Financial dollarization: from second best to first best

2. Financial dollarization:from second best to first best A comment by Ricardo Hausmann Harvard University

3. The conventional wisdom • Borrowing in dollars makes the real exchange rate matter for determining the effective cost of borrowing • The real exchange rate is volatile • Therefore it is best if people avoided borrowing in dollars • They do not because of moral hazard • Financial policies should introduce sticks rather than carrots to internalize the risks • All papers find this logic lousy

4. The papers • Dollarization may not be caused by moral hazard but by risk aversion given the alternatives • Augusto and Sergio argue that it is a risk mitigating device • It need not be caused by low credibility of monetary policy • Ize and Powell assume this from the start • Roberto and Andres do not need it • Dollar assets go up in value when the country gets a bad shock • Smaller economies should dollarize more!!!

5. Volatility of Real Exchange rate over 5-year periods 4.5 Industrialized countries Developing countries Nigeria 4 3.5 Bolivia 3 Romania 2.5 Zambia Venezuela Ecuador China Uruguay Dominican Republic 2 Trinidad and Tobago Burundi Cote d'Ivoire Indonesia Argentina Cameroon Colombia Saudi Arabia Paraguay Kuwait Mexico Chile South Africa Brazil 1.5 Bahrain Pakistan Peru Malaysia Portugal United States Singapore Turkey India Hungary New Zealand Hong Kong, China Fiji United Kingdom Tunisia St.Vinc&Grenadines Costa Rica Philippines Papua New Guinea Thailand 1 Australia Togo Morocco Gambia, The Belize Japan Korea, Rep. Finland Belgium Lesotho St. Lucia Spain Italy Iceland Switzerland Sweden Bahamas, The Germany Malta Cyprus Greece Taiwan Netherlands Canada Denmark France Austria Israel Ireland 0.5 Norway 0

6. Is there a “peso problem” as Ize and Powell assume?

7. There are also differences in Kurtosis and Skewness Kurtosis Skewness 1 YR 1YR 1.164 1.507 Developing 0.757 0.208 Industrial 0.407 1.299 Difference 2.544 4.401 t-statistic 0.993 1.000 P (Dev > Ind)

8. …but this result disappears when we look at 5-year horizons Kurtosis Kurtosis Skewness Skewness 1 YR 5 YR 1YR 5YR 1.164 1.000 1.507 0.873 Developing 0.757 1.039 0.208 1.322 Industrial 0.407 -0.039 1.299 -0.449 Difference 2.544 -0.436 4.401 -0.890 t-statistic 0.993 0.332 1.000 0.188 P (Dev > Ind)

9. What is the alternative?

10. Real interest rates volatility is in a class by itself

11. They move together in the “wrong” direction

12. Floating at its best: Australia 1.8 6 5.8 1.7 5.6 5.4 1.6 5.2 interest rate exchange rate 1.5 5 4.8 1.4 4.6 4.4 1.3 4.2 1.2 4 5/1/97 7/1/97 9/1/97 1/1/98 3/1/98 5/1/98 7/1/98 9/1/98 1/1/99 3/1/99 5/1/99 7/1/99 9/1/99 1/1/97 3/1/97 11/1/97 11/1/98

13. Floating Latin Style: Mexico 55 11 50 10.5 exchange rate 45 10 40 9.5 interbank rate exchange rate 35 9 30 8.5 interbank rate 25 8 20 7.5 15 7 1/2/97 5/2/98 1/2/99 7/2/99 3/2/97 5/2/97 7/2/97 9/2/97 1/2/98 3/2/98 7/2/98 9/2/98 3/2/99 5/2/99 11/2/97 11/2/98

14. Bolivar assets can be very risky

15. Why do financial systems get dollarized? • Lousy monetary credibility • This is what Ize and Powell assume in their basic structure; related to mvp by Ize et al • Related to Jeanne (2003) • To hedge real risks • Chang and Velasco: people hold dollars to hedge income risk • Different from Ize et al and from Lavy-Yeyati mvp • Default dollarization • Ize and Powell, related to Chamon (2002) and ABB • Exchange rates and moral hazard • Implicit in Ize and Powell: but they do not internalize the cost of the bailout from the point of view of savers • Policy recommendations cannot be decided without a view on these theories • Ize and Powell make this point: financial regulation only works if moral hazard by lenders is the problem

16. Why do countries stay dollarized? • Strategic interaction between choice of debt denomination and monetary policy in a world of original sin • Chamon and Hausmann (2003) • Same results as in Chang and Velasco and Ize and Powell • But in C&H there are other determinants: the relative consequences of XR vs. interest rate volatility • Economies of scale and the Immaculate Conception • FDR and the gold clause (Krozner (19??) Flandreau and Sussman (2003) • Europe and financial repression • Australia and the wars (Bordo et al, 2003) Caballero et al (yesterday) • Capital controls promote local markets (Hausmann and Panizza, 2003)

17. Policy implications: the case for sticks • What is the case for sticks? • Moral hazard • Multiple equilibria • They lead to different interventions • MH: “Prudential” financial restrictions • ME: Voluntarism: • The role of public debt • Additionally, pension funds, financial repression, capital controls, forceful pesification

18. Market development • Better monetary policy cannot hurt • All papers make this point • Original sin increases domestic mismatches • Locals want to save abroad to diversify risk • Borrowers then have to may have reasons to borrow from foreigners • But if foreigners do not want to take a long position in pesos (original sin) there is an excess currency risk in the domestic market

19. Why are long-term peso loans less attractive to foreigners than long-term dollar loans? • The problem: at present foreigners are faced with • Different jurisdictions • Convertibility risk • But dollar loans are risky because of real depreciation risk • The solution: make it as simple as possible • Peso or CPI indexed long duration bonds • In a foreign jurisdiction • Paid in dollars (to eliminate convertibility risk) • Issued by a non-resident (to eliminate the correlation between default risk and depreciation risk) • A resident in a foreign jurisdiction is not the same thing as a non-resident • This is a role for IDB