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

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Presentation on theme: "Why Should Emerging Economies Give up National Currencies: A Case for “Institutions Substitution” Enrique G. Mendoza Center for International Economics."— Presentation transcript:

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

2 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

3 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

4 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

5 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

6 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 1987-94 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

7 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”

8 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

9 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

10 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


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