## Dollarization of Financial Intermediation: Causes and Policy Implications

_IMF Working Papers, March 1, 1998_

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## Bibliographic details
- Authors: Eduardo Levy Yeyati, Alain Ize
- Published: March 1, 1998
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451844634.001

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### Summary
- Presents a portfolio model of financial intermediation in which currency choice is determined by hedging decisions on both sides of a bank’s balance sheet.
- Finds that Minimum Variance Portfolio (MVP) allocations provide a natural benchmark to estimate the scope for dollarization of bank deposits and loans as a function of macroeconomic uncertainty.
- Shows that dollarization hysteresis occurs when the expected volatility of the inflation rate is high in relation to that of the real exchange rate.
- Reports evidence that MVP dollarization generally approximates actual dollarization closely for a broad sample of countries.
- Policy implications are explored.

### Model and Mechanism
- Currency choice is modeled through hedging decisions on both assets and liabilities of banks.
- Minimum Variance Portfolio (MVP) allocations are used as the benchmark allocation rule.
- Dollarization hysteresis mechanism:
  - Occurs when expected volatility of the inflation rate is high relative to expected volatility of the real exchange rate.

### Empirical Findings
- MVP dollarization generally approximates actual dollarization closely across a broad sample of countries.
- The scope for dollarization of bank deposits and loans is estimated as a function of macroeconomic uncertainty using MVP allocations.

### Policy Implications (as explored in the paper)
- Implications relate to how macroeconomic volatility (particularly inflation volatility versus real exchange rate volatility) shapes dollarization and its persistence.
- Policy responses should account for the hedging-driven currency choices of banks on both sides of the balance sheet and the potential for hysteresis in dollarization under high relative inflation volatility.

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/30/dollarization-of-financial-intermediation-causes-and-policy-implications-2523_