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Currency substitution is the use of a foreign currency in parallel to or instead of a domestic currency.[New estimates of U.S. currency abroad, the domestic money supply and the unreported Economy Edgar L. Feige September 2011.]
Currency substitution can be full or partial. Full currency substitution can occur after a major economic crisis, such as in Ecuador. Some small economies, for whom it is impractical to maintain an independent currency, use the currencies 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 or use it as exchange currency, as is currently the case in Venezuela.
Name
"Dollarization", when referring to currency substitution, does not necessarily involve use of the United States dollar. The major currencies used as substitutes are the US dollar and the
euro.
Origins
:
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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 (i.e. currency boards) or relinquish control over their own currency (such as currency unions) while "soft pegs" are more flexible and floating exchange rate regimes.[Yeyati (2003) at 1.] 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.[Yeyati (2003) at 3.] Panama adopted the US dollar as legal tender after independence as the result of a constitutional ruling.[Yeyati (2003) at 5.]
Measures
There are two common indicators of currency substitution. The first measure is the share of foreign currency deposits (FCD) 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.
[Savastano at 7.]
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.
Currency substitution can be used semiofficially (or officially, in bimonetary systems), 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 dollarization. External liability currency substitution measures total external debt (private and public) denominated in foreign currencies of the economy.
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.
[Yeyati (2003) at 22.] Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and stabler prices. Rose (2000) 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.
[Yeyati (2003) at 23.] 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.
In 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.
[Yeyati (2003) at 31.]
Commercial banks in countries where saving accounts and loans in foreign currency are allowed may face two types of risks:
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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.
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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.
[Yeyati (2003) at 34.] 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 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.
[Savastano.] 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 (1998) 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
Euro
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(formerly French franc and Spanish peseta; issued non-circulating Andorran diner coins; issues its own euro coins). Since 1278, Andorra has used its neighbours' currencies, at the time the Counties of Foix, in present-day France, and of Urgell, in Catalonia.
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(Sovereign Base Areas of Akrotiri and Dhekelia); formerly used the Cypriot pound)
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(used in the overseas territories of the French Southern Territories, Saint Barthélemy, and Saint Pierre and Miquelon. Euro is used in the French overseas and department region of Guadeloupe)
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(pegged to the CFP franc at a fixed exchange rate)
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(pegged to the CFP franc at a fixed exchange rate)
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(pegged to the CFP franc at a fixed exchange rate)
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(formerly Deutsche Mark and Yugoslav dinar)
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(formerly French franc from 1865 to 2002 and Monégasque franc;
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(formerly Deutsche Mark and Yugoslav dinar)
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(alongside the renminbi, North Korean won, and United States dollar)
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(formerly Italian lira and Sammarinese lira; issues its own euro coins)
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(issues non-circulating Maltese scudo coins at €0.24 = 1 scudo)
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(formerly Italian lira and Vatican lira; issues its own euro coins)
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(alongside the United States dollar, South African rand, Botswana pula, Japanese yen, several other currencies and the Zimbabwean ZiG)
Indian rupee
New Zealand dollar
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(issues its own coins and some notes.)
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(also issues Niue dollar minted at the New Zealand Mint, pegged to the New Zealand dollar.)
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(also issues its own non-circulating commemorative and collector coins pegged to the New Zealand dollar.)
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(also issues its own non-circulating commemorative and collector coins pegged to the New Zealand dollar.)
Pound sterling
British Overseas Territories using the pound, or a local currency pegged to the pound, as their currency:
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(issues non-circulating collector coins for the British Antarctic Territory.)
[
]
Retrieved on 2023-01-17.
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( de jure, U.S. dollar used de facto; also issues non-circulating collector coins for the British Indian Ocean Territory.)
[
Retrieved on 2023-01-17.]
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(alongside the Falkland Islands pound)
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(alongside the Gibraltar pound)
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(Tristan da Cunha; alongside the Saint Helena pound in Saint Helena and Ascension Island; also issues non-circulating collector coins for Saint Helena, Ascension and Tristan da Cunha.)
[
Retrieved on 2023-01-17.]
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(alongside the Falkland Islands pound; also issues non-circulating collector coins for South Georgia and the South Sandwich Islands.)
[
Retrieved on 2023-01-17.]
The Crown Dependencies use a local issue of the pound as their currency:
Under plans published in the Sustainable Growth Commission report by the Scottish National Party, an independent Scotland would use the pound as their currency for the first 10 years of independence. This has become known as sterlingisation.
Other countries:
South African rand
United States dollar
Used exclusively
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(also issues non-circulating British Virgin Islands collector coins pegged to the U.S. dollar)
[
Retrieved on 2022-09-03.]
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Caribbean Netherlands (since 1 January 2011)
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(issued non-circulating collector coins of the Marshall Islands pegged to the U.S. dollar since 1986)
[
Retrieved on 2022-09-03.]
