Negative Externalities of Financial Dollarization

Valida Pantsulaia (), Ana Jangveladze () and Shalva Mkhatrishvili
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Valida Pantsulaia: Financial Stability Analysis and Macro-financial Modeling Division, National Bank of Georgia
Ana Jangveladze: Financial Stability Analysis and Macro-financial Modeling Division, National Bank of Georgia

No 01/2023, NBG Working Papers from National Bank of Georgia

Abstract: Dollarization (usage of a foreign currency in place of a domestic one) is a widely observed phenomenon that historically emerged as a result of extended macro-financial instability and extreme price and nominal exchange rate fluctuations. Complete loss of public confidence in a local currency pushed lenders and borrowers to seek more stable foreign currencies like the US dollar and euro. What is more puzzling though is that in many countries dollarization remained at an elevated level even after taking care of its root cause (i.e. after achieving price stability). There have been several explanations of this phenomenon (the so-called dollarization hysteresis). In this short paper, we propose additional explanations in the form of several dollarization-induced negative externalities, including an amplification of credit procyclicality and exchange rate pass-through or a worsening of credit ratings of dollarized economies. We also offer some back-of-the-envelope calculations showing that these externalities could be economically significant (about 1 pp impact on real GDP growth per year) for a small and highly dollarized country like Georgia. This type of market failures underline the importance of prudential policies that internalize negative externalities and, hence, level the playing field for the local currency.

Keywords: Financial dollarization; Negative externality (search for similar items in EconPapers)
JEL-codes: E44 E58 F34 (search for similar items in EconPapers)
Pages: 16 pages
Date: 2023-04
New Economics Papers: this item is included in nep-mac, nep-mon, nep-opm and nep-tra
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Persistent link: https://EconPapers.repec.org/RePEc:aez:wpaper:2023-01

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