Financial Dollarization in Emerging Markets: Efficient Risk Sharing or Prescription for Disaster?
There is a common view that financial dollarization is a source of financial fragility for emerging market countries. Although we identify sources of fragility in some aspects of dollarization, the common view that financial dollarization is a source fragility is over stated. We find that deposit dollarization (and the currency mismatch that implies for non-financial firms) is not a source of fragility and may even be part of a welfare-raising insurance arrangement among different households within emerging markets. Our insurance view about financial dollarization and the lack of risks to financial stability emerges from a study of a large cross-country dataset. 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.