Financial Dollarization, the portfolio approach and expectations: Evidence for Latin America (1995-2005)

This paper evaluates to what extent financial dollarization in Latin America can be explained by the minimum variance portfolio approach (MVP) proposed by Ize and Levi-Yeyati (2003). Several assumptions behind the portfolio optimization process are studied. If one distinguishes between highly dollarized countries (HD) and the rest of Latin America, the MVP behaves poorly in HD countries (e.g. Peru and Bolivia). In particular, a reduction in the relative volatility does not affect financial dollarization in this group of countries. This result suggests that for HD economies, portfolio considerations are less important than past history to explain the persistence of dollarization.