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paradigm, large international reserves and exchange rate pegs (or quasi-pegs) can thus encourage financial dollarization by enhancing the value of the government guarantee.

Moral hazard can also arise due to market failures or a deposit insurance. In Aghion, Bacchetta, and Banerjee (2001) and Chamon (2001), because borrowers are more likely to default when the exchange rate depreciates and their debt is in dollars, they do not internalize the actual cost of dollar borrowing. At the same time, because creditors do not observe the currency composition of borrowers' total debt, and local currency claims get diluted relative to dollar claims under a liquidation, they require a high premium on local currency loans, thereby increasing the cost of borrowing in local currency. In equilibrium, incentives for excessive dollar borrowing are thus generated from both the supply side and the demand side of the market for loanable funds. Broda and Levy Yeyati (2003) show that, by limiting the risk of lending in dollars, a deposit insurance that applies uniformly across all deposits exacerbates such incentives for dollarization.1<sup>6</sup>

# **B. Empirical Estimates**

Basing our specifications on the above theoretical discussion, we conducted cross-section estimates of the determinants of dollarization levels. Results are reported for three alternative dependent variables: (i) the 2001 level of deposit dollarization (ratio of onshore foreign currency deposits to total bank deposits); (ii) the average level for available years during the sample period 1990-2001; and (iii) a calculated country-specific equilibrium level for 2001, based on a simple trend-augmented autoregressive model. The second and third alternatives have the advantage of being available for more countries; the third is intended to take account of the many countries which experienced substantial variation in dollarization during the sample period and for which the simple average would be unrepresentative of the equilibrium situation at the end of the period. In the event, results for the three alternative dependent variables are quite similar, as are those (unreported) for a fourth, namely the maximum level of dollarization recorded for each country during 1990-2001.

To account for the impact of administrative restrictions on dollar deposits, we constructed a dummy variable based on several indicators.'<sup>7</sup> The main additional explanatory variables

> 16 Risk factors can also work against dollarization. For instance, the risk of local bank failure could encourage the export (legal or otherwise) of all but local currency transactions balances to offshore banks, thereby lowering (onshore) dollarization. The same would apply to the risk of expropriation or capital levies, more so if these were expected to be selectively applied to foreign exchange deposits (as with compulsory conversions at off-market rates in the case of Mexico, 1982 and Argentina, 2001 to mention just the most well-known). Fear of imposition of capital controls or the introduction of non-market-clearing exchange rates would fall into the same category.

17 The IMF's _Annual Report on Exchange Arrangements and Exchange Restrictions_ contains information about the regulatory position in this regard. Our summary of the major features is tabulated in Appendix Table 3 for the countries in our dollarization sample, along with particulars for a handful of other countries included as controls. These additional countries are included because they either have or had in the recent past rather restrictive rules about resident onshore foreign currency deposits. Not surprisingly, most of the countries for which we have data on dollarization have a fairly liberal regime. Indeed, the trend has been generally towards liberalization in this regard. For example, the table provides an instant explanation for the very low rate of dollarization recorded for tiny Dominica: this can easily be attributed to the restrictive rules. On the other hand, although Appendix Table 3 shows our own simple composite index of restrictiveness, it is not possible from the (continued)