Currency substitution: Difference between revisions

This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. Find sources: "Currency substitution" – news · newspapers · books · scholar · JSTOR (January 2010) (Learn how and when to remove this message)

Dollarization occurs when the inhabitants of a country use foreign currency in parallel to or instead of the domestic currency as a store of value, unit of account, and/or medium of exchange within the domestic economy.^[1] The term is not only applied to usage of the United States dollar, but generally to the use of any foreign currency as the national currency. There are two common indicators of dollarization. The first one is the share of foreign currency deposits (FCD) in the domestic banking system in the broad money including of FCD. The second measure is the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets.^[2]

According to Fields & Vernengo (2013), the expression of ‘dollarization’ has at least two different meanings. In the narrow sense, it refers to massive currency substitution, in which a country, most likely a developing one, supplements its domestic reserve assets with a foreign currency, more often than not the United States dollar or, in some cases, the euro. Note that currency substitution could be complete and might even imply the elimination of a domestic token as legal tender. Full dollarization in that sense has taken place in small countries, mostly in Latin America, the Caribbean and the Pacific which are heavily dependent on the United States. Dollarization, in this sense, is the exemplification of a country foregoing its national ‘monetary sovereignty’ (Mundell 1961, p. 661). In the broader sense, dollarization can refer to US hegemony in the world economy as a result of the US dollar being the medium of exchange and unit of account in international markets. Of particular importance in this context is the fact that the key international commodities, including oil, are priced in US dollars in international markets.

The biggest economies to have officially dollarized as of June 2002 are Panama (since 1904), Ecuador (since 2000), and El Salvador (since 2001). As of August 2005^[update], the United States dollar, the Euro, the New Zealand dollar, the Swiss franc, the Indian rupee, and the Australian dollar were the only currencies used by other countries for official dollarization. In addition, the Armenian dram, Turkish lira, the Israeli shekel, and the Russian ruble are used by internationally unrecognized but de facto independent states.

After the gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II, some countries were desperately seeking 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 extreme 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 and dollarization) while "soft pegs" are more flexible and floating exchange rate regimes.^[3] When countries choose to use a major convertible currency parallel to or in place of their national currency, this is called the process of dollarization. The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led dollarization to become a serious policy issue.^[4]

A few cases of full dollarization until 1999 had been the consequence of political and historical factors. In all long-standing dollarization cases, historical and political reasons have been more influential than an evaluation of the effects of dollarization.^[5] Panama, the most salient dollarization example, adopted the U.S. dollar as legal tender after its independence as a result of a constitutional ruling.^[2] Ecuador and El Salvador became full dollarized economies in 2000 and 2001 respectively with different influential factors.^[5] Ecuador underwent the process of dollarization to deal with a widespread political and financial crisis resulted from massive loss of credibility in its political and monetary institutions. In contrary, El Salvador's official dollarization was as a result of internal debates and in a context of stable macroeconomic fundamentals and long-standing unofficial dollarization. The euro area adopted the euro (€) as their common currency and sole legal tender in 1999, which might be considered as a variety of a full-commitment regime similar to full dollarization despite some distinguishable differences from other dollarization.^[6]

Dollarization can occur in a number of situations. The most popular type of dollarization is unofficial dollarization or de facto dollarization. Unofficial dollarization happens when residents of a country choose to hold a significant share of their financial assets denominated in foreign currency although the foreign currency lacks the legal tender.^[7] 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 dollarization or full dollarization 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 is a small number of countries adopting a foreign currency as legal tender. For example, Panama underwent a process of full dollarization by adopting the U.S. dollar as legal tender in 1904. This type of dollarization is also known as de jure dollarization.

