Arellano and Heathcote’s model provides a theoretical case for dollarization as a means of building credibility and increasing global financial integration. But how has dollarizing played out in the real world?
In a separate section of their staff report, the economists review two sets of data on the economic impact of dollarization. They begin by examining time-series data on the experience of four countries that adopted stronger currencies: Ecuador, El Salvador, Italy and Portugal. The first two adopted the U.S. dollar in 2000 and 2001, respectively; the second two adopted the euro in 1999.
In all four countries, adoption of a stronger currency led to lower costs for international borrowing, supporting Arellano and Heathcote’s thesis that nations might be able to improve their credibility with lenders by abandoning their own monetary policy. In Italy, the price spread between deutsche-mark-denominated bonds issued by Italy and similar bonds issued by Germany declined substantially in the year following Italy’s de facto acceptance into the euro zone. Portugal had a similar experience.
The spread between dollar-denominated bonds issued by Ecuador and those issued by the United States jumped prior to Ecuador’s economic crisis in 1999, and then declined by about 800 basis points after it dollarized. El Salvador also found that the spread on its bonds declined significantly after it dollarized. “Thus, in time series data for countries that have surrendered monetary policy, there is evidence that this reform has reduced the cost of international credit,” write Arellano and Heathcote in “Dollarization and Financial Integration.”
A broader look
Four countries is a slim sample, however, limited by the relatively small number of nations that have actually relinquished monetary policy and also have solid data on bond spreads. So the economists examine a similar sort of relationship in a larger sample of 76 countries: the correlation between credit ratings and exchange rate systems.
Just as it rates the quality of bonds issued by various corporations and state governments, Moody’s rating service has established “International Investor Ratings” to convey default risk for foreign currency bonds issued by various countries. (These ratings are highly correlated with bond spreads.) The economists look at correlations between these Investor Ratings and a variety of other variables—inflation, debt ratios, per capita GDP—as well as whether or not a nation has a fixed exchange rate. “Ratings tend to be better for countries with low and stable inflation, low levels of foreign debt to GDP, fixed exchange rate regimes and higher GDP per capita,” they find. The positive correlation between fixed exchange rates and high credit ratings is “consistent with the notion that too much flexibility in monetary policy can crowd out flexibility in debt policy.”
The economists are cautious, though, in interpreting this evidence. Their theory applies only to the hardest of currency pegs, whereas in the real world, even “fixed” exchange rates can change their peg with considerable ease. Moreover, a nation’s choice of exchange rate regime likely correlates with other institutional factors that also impact credibility abroad. “Thus, to properly understand the relationship between dollarization and financial integration,” they write, “we need an explicit model.”