Currency substitution occurs when residents of a country use a foreign currency in parallel to or instead of the domestic currency. It is a phenomenon that arises due to high inflation, economic instability, loss of confidence in the domestic currency, or political uncertainty in a country. Currency substitution has implications for monetary policy, exchange rate management, and economic growth. This comprehensive guide examines the causes, types, effects, examples, and solutions for currency substitution.
Introduction
Currency substitution refers to the use of foreign money as a medium of exchange and store of value within the boundaries of a country. It happens when individuals hold foreign currency bank deposits, conduct transactions in foreign money, or prefer assets denominated in foreign currencies. Typically, substitution occurs when there is a loss of confidence in the domestic currency due to high inflation, exchange rate volatility, or political instability.
The phenomenon leads to partial dollarization, bi-monetization, or full dollarization of an economy. Partial dollarization happens when residents use both domestic and foreign moneys. Bi-monetization is the circulation of two moneys with the foreign money being used for specific transactions or higher denominations. Full dollarization is when the foreign money completely replaces the domestic legal tender.
Currency substitution has implications on the conduct of monetary policy, exchange rate management, interest and inflation rates, international reserves, and overall economic performance. This guide examines the causes, types, effects, historical examples, and potential solutions to currency substitution.
Causes of Currency Substitution
Several factors lead to currency substitution in an economy:
High Inflation
High and volatile inflation erodes the value of a domestic currency and reduces its purchasing power. As the local money loses value rapidly, people opt for stable foreign currencies to preserve wealth. Hyperinflation exceeding 50% per month can quickly lead to substitution.
Currency Devaluations
Frequent devaluations where a government deliberately reduces the exchange rate value of its currency also contribute to dollarization. Expectations of future devaluations due to expansionary monetary policy undermine confidence in the local money.
Political Instability
Political unrest, regime changes, uncertainty around economic policies, and lack of central bank independence increase currency substitution. People fear wealth expropriation or confiscation during periods of instability.
Financial Crisis
Banking and debt crises such as sovereign defaults on external debt obligations can erode trust in the domestic currency leading to partial or full substitution. This may be exacerbated by bank account freezes, withdrawal limits, and collapse of the payments system.
Capital Flight
Residents rapidly move domestic financial assets abroad to avoid depreciation and instability. This capital flight exacerbates currency substitution.
Trade and Financial Openness
Increased trade and financial integration with countries using a dominant currency facilitate its adoption for transactions and as a store of value. For countries closely integrated with the U.S., the dollar naturally becomes the substitute currency.
Types of Currency Substitution
There are three main types of currency substitution:
Dollarization of Assets
Residents prefer to denominate financial assets such as bank deposits, stocks, bonds, insurance, and pensions in stable foreign currencies. Additionally, they use foreign money for savings and wealth storage. Asset substitution arises from expectations of depreciation of the domestic currency.
Dollarization of Transactions
Individuals directly use foreign money as a medium of exchange for payments and pricing of goods and services within the domestic economy. It manifests in twin-currency pricing. The share of transactions in foreign money increases with high expected inflation and currency depreciation.
Official Dollarization
The government adopts a foreign currency as the exclusive legal tender, abandoning the domestic currency. Panama, Ecuador, El Salvador, and Zimbabwe are examples of full official dollarization. It helps stabilize inflation and monetary policy but leads to loss of seigniorage revenues and monetary policy autonomy.
Effects of Currency Substitution
Here are some notable economic effects of currency substitution:
Reduced Monetary Policy Effectiveness
With partial or full dollarization, the central bank loses control over money supply, credit, and interest rates. Conventional monetary tools like exchange rate targetting, inflation targeting, interest rates, reserve requirements become less effective or unusable.
Loss of Seigniorage and Credit Creation Ability
The government loses seigniorage revenues from printing money as currency issuance is now backed by foreign reserves rather than domestic credit creation. It limits the ability to finance deficits and debt monetization.
Limited Lender of Last Resort Capability
The central bank cannot create domestic currency to implement lender of last resort facilities in times of banking or debt crises. This necessitates large foreign exchange reserves.
Altered Inflation Dynamics
Currency substitution alters inflation dynamics. While it may help stabilize very high inflation when the foreign money has low inflation, it can potentially import foreign inflation to the substituting economy.
Reduced Capital Inflows and Investment
Uncertainty from currency substitution can discourage foreign capital inflows and investment until stabilization occurs. It leads to lower economic growth.
Increased Exposure to External Shocks
Over-dependence on a foreign currency reduces the insulation from financial crises or economic shocks in major currency countries. Monetary policy abroad directly affects the domestic economy.
Alteration of Exchange Rate Regimes
Heavy currency substitution typically forces countries to adopt fixed exchange rates or even official dollarization to manage external stability. This leads to loss of independent monetary policy.
Historical Examples of Currency Substitution
Some notable historical cases of currency substitution include:
Dollarization in Ecuador
Repeated economic crises and instability during the 1980s and 1990s led Ecuador to officially dollarize its economy in 2000. It helped stabilize inflation and monetary policy.
German Occupation Currency in World War 2
Nazi Germany imposed its Reichsmark currency in occupied territories during World War 2 leading to substitution of local currencies between 1939-1945.
Dollarization in Zimbabwe
Hyperinflation exceeding 89.7 sextillion percent in 2008 following a decade of economic crises led Zimbabwe to adopt the US dollar and South African rand as legal tender.
Euroization in Kosovo and Montenegro
Despite not being part of the Eurozone, Kosovo and Montenegro have adopted the euro as their official currency due to their close ties with the European Union.
Bitcoin Use in Venezuela and Argentina
Venezuela and Argentina have witnessed growing use of decentralized cryptocurrency Bitcoin as a store of value and means of exchange due to very high inflation in their economies.
Policy Solutions for Currency Substitution
If currency substitution is only minor and temporary, it may not require policy changes. However, significant substitution requires reforms to rebuild confidence in the domestic currency:
Adopt a Nominal Anchor
This involves pegging the exchange rate, using a currency board, or officially dollarizing to stabilize expectations. Currency boards helped reduce substitution in Estonia and Lithuania after the collapse of the Soviet Union.
Reduce Inflation
Undertake fiscal reforms, avoid deficit monetization, establish central bank independence, and pursue prudent monetary policy to lower inflation. This helps revive confidence in the domestic currency.
Regain Policy Credibility
Institutional reforms and commitment mechanisms like inflation targeting help strengthen central bank independence and credibility. This reassures economic actors.
Capital Account Liberalization
Allow free inflows and outflows of capital to prevent capital flight. This enables the return of external assets denominated in foreign currencies back into the domestic financial system over time.
Prioritize Currency Stability
Make currency stability an explicit policy goal and communicate policy intentions clearly. This helps coordinate expectations and confidence.
Conclusion
Currency substitution emerges due to loss of faith in the domestic currency from high inflation, devaluations, financial crises, or political instability. It leads to partial or full dollarization and has implications for monetary policy conduct, seigniorage revenues, external stability, capital flows, and growth. While stabilization reforms take time, reducing inflation and establishing policy credibility are key initial steps. With prudent reforms, currency substitution can be managed and reversed over the long-term.