Dollarization can be used semiofficially (or officially bimonetary systems), where the foreign currency is legal tender alongside the domestic currency.^[8]

In literature, there is a set of related definitions of dollarization such as external liability dollarization, domestic liability dollarization, banking sector's liability dollarization or namely deposit dollarization and credit dollarlization. The external liability dollarization measures total external debt (private and public) denominated in foreign currencies of the economy.^[8][9] Deposit dollarization can be measured as the share of dollar deposit in total deposit of the banking system while credit dollarization can be measured as the share of dollar credit in total credit of the banking system.^[10]

One of the main advantages of adopting of a strong foreign currency as sole legal tender is to reduce the transaction costs of trade among countries using the same currency.^[11] There are at least two ways to infer this impact from data. The first one is a 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.^[12] Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and stabler prices in dollar terms.^[13] 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 dollarization for trade may be large.^[14]

Dollarized economies can invoke greater confidence among international investors, inducing increased investments and growth. The elimination of the currency crisis risk due to full dollarization leads to a reduction of country risk premiums and then to lower interest rates.^[13] These effects result in a higher level of investment. However, there is a positive association between dollarization and interest rates in a dual-currency economy.^[15]

Official dollarization 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.^[12] Firstly, dollarization helps developing countries, providing a firm commitment to stable monetary and exchange rate policies by forcing a passive monetary. Adopting a strong foreign currency as legal tender will help to "eliminate the inflation-bias problem of discretionary monetary policy".^[16] Secondly, official dollarization imposes stronger financial constraint on the government by eliminating deficit financing by issuing money.^[17] An empirical finding suggests that inflation has been significantly lower in dollarized nations than in non-dollarized ones.^[18] The expected benefit of dollarization is the elimination of the risk of exchange rate fluctuations and a possible reduction in the country's international exposure. Though dollarization cannot eliminate the risk of an external crisis, it provides steadier markets as a result of eliminating fluctuations in exchange rates.^[13]

On the other hand, dollarization 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;^[13][19] former chairman of the Federal Reserve Alan Greenspan, for example, has stated that the central bank only considers the effects of its decisions on the US economy.^[20] In a full dollarized economy, exchange rates are indeterminate and monetary authorities cannot devalue the currency.^[21] In a highly dollarized economy, devaluation policy is less effective in changing the real exchange rate because of significant pass-through effects to domestic prices.^[13] 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 dollarized economy) and the business cycle of the anchor country.^[11] In addition, monetary authorities in dollarized economies diminish the liquidity assurance to their banking system.^[13][22]

In a fully dollarized economy, 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.^[23] The loss of the lender of last resort is considered a cost of full dollarization. This cost depends on the initial level of unofficial dollarization before moving to a full dollarized economy. This relation is negative because in a heavily dollarized economy, the central bank already fears difficulties in providing liquidity assurance to the banking system.^[24] 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.^[25]

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.^[26]

However, dollarization eliminates the probability of a currency crisis that impacts negatively on the banking system through the balance sheet channel. Dollarization may reduce the possibility of systematic liquidity shortages and the optimal reserves in the banking system.^[27] Research has shown that official dollarization has played a significant role in improving bank liquidity and asset quality in Ecuador and El Salvador.^[28]

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 dollarization.^[29] In countries with high inflation rates, the domestic currency tends to be gradually displaced by a stable currency, such as the U.S. dollar. 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.^[30]

Ize and Levy-Yeyati (1998) examine the determinants of deposit and credit dollarization, concluding that dollarization is driven by the volatility of inflation and the real exchange rate. Dollarization increases with inflation volatility and decreases with the volatility of the real exchange rate.^[31]

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 dominated in domestic currency, reducing the role of foreign currency as an inflation hedge. The pattern of the dollarization 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.^[29] Evidence for this pattern is given in the absence of dollarization during the pre-reform period in most transition economies, because of constricted controls on foreign exchange and the banking system.^[32] In contrary, by facilitating the domestic holding of foreign currency, a country might mitigate the shift of assets abroad and strengthen its external reserves in exchange for a dollarization process. However, the effect of this regulation on the pattern of dollarization depends on the public's expectations of macroeconomic stability and the sustainability of the foreign exchange regime.^[29]

