FINANCIAL DOLLARIZATION IN EMERGING MARKETS: AN INSURANCE ARRANGEMENT

• Published date: 01 August 2024
• Author: Husnu C. Dalgic
• Date: 01 August 2024
• DOI: http://doi.org/10.1111/iere.12686

INTERNATIONALECONOMIC REVIEW

Vol. 65, No. 3, August 2024 DOI: 10.1111/iere.12686

FINANCIAL DOLLARIZATION IN EMERGING MARKETS: AN INSURANCE

ARRANGEMENT∗

By Husnu C. Dalgic

University of Mannheim, Germany

Households in emerging markets hold significant amounts of dollar deposits whereas firms have signifi-

cant amount of dollar debt. Motivated by perceived dangers, policymakers consider regulations to limit dol-

larization. I draw attention to an important benefit of dollarization: it serves as an insurance arrangement in

which firms provide income insurance. Emerging market exchange rates tend to depreciate in recessions so

that households prefer holding deposits denominated in dollars. They effectively starve local financial markets

of local currency; raising local interest rates over USD rates and causing entrepreneurs to borrow in dollars.

This premium is the price paid by households for insurance.

1. introduction

In many emerging markets (EMs), companies borrow substantial amounts in foreign cur-

rency, often denominated in dollars (see Figure 1).1This “credit dollarization” raises concerns

for policymakers due to significant balance-sheet risks (Aoki et al., 2016). When the exchange

rate depreciates, the interest payments on foreign debt increase, negatively impacting firms’

balance sheets. This, in turn, affects investment, production, and, eventually, employment and

wages. The prevailing explanation attributes the widespread credit dollarization to political in-

stability and the perceived lack of commitment from central banks in emerging economies,

leading to high and volatile domestic interest rates (BIS, 2014). What remains puzzling is the

persistence of high credit dollarization levels despite considerable macroeconomic improve-

ments in many emerging markets (Ize and Levy Yeyati, 2003).

In this article, I offer a complementary explanation for the prevalence of credit dollariza-

tion. In emerging economies, poor economic performance often coincides with exchange rate

depreciations. To hedge against domestic income fluctuations, households invest in savings ac-

counts in foreign currency, which appreciate precisely when domestic economic growth is low

(Table 1). I propose that a significant portion of credit dollarization in emerging economies

arises from an “insurance arrangement.” As households prefer saving in foreign currency, it

reduces the supply of local currency, leading to increased local interest rates and prompting

firms to borrow in dollars. In this framework, households’ foreign currency savings act as a

∗Manuscript received October 2020; revised December 2023.

I am indebted to Lawrence Christiano, Martin Eichenbaum, and Giorgio Primiceri for their guidance and sup-

port. I am especially grateful to Dirk Krueger and Vivian Yue for their thoughtful and expert handling of the ar-

ticle. I thank Klaus Adam, Matthias Doepke, Refet Gurkaynak, Guido Lorenzoni, Sena Coskun, and Yuta Taka-

hasi for helpful comments and appreciate the helpful comments received at the Vienna Cafe (2018), Midwest

Macro Spring Meetings (2019), EEA Summer Meetings (2019), and ES Winter Meetings, 2020. Funding by the

Deutsche Forschungsgemeinschaft (DFG,German Research Foundation) through CRC TR 224 (Project C2) is grate-

fully acknowledged. Please address correspondence to: Husnu C. Dalgic, Department of Economics, University of

Mannheim L 7, 3-5 Room P3. 68161 Mannheim, Germany. E-mail: dalgic@uni-mannheim.de.

1Although the focus here is on the use of the dollar, it is worth noting that euro and Swiss Franc are also in the

mix, as highlighted in Eren and Malamud (2022) and Gourinchas et al. (2022).

1189

© 2024 The Authors. International Economic Review published by Wiley Periodicals LLC on behalf of the Economics

Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research

Association.

This is an open access article under the terms of the Creative Commons Attribution-NonCommercial-NoDerivs Li-

cense, which permits use and distribution in any medium, provided the original work is properly cited, the use is non-

commercial and no modifications or adaptations are made.

1190 dalgic

Notes: The data source is IMF-Financial Soundness Indicators.The data consist of 83 emerging economies. Loan dol-

larization is the fraction of loans denominated in foreign currency over total amount of loans. The value in each year

represents the average loan dollarization in emerging economies. See Appendix Subsection A.8 for details.

Figure 1

loan dollarization in the world

Table1

gdp/fx correlation and dollarization

GDP/FX Correlation Deposit Dollarization

Countries with (+) corr 0.18 14%

Countries with (−)corr −0.37 36%

Note: Data source is World Bank. Thedata cover years from 1994 to 2018. GDP/ Exchange rate correlation has been

calculated separately for each countries from available (20+years) time series. Average correlation and average dol-

larization have been reported for the subsets of countries exhibiting positive and negative correlation. A more de-

tailed version of the data is reported in Figure 4. See Appendix Subsection A.8 for details.

hedge for income fluctuations, whereas firms benefit from lower borrowing costs. In essence,

the origin of dollar credit in the economy lies in the dollar deposits provided by households.

I formalize the concept of dollarization as an “insurance arrangement” within a small open

economy model with financial frictions, where local interest rates and exchange rates are

endogenously determined, and dollarization endogenously arises. Households can choose to

save by purchasing either peso or dollar assets (deposit dollarization), whereas entrepreneurs,

who are subject to financial frictions (costly state verification [CSV]à la Gale and Hellwig,

1985 and Bernanke et al., 1999) can borrow in pesos or dollars (credit dollarization). Through

portfolio choice, interest rate spread, and dollarization emerge endogenously in the model.

The model addresses the primary concern about dollarization; entrepreneurs’ balance sheets

are negatively impacted by an exchange rate depreciation due to the mismatch between rev-

enues (in pesos) and debt (in dollars). Simultaneously, it captures the insurance aspect of

dollarization, the article’s focal point. Following an exchange rate depreciation, the value of

household savings in dollars rises, acting as insurance against the adverse effects. When house-

holds increase investments in dollar assets for hedging benefits, the supply of pesos decreases,

leading to an endogenous increase in the spread between local and foreign interest rates.