus in the aftermath of depreciation to make up for to the increase in liabilities. An adjustment to account for this effect is performed on the previous results. This overshooting, when coupled with sudden stops of capitals, may help explaining the higher volatility of real exchange rates in the region.

Balance sheets, exchange rate policy, and welfare

We evaluate the welfare implications of fixed and flexible exchange rate regimes in a small open-economy model that incorporates the financial accelerator coupled with liability dollarization. We solve the model up to a second-order approximation which allows us to rigorously address the relationship between uncertainty and welfare. We identify leverage and debt-to-GDP ratios above which an exchange rate peg is welfare superior to a flexible exchange rate regime. The results indicate that emerging market countries with even moderate levels of foreign currency-denominated debt may find it beneficial to stabilize their exchange rates.

Real exchange rates, dollarization and industrial employment in Latin America

We use a panel dataset on industrial employment and trade for 9 Latin American countries for which liability dollarization data at the industrial level is available. We test whether real exchange rate fluctuations have a significant impact on employment, and analyse whether the impact varies with the degree of trade openness and liability dollarization. Econometric evidence supports the view that real exchange rate depreciations can impact employment growth positively, but this effect is reversed as liability dollarization increases. In industries with high liability dollarization, the overall impact of a real exchange rate depreciation can be negative.

Exchange Rate Policy and Liability Dollarization: What Do the Data Reveal About Causality?

The paper identifies the contemporaneous relationship between exchange rate policy and liability dollarization using three different definitions of dollarization. The presence of endogeneity makes the empirical identification elusive. We use identification through heteroskedasticity to solve the endogeneity problem in the present context (Rigobon, 2003). While we find that countries with high liability dollarization (external, public, or financial) tend to be more actively involved in exchange rate stabilization operations, we do not find evidence that floating, by itself, promotes de-dollarization.

Exchange Rate Policy and Liability Dollarization: What Do the Data Reveal About Causality?

Exchange Rate Policy and Liability Dollarization: What Do the Data Reveal About Causality?

Monetary Policy Challenges in Emerging Markets: Sudden Stop, Liability Dollarization, and Lender of Last Resort

The paper argues that Emerging Market economies (EMs) face financial vulnerabilities that weaken the effectiveness of a domestic Lender of Last Resort (LOLR). As a result, monetary policy is inextricably linked to the state of the credit market. In particular, the central bank should be ready to operate as LOLR during Sudden Stop (of capital inflows) by releasing international reserves in an effective manner. These conditions also impact on optimal monetary policy in normal but high-volatility periods. The paper further argues that during those periods interest rate rules may engender excessive volatility of exchange rates and, thus, that it may be advisable to temporarily supplement those rules by foreign exchange market intervention or outright exchange rate pegging. At a fundamental level, the analysis suggests that the state-of-the-art literature summarized by Woodford (2003) or even more heterodox approaches exemplified by Stiglitz and Greenwald (2003) are likely fall short of providing a satisfactory guide for monetary policy in EMs.

The dilemma of exchange rate arrangements in East Asia

This paper analyzes exchange rate flexibility in East Asia and explores what has changed since the Asian financial crisis. Our focus is not on the choice of an appropriate exchange rate regime in East Asia, but rather on exchange rate flexibility and management in the region. We find that exchange rate management in East Asia differs based on the country and the time period. We identify major concerns about current exchange rate arrangements in East Asia, including asymmetric responses to external shocks, competitive devaluation, and the dilemma of choosing between asset dollarization and liability dollarization. The paper concludes with some policy implications for an exchange rate arrangement in East Asia.

The Fixed-Income Market in Uruguay

Uruguay’s capital markets remain underdeveloped despite the country’s financial liberalization dating back to the 1970s, which was reinforced by passage of several additional laws in the 1990s whose aim was to promote the local financial markets. The government is able to raise funds domestically in what is a liquid bond market, but private firms continue to fund themselves mostly out of retained earnings or else via bank loans and suppliers’ credit. Moreover, when compared to others in Latin America, Uruguayan firms feature the highest ratios of liability dollarization, and corporate debt structures with the shortest maturities – currency and maturity mismatches that render them (and by extension, their creditors) extremely fragile. A deepening of the domestic capital market would probably alleviate this vulnerability of the Uruguayan economy. The financial fragility of Uruguayan firms amplified by corporate governance issues are the main impediments for the development of the capital markets. Given the current firm practices and the absence of sizeable institutional investors besides pension funds, the fixed-income market will most likely remain a source of funding for very few firms.

A model of liability dollarization and myopic governments

Liability dollarization of the domestic banking system represents a source of vulnerability for emerging market countries. The root cause is a lack of faith in the domestic currency, which ultimately stems from the belief that the government will not follow policies that promote long-run currency stability. This paper presents a model in which government myopia determines the unofficial dollarization of bank credit. Specifically, myopic politicians will choose low interest rates to expand short-run output in order to get re-elected, but this choice has the long-run consequence of increasing dollar lending. Increased liability dollarization is shown to force the hand of future decision-makers into choosing fixed exchange rates because of the fear that large depreciations will destroy balance sheets. The results imply that institutional reforms are necessary to reverse liability dollarization.

Real Exchange Rates, Dollarization and Industrial Employment in Latin America

We use a panel dataset on industrial employment and trade for 9 Latin American countries for which liability dollarization data at the industrial level is available. We test whether real exchange rate fluctuations have a significant impact on employment, and analyze whether the impact varies with the degree of liability dollarization. Econometric evidence supports the view that real exchange rate depreciation can impact employment growth positively, but this effect is reversed as liability dollarization increases. In industries with high liability dollarization, the overall impact of a real exchange rate depreciation can be negative.

