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
were both in the process of converting to the U.S. dollar during the 1990s.
"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 and the Australian dollar
. "Euroization" involves substituting the currency with the euro
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
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 (2013).
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.
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
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
(or officially 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.
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.
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 (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.
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 (the economy with currency substitution) 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:
- 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.
- 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.:1
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.
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.:13
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.
New Zealand dollar
British Overseas Territories using the Pound, or a local currency pegged to the Pound, as their currency:
Crown Dependencies using a local issue of the Pound as their currency:
South African rand
Countries/regions using the US dollar exclusively
Countries using the US dollar alongside other currencies
- Argentina (USD is used for major purchases such as buying properties)
- Barbados (Barbadian dollar pegged at 2:1 but USD is accepted)
- Belize (Belizean dollar pegged at 2:1 but USD is accepted)
- Bermuda (Bermudian dollar pegged at 1:1 but USD is accepted)
- Cambodia (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 US dollars and Cambodian riel. ATMs yield US dollars rather than Cambodian riel.)
- Costa Rica
- East Timor (uses its own coins)
- Ecuador (since 2000. Also uses its own coins):1
- Haiti (uses the U.S dollar alongside its domestic currency, the gourde)
- Honduras (used alongside the Honduran lempira)
- Lebanon (along with the Lebanese pound)
- Liberia (exclusively used the US dollar during the early PRC period, but the National Bank of Liberia began issuing five dollar coins in 1982;:3 United States dollar still in common usage alongside the Liberian dollar)
- North Korea (along with the Chinese yuan, euro, and North Korean won)
- Panama (since 1904. Also uses its own coins):6
- Somalia (along with the Somali shilling)
- Venezuela (along with the Venezuelan bolívar; due to hyperinflation, USD is used for major purchases such as buying electrical appliances, clothes, spare car parts and food)
- Zimbabwe since 2009 (alongside South African rand, British pound, Botswana pula, Chinese yuan, and several other currencies)
- ^ New estimates of U.S. currency abroad, the domestic money supply and the unreported Economy Edgar L. Feige September 2011.
- ^ a b c d e f g Berg, Andrew; Borensztein, Eduardo (2000). "The Pros and Cons of Full Dollarization". IMF Working Paper; Full Dollarization. IMF (/50). Retrieved 13 October 2011.
- ^ Yeyati (2003) at 1.
- ^ Rochon, Louis-Philippe (2003). Dollarization Lessons from Europe and the Americas. London and New York: Routledge. pp. 1.
- ^ a b Yeyati (2003) at 3.
- ^ a b Savastano at 7.
- ^ Yeyati (2003) at 5.
- ^ Balino; Berensztein (1999). "Monetary Policy in Dollarized Economies". IMF Occasional Paper 171.
- ^ Mundell, R. A. (1961). "A Theory of Optimum Currency Areas". American Economic Review. 51 (4): 657–665. JSTOR 1812792.
- ^ a b Bogetic (200). "Official Dollarization: Current Experiences and Issues". Cato Journal. 20 (2): 179–213.
- ^ Berkmen, S. Pelin; Cavallo, Eduardo (2010). "Exchange Rate Policy and Liability currency substitution: What Do the Data Reveal about Causality?". Review of International Economics. 18 (5): 781–795. doi:10.1111/j.1467-9396.2010.00890.x.
- ^ Pinon, Marco (2008). Macroeconomic Implications of Financial currency substitution The Case of Uruguay. Washington DC: International Monetary Fund. p. 22.
- ^ a b Alesina, Alberto; Barro (2001). "Dollarization". The American Economic Review. 91 (2): 381–385. doi:10.1257/aer.91.2.381. JSTOR 2677793.
- ^ a b Yeyati (2003) at 22.
- ^ Rose, Andrew (2000). "One Money, One Market: the effect of common currencies on trade". Economic Policy. 15 (30): 8–0. doi:10.1111/1468-0327.00056.
- ^ Honohan, Patrick (2007). "Dollarization and Exchange Rate Fluctuations". World Bank Policy Research Working Paper. Policy Research Working Papers (4172). doi:10.1596/1813-9450-4172. hdl:10986/7252.
