http://researchcommons.waikato.ac.nz/ Research Commons at the University of Waikato Copyright Statement: The digital copy of this thesis is protected by the Copyright Act 1994 (New Zealand). The thesis may be consulted by you, provided you comply with the provisions of the Act and the following conditions of use: Any use you make of these documents or images must be for research or private study purposes only, and you may not make them available to any other person. Authors control the copyright of their thesis. You will recognise the author’s right to be identified as the author of the thesis, and due acknowledgement will be made to the author where appropriate. You will obtain the author’s permission before publishing any material from the thesis. An Investigation of the Macroeconomic and Monetary Effects of Dollarization in Eritrea A thesis submitted in fulfilment of the requirements for the degree of Doctor of Philosophy in Economics at The University of Waikato by Lula G. Mengesha 2013 i Abstract 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 ii 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. iii 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. iv Notes on Papers for Publication From this thesis, the following papers have been submitted for publication. Some of these papers have also been presented at conferences. PUBLICATION . The Dollarization of Less Developed Countries: A Note on the Computation of a Hard Currency Index, Journal of International Economics and Research (Published) PAPERS . Does Dollarization Alleviate or Aggravate Exchange Rate Volatility? Journal of Economic Development (Accepted) . Monetary Policy and its Transmission Mechanisms in Eritrea, Journal of Policy Modeling (Accepted) . Does Dollarization Reduce or Produce Inflation? Journal of Economic studies (Under Revision) . The How, Why and What questions of Dollarization, Economic Notes (Under Review) . Dollarization and its Determinants in the Eritrean Economy, Journal of African Development (Under Review) . On Dollarization and Monetary Policy Transmission Mechanisms (to be submitted in the near future) CONFERENCES . The 9th Biennial Pacific Rim Conference of the Western Economic Association International (WEAI), Brisbane, Australia (April, 2011) (Does Dollarization Alleviate or Aggravate Exchange Rate Volatility?) . The 14th Annual Waikato Management School Student Research Conference, Hamilton (October, 2010) (Does Dollarization Alleviate or Aggravate Exchange Rate Volatility?) . The 15th Annual Waikato Management School Student Research Conference, Hamilton (October, 2011) (Does Dollarization Reduce or Produce More Inflation?) . The 16th Annual Waikato Management School Student Research Conference, Hamilton (October, 2012) (Dollarization and Monetary Policy Transmission Mechanisms) v Acknowledgments First of all, I would like to thank the invisible one yet visible in his work, the Lord God Almighty, for His invisible assistantship yet visible in effect. I am grateful for all His provision of wisdom and understanding to overcome the challenges encountered during the course of writing. To Him and to Him alone be all the praises. I am indebted to Professor Rose Anne Devlin who provided personal financial assistantship that bridged me over the most critical period of the program in Canada. I am grateful to the scholarship committee at the University of Waikato for their decisions to support the research through the provision of funding. I am also thankful to Gwenda Pennington at the Scholarship Office for her timely information and friendly approach. I would like to thank my chief supervisor, Professor Mark Holmes, for all his time, comments, suggestions and advice in shaping up the thesis and also for his encouragement and help in sending out the papers for publication. I am very grateful for his support in writing the recommendation letters for the scholarship application in the midst of his busy schedule and also for his econometrics resources that helped me in the analytical part of the thesis. I would also like to thank my second supervisor, Professor John Gibson, for taking up a supervisory role and for his helpful comments. I am thankful to Associate Professor John Tressler and Doctor Dan Marsh for their support of the scholarship application and also Maria Fitzgerald for her excellent service provision in dealing with the administrative aspects related to the thesis. I would also like to extend my gratitude to the organisers of the Doctoral Writing Conversation, especially to Andrea Haines and Marcia Johnson, for organising very timely and helpful sessions that motivate and support students during the thesis writing process. I always felt recharged after attending these sessions and ready to carry on the race. I am also grateful to Grant Harris and the team at the University of Waikato‟s Language and Learning Development Unit for their assistance with academic writing.