# **_(c)  Quantifying the medium-term causal factors_**

A country’s inflationary history is not the only factor likely to influence concerns about a recurrence of a major macroeconomic collapse. For one thing, weak governmental institutions, for example those inhibiting the government from credible precommitment would be likely to adversely affect confidence in the domestic currency and promote foreign currency holdings. (See De Nicoló, Honohan and Ize, 2005, for a review of the literature in this area.) Even if there were no great concerns about a significant collapse of monetary policy discipline or of the exchange rate, normal volatility of inflation and exchange rates provide a reason why the optimal deposit portfolio might include dollars. After all, as pointed out by Ize and Levy Yeyati (2003), the volatility of the real value of a dualcurrency portfolio depends on the variance and covariance of inflation and exchange rates. If the mean return on each currency is equal, standard mean-variance portfolio optimization points point to a “warranted” dollarization share λ based on the minimum variance portfolio calculated from historic variances and covariances of prices and exchange rates.<sup>8</sup> Recent attempts to quantify these considerations and to estimate the impact of each on cross-country variation in average dollarization ratios have been reasonably successful. De Nicoló, Honohan and Ize. (2005) used the World Bank’s composite indicators of political and institutional development (cf. Kaufman, Kraay and Mastruzzi, 2006) as a measure of governance and a proxy for policy credibility, and supplemented this by a dummy for countries whose legal system is inherited from Napoleonic code—an inheritance which is often thought to offer lower protections to creditors and lead to shallower financial systems (cf. La Porta, López-de-Silanes, Shleifer, and Vishny, 1998; Levine, Loayza and Beck, 2000). The regression equations of De Nicoló, Honohan and Ize (2005) also included the average historic rate of inflation, a dummy for Transition economies and the warranted share from mean-variance considerations λ. Finally, they included a dummy variable summarizing the restrictiveness of rules on resident holdings of foreign currency deposits onshore in 2000, and based on the IMF’s _Annual Report on Exchange Arrangements and Exchange Restrictions_ .

Using these variables measuring institutional quality, regulatory frameworks, and the macroeconomic environment, De Nicoló, Honohan and Ize (2005) were able to explain about half of the cross-country variation in the 75 countries included in their sample. As expected, high inflation and weak institutions increased dollarization shares substantially. For instance an increase of 2 percentage points in the warranted portfolio share λ is associated in the regression with an increase in actual dollarization by almost 1 percentage point. Inflation is also found to have a strong effect; a doubling of inflation increasing dollarization by about 5 percentage points. But inflation loses significance when structural and institutional proxies for credibility effects are added in, suggesting

> 8 The warranted share λ  is λ= _V_ <u>(</u> π <u>)</u> + _Cov_ <u>(</u> π <u>,</u> _s_ <u>)</u> ,  where _π_ is inflation and _s_ is real depreciation. _V_ ( π ) + _V_ ( _s_ ) + 2 _Cov_ ( π , _s_ )