Do domestic bond markets participation help reduce financial dollarization in developing countries?

- Domestic Bond Markets (BM) participation reduces financial dollarization in developing countries.
- This favorable effect is sensitive to several macroeconomic policy regimes.
- The decrease in inflation rate and its variability, nominal exchange rate variability, and seigniorage revenue are potential transmission mechanisms through which the presence of domestic BM reduces financial dollarization in domestic BM countries.
- Developing domestic BM helps improved the effectiveness of monetary and fiscal policies in developing countries.

In this paper, I analyze the effect of domestic sovereign bond market (BM) participation on financial dollarization using a large panel of 114 developing countries over the period 1984-2009. Building on entropy balancing, my results reveal strong evidence that domestic BM participation significantly reduces financial dollarization in domestic BM countries compared to their non-domestic BM peers. Moreover, I find that the favorable impact of domestic BM on financial dollarization (i) is larger for inflation targeting countries compared to non-inflation targeting countries, (ii) is apparent exclusively in a non-pegged exchange rate regime, (iii) and is larger when there are fiscal rules that constrain the discretion of fiscal policy makers. Finally, I show that the induced drop in inflation rate and its variability, nominal exchange rate variability, and seigniorage revenue are potential transmission mechanisms through which the presence of domestic BM reduces financial dollarization in domestic BM countries.