• British Virgin Islands
• Caribbean Netherlands (from 1 January 2011)
• East Timor (uses its own coins)
• Ecuador (uses its own coins in addition to U.S. coins; Ecuador adopted the U.S. dollar as its legal tender in 2000.^[33]
• El Salvador
• Marshall Islands
• Federated States of Micronesia (Micronesia used the U.S. dollar since 1944^[34])
• Palau (Palau adopted the U.S. dollar since 1944^[34])
• Panama (uses its own coins in addition to U.S. coins. This country has adopted the U.S. dollar as legal tender since 1904).^[35]
• Turks and Caicos Islands

• Bahamas
• Belize (Belizien Dollar pegged 2/1 but USD is accepted)
• Uruguay^[36]
• Cambodia (uses 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.)
• Lebanon (along with the Lebanese pound)
• Liberia (was fully dollarized until 1982, when the National Bank of Liberia began issuing five dollar coins;^[37] U.S. dollar still in common usage alongside the Liberian dollar)
• Zimbabwe
• Haiti (uses the U.S Dollar alongside its domestic currency, the Gourde)
• Vietnam (along with the Vietnamese Dong)
• Somalia (along with the Somali Shilling)
• North Korea (along with the Yuan, Euro, and North Korean Won^[38]

• Andorra (formerly French franc and Spanish peseta since 1278^[34])
• Kosovo (formerly German mark and Yugoslav dinar)
• Monaco (formerly French franc since 1865;^[34] issues its own euro coins)
• Montenegro (formerly German mark and Yugoslav dinar)
• San Marino (formerly Italian lira; issues its own euro coins)
• Vatican City (formerly Italian lira; issues its own euro coins)
• Zimbabwe (Alongside USD, South African Rand and Botswana pula)

• Cook Islands (issues its own coins and some notes)
• Nauru (alongside Australian dollar from 25 May 2013^{[citation needed]})
• Niue
• Pitcairn Island
• Tokelau

• Kiribati (issues its own coins; Kiribati has used Australian currency since 1943^[34])
• Nauru (has fully used Australian currency since 1914^[34])
• Tuvalu (issues its own coins; Tuvalu has used Australian currency alongside its domestic currency since 1892^[34])

• Lesotho
• Namibia
• Swaziland
• Zimbabwe (Alongside the American dollar, Euro and Botswana pula)

Due to the hyperinflation and official abandonment of the Zimbabwean dollar several currencies are used instead:

• British Pound Sterling
• Botswana pula
• Euro
• South African rand
• United States dollar

The U.S. dollar has been officially adopted for all transactions involving the new power-sharing government.

• Armenian dram: Nagorno-Karabakh Republic
• Russian ruble: Abkhazia and South Ossetia (de facto independent states, but recognized as part of Georgia by nearly all other states)
• Indian rupee:
  • Bhutan (Alongside Bhutanese Ngultrum, pegged at par with the rupee)
  • Nepal (Alongside the Nepali Rupee, pegged at ₹0.625)
• Swiss franc: Liechtenstein
• Israeli shekel: Palestinian territories
• Jordanian Dinar: West Bank (Alongside Israeli New Sheqel)
• Egyptian Pound: Gaza Strip (Alongside Israeli New Sheqel)
• Turkish lira: Turkish Republic of Northern Cyprus (de facto independent state, but recognized as part of Cyprus by all states but Turkey)
• Canadian Dollar: St Pierre and Miquelon (Alongside Euro^[39]
• Pound Sterling and Botswana pula: Zimbabwe (Alongside South African Rand, Euro and USD)

• Monetary union
• Currency board
• Domestic Liability Dollarization

Fields, David, & Matias Vernengo (2012), “Hegemonic currencies during the crisis: The dollar versus the euro in a Cartalist perspective,” Review of International Political Economy, DOI:10.1080/09692290.2012.698997.

Fields, David & Matias Vernengo (2013), "Dollarization." Wiley-Blackwell Encyclopedia of Globalization.

Mundell, R. A. (1961), “A theory of optimum currency areas,” American Economic Review, 51, pp. 657-65.

Vernengo, M. (2006), “From Capital Controls to Dollarization,” in M. Vernengo (ed.) Monetary Integration and Dollarization: No Panacea, Cheltenham: Edward Elgar, pp. 245-58.