Currency substitution


Currency substitution or dollarization is the use of a foreign currency in parallel to or instead of the domestic currency.
Currency substitution can be full or partial. Most, if not all, full currency substitution has taken place after a major economic crisis, for example, Ecuador and El Salvador in Latin America and Zimbabwe in Africa. Some small economies, for whom it is impractical to maintain an independent currency, use those of their larger neighbours; for example Liechtenstein uses the Swiss franc.
Partial currency substitution occurs when residents of a country choose to hold a significant share of their financial assets denominated in a foreign currency. It can also occur as a gradual conversion to full currency substitution, for example, Argentina and Peru were both in the process of converting to the U.S. dollar during the 1990s.

Name

"Dollarization", when referring to currency substitution, does not necessarily involve use of the United States dollar. The currencies that have been used as substitutes have been the US dollar, the euro, and the Australian dollar.

Origins

After the gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II, some countries sought exchange rate regimes to promote global economic stability, and hence their own prosperity. Countries usually peg their currency to a major convertible currency. "Hard pegs" are exchange rate regimes that demonstrate a stronger commitment to a fixed parity or relinquish control over their own currency while "soft pegs" are more flexible and floating exchange rate regimes. The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led to currency substitution becoming a serious policy issue.
A few cases of full currency substitution prior to 1999 had been the consequence of political and historical factors. In all long-standing currency substitution cases, historical and political reasons have been more influential than an evaluation of the economic effects of currency substitution. Panama adopted the US dollar as legal tender after independence as the result of a constitutional ruling. Ecuador and El Salvador became fully dollarized economies in 2000 and 2001 respectively, for different reasons. Ecuador underwent currency substitution to deal with a widespread political and financial crisis resulting from massive loss of confidence in its political and monetary institutions. By contrast, El Salvador's official currency substitution was a result of internal debates and in a context of stable macroeconomic fundamentals and long-standing unofficial currency substitution. The eurozone adopted the euro as its common currency and sole legal tender in 1999, which might be considered a variety of full-commitment regime similar to full currency substitution despite some evident differences from other currency substitutions. For more on dollarisation, cf. Fields, David, and Matías Vernengo. "Dollarization." The Wiley-Blackwell Encyclopedia of Globalization.

Measures

There are two common indicators of currency substitution. The first measure is the share of foreign currency deposits in the domestic banking system in the broad money including FCD. The second is the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets.

Types

Unofficial currency substitution or de facto currency substitution is the most common type of currency substitution. Unofficial currency substitution occurs when residents of a country choose to hold a significant share of their financial assets in foreign currency, even though the foreign currency is not legal tender there. They hold deposits in the foreign currency because of a bad track record of the local currency, or as a hedge against inflation of the domestic currency.
Official currency substitution or full currency substitution happens when a country adopts a foreign currency as its sole legal tender, and ceases to issue the domestic currency. Another effect of a country adopting a foreign currency as its own is that the country gives up all power to vary its exchange rate. There are a small number of countries adopting a foreign currency as legal tender.
Full currency substitution has mostly occurred in Latin America, the Caribbean and the Pacific, as many countries in those regions see the United States Dollar as a stable currency compared to the national one. For example, Panama underwent full currency substitution by adopting the US dollar as legal tender in 1904. This type of currency substitution is also known as de jure currency substitution.
Currency substitution can be used semiofficially, where the foreign currency is legal tender alongside the domestic currency.
In literature, there is a set of related definitions of currency substitution such as external liability currency substitution, domestic liability currency substitution, banking sector's liability currency substitution or deposit currency substitution, and credit dollarlization. External liability currency substitution measures total external debt denominated in foreign currencies of the economy. Deposit currency substitution can be measured as the share of foreign currency deposits in the total deposits of the banking system, and credit currency substitution can be measured as the share of dollar credit in the total credit of the banking system.

Effects

On trade and investment

One of the main advantages of adopting a strong foreign currency as sole legal tender is to reduce the transaction costs of trade among countries using the same currency. There are at least two ways to infer this impact from data. The first is the significantly negative effect of exchange rate volatility on trade in most cases, and the second is an association between transaction costs and the need to operate with multiple currencies. Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and stabler prices. Rose applied the gravity model of trade and provided empirical evidence that countries sharing a common currency engage in significantly increased trade among them, and that the benefits of currency substitution for trade may be large.
Countries with full currency substitution can invoke greater confidence among international investors, inducing increased investments and growth. The elimination of the currency crisis risk due to full currency substitution leads to a reduction of country risk premiums and then to lower interest rates. These effects result in a higher level of investment. However, there is a positive association between currency substitution and interest rates in a dual-currency economy.

