Financial Dollarization in Emerging Markets: Efficient Risk Sharing or Prescription for Disaster?
This paper pushes back against two views about the effects of dollarization. First, there is a view that the dollar is a device by which rich countries provide business cycle insurance to poor countries. We find that the dollar is important for risk sharing, but the evidence suggests that it is primarily a device to shift business cycle risk across dierent people within individual EMEs and within rich countries rather than across countries. Second, there is a widespread view that dollarization raises the risk of systemic banking and other crises. Although we identify sources of fragility in some aspects of dollarization, the common view that financial dollarization is a source fragility is over-stated. Our insurance view about financial dollarization and the lack of risks to financial stability emerges from a study of a large cross-country dataset, as well as a case study of Peru. We develop a simple model which formalizes the insurance view, which is consistent with the key cross-country facts on interest rate differentials, deposit dollarization and exchange rate depreciations in recessions that we find in our dataset.