An Investigation of the Macroeconomic and Monetary Effects of Dollarization in Eritrea

Most countries of the developing world have voluntarily or involuntarily been involved in using foreign currencies and trapped their economies for either the best or worst outcomes of dollarization. For those countries that have fully dollarized their economies, dollarization has provided some benefits in terms of bringing economic stability. However, the benefits in these economies came with costs that have worsened the income inequality and poverty that exist within their economies. Similarly, some countries that rely partially on their own currencies and partially on foreign currencies have seen different outcomes of partial dollarization. This research has specifically examined the reliance of the Eritrean economy on hard currency. Despite numerous studies that have been conducted regarding the Eritrean economy, the dollarization of Eritrea is an important issue that has not been investigated. This research has uncovered what kind of dollarization the Eritrean economy has and also what factors drive the Eritrean dollarization. It has been found that there is partial dollarization with evidence of financial, sovereign liability and underground dollarization in the economy. Real dollarization is only manifested in the form of selling houses and lands in exchange for hard currency. It has also been discovered that banking practices, the structure of the interest rate, loans issued to the private sector relative to the government sector and the Eritrean monetary system, particularly the introduction of new currency, followed by the second war with Ethiopia in 1998, are some of the causative factors. Furthermore, this research has investigated the impact of partial dollarization of the Eritrean economy on macro-economic variables with specific examination on the exchange rate volatility, inflation and the monetary policy transmission mechanisms. In each analysis, quarterly data starting from 1996 to 2008 is employed. The fundamental reason for selecting this time period for the study is the inability to obtain the data for some of the variables outside the specified time period. Exponential Generalised Autoregressive Conditionally Heteroscedasticity in mean (EGARCH) model is applied over real official exchange rate and on both nominal as well as real black market exchange rates. Dollarization measured by a hard currency index is then augmented in the variance equation of EGARCH-M (1, 1). The results show that partial dollarization of the Eritrean economy enhances the volatility of the real official exchange rate, the nominal and the real black market exchange rates. To see whether partial dollarization reduces or produces inflation in the Eritrean economy, Vector Error Correction Models together with Dynamic Ordinary Least Squares (DOLS) are employed. The results indicate that inflation increases as a result of an increase in dollarization. This applies regardless of whether official or black market exchange rate data are used in the estimation. In terms of the short-run dynamics involved in the long-run relationship between dollarization and inflation, the speed of adjustment towards long-run equilibrium ranges from 7.2-7.6 percent per quarter. Both error correction terms are negative. This indicates that the adjustment process is stable and convergent towards the long-run equilibrium which implies that there is a guaranteed long-run relationship between inflation and the remaining variables including dollarization. To examine the effectiveness of the channels of the monetary policy, Vector Autoregressive (VAR), Structural Autoregressive (SVAR) and Toda and Yamamoto (TY) models have been used. The results suggest that there is an effective exchange rate channel through the black market, an ineffective credit channel through the credit issued to the private sector and an effective credit channel through the credit issued to the government. In general, the contribution of this study can be summarized in three different areas: first, the measurement of dollarization; second, the determinants of dollarization; third, the effects of dollarization. Some of the policy implications of the findings are first, the Bank of Eritrea should address its exchange rate policy by revisiting the current official exchange rate and, at the same time, by addressing the growth of the black market foreign exchange. The Bank of Eritrea should also address its regulation on banking practices and the structure of interest rates. Second, the bank should create a conducive environment for the private sector to promote economic growth and minimise excessive government expenditure which requires fiscal discipline. Third, there should be an effort made to pave the ways for economic and financial cooperation with neighbouring countries