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Dollarization and financial integration

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  • Cristina Arellano
  • Jonathan Heathcote

Abstract

How does a country's choice of exchange rate regime impact its ability to borrow from abroad? We build a small open economy model in which the government can potentially respond to shocks via domestic monetary policy and by international borrowing. We assume that debt repayment must be incentive compatible when the default punishment is equivalent to permanent exclusion from debt markets. We compare a floating regime to full dollarization. ; We find that dollarization is potentially beneficial, even though it means the loss of the monetary instrument, precisely because this loss can strengthen incentives to maintain access to debt markets. Given stronger repayment incentives, more borrowing can be supported, and thus dollarization can increase international financial integration. This prediction of theory is consistent with the experiences of El Salvador and Ecuador, which recently dollarized, as well as with that of highly-indebted countries like Italy which adopted the Euro as part of Economic and Monetary Union: in each case, around the time of regime change, spreads on foreign currency government debt declined substantially.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Staff Report with number 385.

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Date of creation: 2007
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Handle: RePEc:fip:fedmsr:385
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Keywords: Financial crises ; Foreign exchange administration;

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Find related papers by JEL classification:
  • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
  • F3 - International Economics - - International Finance

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Cited by:

  1. Asonuma, Tamon, 2014. "Sovereign defaults, external debt and real exchange rate dynamics," MPRA Paper 55133, University Library of Munich, Germany.
  2. Krzysztof Makarski, 2014. "Dollarization as a signaling device," Bank i Kredyt, National Bank of Poland, Economic Institute, vol. 45(1), pages 17-36.
  3. Pierre M. Picard & Tim Worrall, 2015. "Currency Areas and Voluntary Transfers," CREA Discussion Paper Series 15-12, Center for Research in Economic Analysis, University of Luxembourg.
  4. Michael Kumhof, 2004. "Fiscal Crisis Resolution: Taxation versus Inflation," Working Papers 102004, Hong Kong Institute for Monetary Research.
  5. Eduardo Borensztein & Ugo Panizza, 2008. "The Costs of Sovereign Default," IMF Working Papers 08/238, International Monetary Fund.
  6. Samir Jahjah & Bin Wei & Vivian Zhanwei Yue, 2013. "Exchange Rate Policy and Sovereign Bond Spreads in Developing Countries," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(7), pages 1275-1300, October.
  7. Marcelin, Isaac & Mathur, Ike, 2016. "Financial sector development and dollarization in emerging economies," International Review of Financial Analysis, Elsevier, vol. 46(C), pages 20-32.
  8. Schmitz, Birgit & von Hagen, Jürgen, 2011. "Current account imbalances and financial integration in the euro area," Journal of International Money and Finance, Elsevier, vol. 30(8), pages 1676-1695.
  9. Roc Armenter & Martin Bodenstein, 2006. "Does the time inconsistency problem make flexible exchange rates look worse than you think?," International Finance Discussion Papers 865, Board of Governors of the Federal Reserve System (U.S.).
  10. Adam, Klaus & Grill, Michael, 2013. "Optimal sovereign default," Discussion Papers 09/2013, Deutsche Bundesbank, Research Centre.
  11. Betty C. Daniel & Christos Shiamptanis, 2010. "Sovereign Default Risk in a Monetary Union," Working Papers 2010-3, Central Bank of Cyprus.
  12. Slavov, Slavi T., 2009. "Do common currencies facilitate the net flow of capital among countries?," The North American Journal of Economics and Finance, Elsevier, vol. 20(2), pages 124-144, August.

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