## _wp11129

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---

### I. Introduction and scope
- Analyzes effects of official dollarization on macroeconomic performance in El Salvador, focusing on transition from a pegged exchange rate (colón ≈ 8.75 per U.S. dollar, 1993–2000) to full legal tendering of the U.S. dollar as of January 1, 2001.
- Primary areas of analysis:
  - Effects of the monetary regime on currency risk (perceived exchange-rate fluctuation risk).
  - Interaction of U.S. monetary policy with the El Salvador business cycle.
  - Transmission of monetary policy to El Salvador’s economy.
- Context at the time of dollarization: low and stable inflation, economic growth, manageable public and external debt, and no banking-system turmoil.
- Motivations for official dollarization highlighted in the source: tightening links to the U.S. economy and spurring foreign investment, trade, and economic growth.

### II. Analytical approach
- Methods applied:
  - An uncovered interest parity framework to estimate the impact of official dollarization on commercial bank interest rates via changes in perceived devaluation risk.
  - Various empirical methods to quantify effects of the move from a peg to official dollarization.
- Focus restricted to effects that can be clearly identified given similarity between the peg and official dollarization and the successful maintenance of the peg until dollarization.

### III. Key empirical findings and quantitative results (summary)
- Reduction in currency risk associated with official dollarization estimated to have lowered lending and deposit rates by "4 to 5 percentage points."
- This reduction in interest rates translates into:
  - Net interest savings of "about ½ percent of GDP per year" for the private sector.
  - After accounting for losses from foregone seigniorage, net savings of "¼ percent of GDP per year" for the public sector.
- Country-wide total estimated gains from reduction of the currency risk premium under dollarization: on the order of "1 percent of GDP per year" (static estimate).

### Dollarization and currency risk — descriptive statistics (January 1995 to December 1999)
- Colón interest-rate behavior:
  - Rose in 1995 and peaked at "16 to 18 percent" in early 1996 before dropping by "5 to 6 percentage points" over the next year.
  - Increased moderately in 1997, fell in the first half of 1998, rose again in 1999, and fell by "4 percentage points" in 2000.
- Correlations:
  - Correlations between the spread and colón rates averaged more than "0.9."
  - Correlations between the spread and U.S. dollar rates averaged less than "0.5."
- Descriptive statistics (means and standard deviations preserved exactly):
  - Interest rates on Colón-denominated instruments:
    - 30-day deposits: Mean 12.45, Standard deviation 1.91, Coefficient of variation 15.37, Correlation with dollar rate 0.64
    - 90-day deposits: Mean 11.88, Standard deviation 1.81, Coefficient of variation 15.22, Correlation with dollar rate 0.77
    - 180-day deposits: Mean 11.73, Standard deviation 2.01, Coefficient of variation 17.11, Correlation with dollar rate 0.76
    - Loans up to one year: Mean 16.28, Standard deviation 1.93, Coefficient of variation 11.87, Correlation with dollar rate 0.93
  - Interest rates on dollar-denominated instruments:
    - 30-day deposits: Mean 6.71, Standard deviation 0.56, Coefficient of variation 8.39, Correlation with colón rate 0.64
    - 90-day deposits: Mean 7.03, Standard deviation 0.79, Coefficient of variation 11.26, Correlation with colón rate 0.77
    - 180-day deposits: Mean 7.45, Standard deviation 0.73, Coefficient of variation 9.85, Correlation with colón rate 0.76
    - Loans up to one year: Mean 11.20, Standard deviation 1.15, Coefficient of variation 10.28, Correlation with colón rate 0.93
  - Colón-dollar spreads:
    - 30-day deposits: Mean 5.74, Standard deviation 1.62, Coefficient of variation 28.14, Correlation with colón rate 0.96, Correlation with dollar rate 0.40
    - 90-day deposits: Mean 4.84, Standard deviation 1.29, Coefficient of variation 26.74, Correlation with colón rate 0.92, Correlation with dollar rate 0.47
    - 180-day deposits: Mean 4.76, Standard deviation 1.34, Coefficient of variation 28.24, Correlation with colón rate 0.93, Correlation with dollar rate 0.47
    - Loans up to one year: Mean 5.55, Standard deviation 0.78, Coefficient of variation 14.10, Correlation with colón rate 0.84, Correlation with dollar rate 0.57

### Empirical drivers of the colón-dollar spread (Table 2 summary; sample January 1995 through December 1999)
- Coefficients and significance preserved:
  - Credit growth (lagged): 0.040   *** ; 0.026   *** ; 0.028   *** ; 0.025   ***
  - Reserve growth (lagged): -0.011   ** ; -0.009   *** ; -0.010   *** ; -0.006   *
  - Economic growth: -0.296 ; -0.361   *** ; -0.314   ** ; -0.186
  - Inflation (lagged): 0.019 ; 0.013 ; 0.031   ** ; 0.031   **
  - Lagged dependent variable: 0.717   *** ; 0.724   *** ; 0.687   *** ; 0.571   ***
  - Adjusted R-squared: 0.93 ; 0.92 ; 0.91 ; 0.85
  - Durbin-Watson stat: 1.60 ; 1.87 ; 1.83 ; 1.84
  - Note: Heteroskedasticity and autocorrelation-adjusted standard errors are in parentheses in the original; *, **, and *** represent significance at the 10, 5, or 1 percent levels.
- Interpretation of drivers:
  - Faster growth in private sector credit associated with significantly higher spreads.
  - Faster NIR growth associated with significantly lower spreads.
  - Faster economic growth associated with lower deposit and lending spreads (not always statistically significant).
  - Higher inflation raised spreads, statistically significant for longer-term deposits and loans.

