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Home , Currency, Currency substitution, Larization

Substitution in High Countries

GUILLERMO A. CALVO AND CARLOS A. VEGH

relatively successful in maintaining their pur- real of the domestic currency. Even urrency substitution—the chasing power over time. Not surprisingly, though during most of these , then, the public turns to a foreign in its governments attempted to impose foreign ex- use in a given country of quest for a healthy currency. Currency substi- change controls to prevent a flight from the multiple as tution—the use of a foreign currency as a currency, the public managed to circumvent C —is pervasive in high in- these controls and resorted to foreign cur- media of exchange— flation countries. In many American rency to satisfy most of their needs. raises major and often contro- countries, for instance, the US is widely The presence of used in conducting transactions, especially raises important, and often controversial, pol- versial policy questions: those involving "big-ticket" items. This ex- icy questions. Should currency substitution be plains the use of the term "dollarization" • Should currency substitution be encour- when referring to the phenomenon of cur- aged or discouraged? One argument holds encouraged or discouraged? rency substitution in Latin America. This that rates should be increased to in- How does it affect the choice term, however, is also frequently used to refer duce people to hold the , while of a nominal anchor? What is its to the use of a foreign currency as a unit of ac- another advocates full adoption of a foreign count and a . currency as the only (as in impact on the level and Unfortunately, the extent of currency sub- ). variability of the inflation ? stitution is difficult to quantify since there are • The presence of foreign money implies usually no data on foreign currency circulat- that the relevant —which in- Unfortunately, there are ing in an . Only some rough, and ad- cludes the domestic value of foreign currency few clear-cut answers to these mittedly crude, estimates exist. In , circulating in the economy—has a component for instance, theft reports filed with the police that cannot be controlled. Might this hamper questions. suggest that the ratio of to domestic the ability of policymakers to reduce inflation, currency might be as high as three to one. In as it makes it more difficult to establish a Bolivia, a recent study estimates that the ratio nominal anchor? Understanding how cur- Few national currencies survive the destruc- of circulating dollars to M2 reached 0.8 in rency substitution affects the choice of a nom- tive power of high inflation. Like a crippling 1985. Because of a lack of data, the share of inal anchor is thus key in the fight against disease that leaves no part of an organism un- foreign currency deposits in total financial as- inflation. touched, high inflation severely hinders the sets (computed as M2 in domestic currency • Since currency substitution results from ability of a currency to perform its basic func- plus foreign currency deposits) is commonly the need to resort to inflation to finance tions as a store of value, a , and used as a proxy for currency substitution. chronic budget deficits, what are the effects of a medium of exchange. Indeed, a currency During the 1980s, this share surpassed 50 currency substitution on the ability of the whose value declines over time, often in an percent in Bolivia, , and Uruguay, and re- government to raise from money unpredictable manner, is ill suited to serve as mains very high, as documented in numerous creation? a store of value. Nominal with an ever- studies. For instance, this share was almost 60 This article analyzes these important is- increasing number of digits make the use of a percent in Bolivia in 1990, and 83 percent in sues and examines the main policy choices. currency as a unit of account inconvenient Uruguay in 1991. Discourage currency substitution? and devoid of much meaning. Sellers become The phenomenon of currency substitution reluctant to accept as a medium of exchange a is nothing new: large quantities of foreign cur- The policy of discouraging currency sub- currency with uncertain value. rencies circulated in most of the stitution tends to be favored by governments Unlike an organism that is unique and can- that suffered after the two that rely heavily on revenues from money cre- not be replaced, substitutes for a sick cur- wars. In , for instance, it has ation. If successful, such a policy would in- rency are easy to come by. Some currencies, been estimated that by October 1923, the real crease the demand for domestic money and such as the US dollar, enjoy worldwide recog- value of foreign currencies circulating was at thus attenuate the inflationary consequences nition and have earned a reputation for being least equal to and perhaps several times the of a given budget deficit.

