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Dollarization an its effect on capital markets

ITIPress.org - Marlon Jerez / Consulting in Economics and Finance

According to the Joint Economic Committee, dollarization can be unofficial, semiofficial or official. The unofficial dollarization takes place when people carry most of their values in foreign assets, even if the foreign currency is not an official currency in the country in question. The semiofficial dollarization takes place when the dollar is an official currency in the country in question. It can dominate bank deposits, but it is a secondary paper compared to the local currency when it comes to paying salaries, taxes, etc. This situation is referred to as officially bi-monetary system.

The official dollarization, known as well as total dollarization, takes place when the dollar receives an exclusive or predominate legal status. This means that the dollar is not only the legal currency of private contracts, but as well the government uses it for payments. If there is a domestic currency in existence, it can receive a restricted secondary status.

When introducing an official dollarization, there are a series of technical challenges which have to be taken into account. There is e.g. an inflationary momentum, because of the demand of exchanging the currency; economic swings, due to external shocks which directly influence the country which took the decision; legal matters, due to need to change existing contracts; problems when rounding the conversions, etc. Countries like Panama, Ecuador and El Salvador have already dollarized and the experiences of every case are diverse.

However, what interests us is the effect on capital markets. When introducing the dollar, the exchange risk and the risk of devaluation disappears. Thus, the interest rates tend to be lower and have to adjust to international rates. The market for variable interest (stock market) would be more attractive because profitability depends on flows of capital of the companies which will be higher when there is less uncertainty.

One problem may arise due to the fact that many fixed interest investment instruments are tied to variable reference rates, which will adjust rapidly if payment of these titles is modified. This certainly has an impact on the internal return of the title.

At first, the stock market can experience a lower demand, but later on after the initial impact, the market can benefit due to better integration of the international markets due to the fact that investors are more interested in a country where the risk of devaluation is zero.

Especially important to mention is that the mentioned benefits need a supervision of the regulatory entities due to the fact that there is a high incentive for speculation with near term entries of capital. This is called speculative capital.

"I violated the Noah rule. Predicting  rain doesn't count; building arks does." - Warren Buffet

 

 

 

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