Increasingly widespread growth in t

Increasingly widespread growth in the use of foreign currency deposits in most countries around the world has complicated banking practice and supervisory concerns. This trend has also had an impact on exchange rate policy. While driven by a desire on the part of firms and individuals to hedge inflation and exchange rate risks, it may have increased systemic risks and the vulnerability of individual banks. We have shown that higher interest rates and interest rate spreads, reflecting fears of depreciation and suspension, are statistically associated with high dollarization.
This paper has concentrated on the two-way link between exchange rate movements and dollarization. Exchange rate movements (the surge and subsequent weakness in the US dollar) and regime changes (the arrival of the euro) have complicated the analysis of global dollarization trends. Our analysis, having disentangled these factors, suggests that, though underlying dollarization shares may not have fallen back, there has been a break in trend. Dollarization is here to stay. But, while there is still probably an underlying upward momentum in deposit dollarization that will continue to present policy challenges, the growth is likely to be slower than in the 1990s.
Specific policy addressing the consequences of dollarization itself, including steps to ensure that the credit and market risks, including the systemic risks are adequately internalized in the prudential management of intermediaries and their customers, represent one level of the needed response.15 But, to the extent that high levels of dollarization have their roots in volatile macro policy and weak institutions, more lasting and more effective cures will address these underlying causes.
On the other hand, policymakers should not overreact. Fearful that exchange rate movements might destabilize monetary holdings in an environment of deposit dollarization, some may have succumbed to a “fear of floating.” But our econometric results suggest that such fears can be exaggerated.16 Exchange rate movements do not, on average, result in extrapolative destabilizing re-denomination of the currency of deposits. While dollarization shares are impacted by exchange rate changes, even the mechanical exchange rate impact is on average partly rebalanced within the year.
Indeed, if fear of floating is carried to the point of persisting with a fixed exchange rate that has become seriously out of line with fundamentals, the eventual large exchange rate adjustment which may be forced on the authorities could, with a highly dollarized banking system, have severe solvency effects both on unhedged borrowers and on their creditor financial institutions.