### Effects of dollarization on nominal interest rates and fiscal/private sector impacts (counterfactual 2001–09)
- Counterfactual simulation (peg maintained) based on Table 2 averages:
  - Estimated currency risk premium would have fluctuated between "3 and 6 percentage points," peaking during the global financial crisis and domestic downturn in late 2008 and early-2009.
  - Adoption of the U.S. dollar is estimated to have lowered commercial bank interest rates by an average of "4 to 5 percentage points."
- Static estimates of net interest savings:
  - Non-financial private sector average net savings over the dollarization period: "½ percent of GDP."
  - Public sector average net savings: "½ percent of GDP."
  - Country-wide total estimated gains from reduction of the currency risk premium under dollarization: on the order of "1 percent of GDP per year."
- Notes:
  - These are static gains; potential dynamic gains via lower financial intermediation costs and freed public resources are acknowledged but not quantified.
  - Reduction in rates is isolated from the reduction in U.S. interest rates in the 2000s relative to the 1990s.

### Magnitude of foregone seigniorage
- Estimated seigniorage under dollarization:
  - Upper-bound estimates yield seigniorage of "¼ percent of GDP per year" (two approaches yield same).
- Comparison for the public sector:
  - In annual flows, public sector gains from lower interest rates outweigh estimated foregone seigniorage by "¼ percent of GDP per year."
- Additional cost:
  - Central bank one-time outlay in retiring the stock of domestic currency at dollar adoption: "US$449 million" (non-recurring).

### Dollarization and cyclical stabilization — Taylor-rule analysis and implications
- Methodology:
  - Uses Taylor-rule framework relating policy rate to inflation and output (four-quarter percent change in real GDP included).
  - Output growth used as preferred measure of productive capacity (results unchanged when using HP-filtered potential output).
  - Long-run monetary policy responses to inflation and output equal estimated coefficients divided by (1 − coefficient on lagged policy rate).
- Key empirical findings:
  - Under the peg:
    - U.S. Federal Reserve policy was acyclical with respect to Salvadoran inflation.
    - U.S. Federal Reserve policy was mildly countercyclical with respect to Salvadoran activity.
    - The domestic short-term lending rate tended to tighten in times of higher inflation and ease when output growth was rising (consistent with an exchange-rate focus).
  - Under official dollarization:
    - Federal Funds rate has been mildly procyclical with respect to inflation but highly countercyclical with respect to Salvadoran growth.
    - Using core inflation, under dollarization the Federal Funds rate has helped stabilize both inflation and output.
  - Forward-looking assessment (four-quarter-ahead actual inflation and output growth):
    - Increases in Salvadoran activity have generally been preceded by Federal Reserve tightening, more so than under the peg.
    - Since dollarization, Federal Reserve policy has tended to tighten in advance of inflation—especially core inflation—more than it or the domestic short-term lending rate did under the peg.
- Conclusion regarding stabilization:
  - Compared to the peg, monetary policy prevailing under official dollarization has not been detrimental to stabilization of El Salvador’s business cycle.
  - Enhanced cyclical stabilization follows from closer synchronization of business cycles under dollarization (correlation of year-on-year output growth has risen).

### Cross-country synchronization and cyclical stabilization (selected correlations)
- Year-on-year inflation correlation with the U.S. cycle for El Salvador has risen to "0.8" from "0.3."
- Correlation of real activity with U.S. growth:
  - El Salvador: "0.7"
  - Ecuador: "0.3"
  - Panama: "0.5"
- Greater synchronization with the United States since dollarization suggests some endogeneity in optimum currency-area criteria.

### Dollarization and monetary policy transmission: pass-through overview and findings
- Key question: whether U.S. Federal Reserve policy affects Salvadoran lending and deposit rates sufficiently for dollarization to deliver countercyclical benefits.
- Pass-through measured with an autoregressive distributed lag (ADL) specification; long-run pass-through equal to β2 = 1 implies complete pass-through.
- Empirical findings:
  - Under the peg, pass-through of the Federal Funds rate to dollar-denominated rates in El Salvador was never significantly different from zero for dollar rates; colón rates were driven by the domestic short-term lending rate in colones.
  - Under official dollarization:
    - Pass-through is statistically significant in most series (except lending rates in one specification), with magnitudes in the same range as other estimates.
    - Average long-run impact of a 100 basis points change in the monetary policy rate has typically generated a movement of "50 to 90 basis points" in rates prevailing at commercial banks (same as under the peg).
- Selected sample figures (preserve numeric values as presented):
  - In Dollars, 1995 to 1999: 0.279 -0.168 -0.117 0.169 -0.039
  - In Colones, 1995 to 1999: 0.892 *** 0.717 *** 0.502 ** 0.580 *** 0.599
  - In Dollars, 2001 to 2010: 0.502 0.855 ** 0.696 ** 0.568 *** 0.706
- Net assessment: dollarization strengthened linkage to U.S. policy without materially weakening pass-through magnitudes.

