Currency substitution is the use of a foreign currency in lieu of or in parallel with a national currency. This is often done with a global reserve currency such as the US dollar or one that is regional, such as the euro.
It is something that can typically occur after a major crisis, as was the case in Ecuador and El Salvador. The tendency to turn to something with more stability is desired. This is where the substitution enters.
Partial substitution is often driven by the popular. While official monetary policy will still focus on the native currency, individuals and merchants will prefer to use the alternative. This is often the case with the USD.
Total substitution is typically when the government steps in and makes the decision to accept something completely different. This can be done by placing legal tender status upon the external currency.
This principal applies to asset allocation.
Pegs
Countries that engage in currency substitution have a couple different approaches they can take.
The first is a hard peg. This is total commitment to the substitutions and is a relinquishing of control over one's currency. Things such as currency boards are set up to maintain the peg.
Soft pegs are undertaken whereby a floating exchange rate is adopted. This is the most common official approach and one that is proving to be full of risk. The Asian Crisis in the late 1990s showed how soft pegs can collapse.
The advantage to a soft peg is local monetary policy can still be enacted as control is retained.
Types
We can actually break the currency substitution down into two more camps:
- Unofficial - this is mostly partial. The residents choose to engage in the foreign currency and keep the majority of their assets denominated in it.
- Official - the country makes the foreign currency legal tender and ceases to uses its currency. It is full and complete.
Of course, there can be an official were a country can opt to make the foreign currency legal tender and have it used alongside the native one.
Asset Holdings
Money extends far beyond currency, especially in the digital world.
For this reason, a major portion of currency distribution is outside the concept of medium of exchange. Store of value is viewed by looking at the denomination of assets.
When residents of a country decide to purchase a large amount of assets denominated in another currency, it is showing their confidence that it will hold its value as compared to the native one. This often is not only due to the local economic and political circumstances but also because of the outlook of the global markets upon the currency.
We see this play out with loans often written within a country in a denomination not native to that location. Today, that usually means debt in USD. This is done because banks have the easiest time selling the debt into the public markets if priced in dollars.
Inflation
Currency stabilization is a way to offset the impact of inflation.
Countries that can print their currencies will often abuse this privilege. When the economy encounters a setback, often due to the business cycle, politicians tend to overreact. This causes them to force monetary policy in a direction that has averse consequences.
Often the result is "money printing" by the central bank. This is only possible in countries where this institution has control over the money supply (as opposed to the monetary base). When this happens, currency expansion takes place at a rapid rate.
Since the economy and business activity did not grow in relation to the money supply, unlike with fractional reserve banking, we end up with a situation of "too much money chasing too few goods and services". This is especially true when dealing with the physical realm. Digital brings a different effect to the table.
This situation can have a devastating impact. The same is true if the reserve currency, presently the US dollar, strengthens relative to the other fiat currencies. We see the effects multiplied on the developing nations as the exchange rate of the national currency is obliterated. This makes debt repayment more difficult. Also, import costs go up, echoing throughout the economy.
Currency substitution can eliminate these risks. When prices and inflation rates are high, the local currency will be continually displaced by the substitution currency.