Why Should Emerging Economies Give up National Currencies: A Case for “Institutions Substitution” Enrique G. Mendoza Center for International Economics University of Maryland & NBER

The Debate on Exchange Rate Regimes & Emerging Markets Crises Two key culprits behind emerging markets crises were  Lack of credibility of economic policy  Financial market frictions … but traditional debates on currency regimes focus mainly on  Origin/nature of macro shocks  Independence of monetary policy

Lessons of Emerging Markets Crises: Sudden Stops & Contagion Features of a sudden stop:  Sudden reversals of capital inflows & current account deficits  Collapses of credit, output & absorption  Collapses of relative prices & asset prices Co-movements in country risk & domestic asset prices Systemic, exogenous changes in net capital inflows

Why are emerging markets policies less credible? “Bad government,” “weak institutions” Good, wise government but facing time inconsistency problems  Exchange-rate-based stabilizations Monetary/ex. rate policies repeatedly used to redistribute/confiscate wealth and solve financial collapses

Why are financial frictions more relevant for emerging markets? (Calvo & Mendoza JIE 2000, Calvo 1999) Severe informational frictions Weaker incentives to acquire and process country information  Adverse effect of globalization  Markets split: specialists/ uninformed Information is less useful  Larger “signal extraction problems” Contagion can be rational Short-selling constraints, margin constraints and VAR collateralization amplify these effects

How do Non-credible Policies and Financial Frictions Create a Sudden Stop? Policy uncertainty acts like a random tax on savings and factor incomes  Mexico’s non-credible currency peg (Mendoza & Uribe CRCS 2000) Sudden stops occur when policy uncertainty triggers financial constraints  Liquidity requirements with liability dollarization (Mendoza, 2002)  Margin calls and trading costs (Mendoza & Smith, 2002) Sudden stops nested within smoother, more common business cycles Economies can “outgrow” sudden stops Large, unexpected shocks can cause sudden stops

Margin Calls, Trading Costs & Prices in Emerging Markets: An Example LTCM Style SOE trades equity & debt in global market s.t. margin and short-selling constraints Foreign traders incur recurrent & per-trade transactions costs (partial adjustment rule) Dynamics of a sudden stop:  Policy uncertainty triggers margin call  SOE “fire sells” equity to meet call  Foreign traders can only buy at discount  Equilibrium prices fall, triggering new round of margin calls (Fisherian deflation) World liquidity shocks “carry the virus”

So, what does this have to do with giving up national currencies? Analysis hardly used money and exchange rates Real effects of policy uncertainty & credit frictions exist in any currency regime Dollarization cannot rule out all financial crises Dollarization cannot address chronic fiscal & institutional problems

In Emerging Markets, it has a lot to do with giving up national currencies…. Remove exchange rate uncertainty Simplify informational needs  Study Mr. Greenspan only, not him and also De la Rua, Duhalde, Cavallo, ….  Eliminate “liability dollarization”  Improve contracting environment, weaken financial constraints (welfare gains can be large, Mendoza JMCB 2001)  Increase demand elasticity for emerging markets assets Still, voluntary dollarization will not happen  Governments value a currency’s power to tax, confiscate and redistribute wealth  Loss of national symbol, seigniorage, sovereignty & independent monetary policy

If it is a great but unrealistic idea, what else can be done? Price guarantees for emerging markets  Ex ante (Calvo)  Ex post, direct (Lerrick-Meltzer) or indirect (IMF) Internationalized financial systems with pre-committed credit lines or narrow- banking constraints Enhanced surveillance Socially costly means to try to do indirectly what dollarization does directly: tie as tight as possible the policymakers’ hands