### Cross-country pass-through comparisons (summaries)
- Figure 8:
  - Long-run pass-through to lending rates: El Salvador > Ecuador and Panama (low levels), but < United States (near-complete pass-through).
  - Pass-through to deposit rates: El Salvador < United States, > Ecuador, and on par with Panama.
- Figure 9 (Central America, 2001 onward median for Costa Rica, Dominican Republic, Guatemala, Honduras, Nicaragua):
  - Pass-through to both lending and deposit dollar rates in El Salvador is equal to or greater than elsewhere in Central America.
- Figure 10 (Central America, domestic-currency rates):
  - Long-run responses in El Salvador are almost the same as those in the rest of the region.

### Factors explaining pass-through (regression evidence; Q4-2003 through 2010-Q1)
- Regression controls include real GDP growth, EMBI spread, VIX volatility index, banking-system variables (capital-asset ratio, liquid asset ratio, non-performing loan ratio), and lagged interest-rate gap.
- Table 4 key coefficient estimates and interpretations (significance preserved):
  - Real GDP growth (four-quarter percent change) coefficients include: -0.23 **, -0.31 **, -0.18, -0.25 **, -0.19 *
  - EMBI spread (lagged change) coefficients include: 0.39 ***, 0.33 ***, 0.54 ***, 0.44 ***, 0.28 ***
  - Capital-asset ratio (lagged change) coefficients include: -0.88 **, -0.88 *, -0.83 **, -0.82 **, -0.73 **
  - Liquid asset ratio (lagged change) coefficients around: -0.05 (not significant)
  - Non-performing loans (change, in percent of total loans) coefficients include: 0.86 **, 1.04 ***, 0.70 *, 0.75 *, 0.57
  - VIX volatility index (percent change) coefficients include: 0.05 ***, 0.04 ***, 0.03 ***, 0.02 ***, 0.01 ***
  - Lagged interest rate gap coefficients include: -0.23 **, -0.33 **, -0.27, -0.39 *, -0.29
  - Adjusted R-squared: 0.64, 0.58, 0.78, 0.69, 0.58
- Average/cohort-level interpretations:
  - An increase of 100 basis points in the EMBI spread raises lending and deposit rates by "35 to 40 basis points."
  - An increase of one percentage point in the ratio of banks’ capital to assets (lagged) reduces Salvadoran lending rates by "90 basis points" and deposit rates by "80 basis points."
  - An increase of one percentage point in the ratio of non-performing loans to total loans raises the gap on Salvadoran lending rates by "95 basis points" and on deposit rates by "70 basis points."
  - Liquidity holdings (lagged) are not found to significantly affect changes in interest rates vis-à-vis the United States.
- Interpretation: transmission of U.S. interest rates to El Salvador depends heavily on banking-system conditions and market views of fiscal sustainability; these factors explain over half of the variation in the El Salvador–U.S. interest rate gap.

### Quantified benefits and final conclusions
- Currency risk premium and interest-rate savings under dollarization:
  - Counterfactual simulation suggests lending and deposit rates under official dollarization have been "4 to 5 percentage points" lower than they would have been if the peg had remained in effect.
  - Implied net interest savings:
    - "½ percent of GDP per year" for the Salvadoran private sector.
    - "¼ percent of GDP" for the public sector (after accounting for the opportunity cost of foregone seigniorage under dollarization).
- Monetary-policy synchronization and stabilization:
  - U.S. monetary policy has contributed more to cyclical stability of inflation and output in El Salvador under official dollarization than under the peg, due to tight integration and high business-cycle correlation.
  - Taylor-rule estimates indicate U.S. Federal Reserve policy under dollarization tended to stabilize Salvadoran prices and was highly countercyclical with respect to Salvadoran activity.
  - Central American floating-rate experience does not suggest an independent monetary policy would yield large additional stabilization gains for El Salvador.
- Pass-through summary:
  - Pass-through of the U.S. Federal Funds rate to Salvadoran commercial bank interest rates is stronger under dollarization than under the peg.
  - Pass-through is comparable to Panama and generally more complete than in Ecuador.
  - Pass-through of U.S. monetary policy to El Salvador is similar to pass-through of domestic policy rates to domestic-currency rates in other Central American countries.

### Policy implications (explicit)
- Progress on fiscal consolidation and maintaining sound risk management in the banking system are crucial to fully realizing the benefits of low interest rates and rapid transmission of U.S. monetary policy under official dollarization.
- Sustainable fiscal policy and sound financial supervision are underscored as essential in an officially dollarized economy.

*Source: _wp11129 - References (IMF working-paper section content as provided).*

### References .............................................................................................................

### _wp11129 - References .....................................................................................................................

