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The World Bank Economic Review Advance Access originally published online on September 30, 2008
The World Bank Economic Review 2009 23(1):101-117; doi:10.1093/wber/lhn012
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© The Author 2008. Published by Oxford University Press on behalf of the International Bank for Reconstruction and Development / THE WORLD BANK. All rights reserved. For permissions, please e-mail: journals.permissions@oxfordjournals.org

Systemic Risk, Dollarization, and Interest Rates in Emerging Markets: A Panel-Based Approach

Edmar L. Bacha, Márcio Holland, and Fernando M. Gonçalves

Edmar Bacha is executive director of the Institute of Economic Policy Studies (Casa das Garças), Brazil; his email address is edmarbacha{at}iepecdg.com
Márcio Holland (corresponding author) is professor of economics at São Paulo School of Economics, Fundação Getulio Vargas, Brazil, and Conselho Nacional de Desenvolvimento Científico e Tecnológico (CNPq) researcher
Fernando M. Gonçalves is an economist at JGP Asset Management; his email address is fmg215{at}gmail.com

Correspondence: his email address is marcio.holland{at}fgv.br

JEL codes: E43, F31, O16, O23, O54

This study investigates the impact of systemic risks and financial dollarization on real interest rates in emerging economies. Higher systemic risks induce both higher real interest rates and increased dollarization. Using appropriate instruments for the dollarization ratio, the study overcomes the simultaneous equation problem and correctly estimates a negative coefficient for the dollarization ratio in the interest rate equation. It confirms the theoretical prediction that a strategy of "dedollarizing" the economy will raise the equilibrium domestic real interest rate if the strategy fails to address fundamental macroeconomic risks. Even so, it also finds that this effect is small, after controlling for the risks of dilution and default. The results bring to light the systemic-risk reasons for high interest rates in emerging economies—and contribute to evaluating the difficulties of dedollarization policies.


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