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There has been an ongoing debate on whether dollarization helps stabilize exchange rates for emerging economies. This paper discusses this issue in a highly dollarized country, Cambodia, by empirically examining the relationship between dollarization and exchange rate movements. The GARCH analysis suggests that dollarization induces the depreciation of the Cambodian riel as well as intensifies exchange rate variability. The result is consistent with the argument that dollarization is one of the crucial causes of exchange rate instability. Dollarization in Cambodia could be a constraint on poverty reduction since it tends to affect the living standard of the poor who earn the income in the riel through the depreciation of the currency and intensified volatility of exchange rates.
Keywords: Dollarization, exchange rates, Cambodia.
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I. Introduction
Prolonged price instability has enforced some developing countries to allow for free circulation of foreign currency, particularly the U.S. dollar, alongside their local currency. Cambodia is now one of the highly dollarized economies.1 However, this does not imply that exchange rates are irrelevant to the economy. Indeed, exchange rates are still one of the main concerns for low-income people, especially in rural areas, since most of them receive their daily earnings in the local currency, the riel (Beresford et al. 2004; Kang 2005). 2 Given the fact that Cambodia has been adopting floating, although managed, exchange rate regime since 1993, the National Bank of Cambodia (NBC) has always paid attention to exchange rate movements. Due to the high degree of dollarization, exchange rate becomes the only tool for managing monetary policy in order to stabilize the price level since NBC does not have any other effective tools to manage its monetary policy (Beresford et al. 2004; Kang 2005; Pum and Vanak 2010).
A main focus in this study is on the relationship between dollarization and exchange rate movements in Cambodia. Although some literature on currency substitution mentions that dollarization mitigates price instability,3 several studies, such as McKinnon (1982, 1993), Willett and Banaian (1996), Akçay, Alper and Karasulu (1997), Berg and Borensztein (2000), and Yinusa (2008), emphasize that dollarization could be a crucial source to exchange rate instability. Despite its importance of this issue, only a few attempts have been made to evaluate dollarization especially in...