### I. Introduction and scope
- The paper analyzes the effects of official dollarization on macroeconomic performance in El Salvador, focusing on the transition from a pegged exchange rate (colón ≈ 8.75 per U.S. dollar, 1993–2000) to full legal tendering of the U.S. dollar as of January 1, 2001.
- Primary areas of analysis:
  - Effects of the monetary regime on currency risk (perceived exchange-rate fluctuation risk).
  - Interaction of U.S. monetary policy with the El Salvador business cycle.
  - Transmission of monetary policy to El Salvador’s economy.
- Context at the time of dollarization: low and stable inflation, economic growth, manageable public and external debt, and no banking-system turmoil.
- Motivations for official dollarization highlighted in the source: tightening links to the U.S. economy and spurring foreign investment, trade, and economic growth.

### II. Analytical approach
- Methods applied:
  - An uncovered interest parity framework to estimate the impact of official dollarization on commercial bank interest rates via changes in perceived devaluation risk.
  - Various empirical methods to quantify effects of the move from a peg to official dollarization.
- Focus is restricted to areas where the monetary regime’s effects can be clearly identified, given the similarity between the peg and official dollarization and the successful maintenance of the peg until dollarization.

### III. Key empirical findings and quantitative results
- Reduction in currency risk associated with official dollarization is estimated to have lowered lending and deposit rates by "4 to 5 percentage points."
- This reduction in interest rates translates into:
  - Net interest savings of "about ½ percent of GDP per year" for the private sector.
  - After accounting for losses from foregone seigniorage, net savings of "¼ percent of GDP per year" for the public sector.

### IV. Framing within the literature
- No consensus in the literature on the optimal monetary regime; country-specific circumstances matter.
- Prior studies offer mixed results:
  - Some favor floating exchange rates (Ball, 2010; Walsh, 2009).
  - Some find fixed exchange rates enhance performance (Frankel and Rose, 2002; Rose and Stanley, 2005).
  - Others find no significant differences (Edwards and Magendzo, 2006; Klein, 2005).
  - Rogoff and others (2004) find performance varies with financial development and openness.

*Source: _wp11129 - References .................................................................................................................................*

### Section III uses Taylor rules to examine the stabilization properties of monetary policy over

### _wp11129 - Section III uses Taylor rules to examine the stabilization properties of monetary policy over

### II. Dollarization and currency risk — key findings and quantitative results
- Under the peg, the colón-dollar interest rate spread averaged over 5 percentage points, with substantial variation over time.
- Colón interest rates:
  - Rose in 1995 and peaked at 16 to 18 percent in early 1996 before dropping by 5 to 6 percentage points over the next year.
  - Increased moderately in 1997, fell in the first half of 1998, rose again in 1999, and fell by 4 percentage points in 2000.
- Correlations:
  - Correlations between the spread and colón rates averaged more than 0.9.
  - Correlations between the spread and U.S. dollar rates averaged less than 0.5.
- Descriptive statistics for January 1995 to December 1999 (Table 1 — means and standard deviations preserved exactly):
  - Interest rates on Colón-denominated instruments:
    - 30-day deposits: Mean 12.45, Standard deviation 1.91, Coefficient of variation 15.37, Correlation with colón rate ..., Correlation with dollar rate 0.64
    - 90-day deposits: Mean 11.88, Standard deviation 1.81, Coefficient of variation 15.22, Correlation with colón rate ..., Correlation with dollar rate 0.77
    - 180-day deposits: Mean 11.73, Standard deviation 2.01, Coefficient of variation 17.11, Correlation with colón rate ..., Correlation with dollar rate 0.76
    - Loans up to one year: Mean 16.28, Standard deviation 1.93, Coefficient of variation 11.87, Correlation with colón rate ..., Correlation with dollar rate 0.93
  - Interest rates on dollar-denominated instruments:
    - 30-day deposits: Mean 6.71, Standard deviation 0.56, Coefficient of variation 8.39, Correlation with colón rate 0.64, Correlation with dollar rate ...
    - 90-day deposits: Mean 7.03, Standard deviation 0.79, Coefficient of variation 11.26, Correlation with colón rate 0.77, Correlation with dollar rate ...
    - 180-day deposits: Mean 7.45, Standard deviation 0.73, Coefficient of variation 9.85, Correlation with colón rate 0.76, Correlation with dollar rate ...
    - Loans up to one year: Mean 11.20, Standard deviation 1.15, Coefficient of variation 10.28, Correlation with colón rate 0.93, Correlation with dollar rate ...
  - Colón-dollar spreads:
    - 30-day deposits: Mean 5.74, Standard deviation 1.62, Coefficient of variation 28.14, Correlation with colón rate 0.96, Correlation with dollar rate 0.40
    - 90-day deposits: Mean 4.84, Standard deviation 1.29, Coefficient of variation 26.74, Correlation with colón rate 0.92, Correlation with dollar rate 0.47
    - 180-day deposits: Mean 4.76, Standard deviation 1.34, Coefficient of variation 28.24, Correlation with colón rate 0.93, Correlation with dollar rate 0.47
    - Loans up to one year: Mean 5.55, Standard deviation 0.78, Coefficient of variation 14.10, Correlation with colón rate 0.84, Correlation with dollar rate 0.57

