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Exchange Rate Volatility and Productivity Growth: The Role of Liability Dollarization


This paper studies how liability dollarization conditions the effect of exchange rate flexibility on growth. It develops a model with credit-constrained firms facing liquidity shocks denominated in tradables while their revenues are both in tradable and nontradables. With frictions in the reallocation between tradables and nontradables, a peg is more growth-enhancing than a float in countries with dollarized debt because it stabilizes firms’ cash flows and therefore allows them to face liquidity shock and complete their innovation process. However, this relative advantage diminishes when dollarization decreases. These theoretical predictions are confirmed by an empirical analysis on a panel of 76 countries spanning 1995–2004: the higher the degree of dollarization, the more negative the impact of exchange rate flexibility on growth. The empirical results are robust to various specifications and to the treatment of endogeneity.

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  1. 1.

    Baxter and Stockman (1989) were the first to bring this “instability puzzle” forward. The literature has since been inconclusive on the subject: Husain et al. (2005) find that exchange rate flexibility is growth-enhancing in industrial countries and neutral in developing economies, while Dubas et al. (2005), relying on an alternative exchange-rate classification, find that a fixed exchange rate has good growth performances in the latter while it is neutral in the former. Levy-Yeyati and Sturzenegger (2003) find that, on average, countries with a fixed exchange rate regime grow at a slower rate. See Tavlas et al. (2008) for a recent survey on this literature.

  2. 2.

    Early contributions include, among others, Calvo (2000; Krugman (2000; Aghion et al. (2000).

  3. 3.

    Note that even in the Mundell-Fleming model, the type of shocks and capital controls can also reverse this oft-quoted result. See Ball (2010).

  4. 4.

    See for example on liability dollarization Arteta (2005), Calvo et al. (2004), De Nicolo et al. (2003), Reinhart et al. (2003), Levy-Yeyati (2006), Eichengreen et al. (2005), Bleaney and Vargas (2009) and in particular, on its impact on growth Reinhart et al. (2003), Levy-Yeyati (2006) and Bleaney and Vargas (2009).

  5. 5.

    See for example Eichengreen and Hausmann (1999).

  6. 6.

    Yet, some authors find that exchange rate regimes do affect firms’ balance sheets. In particular, the adoption of a floating exchange rate regime leads to a higher degree of currency matching (and the opposite for the adoption of fixed regimes), as Galiani et al. (2003) show for the case of Argentina’s currency board and Kamil (2008) does for a panel of emerging countries. However, these studies are conducted on developing countries only. On our macro data set, for a given exchange rate regime, developing countries still exhibit higher liability dollarization than industrial ones, which is a symptom of imposed original sin.

  7. 7.

    Existing explanations point at time inconsistency problems related to the temptation to “default” on local currency debt through inflation (Calvo and Guidotti 1989), the incidence of implicit debtor guarantees (Burnside et al. 2001) and signaling problems (De la Torre et al. 2003), among others. De Nicolo et al. (2003) provides evidence that the credibility of macroeconomic policy and the quality of institutions are both key determinants of cross-country variations in dollarization.

  8. 8.

    The current account in the tradable sector is balanced because we have assumed that there is no intertemporal trading, that is no asset trade. This assumption simplifies the analysis but is not crucial. Qualitatively, the results would be unchanged if we introduced intertemporal trade in bonds. This is because, as long as there is imperfect risk sharing, a productivity shock leads households to alter their consumption, which is at the origin of the mechanisms of the model. Trade in bonds only limits the impact of productivity shocks on consumption by sharing their effect between current and future consumption; it does not suppress it. The difference with the model without trade in bonds is only quantitative and does not alter the comparison between regimes.

  9. 9.

    The log-linearized version of the model as well as the proofs of Propositions 1 and 2 are available in the technical appendix at:

  10. 10.

    See the technical appendix for the definition of κ.

  11. 11.