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(since 1944)
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(since 1944; issued non-circulating Palauan collector coins pegged to the U.S. dollar since 1992)
[
Retrieved on 2022-07-22.]
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(issued non-circulating Turks and Caicos Islands collector coins denominated in "Crowns" and pegged to the U.S. dollar since 1969)
[
Retrieved on 2022-09-03.]
Used partially
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(the United States dollar is used for major purchases such as buying properties)
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(Bahamian dollar pegged at 1:1 but the United States dollar is accepted)
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(Barbadian dollar pegged at 2:1 but the United States dollar is accepted)
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(Belizean dollar pegged at 2:1 but the United States dollar is accepted)
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(Bermudian dollar pegged at 1:1 but the United States dollar is accepted)
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(alongside the Bolivian boliviano)
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(uses the Cambodian riel for many official transactions but most businesses deal exclusively in dollars for all but the cheapest items. Change is often given in a combination of U.S. dollars and Cambodian riel. ATMs yield U.S. dollars rather than Cambodian riel)
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(many institutions accept both the Congolese franc and U.S. dollars)
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(uses alongside the Costa Rican colón)
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(uses alongside the Dominican peso)
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(since 2000; also uses its own coins)
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(uses alongside bitcoin) (see Bitcoin Law and Bitcoin in El Salvador)
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(uses alongside the Guatemalan quetzal)
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(uses the U.S. dollar alongside its domestic currency, the Haitian gourde)
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(uses alongside the Honduran lempira)
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(alongside the Iraqi dinar)
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(alongside the Lebanese pound)
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(exclusively used the U.S. dollar during the early PRC period, but the National Bank of Liberia began issuing five dollar coins in 1982;
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(uses alongside the Nicaraguan córdoba)
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(alongside the euro, North Korean won, and renminbi)
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(since 1904; also uses its own coins)
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(the main currency is the Paraguayan guaraní)
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(the main currency is the Peruvian sol)
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(alongside the Somali shilling)
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(alongside the Somaliland shilling)
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(uses its own coins)
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(alongside the Venezuelan bolívar; due to hyperinflation, USD is used for purchases such as buying electrical appliances, clothes, spare car parts, and food)
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(alongside the Vietnamese đồng)
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(since 2020; alongside the South African rand, pound sterling, Botswana pula, Japanese yen, and the Zimbabwean ZiG)
Others
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Algerian dinar: Sahrawi Arab Democratic Republic ( de facto independent state, recognized by 45 UN member states, but mostly occupied by Morocco; used in the Sahrawi refugee camps)
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Botswana pula: (alongside several other currencies and U.S. dollar-denominated bond coins and bond notes of the Real Time Gross Settlement (RTGS) dollar)
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Brunei dollar: (alongside the Singapore dollar)
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Canadian dollar: (alongside the euro)
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Renminbi: (alongside several other currencies and U.S. dollar-denominated bond coins and bond notes of the Real Time Gross Settlement (RTGS) dollar)
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Colombian peso: (mainly in western states, alongside U.S. dollar)
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Danish krone:
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(also issues its own coins and some notes)
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Egyptian pound: (Palestinian territories)
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Hong Kong dollar: (alongside the Macanese pataca, pegged at $1.032)
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Japanese yen: (alongside several other currencies and the Zimbabwean ZiG)
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Jordanian dinar: (alongside the New Israeli shekel)
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Mauritanian ouguiya: ( de facto independent state, recognized by 45 UN member states, but mostly occupied by Morocco; used in the Sahrawi refugee camps)
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Moroccan dirham: ( de facto independent state, recognized by 45 UN member states, but mostly occupied by Morocco; used in claimed areas under Moroccan control; issues the non-circulating Sahrawi peseta for collectors)
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New Israeli shekel: (Palestinian territories)
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Russian ruble:
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( de facto independent state, but recognized as a part of Georgia internationally; issues non-circulating collector coins and non-circulating banknotes (Abkhazian apsar) pegged to the Russian ruble)
[
Retrieved on 2022-10-14.]
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( de facto independent state, but recognized as a part of Georgia internationally; issues non-circulating collector coins (South Ossetian zarin) pegged to the Russian ruble)
[
Retrieved on 2022-10-14.]
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Singapore dollar: (alongside the Brunei dollar at par)
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Swiss franc:
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(uses in the exclave of Büsingen am Hochrhein, alongside the euro)
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(uses in the enclave of Campione d'Italia, alongside the euro)
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(also issues non-circulating collector coins)
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Turkish lira: ( de facto independent state, but recognized as a part of Cyprus by all UN member states except Turkey. The Euro is also accepted in circulation in Northern Cyprus)
See also
Footnotes
Works cited