- Empirical drivers of the colón-dollar spread (summary of Table 2 results; coefficients and significance preserved):
  - Credit growth (lagged): 0.040   *** ; 0.026   *** ; 0.028   *** ; 0.025   ***
  - Reserve growth (lagged): -0.011   ** ; -0.009   *** ; -0.010   *** ; -0.006   *
  - Economic growth: -0.296 ; -0.361   *** ; -0.314   ** ; -0.186
  - Inflation (lagged): 0.019 ; 0.013 ; 0.031   ** ; 0.031   **
  - Lagged dependent variable: 0.717   *** ; 0.724   *** ; 0.687   *** ; 0.571   ***
  - Adjusted R-squared: 0.93 ; 0.92 ; 0.91 ; 0.85
  - Durbin-Watson stat: 1.60 ; 1.87 ; 1.83 ; 1.84
  - Note: Sample period is January 1995 through December 1999. Heteroskedasticity and autocorrelation-adjusted standard errors are in parentheses; *, **, and *** represent significance at the 10, 5, or 1 percent levels.

- Interpretation of drivers:
  - Faster growth in private sector credit was associated with significantly higher spreads.
  - Faster NIR growth was associated with significantly lower spreads.
  - Faster economic growth was associated with lower deposit and lending spreads (not always statistically significant).
  - Higher inflation raised spreads, statistically significant for longer-term deposits and loans.

### II.C — Effects of dollarization on nominal interest rates and fiscal/private sector impacts
- Counterfactual simulation 2001–09 (peg maintained) based on Table 2 averages:
  - Estimated currency risk premium would have fluctuated between 3 and 6 percentage points, peaking during the global financial crisis and domestic downturn in late 2008 and early-2009.
  - Adoption of the U.S. dollar is estimated to have lowered commercial bank interest rates by an average of 4 to 5 percentage points.
- Static estimates of net interest savings:
  - Non-financial private sector average net savings over the dollarization period: ½ percent of GDP (symbol as in source).
  - Public sector average net savings: ½ percent of GDP.
  - Country-wide total estimated gains from reduction of the currency risk premium under dollarization: on the order of 1 percent of GDP per year.
- Notes:
  - These are static gains; potential dynamic gains (via lower financial intermediation costs and freed public resources) are acknowledged but not quantified.
  - Reduction in rates is separate from the reduction in U.S. interest rates in the 2000s relative to the 1990s; these results isolate the effect of moving from the colón to the dollar.

### II.D — Magnitude of foregone seigniorage
- Estimated seigniorage under dollarization:
  - Upper-bound estimates yield seigniorage of ¼ percent of GDP per year (two approaches yield same).
- Comparison public sector:
  - In annual flows, public sector gains from lower interest rates outweigh estimated foregone seigniorage by ¼ percent of GDP per year (as shown in Figure 4).
- Additional cost:
  - Central bank one-time outlay in retiring the stock of domestic currency at dollar adoption: US$449 million (non-recurring).

### III. Dollarization and cyclical stabilization — Taylor-rule analysis and implications
- Methodology:
  - Uses Taylor-rule framework (equations (4) and (5) in source) relating policy rate to inflation and output (four-quarter percent change in real GDP included).
  - Output growth is used as the preferred measure of productive capacity (results unchanged when using HP-filtered potential output).
  - Long-run monetary policy responses to inflation and output equal the estimated coefficients divided by (1 − coefficient on lagged policy rate) as per the paper.
- Key empirical findings:
  - Under the peg:
    - U.S. Federal Reserve policy was acyclical with respect to Salvadoran inflation.
    - U.S. Federal Reserve policy was mildly countercyclical with respect to Salvadoran activity (made a modest contribution to stabilizing domestic output).
    - The domestic short-term lending rate tended to tighten in times of higher inflation and ease when output growth was rising (consistent with an exchange-rate focus).
  - Under official dollarization:
    - The U.S. Federal Funds rate has been mildly procyclical with respect to inflation but highly countercyclical with respect to Salvadoran growth.
    - Using core inflation, under dollarization the Federal Funds rate has helped stabilize both inflation and output.
  - Forward-looking assessment (using four-quarter-ahead actual inflation and output growth):
    - Increases in Salvadoran activity have generally been preceded by Federal Reserve tightening, much more so than either the U.S. Federal Funds rate or the domestic short-term lending rate did under the peg.
    - Since dollarization, Federal Reserve policy has tended to tighten in advance of inflation—especially core inflation—more than it or the domestic short-term lending rate did under the peg.
- Conclusion regarding stabilization:
  - Compared to the peg, monetary policy prevailing under official dollarization has not been detrimental to stabilization of El Salvador’s business cycle.
  - Enhanced cyclical stabilization follows from closer synchronization of business cycles under dollarization (the correlation of year-on-year output growth has risen under dollarization).

