Financial Dollarization and Financial (In)Stability: Evidence from Latin America

Abstract

Financial dollarization, defined as the holding of foreign currency assets and liabilities by residents, has been placed at the forefront of the policy debate in developing economies for reasons ranging from its apparent influence on the conduct of monetary policy to the harmful impact of exchange rate depreciations on the solvency of dollar debtors. There is very little empirical work, however, to support or refute the claims theoretical literature on financial dollarization proposes. This paper contributes to the debate on financial dollarization by (1) revisiting the evidence on determinants of financial dollarization, namely its effect on the currency composition of an individual's savings so as to maximize the returns of his savings portfolio and (2) testing the impact of financial dollarization on financial stability in Latin American countries. I test both determinants and financial stability on data from 18 Latin American countries from the years 1980 to 2008. I find that economies holding financially dollarized deposits above 10% display a greater propensity to suffer banking crises, yet this propensity is offset by the ratio of foreign liabilities to foreign assets.