Is Brazil Different? Risk, Dollarization, and Interest Rates in Emerging Markets
IMF Working Papers, December 1, 2007
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Bibliographic details
- Authors: Márcio Holland, Edmar L. Bacha, Fernando M. Gonçalves
- Published: December 1, 2007
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451868579.001
Summary
- Investigates the role of financial dollarization in the determination of real interest rates in emerging economies.
- Analytical model result: a strategy of "dedollarizing" the economy, if it fails to address fundamental macroeconomic risks, leads to higher domestic real interest rates.
- Empirical confirmation: the prediction is confirmed in an empirical model, but the effect is small after controlling for the risks of dilution and default.
- Brazil as case study: low degree of financial dollarization and very high real interest rates.
- Historical pattern for Brazil:
- The estimated model is unable to explain the high interest rate levels in the aftermath of Brazil's 1994 inflation stabilization.
- Since the adoption in 1999 of inflation targeting and floating exchange rates, Brazil's real interest rates are gradually converging to the model's predicted values.
- Policy-relevant conclusion: further drops in Brazil's real interest rates could be achieved more effectively through improvements in fundamentals that lead to investment-grade status rather than through financial dollarization.
Empirical Results and Key Findings
- The dedollarization strategy raises domestic real interest rates unless fundamental macroeconomic risks are addressed.
- After controlling for the risks of dilution and default, the measured effect of financial dollarization on real interest rates is small.
- Convergence evidence: Brazil's real interest rates show gradual convergence to model predictions post-1999 policy regime change (inflation targeting and floating exchange rates).
- Model limitations: cannot account for Brazil's very high real interest rates immediately following the 1994 inflation stabilization.
Brazil Case Study Details
- Rationale: Brazil combines a low degree of financial dollarization with very high real interest rates, providing a natural case to test the model.
- Timeline points:
- 1994: inflation stabilization (model unable to explain subsequent high real interest rates).
- 1999: adoption of inflation targeting and floating exchange rates (subsequent gradual convergence of real rates toward model predictions).
- Policy implication specific to Brazil: targeting improvements in fundamentals to reach investment-grade status is a more effective route to lower real interest rates than pursuing dedollarization alone.
Policy Implications and Recommendations
- Dedollarization alone is insufficient and can be counterproductive for lowering domestic real interest rates if macroeconomic risks remain unaddressed.
- Priority should be given to improving macroeconomic fundamentals that reduce dilution and default risks and can lead to investment-grade status.
- For countries in situations similar to Brazil, structural and risk-reducing reforms may yield larger reductions in real interest rates than changes in the degree of financial dollarization.