*Italic: IMF working paper section content as provided.*

### 0.7 from minus 0.3 under the peg, and the correlation of year-on-year inflation has risen to

### _wp11129 - 0.7 from minus 0.3 under the peg, and the correlation of year-on-year inflation has risen to

### Cross-Country synchronization and cyclical stabilization
- Year-on-year inflation correlation with the U.S. cycle for El Salvador has risen to 0.8 from 0.3.
- Correlation of real activity with U.S. growth:
  - El Salvador: 0.7
  - Ecuador: 0.3
  - Panama: 0.5
- Greater synchronization with the United States since dollarization suggests some endogeneity in optimum currency-area criteria (Frankel and Rose (1998) argument).
- Taylor-rule evidence for Costa Rica, Dominican Republic, and Guatemala (2005–07 expansion; 2008–09 slowdown) finds:
  - Policy response to core inflation averaged 0.4.
  - Long-run response of policy to output growth averaged about 0.4.
  - Tentative conclusion: an independent monetary policy can help stabilize inflation and output, but gains relative to El Salvador’s experience under dollarization do not appear substantial.

### Dollarization and monetary policy transmission: overview
- Key question: whether U.S. Federal Reserve policy affects Salvadoran lending and deposit rates sufficiently for dollarization to deliver countercyclical benefits.
- Pass-through measured with an autoregressive distributed lag (ADL) specification; long-run pass-through equal to β2 = 1 implies complete pass-through.

### Pass-through in El Salvador (empirical findings)
- Under the peg, pass-through of the Federal Funds rate to dollar-denominated rates in El Salvador was never significantly different from zero for dollar rates; colones rates were driven by the domestic short-term lending rate in colones.
- Under official dollarization:
  - Pass-through is statistically significant in most series (except lending rates in one specification), with magnitudes in the same range as other estimates.
  - Average long-run impact of a 100 basis points change in the monetary policy rate has typically generated a movement of 50 to 90 basis points in rates prevailing at commercial banks (same as under the peg).
- Table 3 sample figures (preserve numeric values as presented):
  - In Dollars, 1995 to 1999: 0.279 -0.168 -0.117 0.169 -0.039 (standard errors shown in parentheses in original table).
  - In Colones, 1995 to 1999: 0.892 *** 0.717 *** 0.502 ** 0.580 *** 0.599 (standard errors shown in parentheses).
  - In Dollars, 2001 to 2010: 0.502 0.855 ** 0.696 ** 0.568 *** 0.706 (standard errors shown in parentheses).
- Linkages between U.S. monetary policy and Salvadoran interest rates have become tighter under official dollarization.
- Net assessment: monetary regime has not altered the power of the monetary transmission mechanism in El Salvador; dollarization strengthened linkage to U.S. policy without materially weakening pass-through magnitudes.

### Cross-country pass-through comparisons
- Figure 8 (economies using the U.S. dollar):
  - Long-run pass-through to lending rates: El Salvador > Ecuador and Panama (low levels), but < United States (near-complete pass-through).
  - Pass-through to deposit rates: El Salvador < United States, > Ecuador, and on par with Panama.
- Figure 9 (Central America, dollar rates; 2001 onward median for Costa Rica, Dominican Republic, Guatemala, Honduras, Nicaragua):
  - Pass-through to both lending and deposit dollar rates in El Salvador is equal to or greater than elsewhere in Central America.
- Figure 10 (Central America, domestic-currency rates):
  - Long-run responses in El Salvador are almost the same as those in the rest of the region; no substantial differences between pass-through of the U.S. Federal Funds rate to Salvadoran dollar rates and pass-through of domestic monetary policy rates to domestic-currency rates in other Central American countries.

### Factors explaining pass-through (regression evidence)
- Regression specification (equation (9)) uses controls including real GDP growth, EMBI spread (proxy for markets’ views of fiscal sustainability), VIX volatility index, banking-system variables (capital-asset ratio, liquid asset ratio, non-performing loan ratio), and lagged interest-rate gap.
- Table 4 key coefficient estimates (samples and significance preserved as presented):
  - Real GDP growth (four-quarter percent change) coefficients include: -0.23 **, -0.31 **, -0.18, -0.25 **, -0.19 * (standard errors reported in table).
  - EMBI spread (lagged change) coefficients include: 0.39 ***, 0.33 ***, 0.54 ***, 0.44 ***, 0.28 ***.
  - Capital-asset ratio (lagged change) coefficients include: -0.88 **, -0.88 *, -0.83 **, -0.82 **, -0.73 **.
  - Liquid asset ratio (lagged change) coefficients around: -0.05 (not significant).
  - Non-performing loans (change, in percent of total loans) coefficients include: 0.86 **, 1.04 ***, 0.70 *, 0.75 *, 0.57 (varying significance).
  - VIX volatility index (percent change) coefficients include: 0.05 ***, 0.04 ***, 0.03 ***, 0.02 ***, 0.01 ***.
  - Lagged interest rate gap coefficients include: -0.23 **, -0.33 **, -0.27, -0.39 *, -0.29.
  - Adjusted R-squared in these specifications: 0.64, 0.58, 0.78, 0.69, 0.58.
  - Sample period: Q4-2003 through 2010-Q1.
- Average/cohort-level interpretations highlighted in text:
  - An increase of 100 basis points in the EMBI spread raises lending and deposit rates by 35 to 40 basis points (effects similar to those estimated for Panama).
  - An increase of one percentage point in the ratio of banks’ capital to assets (lagged) reduces Salvadoran lending rates by 90 basis points and deposit rates by 80 basis points.
  - An increase of one percentage point in the ratio of non-performing loans to total loans raises the gap on Salvadoran lending rates by 95 basis points and on deposit rates by 70 basis points.
  - Liquidity holdings (lagged) are not found to significantly affect changes in interest rates vis-à-vis the United States in El Salvador or Panama.
- Interpretation: transmission of U.S. interest rates to El Salvador depends heavily on banking-system conditions and market views of fiscal sustainability; these factors explain over half of the variation in the El Salvador–U.S. interest rate gap.

