Unintended Consequences of Foreign Exchange Reserve Movements? Financial Dollarization in Emerging Market Economies

This paper investigates the determinants of financial dollarization in emerging market economies, a phenomenon where domestic residents hold large shares of their portfolios in foreign currencies. In addition to common explanatory variables, this paper places an emphasis on central banks' foreign exchange reserve movements. A dataset of 30 emerging market economies is compiled using monthly data from January 2004 to December 2014 on foreign currency loans and deposits. Foreign exchange interventions are quantified as the changes in central banks' foreign exchange reserves, adjusted by valuation effects such as exchange rate movements and asset returns. Results from panel regressions confirm a positive and statistically significant association between lagged foreign exchange interventions and the private sector's foreign currency positions. In addition, past changes in foreign exchange reserves are positively associated with increases in financial dollarization. Panel data instrumental variable regressions are applied to establish a causal relationship between foreign exchange reserve movement and the private sector’s risk-taking behavior in financial dollarization. We find that a rise in foreign exchange reserve does not affect the share of foreign currency in the portfolios, but it increases the depth of financial dollarization in percent of GDP.