Trust, Freedom, and Wealth Creation: A Political Economy of Dollarization in Lebanon

This paper explores currency substitution in Lebanon within the context of the recently growing debate on dollarization. Indeed, a number of distinguished scholars have lately made the case for full dollarization following its adoption in Ecuador (2000) and El Salvador (2001). This study, one of the very few focusing on Lebanon, looks at deposit, private liability, and public debt dollarization ratios and finds that Lebanon, when compared to Latin American countries, ranks 5th in deposit dollarization and 2nd in liability dollarization. The study also reveals that dollarization ratios have stayed persistently high despite declining inflation rates and high real returns on Lebanese Pound denominated assets. The paper suggests a political economy based interpretation of the persistently high rates of dollarization, and finds that the latter seem to be a market imposed monetary condition, a response to the unfree and co-opted nature of the state. Indeed, it is possible to argue that currency substitution gives domestic consumers the necessary protection from local wealth-destroying policies. While advocates of dollarization perceive the process as the least bad alternative to macroeconomic mismanagement, I suggest that it is in fact the worst alternative to learning the tools and techniques of domestic wealth creation. Money is the very symbol of societal trust, and is thus more elemental than exchange rate policy. In the case of Lebanon, theoretical and idiosyncratic reasons lead to the recommendation of a de-dollarization process. On a suggestive basis, I propose that the issuing of a new Lebanese Lira could be a viable way of providing incentives and inspiring trust.

Sudden Stops and Phoenix Miracles in Emerging Markets

A decade has passed since the salvos from Mexico’s Tequila Crisis of 1994–1995 echoed around the financial world. Since then, many more crises have taken place in emerging market economies (EMs). Furthermore, crises have tended to bunch together, bringing to the forefront the systemic nature of these events. True, every new crisis has its own idiosyncratic features, but useful policy lessons must be derived from robust, empirical regularities. This is the research strategy we have pursued in the last few years. We will report on two types of regularities that strike us as highly robust across EM crises: (a) Sudden Stops (of capital inflows) and (b) Phoenix Miracles. A Sudden Stop is a sharp fall in capital inflows relative to their past trajectory. Sudden Stops are not a common feature in developed economies and display a large degree of temporal bunching, suggesting that global capital market turmoil acts as a coordinating factor external to EMs. As shown in Section I, however, balance-sheet effects—namely, the interaction of large changes in the real exchange rate during Sudden Stops and Liability Dollarization (i.e., foreign-exchange-denominated debts)—are key in influencing the likelihood of a Sudden Stop. Thus, even though the initial shock is, in principle, exogenous to the economy, whether or not it materializes into a Sudden Stop depends on domestic financial vulnerabilities. On the other hand, a Phoenix Miracle is defined as a case in which output recovers relatively quickly from a sharp collapse with virtually no recovery in credit or capital inflows, and a very weak recovery in investment— hence the reference to the mythical bird “rising from the ashes.” The existence of phoenix-like recoveries suggests that financial frictions play a key role in pushing economies to the abyss from which, in some way or another, they can crawl back to safe ground by means less than apparent to the conventional observer looking for standard “fundamentals” and, thus, may appear miraculous. Interestingly, the Great Depression of the 1930s shares some of the key features of Phoenix Miracles in EMs, but shows salient differences as well that suggest nominal labor market rigidities are not crucial in explaining output collapse in EMs. Understanding these regularities could, and we believe does, shed light on policies aimed at preventing crises and attenuating their effects.

Is there a link between dollarization and banking crises?

AbstractI estimate a multivariate probit model to identify key variables that are predictive of banking crises. To add to the literature on this subject, I focus on the role played by unofficial dollarization of domestic banking systems. Unofficial dollarization is a source of vulnerability for emerging markets as large depreciations render both domestic firms and banks unable to pay dollar‐denominated debt. Surprisingly, I find only weak evidence that unofficial dollarization affects the probability of a banking crisis. This finding casts doubt on the widely held belief that liability dollarization is a significant source of risk for emerging markets and developing nations, although there are still reasons to believe that dollarization remains a significant source of risk. Copyright © 2006 John Wiley & Sons, Ltd.

Dollar Debt in Developing Countries: Too Much of a Good Thing?

In the early 2000s, many developing countries in Eastern Europe, Latin America and Asia presented substantial corporate dollar debts. This paper suggests an explanation for this worrisome phenomenon, which builds on the traditional signaling approach. The model brings into the picture specific institutional characteristics of the credit market in these countries. If lenders have no direct possibility to infer a firm's financial status, sound firms might want to borrow dollars and bear a high clearance cost -- connected to the grant procedure -- just in order to signal their type. The success of this policy depends on the behavior of bad firms. When dollar borrowing clearance costs are relatively small with respect to the clearance cost of borrowing in the local currency, the whole corporate sector would opt for liability dollarization. In this most inefficient case, the signaling effect vanishes, while all firms bear high clearance costs. We also put forward the necessary conditions for a separating equilibrium to occur.

Real Exchange Rates, Dollarization and Industrial Employment in Latin America

We use a panel dataset on industrial employment and trade for 9 Latin American countries for which liability dollarization data at the industrial level is available. We test whether real exchange rate fluctuations have a significant impact on employment, and analyze whether the impact varies with the degree of trade openness and liability dollarization. Econometric evidence supports the view that real exchange rate depreciations can impact employment growth positively, but this effect is reversed as liability dollarization increases. In industries with high liability dollarization, the overall impact of a real exchange rate depreciation can be negative.