### Quantified benefits and final conclusions
- Currency risk premium and interest-rate savings under dollarization:
  - Counterfactual simulation suggests lending and deposit rates under official dollarization have been 4 to 5 percentage points lower than they would have been if the peg had remained in effect.
  - Implied net interest savings:
    - ½ percent of GDP per year for the Salvadoran private sector.
    - ¼ percent of GDP for the public sector (after accounting for the opportunity cost of foregone seigniorage under dollarization).
- Monetary-policy synchronization and stabilization:
  - U.S. monetary policy has contributed more to cyclical stability of inflation and output in El Salvador under official dollarization than under the peg, due to tight integration and high business-cycle correlation.
  - Taylor-rule estimates indicate U.S. Federal Reserve policy under dollarization tended to stabilize Salvadoran prices and was highly countercyclical with respect to Salvadoran activity.
  - Central American floating-rate experience does not suggest an independent monetary policy would yield large additional stabilization gains for El Salvador.
- Pass-through summary:
  - Pass-through of the U.S. Federal Funds rate to Salvadoran commercial bank interest rates is stronger under dollarization than under the peg.
  - Pass-through is comparable to Panama and generally more complete than in Ecuador.
  - Pass-through of U.S. monetary policy to El Salvador is similar to pass-through of domestic policy rates to domestic-currency rates in other Central American countries.
- Policy implications emphasized:
  - Progress on fiscal consolidation and maintaining sound risk management in the banking system are crucial to fully realizing the benefits of low interest rates and rapid transmission of U.S. monetary policy under official dollarization.
  - Sustainable fiscal policy and sound financial supervision are underscored as essential in an officially dollarized economy.

*Source: Author's calculations and analysis in the referenced IMF working-paper text.*

### References

### References

### Dollarization and Currency Regimes
- Aizenman, J., K. Kletzer, and B. Pinto, 2005, “Sargent-Wallace Meets Krugman-Flood-Garber, or: Why Sovereign Debt Swaps do not Avert Macroeconomic Crises,” The Economic Journal, Vol. 115, No. 2, pp. 343–367.
- Berg, A., and E. Borensztein, 2000, “The Pros and Cons of Full Dollarization,” IMF Working Paper 00/50 (Washington: International Monetary Fund). Available on the internet at: http://www.imf.org/external/pubs/ft/wp/2000/wp0050.pdf
- Edwards, S., and I. Magendzo, 2006, “Strict Dollarization and Economic Performance: An Empirical Investigation” Journal of Money, Credit, and Banking, Vol. 38, No. 1, pp. 269–282.
- Hinds, M., 1999, Prepared Testimony for U.S. Senate Banking Committee, Hearing on Official Dollarization in Emerging-Market Countries. Available on the internet at: http://banking.senate.gov/99_07hrg/071599/hinds.htm
- Hinds, M., 2002, “Why Dollarize? The Case of El Salvador,” Presentation at Summit of the Americas Center, March. Available on the internet at: http://www.americasnet.net/events/Dollarization/presentations/why_dollarizing.pps
- Peterson, M, 1999, “Dark Horse Leads Race to Greenback,” Euromoney, May 1999, p. 22.
- Sachs, J., and F. Larraín, 1999, “Why Dollarization is More Straightjacket Than Salvation,” Foreign Policy, Fall 1999, pp. 80–92.
- von Furstenberg, G., 2000, “A Case Against U.S. Dollarization,” Challenge, Vol. 43, No. 4, pp. 108–120.
- The Economist, 2000, “Dollars and Debts,” April 8, Vol. 355, Issue 8165, p. 38.

### Exchange Rates, Optimum Currency Areas, and Trade Effects
- Frankel, J., and A. Rose, 2002, “An Estimate of the Effects of Common Currencies on Trade and Income,” Quarterly Journal of Economics, Vol. 117, No. 2, pp. 437–466.
- Frankel, J., and A. Rose, 1998, “The Endogeneity of the Optimum Currency Area Criteria,” Economic Journal, Vol. 108, July, pp. 1009–1025.
- Klein, M., 2005, “Dollarization and Trade,” Journal of International Money and Finance, Vol. 24, No. 6, pp. 935–943.
- Krugman, P., 1979, “A Model of Balance-of-Payments Crises,” Journal of Money, Credit, and Banking, Vol. 12, No. 3, pp. 311–325.
- Mundell, R., 1961, “A Theory of Optimum Currency Areas,” American Economic Review, Vol. 51, No. 4, pp. 657–665.
- Rose, A., and T. Stanley, 2005, “A Meta-analysis of the Effect of Common Currencies on International Trade,” Journal of Economic Surveys, Vol. 19, No. 3, pp. 347–365.
- Taylor, A., and M. Taylor, 2004, “The Purchasing Power Parity Debate,” Journal of Economic Perspectives, Vol. 18, No. 4, pp. 135–158.
- Van Poeck, A., J. Vanneste, and M. Veiner, 2007, “Exchange Rate Regimes and Exchange Market Pressure in the New EU Member States,” Journal of Common Market Studies, Vol. 45, No. 2, pp. 459–485.
- Flood, R., and P. Garber, 1984, “Collapsing Exchange-Rate Regimes: Some Linear Examples,” Journal of International Economics, Vol. 17, No. 1, pp. 1–13.
- Rogoff, K., A. Husain, A. Mody, R. Brooks, and N. Oomes, 2004, Evolution and Performance of Exchange Rate Regimes. IMF Occasional Paper 229 (Washington: International Monetary Fund).

