Want Dollarization?no! No! No!

GLIM WORKING PAPER SERIES

WANT DOLLARIZATION ?

NO! NO!

Sundara B Reddy

GREAT LAKES INSTITUTE OF MANAGEMENT

South Mada Street, Srinagar Colony,

Saidapet, Chennai

July 2004

We are indebted to Lakshmi Kumar, Bala V Balachandran, Gulshan, Shishir, Praveen for useful comments and suggestions. Of course, we are solely responsible for any shortcomings. The views expressed herein are those of the authors and not necessarily those of the Great Lakes Institute of Management.

© 2004 by Sundara B Reddy. All rights reserved. Short sections of text, not to exceed

two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Want Dollarization? No! No!

Sundara B Reddy

GLIM Working Paper

July 2004

JEL No. E42, F41, F42

ABSTRACT

This paper discusses major analytical aspects of dollarization and their practical implications. We develop a simple model to stress that dollarization implies the loss of independent monetary policy, yet the significance of such losses can only be evaluated in conjunction with assumptions about the policymaking process. If the government is benevolent and has no credibility problems, dollarization causes a fall in welfare, which can be measured. However, outcomes are rather different if credibility is absent and dollarization can serve as a commitment device: the welfare impact of dollarization is ambiguous. We also evaluate other implications of dollarization, such as those related to last resort lending and financial stability.

Sundara B Reddy

1 Introduction

In the dollarization debate, some have indeed argued that dollars would provide for a"better" currency than existing national currencies while others have argued exactly the opposite. We prefer to be agnostic here. Given the absence of better micro-foundations, it is probably best to impose an assumption that does not bias the desirability of dollarization in one way or another. Fixing the exchange rate involves a welfare loss relative to the Ramsey policy. So, in the absence of commitment, expected welfare under fixed exchange rates may or may not improve. There is a tradeoff between credibility and flexibility, and the better choice depends on model parameters.

2 Dollarization and the Lender of Last Resort - 3 -

The recent crises in emerging markets have underscored a crucial question: what is the role of exchange rate policy in the generation and/or prevention of those crises? Arguably, it is this issue that has provided the main impetus for dollarization proposals in developing countries. And, paradoxically, consideration of the same question has led to calls for the exact opposite, flexible exchange rates.

The debate has been influenced by some prominent aspects of observed

crises. In them, the financial system, and particularly domestic banks, played a key role. Exchange rate pegs often collapsed as the central bank was attempting to bail out the domestic financial system in the midst of a panic. The panic was possible, in turn, because the countries that went into crises were in a state of international illiquidity: their short term potential liabilities, measured in international currency, clearly exceeded the value of the assets they could have access to on short notice.

In this context, it has been argued that dollarization would make crises more likely by preventing the domestic central bank from acting as a domestic lender of last resort. Loosely speaking, a lender of last resort is an institution that stands ready to provide credit to banks in the event that they experience a sudden demand for liquidity, as when bank runs occur. Such an institution is crucial in a system of banks with fractional reserves in order to reassure bank depositors and short-term creditors that their claims on the banks will always be honored if they attempt to liquidate them. This may help prevent confidence crises and associated bank runs. - 1 -

In most countries, the role of lender of last resort has traditionally been played by central banks. This role is natural because the central bank can create credit quickly and at a negligible cost simply by issuing domestic currency. But the ability to print currency would disappear under dollarization, and hence the central bank would no longer be able to serve as the lender of last resort.

Advocates of dollarization admit that it would prevent the central bank from acting as a domestic lender of last resort, but that this may not be too difficult to deal with. One way to cope with the possibility of financial panics, which Argentina actually implemented, would be to secure foreign lines of short term credit to be drawn upon in the event of a run.

This suggests that the welfare impact of losing the central bank's ability to be the lender of last resort can be measured by the cost of a contingent line of credit large enough to prevent runs. What"large enough" means is debatable. In light of our model, and recalling the meaning of international illiquidity, the size of the credit line should be at least as large as the gap between the potential short run liabilities and assets of the financial system, which can be substantial. In particular, the Argentinean credit lines are

unlikely to have met this criterion. On the other hand, the "commitment rate" at which the Argentinean lines were secured were small enough that the total cost of the strategy would have been relatively small even if the credit line had to increase several fold.

In the same scenario, the contractual interest rate on loans to the home

country would be higher than the world interest