Escaping the Financial Dollarization Trap: The Role of Foreign Exchange Intervention

EscapingtheFinancialDollarizationTrap: TheRoleofForeignExchangeIntervention PaulCastillo,RuyLama,andJuanPabloMedina WP/24/127 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate. TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. 2024 JUN ©2024InternationalMonetaryFundWP/24/127 IMFWorkingPaper MonetaryandCapitalMarketsDepartment EscapingtheFinancialDollarizationTrap:TheRoleofForeignExchangeInterventionPreparedbyPaulCastillo,RuyLama,andJuanPabloMedina* AuthorizedfordistributionbyJesperLindé June2024 IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement. ABSTRACT:Financialdollarizationisconsideredasourceofmacroeconomicinstabilityinmanyemergingeconomies.Dollarizationconstrainstheabilityofcentralbankstostimulateoutputduringeconomicdownturns.Incontrasttotheconventionalmonetarytransmissionmechanism,amonetarypolicylooseninginadollarizedeconomyleadstoacurrencydepreciation,adversebalancesheeteffects,andacontractionininvestmentandoutputgrowth.Inthispaperweevaluatetheroleofforeignexchangereservesinfacilitatingmacroeconomicstabilizationinafinanciallydollarizedeconomy.Wefirstshowempiricallythatforeignexchangeinterventioninresponsetocapitaloutflowscanlargelyreducethevolatilityofoutputandtherealexchangerateindollarizedeconomies.Wethendevelopasmallopeneconomymodelwithforeigncurrencydebtandbalancesheetseffects.Ourquantitativemodelshowsthatanactiveforeignexchangeinterventionpolicyissufficientforoffsettingtheoutputvolatilityassociatedwithfinancialdollarization.Theseresultscanexplaintheprevalenceoflowmacroeconomicvolatilityinsomedollarizedeconomies(Christianoetal.,2021)andtheyhighlighttheroleofforeignexchangereservesinreducingthewelfarecostsofdollarization. JELClassificationNumbers: E58,F31,F41 Keywords: ForeignExchangeIntervention;GlobalFinancialCycle;FinancialDollarization;BalanceSheetEffects;EmergingEconomies. Author’sE-MailAddress: paul.castillo@bcrp.gob.pe;rlama@imf.org;juan.medina@uai.cl *WethankLarryChristiano,JesperLindé,MathiasTrabandt,MarcinKolasa,NikhilPatel,SergioGarcíaMonroy,DmitryPlotnikov,SoniaMuñoz,TomohiroTsuruga,JuliaOtten,andparticipantsatthe27thLACEAConferenceandtheseminarattheMonetaryandCapitalDepartmentoftheInternationalMonetaryFund(IMF)forhelpfulcommentsandsuggestions.TheviewsexpressedhereareoursanddonotnecessarilyrepresenttheviewsoftheCentralBankofPeru,theIMF,itsExecutiveBoard,orIMFmanagement. INTERNATIONALMONETARYFUNDii 1.Introduction Theconventionalwisdomamongpolicymakersisthatfinancialdollarization(i.e.,privatesectorborrowingdenominatedinforeigncurrency)isasourceofmacroe-conomicvolatilityandfinancialinstabilityinemergingeconomies.1IncontrasttothestandardMundell-Flemingparadigm,underfinancialdollarization,theexchangerateisunabletoabsorbnegativeexternalshocks.Instead,anexchangeratede-preciationcanamplifyexternalshocksbyraisingtheeffectivecostofborrowing,triggeringbalancesheeteffectsandexacerbatingacontractionininvestmentandoutputgrowth.Moreover,attemptstofixtheexchangeratedonotnecessarilyim-provemacroeconomicoutcomes,asthestabilizationofthenominalexchangeratemightrequireaprocyclicalmonetarystancethatresultsinalargeroutputcontrac-tion(V´eghetal.,2017).Alternativepoliciesforde-dollarization,suchasahigherreserverequirementsinforeigncurrencyorlimitsonbank’sforeignexchangeposi-tions,couldpotentiallyleadtofinancialdisintermediationandlowergrowth(CataoandTerrones,2016).Inturn,financialdollarizationimposesapolicydilemmaforcentralbanks,astheavailablepolicyoptionstomitigateitsharmfuleffectsintheeconomyarelimited.Werefertothisdilemmaencounteredbymanycentralbanksasthefinancialdollarizationtrap. Nevertheless,andcontrarytotheconventionalview,somedollarizedcountrieshavebeenhighlyresilienttoexchangeratedepreciations.Recentempiricalworkshowsaweakrelationshipbetweendollarization,bankingcrisis,andmacroeconomicvolatility.Forinstance,Christianoetal.(2021)analyzealargepaneloffirmsinArmeniaandPeruanddonotfindthatexchangeratedepreciationsaffectinvestmentandemploymentdecisions.Theyarguethatanefficientmacroprudentialpolicycouldexplaintheweaknessofbalancesheeteffects.BleakelyandCowan(2008)findsimilarresultsforLatinAmericancountries,wherethelackofbalancesheeteffectscouldbeexplainedbythefactthatliabilitydollarizationisconcentratedamongexportfirmsthatarenaturallyhedgedagainstexchangeratefluctuations.Inthiscontext,ourpaperfocusesontwokeypolicyquestions:(i)Canforeignexchangeinterventionlowermacroeconomicvolatilityunderdollarization?;and(ii)Howlargearethewelfaregainsfromdeployingforeignexchangerateinterventionpoliciesineconomieswithfinancialdollarization?Despiteextensivepolicydebates,theseissuearefarfromsettled. Thispaperexplorestheideathatanoptimalforeignexchangeinterventionpol-icycansubstantiallyredu