On monetary and exchange rate policies

Official currency substitution helps to promote fiscal and monetary discipline and thus greater macroeconomic stability and lower inflation rates, to lower real exchange rate volatility, and possibly to deepen the financial system. Firstly, currency substitution helps developing countries, providing a firm commitment to stable monetary and exchange rate policies by forcing a passive monetary policy. Adopting a strong foreign currency as legal tender will help to "eliminate the inflation-bias problem of discretionary monetary policy". Secondly, official currency substitution imposes stronger financial constraint on the government by eliminating deficit financing by issuing money. An empirical finding suggests that inflation has been significantly lower in economies with full currency substitution than nations with domestic currencies. The expected benefit of currency substitution is the elimination of the risk of exchange rate fluctuations and a possible reduction in the country's international exposure. Currency substitution cannot eliminate the risk of an external crisis but provides steadier markets as a result of eliminating fluctuations in exchange rates.
On the other hand, currency substitution leads to the loss of seigniorage revenue, the loss of monetary policy autonomy, and the loss of the exchange rate instruments. Seigniorage revenues are the profits generated when monetary authorities issue currency. When adopting a foreign currency as legal tender, a monetary authority needs to withdraw the domestic currency and give up future seigniorage revenue. The country loses the rights to its autonomous monetary and exchange rate policies, even in times of financial emergency. For example, former chairman of the Federal Reserve Alan Greenspan has stated that the central bank considers the effects of its decisions only on the US economy. In a full currency substituted economy, exchange rates are indeterminate and monetary authorities cannot devalue the currency. In an economy with high currency substitution, devaluation policy is less effective in changing the real exchange rate because of significant pass-through effects to domestic prices. However, the cost of losing an independent monetary policy exists when domestic monetary authorities can commit an effective counter-cyclical monetary policy, stabilizing the business cycle. This cost depends adversely on the correlation between the business cycle of the client country and the business cycle of the anchor country. In addition, monetary authorities in economies with currency substitution diminish the liquidity assurance to their banking system.

On banking systems

In an economy with full currency substitution, monetary authorities cannot act as lender of last resort to commercial banks by printing money. The alternatives to lending to the bank system may include taxation and issuing government debt. The loss of the lender of last resort is considered a cost of full currency substitution. This cost depends on the initial level of unofficial currency substitution before moving to a full currency substituted economy. This relation is negative because in a heavily currency substituted economy, the central bank already fears difficulties in providing liquidity assurance to the banking system. However, literature points out the existence of alternative mechanisms to provide liquidity insurance to banks, such as a scheme by which the international financial community charges an insurance fee in exchange for a commitment to lend to a domestic bank.
Commercial banks in countries where saving accounts and loans in foreign currency are allowed may face two types of risks:
  1. Currency mismatch risk: Assets and liabilities on the balance sheets may be in different denominations. This may arise if the bank converts foreign currency deposits into local currency and lends in local currency or vice versa.
  2. Default risk: Arises if the bank uses the foreign currency deposits to lend in foreign currency.
However, currency substitution eliminates the probability of a currency crisis that negatively affects the banking system through the balance sheet channel. Currency substitution may reduce the possibility of systematic liquidity shortages and the optimal reserves in the banking system. Research has shown that official currency substitution has played a significant role in improving bank liquidity and asset quality in Ecuador and El Salvador.

Determinants of the currency substitution process

The dynamics of the flight from domestic money

High and unanticipated inflation rates decrease the demand for domestic money and raise the demand for alternative assets, including foreign currency and assets dominated by foreign currency. This phenomenon is called the "flight from domestic money". It results in a rapid and sizable process of currency substitution. In countries with high inflation rates, the domestic currency tends to be gradually displaced by a stable currency. At the beginning of this process, the store-of-value function of the domestic currency is replaced by the foreign currency. Then, the unit-of-account function of the domestic currency is displaced when many prices are quoted in a foreign currency. A prolonged period of high inflation will induce the domestic currency to lose its function as medium of exchange when the public carries out many transactions in foreign currency.
Ize and Levy-Yeyati examine the determinants of deposit and credit currency substitution, concluding that currency substitution is driven by the volatility of inflation and the real exchange rate. Currency substitution increases with inflation volatility and decreases with the volatility of the real exchange rate.

Institutional factors

The flight from domestic money depends on a country's institutional factors. The first factor is the level of development of the domestic financial market. An economy with a well-developed financial market can offer a set of alternative financial instruments denominated in domestic currency, reducing the role of foreign currency as an inflation hedge. The pattern of the currency substitution process also varies across countries with different foreign exchange and capital controls. In a country with strict foreign exchange regulations, the demand for foreign currency will be satisfied in the holding of foreign currency assets abroad and outside the domestic banking system. This demand often puts pressure on the parallel market of foreign currency and on the country's international reserves. Evidence for this pattern is given in the absence of currency substitution during the pre-reform period in most transition economies, because of constricted controls on foreign exchange and the banking system. In contrast, by increasing foreign currency reserves, a country might mitigate the shift of assets abroad and strengthen its external reserves in exchange for a currency substitution process. However, the effect of this regulation on the pattern of currency substitution depends on the public's expectations of macroeconomic stability and the sustainability of the foreign exchange regime.

Anchor currencies

Australian dollar

Countries using the US dollar exclusively

Works cited