16 Facts About Currency substitution

Currency substitution is the use of a foreign currency in parallel to or instead of a domestic currency.

Full currency substitution can occur after a major economic crisis, such as in Ecuador, El Salvador, and Zimbabwe.

Partial currency substitution occurs when residents of a country choose to hold a significant share of their financial assets denominated in a foreign currency.

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.

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.

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Currency substitution can be used semiofficially, where the foreign currency is legal tender alongside the domestic currency.

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.

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.

Secondly, official currency substitution imposes stronger financial constraint on the government by eliminating deficit financing by issuing money.

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.

However, currency substitution eliminates the probability of a currency crisis that negatively affects the banking system through the balance sheet channel.

Research has shown that official currency substitution has played a significant role in improving bank liquidity and asset quality in Ecuador and El Salvador.

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.

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.