Fear of floating and domestic liability dollarization

Previous attempts to analyze the effect of liability dollarization on “fear of floating” have focused exclusively on the role played by foreign liabilities. Liability dollarization of the domestic banking system, however, poses a similar risk as dollar-denominated deposits and credit impose a source of currency risk on domestic banks and firms, respectively. Findings from a large cross-country sample indicate that domestic liability dollarization plays a central role in producing a “fear of floating” among emerging market countries and developing nations. This is an important result because domestic liability dollarization is more reversible than the dollarization of foreign liabilities, providing a reason for optimism that these countries can regain flexibility in the choice of exchange rate regime and overcome their “fear of floating”.