Edmar Lisboa Bacha

A panel-data analysis of interest rates and dollarization in Brazil

Contents: 1. Introduction; 2. Analytical Model; 3. Empirical Findings; 4. The Mistery of High Interest Rates in Brazil; 5. Conclusions; 6. Appendix I; 7. Appendix II; We investigate the role of financial dollarization and systemic risks in the determination of real interest rates in Brazil. In a simple currency- choice portfolio model, we show that a strategy of reducing dollari- zation, if it fails to address fundamental macroeconomic risks, leads to higher domestic real interest rates. We confirm this prediction in an empirical panel-based model, involving systemic risk variables, but find that the effect is small after controlling for the risks of dilution and default. We apply our empirical estimates to the case of Brazil - a na- tural case study given its low degree of financial dollarization and very high real interest rates. The estimated model is unable to explain the high interest rate levels in the aftermath of Brazils 1994 inflation sta- bilization. However, since the adoption in 1999 of inflation targeting and floating exchange rates, Brazils real interest rates are found to be gradually converging to the models predicted values. The estimation also shows that further reductions in Brazils real interest rates could be achieved through sound fundamentals that led to investment-grade status rather than financial dollarization.