Ize and Levy-Yeyati (2003) proposed the minimum variance portfolio and attributed dollarization to expectations of high uncertainties associated with inflation relative to that of the real exchange rate6. The theory assumes the validity of the uncovered interest rate parity, such that an increase in the variance of domestic inflation relative to the variance of real currency depreciation induces financial dollarization as the domestic currency becomes unattractive. This theory predicts that risk-averse resident investors seek to optimise the gains in the determination of asset portfolio. Consequently, while the real return on assets denominated in local currency is influenced by variations in inflation, the real return on foreign currency denominated assets is affected by real exchange rate fluctuations.
Consider a risk-averse resident investor with an investment menu comprising foreign and domestic interest-bearing bank deposits. The real returnsrE r( ) s, andr* E r( )s,
respectively, whereandsare zero-mean disturbances to the local inflation and real
devaluation rates, andE r( )j denotes the expected real return on the assets. Assuming further that the investor maximizes the utility function
maxxjUE r( ) var( ) / 2 r , withxj 0, jd f, , (2.3)
denote the domestic and foreign proportions, respectively, andr
jx rj jis the real return onthe portfolio. If the uncovered interest rate parity condition holds, the foreign currency share of the optimal investment portfolio is equal to
6 See also De Nicolo et al. (2005)
var( ) cov( , ) var( ) var( ) 2 cov( , )
s mvp s s (2.4)
Replacings e , whereedenotes the nominal rate of depreciation, the deposit
dollarization ration reduces to
var( ) cov( , ) mvp e (2.5)
The proponents of this theory argue that, barring real interest rate differentials across currencies, investors design currency portfolios that minimize the variance of portfolio returns which depends on the volatility of inflation and the rate of real currency depreciation. The portfolio model has the following implications: First, exchange rate regimes are effective only when they combine with monetary policy. In the context of a floating exchange rate regime, a high and volatile inflation may induce residents to dollarize. This infers that a combination of flexible exchange rates and price stability curtails incentives to dollarize. Second, more open countries are likely to display higher rates of dollarization, suggesting that when the import component is large it feeds into higher pass-through effect of exchange rates to price dynamics.
The role of interest rate spreads on residents‘ decision to switch demand between local and foreign currency holdings has been captured in some aspect of the literature. These differentials relate expectations of exchange rate movements through the uncovered interest parity. Studies that confirm the role of interest rate differentials include Basso, Calvo-Gonzales, and Jurgilas (2011), Rosenberg and Tirpak (2008), Luca and Petrova (2008), inter alia. According to Basso et al. (2011), the interest rate differential has a negative effect on deposit dollarization while access to foreign funds increases credit dollarization but at the same time decreases deposit dollarization. They report a negative relationship between deposit dollarization and the difference between domestic and foreign currency interest rates for 24 transition economies over the period 2000 – 2006.
A panel of 10 countries was studied by Rosenberg and Tirpak (2008) using quarterly data for the period 1999 – 20077. The share of loans denominated in (and indexed to) foreign currency in total domestic bank loans to the non-financial private sector was used as the dependent variable, together with an alternative specification that includes the private sector‘s direct borrowing from abroad. Interest rate differential, loan-to-deposit ratio, openness, and severity of regulatory measures aimed at discouraging foreign currency borrowing were used as regressors. It was reported that interest rate differential is an important factor in decisions to borrow in foreign currency. Consistent with the theory, a higher interest rate differential causes liability dollarization in a country.
For emerging Europe, Luca and Petrova (2008) provides an in-depth analysis of the impact of bank and firm variables on credit dollarization. They study specified an optimal portfolio allocation model and used new aggregate data for 21 economies from Central and Eastern Europe and Central Asia for the period 1990 – 20038. Variables used in the baseline model included interest rate differential, the minimum variance portfolio dollarization share, the change in the rate of inflation, an index of asymmetry of exchange rate movements, and exchange rate intervention. They find a positive relationship between aggregate shares of foreign currency loans to interest rate differentials. Neanidis and Savva (2009) used an unbalanced panel monthly data for 11 transition economies from 1993 – 20069. The evidence is that the short-run dynamics of both deposit and loan dollarization are influenced by the relative rate of return.
7 The sample of countries includes Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Slovakia, Bulgaria,
Romania, and Croatia
8 The sample includes Albania, Armenia, Azerbaijan, Bulgaria, Croatia, Czech Republic, Estonia, Georgia, Hungary, Kazakhstan,
Kyrgyz Republic, Latvia, Lithuania, Macedonia, Moldova, Poland, Romania, Russia, Slovak Republic, Slovenia, and Ukraine.