    In practice, Eq. 14 is differentiated and the second lag of the endogenous variable \(y_{t-2}^i\) is used as an instrument for \(\Delta y_{t-1}^i\), as well as further lags. Though our sample has only two available observations because of the scarcity of dollarization data, we can rely on lags of \(y_{t}^i\) beyond the limits of our data. To limit the number of instruments, I use only \(y_{t-2}^i\) and \(y_{t-3}^i\) to instrument \(\Delta y_{t-1}^i\). Since we assume that the other regressors are predetermined, we use their first and second lags as instruments. The system-GMM method consists in adding Eq. 14 in level as additional observations to limit the problem of weak instruments in presence of persistence. \(y_{t-1}^i\) is then instrumented with \(\Delta y_{t-1}^i\) and the other regressors in levels.

  12. 12.

    This assumption has also been chosen for practical reasons. Because of data scarcity, it is impossible to use second order lags of original sin. It can be therefore considered at best as predetermined (the other variables, in particular the lagged explained variable, can still be instrumented thanks to the available higher lags).

  13. 13.

    For further discussion of the endogeneity issues associated with exchange rate flexibility, see Aghion et al. (2009).

  14. 14.

    Interestingly, when adding additional variables and controlling for endogeneity, the linear term becomes unsignificant, which does not contradict previous evidence in the literature.


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Financial support by CREST-INSEE is gratefully acknowledged. I would like to thank two referees, for many useful comments that helped improve the paper. Earlier versions of this paper also benefited from helpful comments from Agnès Bénassy-Quéré, Daniel Cohen, Guy Laroque, Philippe Martin, Valérie Mignon, Romain Rancière, Hélène Rey, seminar participants at CREST and EQUIPPE (Lille), the RIEF 2007 conference and 2008 doctoral meeting, the 2007 ESEM meeting, the 2008 T2M conference and the 2008 SMYE meeting.

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Correspondence to Kenza Benhima.


Appendix A: Countries in Sample

Appendix B: Descriptive Statistics

Summary statistics 1995–2004 (data in five-year averages)

Variable Observations Mean Std. Dev. Min Max
Productivity growth 134 0.02 0.02 −0.05 0.10
Initial productivity 134 26,413.24 18,668.75 2,172.53 70,091.68
Financial development 134 0.53 0.39 0.03 1.63
Education 134 83.79 28.43 14.00 158.76
Trade openness 134 81.38 46.03 18.11 322.35
Inflation 134 0.08 0.11 −0.02 0.78
Government burden 134 15.87 5.17 5.52 29.21
Kaufman governance index 134 3.19 4.83 −7.06 11.69
Net external debt 134 0.24 0.42 −2.15 1.88
REER vol. 90 0.06 0.04 0.01 0.19
LS index of ER flex. 129 2.40 1.18 1.00 4.00
Original sin 134 0.86 0.22 0.20 1.00

Sample correlations 1995–2004 (data in five-year averages)

  Prod. growth Initial prod. Fin. dev. Education Trade open. Inflation
Prod. growth      
Initial prod. 0.13     
Fin. dev. 0.19 0.61    
Education 0.22 0.74 0.51   
Trade open. 0.11 −0.05 0.00 0.01  
Inflation −0.44 −0.44 −0.48 −0.34 −0.01
Gov. burden −0.09 0.50 0.20 0.62 0.06 −0.20
Gov. index 0.29 0.84 0.63 0.80 0.02 −0.48
Net ext. debt −0.24 −0.39 −0.36 −0.22 −0.24 0.18
REER vol. −0.51 −0.37 −0.31 −0.25 −0.07 0.59
LS index of ER flex. −0.22 −0.18 −0.21 −0.06 −0.30 0.10
O. sin −0.02 −0.68 −0.65 −0.50 0.24 0.35

Sample correlations 1995–2004 (data in five-year averages)

  Gov. burden Gov. index Net external debt REER vol. LS index of ER flex.
Prod. growth      
Initial prod.      
Fin. dev.      
Trade open.      
Gov. burden     
Gov. index 0.44    
Net ext. debt 0.01 −0.31   
REER vol. −0.16 −0.42 0.11  
LS index of ER flex. −0.07 −0.16 0.09 0.26
O. sin −0.23 −0.59 0.31 0.17 0.00

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Benhima, K. Exchange Rate Volatility and Productivity Growth: The Role of Liability Dollarization. Open Econ Rev 23, 501–529 (2012).

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  • Exchange rate regimes
  • Growth
  • Liability dollarization

JEL Classification

  • O16
  • O24
  • O41
  • O42