### Monetary Policy, Transmission Mechanisms, and Interest Rate Pass-Through
- Cottarelli, C., and A. Kourelis, 1994, “Financial Structure, Bank Lending Rates, and the Transmission Mechanism of Monetary Policy,” IMF Staff Papers, Vol. 41, No. 4, pp. 587–623.
- de Bondt, G., 2002, “Retail Bank Interest Rate Pass-Through: New Evidence at the Euro Area Level,” ECB Working Paper No. 136 (Frankfurt: European Central Bank). Available on the internet at: http://www.ecb.int/pub/pdf/scpwps/ecbwp136.pdf
- Espinosa-Vega, M., and A. Rebucci, 2003, “Retail Bank Interest Rate Pass-Through: Is Chile Atypical?” IMF Working Paper 03/112 (Washington: International Monetary Fund). Available on the internet at: http://www.imf.org/external/pubs/ft/wp/2003/wp03112.pdf
- Mojon, B., 2000, “Financial Structure and the Interest Rate Channel of Monetary Policy,” ECB Working Paper No. 40 (Frankfurt: European Central Bank). Available on the internet at: http://www.ecb.int/pub/pdf/scpwps/ecbwp040.pdf
- Siklos, P., and M. Bohl, 2009, “Asset Prices as Indicators of Euro Area Monetary Policy: An Empirical Assessment of Their Role in a Taylor Rule,” Open Economies Review, Vol. 20, No. 1, pp. 39–59.
- Walsh, C., 2009, “Inflation Targeting: What Have We Learned?” International Finance, Vol. 12, No. 2, pp. 195–233.
- López, T., 2001, “Elementos de la Política Monetaria en El Salvador Hasta el Año 2000,” Boletín Económico del Banco Central de Reserve de El Salvador, Vol. 14, No. 144.
- de García, Y., J. Arévalo, and A. Hernández, 2010, “Fundamentos Económicos del Sistema Monetario en El Salvador,” Central Reserve Bank of El Salvador Occasional Paper 2010/01. Available on the internet at: http://www.bcr.gob.sv/downloads.php?dta=931
- Medina Cas, S., F. Frantischek, and A. Carrion-Menendez, 2011, “Enhancing the Effectiveness of Monetary Policy and Developing and Interest Rate Transmission Mechanism in Central America,” unpublished manuscript.

### Rules, Methodologies, and Econometric Approaches
- Orphanides, A., 2007, “Taylor Rules,” Finance and Economics Discussion Series 2007-18 (Washington: Federal Reserve Board). Available on the internet at: http://www.federalreserve.gov/pubs/feds/2007/200718/200718pap.pdf
- Orphanides, A., 2003, “Historical Monetary Policy Analysis and the Taylor Rule,” Journal of Monetary Economics, Vol. 50, No. 5, pp. 983–1022.
- Hendry, D., and B. Nielsen, 2007, Econometric Modeling: A Likelihood Approach (Princeton, New Jersey: Princeton University Press).
- Lee, J., G. Milesi-Ferretti, J. Ostry, A. Prati, and L. Ricci, 2008, “Exchange Rate Assessments: CGER Methodologies,” IMF Occasional Paper 261 (Washington: International Monetary Fund).

### Financial Stability, Crises, and Sovereign Risk
- Doblas-Madrid, A., 2009, “Fiscal Trends and Self-Fulfilling Crises,” Review of International Economics, Vol. 17, No. 1, pp. 187–204.
- Krugman, P., 1979, “A Model of Balance-of-Payments Crises,” Journal of Money, Credit, and Banking, Vol. 12, No. 3, pp. 311–325.
- Schmukler, S., and L. Servén, 2002, “Pricing Currency Risk Under Currency Boards,” Journal of Development Economics, Vol. 69, No. 2, pp. 367–391.
- Swiston, A., 2010, “Spillovers to Central America in Light of the Crisis: What a Difference a Year Makes,” IMF Working Paper 10/35 (Washington: International Monetary Fund). Available on the internet at: http://www.imf.org/external/pubs/ft/wp/2010/wp1035.pdf
- Aizenman, J., K. Kletzer, and B. Pinto, 2005, “Sargent-Wallace Meets Krugman-Flood-Garber, or: Why Sovereign Debt Swaps do not Avert Macroeconomic Crises,” The Economic Journal, Vol. 115, No. 2, pp. 343–367.

*Source: _wp11129 - References (PDF).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2011/_wp11129.pdf_