De-dollarization and financial robustness (Capítulo) 

Abstract

We evaluate the implications of financial de-dollarization on the strength of balance sheet effects in a small open economy following an unanticipated shock to the foreign risk-free interest rate. In particular, we extend the Cespedes, Chang and Velasco (2004) open economy model by allowing entrepreneurs to borrow in both foreign and domestic currency so as to finance firms’ capital needs. A real depreciation reduces the value of firms’ net worth whenever there is a currency mismatch in their balance sheets. Under flexible exchange rates, a low degree of dollarization lessens the negative impact on output and investment, since there is a small increase in the cost of external borrowing. The quantitative results show that the model is able to account for about 80 percent of the output and investment drops, and 60 percent of the real exchange rate depreciation in Peru following the Russian Crisis. Moreover, de-dollarization would have moderated the decline in output growth by 0.7 percent.