The Twin Risks in the Dollarization Debate: Country and Devaluation Risks

The recent debate over dollarization has been more focused on the motives of the idea than in analyzing the proposal more formally. Here we attempt to prove a very simple point that should be considered as the hardest lesson ever learnt by emergent economies: no stability is achieved without fiscal sustainability. The purpose of devaluation has been usually to find a way to finance a deficit. Obviously within a dollarized economy that avenue is closed. Under the assumption that there is a deficit that needs to be financed out, investors will expect some reaction from the government: either lose reserves, increase its debt or print money. Another way to accomplish the objective when all these scapegoats are banned is to confiscate somebody devaluing the domestic currency or defaulting on its external obligations. The paper shows that the risk posed by the presence of an unexpected deficit would get transferred from one sector to another. This paper stress the idea that dollarization is at the very end a fiscal issue, and the results over the economy depends on the existence of the balance sheet effect. These results are: i) when the economy does not face a balance sheet effect, as the devaluation risk disappears, the country risk goes up, and ii) when the economy face a balance sheet effect, a dollarization could reduce the country risk. A caveat of the second result is that, the higher the balance sheet effect, the higher the reduction in the country risk. JEL Codes: