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Liquidity Insurance in a Financially Dollarized Economy

In: Financial Markets Volatility and Performance in Emerging Markets

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  • Eduardo Levy Yeyati

Abstract

Unlike the financial dollarization (FD) of external liabilities, the dollarization of domestic financial assets (domestic FD) has received comparatively less attention until very recently, when it has been increasingly seen as a key source of balance sheet exposure. This paper focuses on a complementary –and often overlooked– angle of domestic FD: the limit it imposes on the central bank as domestic lender of last resort, and the resulting exposure to dollar liquidity runs. The paper discusses the incidence of FD on banking crisis propensity, shows that FD has been an important motive for self insurance in the form of international reserves, and highlights the moral hazard associated with centralized reserve accumulation. Next, it illustrates the authorities’ belated recourse to suspension of convertibility in two recent banking crises (Argentina 2001 and Uruguay 2002). Finally, it argues for a combined scheme of decentralized reserves (liquid asset requirements on individual banks) to limit moral hazard, and an ex-ante suspension-of-convertibility clause (“circuit breakers”) to reduce self-insurance costs while limiting bank losses in the event of a run.

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This chapter was published in:

  • Sebastian Edwards & Márcio G. P. Garcia, 2008. "Financial Markets Volatility and Performance in Emerging Markets," NBER Books, National Bureau of Economic Research, Inc, number edwa05-1, October.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 4778.

    Handle: RePEc:nbr:nberch:4778

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    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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    1. Charles W. Calomiris & Gary Gorton, . "The Origins of Banking Panics: Models, Facts, and Bank Regulation," Rodney L. White Center for Financial Research Working Papers 11-90, Wharton School Rodney L. White Center for Financial Research.
    2. Ricardo J. Caballero & Arvind Krishnamurthy, 2003. "Excessive Dollar Debt: Financial Development and Underinsurance," Journal of Finance, American Finance Association, vol. 58(2), pages 867-894, 04.
    3. Tito Cordella & Eduardo Levy Yeyati, 2006. "A (New) Country Insurance Facility," International Finance, Wiley Blackwell, vol. 9(1), pages 1-36, 05.
    4. Gianni De Nicoló & Patrick Honohan & Alain Ize, 2003. "Dollarization of the Banking System: Good or Bad?," IMF Working Papers 03/146, International Monetary Fund.
    5. Aizenman, Joshua & LEE, JAEWOO, 2005. "International Reserves: Precautionary versus Mercantilist Views, Theory and Evidence," Santa Cruz Center for International Economics, Working Paper Series qt44g3n2j8, Center for International Economics, UC Santa Cruz.
    6. Eduardo Levy Yeyati & Augusto de la Torre & Sergio Schmukler, 2003. "Living and Dying with Hard Pegs: The Rise and Fall of Argentina´s Currency Board," Business School Working Papers catorce, Universidad Torcuato Di Tella.
    7. Eduardo Levy Yeyati & Alain Ize & Miguel A. Kiguel, 2005. "Managing Systemic Liquidity Risk in Financially Dollarized Economies," IMF Working Papers 05/188, International Monetary Fund.
    8. Rajan, Raghuram G. & Tokatlidis, Ioannis, 2005. "Dollar Shortages and Crises," MPRA Paper 832, University Library of Munich, Germany.
    9. Eduardo Levy-Yeyati, 2004. "FINANCIAL DOLLARIZATION: Evaluating the consequences," Econometric Society 2004 Latin American Meetings 184, Econometric Society.
    10. Eduardo Levy Yeyati & Tito Cordella, 2004. "Country Insurance," Econometric Society 2004 Latin American Meetings 136, Econometric Society.
    11. Romain Ranciere & Olivier Jeanne, 2006. "The Optimal Level of International Reserves for Emerging Market Countries: Formulas and Applications," IMF Working Papers 06/229, International Monetary Fund.
    12. Roberto Chang & Andres Velasco, 1997. "Financial fragility and the exchange rate regime," Working Paper 97-16, Federal Reserve Bank of Atlanta.
    13. Carlos O. Arteta, 2003. "Are financially dollarized countries more prone to costly crises?," International Finance Discussion Papers 763, Board of Governors of the Federal Reserve System (U.S.).
    14. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
    15. Shah, Parth J, 1997. " The Option Clause in Free-Banking Theory and History: A Reappraisal," The Review of Austrian Economics, Springer, vol. 10(2), pages 1-25.
    16. Guillermo A. Calvo, 2005. "Emerging Capital Markets in Turmoil: Bad Luck or Bad Policy?," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262033348, January.
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    Cited by:
    1. Levy-Yeyati, Eduardo & Sturzenegger, Federico, 2007. "Fear of Appreciation," Working Paper Series rwp07-047, Harvard University, John F. Kennedy School of Government.
    2. Anastasia Guscina, 2008. "Impact of Macroeconomic, Political, and Institutional Factors on the Structure of Government Debt in Emerging Market Countries," IMF Working Papers 08/205, International Monetary Fund.
    3. Aizenman, Joshua, 2007. "International reserves management and the current account," Santa Cruz Department of Economics, Working Paper Series qt22q271t2, Department of Economics, UC Santa Cruz.
    4. Aizenman, Joshua, 2010. "International Reserves and Swap Lines in Times of Financial Distress: Overview and Interpretations," ADBI Working Papers 192, Asian Development Bank Institute.
    5. Joshua Aizenman, 2009. "Hoarding International Reserves Versus a Pigovian Tax-Cum-Subsidy Scheme: Reflections on the Deleveraging Crisis of 2008-9, and a Cost Benefit Analysis," NBER Working Papers 15484, National Bureau of Economic Research, Inc.
    6. Aizenman, Joshua, 2010. "Macro prudential supervision in the open economy, and the role of central banks in Emerging Markets," Santa Cruz Department of Economics, Working Paper Series qt97j5w7qk, Department of Economics, UC Santa Cruz.
    7. Joshua Aizenman, 2007. "Large Hoarding of International Reserves and the Emerging Global Economic Architecture," NBER Working Papers 13277, National Bureau of Economic Research, Inc.
    8. Aizenman, Joshua, 2011. "Hoarding international reserves versus a Pigovian tax-cum-subsidy scheme: Reflections on the deleveraging crisis of 2008-2009, and a cost benefit analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 35(9), pages 1502-1513, September.
    9. Cerezo Aguirre, Sergio Cerezo Aguirre, 2010. "Consideraciones sobre el nivel óptimo de reservas internacionales para Bolivia: 2003-2009," Revista Latinoamericana de Desarrollo Economico, Instituto de Investigaciones Socio-Económicas (IISEC), Universidad Católica Boliviana, issue 14, pages 41-70.
    10. Glüzmann, Pablo Alfredo & Levy-Yeyati, Eduardo & Sturzenegger, Federico, 2012. "Exchange rate undervaluation and economic growth: Díaz Alejandro (1965) revisited," Economics Letters, Elsevier, vol. 117(3), pages 666-672.

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