- ^ Alesina, Alberto; Barro (2001). "Dollarization". The American Economic Review. 91 (2): 382. doi:10.1257/aer.91.2.381. JSTOR 2677793.
- ^ Yeyati (2003) at 23.
- ^ Edwards, Sebastian; Magendzo, I. Igal (2003). "Dollarization And Economic Performance: What Do We Really Know?". International Journal of Finance and Economics. 8 (4): 351–363. CiteSeerX 10.1.1.557.6231. doi:10.1002/ijfe.217.
- ^ Broda, Levy Yeyati, Christian, Eduardo (2003). "Endogenous deposit dollarization". Federal Reserve Bank of New York.
- ^ Moreno-Bird, Juan Carlos (Fall 1999). "Dollarization in Latin America: Is it desirable?". ReVista: Harvard Review of Latin America. Archived from the original on 11 August 2011. Retrieved 27 June 2012.
- ^ John, Kareken; Wallace (1981). "On the Indeterminacy of Equilibrium Exchange Rates". Quarterly Journal of Economics. 96 (2): 207–222. doi:10.2307/1882388. JSTOR 1882388.
- ^ Yeyati, Eduardo Levy (2008). "Liquidity Insurance in a Financially Dollarized Economy". In Edwards; Garcia (eds.). Financial Markets Volatility and Performance in Emerging Markets. University of Chicago Press. pp. 185–218. ISBN 978-0-226-18495-1.
- ^ Bencivenga, Valerie; Huybens, Smith (2001). "Dollarization and the Integration of International Capital Markets: a Contribution to the Theory of Optimal Currency Areas". Journal of Money, Credit and Banking. 33 (2, Part 2): 548–589. doi:10.2307/2673916. JSTOR 2673916.
- ^ Broda, Christian; Yeyati (2001). "Dollarization and the Lender of Last Resort". Book: Dollarization: 100–131.
- ^ Yeyati (2003) at 31.
- ^ Kutan, Rengifo, Ozsoz, Ali, Erick, Emre. "Evaluating the Effects of Deposit Dollarization in Bank Profitability" (PDF). Fordham University Economics Department.[permanent dead link]
- ^ Yeyati (2003) at 34.
- ^ "Federal Reserve Bank of Atlanta, Official Dollarization and the Banking System in Ecuador and El Salvador, 2006" (PDF). Archived from the original (PDF) on 19 October 2012. Retrieved 14 September 2012.
- ^ a b c Savastano.
- ^ a b Sahay, Ratna; Vegh, Carlos (September 1995). "Dollarization in Transition Economies: Evidence and Policy Implications". IMF Working Paper No. 95/96. SSRN 883243.
- ^ Catão, Luis; Terrrones, Marco E. (August 2000). "Determinants of Dollarization: The Banking Side". IMF Working Paper No. 00/146: 5. SSRN 879949.
- ^ a b c d e f g h i j Edwards, Sebastian (May 2001). "Dollarization and Economic Performance: An Empirical Investigation". NBER Working Paper No. 8274. doi:10.3386/w8274.
- ^ a b Ruwitch, John; Park, Ju-min (2 June 2013). "Insight: North Korean economy surrenders to foreign currency invasion". Reuters. Changbai, China/Seoul. Retrieved 11 January 2017.
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- ^ Pilling, David; Peel, Michael (28 July 2014). "Cambodia: Wave of discontent". Financial Times. Retrieved 11 January 2017. Dollars account for 90 per cent of money in Cambodia’s banking system and almost the same proportion of cash used in everyday transactions, according to official estimates.
- ^ Carter, Chris (8 May 2013). "Economy: The effect of dollarisation in Honduras". Pulsamerica. Archived from the original on 13 January 2017. Retrieved 11 January 2017.
- ^ Pinon, Marco; Gelos, Gaston (28 August 2008). "Uruguay's Monetary Policy Effective Despite Dollarization". IMF Survey Magazine. Retrieved 4 March 2012.
- ^ Zerpa, Fabiola (5 November 2019). "Venezuela Is Now More Than 50% Dollarized, Study Finds". Bloomberg. Retrieved 9 November 2019.
- ^ "Maduro says 'thank God' for dollarization in Venezuela". Reuters. 17 November 2019. Retrieved 18 November 2019.
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