Working Paper: NBER ID: w8950
Authors: Enrique G. Mendoza
Abstract: Financial contagion and Sudden Stops of capital inflows experienced in emerging-markets crises may originate in an explosive mix of lack of policy credibility and world capital market imperfections that afflict emerging economies with national currencies. Hence, this paper argues that abandoning national currencies to adopt a hard currency can significantly reduce the emerging countries' vulnerability to these crises. The credibility of their financial policies would be greatly enhanced by the implicit subordination to the policy-making institutions of the hard currency issuer. Their access to international capital markets would improve as the same expertise and information that global investors gather already to evaluate the monetary policy of the hard currency issuer would apply to emerging economies. Yet, adopting a hard currency does not eliminate business cycles, rule out all forms of financial crises, or solve severe fiscal problems that plague emerging economies, and it entails giving up seigniorage and potential benefits of conducting independent monetary policy. However, these disadvantages seem dwarfed by the urgent need to enable emerging countries to access global capital markets without exposing them to the risk of recurrent Sudden Stops.
Keywords: emerging economies; national currencies; hard currency; financial crises; capital markets
JEL Codes: F3; F41; E3; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lack of credibility of domestic policymaking institutions (D73) | increased vulnerability to financial crises (F65) |
| imperfections in capital markets (G19) | increased vulnerability to financial crises (F65) |
| adopting a hard currency (F31) | enhanced credibility of financial policies (E61) |
| adopting a hard currency (F31) | improved access to international capital markets (F30) |
| adopting a hard currency (F31) | reduced vulnerability to financial crises (F65) |