34 Finance & Development /March 1993

©International Monetary Fund. Not for Redistribution A popular method of discouraging the use of ments crises attest. The recent events in the tually argue that this is all for the better be- foreign currencies in Latin American coun- European certainly support cause the lack of a will im- tries—most notably Brazil—consists of paying this view. pose stricter discipline on the domestic - attractive interest rates on demand deposits. Full dollarization may be criticized on sev- ing system. However, the most likely outcome This is an ineffective method of discouraging eral grounds. First, there is never a complete is that, as soon as the domestic financial sys- the use of foreign currency because it amounts guarantee that the system will not be discon- tem threatens to collapse, rules will be relaxed to paying interest on domestic money. The de- tinued in the future. , for instance, had and the banking system bailed out, which mand for domestic money is likely to increase, the same dollar-based monetary system as could lead to, at least, a temporary abandon- but if the fundamental problems leading to Panama until the mid-1980s, when political ment of full dollarization. high inflation are not being quickly resolved, upheaval and large budget deficits forced a de Short of full dollarization, the greatest such a method only postpones the "moment of facto abandonment of the system. A large ex- drawback of encouraging the use of foreign truth," and contributes to magnifying the even- ternal shock could also lead a government to money is that it would worsen the inflationary tual inflationary explosion. renege on its commitment in order to recover impact of a given fiscal deficit, by reducing An extreme measure designed to prevent the use of the as a policy instru- the base of the inflation tax (given by the the use of a foreign currency—which was ment. Thus, it would be naive to expect that of real domestic money balances). In ad- adopted in Bolivia (1982), Mexico (1982), and full dollarization would result in a quick dition, if encouraging the use of foreign Peru (1985)—is the forced conversion into do- equalization of prices and interest rates with money takes the form of allowing individuals mestic currency of the stock of foreign cur- the rest of the world, as credibility problems to hold "dollar" bank accounts, the same fi- rency deposits in the domestic financial sys- are not likely to go away immediately. nancial vulnerability mentioned in connection tem. Such forced de-dollarization has often A traditional argument against full dollar- with full dollarization could be created. had effects opposite to those intended by the ization is that the government gives up rev- In sum, there does not seem to be a strong authorities. In Bolivia, for instance, the au- enues from the inflation tax. In many coun- general case for or against discouraging the thorities expected that this measure would re- tries, constitutes over 20 percent of use of foreign currencies. Hence, except under duce the demand for dollars and increase the total revenues. From a point of specific circumstances, policymakers should tax base for the inflation tax. Instead, it seems view, replacing the revenues from inflation by probably refrain from imposing measures de- to have stimulated and driven conventional could indeed lead to wel- signed to influence through artificial means the "dollarized" economy underground. With fare losses if an inefficient tax system made it the use of a foreign currency. Naturally, a the stabilization plan of 1985, the official de- optimal to resort to the inflation tax. However, greater use of domestic money that reflected dollarization program ended. since governments may be tempted to renege increased confidence in government policy Despite the negative assessment of mea- on announced policies in order to secure short- would be welcome. But, in this case, the sures destined to discourage the demand for term gains in terms of, for instance, higher eco- greater use of domestic money would be a foreign currency, the case for encouraging its nomic activity, they may end up not behaving demand is also less than obvious. An extreme in an optimal manner. Therefore, "tying the form would be for a country to give up its own hands" of the government through full dol- money and adopt a foreign currency (full dol- could actually enhance welfare. larization). This type of solution is usually Perhaps a more fundamental criticism proposed after several failed stabilization pro- of full dollarization is that—unless do- grams. By removing the power to produce mestic are also fully integrated high-powered money from the , it with the "Fed," that is, the central is hoped that inflation will be stopped in its bank issuing the foreign cur- tracks. In principle, a fully dollarized economy rency—the system will be forced should inherit the inflation rate of the foreign to operate without a "lender of currency that has been adopted. Such a sys- last resort." Optimists may ac- tem should also command higher credibility than a fixed exchange rate because it repre- sents a higher degree of commitment to a sta- ble money. It has also been argued that full dollariza- tion should provide the domestic government with more discipline. Presumably, this means that a government that cannot resort to infla- tionary finance will feel constrained to "put its house in order," rather than find alternative sources of finance (such as domestic ). While there may be some merit to this argu- ment—avoiding temptation is the first step to- ward abstinence—we tend to believe that poli- cies follow discipline rather than the other way around. In other words, the does not guarantee that a government will follow the fiscal policies needed to sustain such a regime, as countless balance of pay-

Finance & Development /March 1993 35

©International Monetary Fund. Not for Redistribution consequence of good policies, and not an indi- observed. However, the case of perfect substi- and foreign currency, the larger the apprecia- cation that encouraging the use of domestic tution is still useful because it illustrates the tion of the domestic currency and the more money is a good policy in and of itself. fragility of the money supply as the nominal pronounced the . anchor in situations of extreme currency sub- Choice of the nominal anchor In the case of exchange rate-based stabiliza- stitution. Moreover, perfect substitution might tion, the domestic money supply can adjust in- Since currency substitution is a by-product be a reasonable description of reality in the stantaneously (assuming high capital mobil- of high inflation, putting an end to inflation is medium run, after enough time has elapsed ity), which prevents the recession that results a necessary condition to ensuring a return to for the financial system and the transactions from money-based stabilization. Hence, a fully the domestic currency. In an open economy, an technology to adapt to the use of the foreign credible stabilization (in the sense that the inflation stabilization plan can be based on currency. Under these circumstances, the public expects the lower rate of to controlling either the exchange rate (exchange gradual evolution of a currency substitution be maintained for the indefinite future) will re- rate-based stabilization) or the money supply process under floating exchange rates might duce inflation instantaneously with no real (money-based stabilization), thus letting the eventually lead to a highly unstable situation costs. If there is no credibility, currency substi- exchange rate float. The question arises as to as the system loses its nominal anchor. tution does not alter the boom-recession cycle the effects of currency substitution on the When currency substitutability is imper- predicted by some theoretical models and ob- choice of the nominal anchor. fect, the system is not left without a nominal served in chronic inflation countries. The conventional wisdom on this issue is anchor under floating exchange rates, since a To summarize, a high degree of currency that if there are substantial holdings of foreign substitution seems to significantly strengthen money in circulation, fixed exchange rates the case in favor of fixed exchange rates, par- provide a more effective nominal anchor. The ticularly if an early deceleration of inflation reason is that, as a first approximation, the rel- contributes significantly to the credibility of evant concept of money includes holdings of Guillermo A. Calvo the stabilization program. This is more likely the foreign currency. Thus, if the exchange from , is a to happen under predetermined exchange rate is allowed to vary, the Senior Advisor in the rates because the exchange rate "anchors" the would not be able to control the money supply IMF's Research of traded . (inclusive of foreign exchange) in terms of do- Department. He holds a Even if inflation is successfully brought PhD from Yale University. mestic currency. Conceivably, if domestic down, evidence for Latin American countries prices double, a depreciation of the domestic (such as Bolivia, Mexico, Peru, and Uruguay) currency could accommodate the nominal suggests that the demand for domestic money money supply to the higher nominal money may not go all the way back to the levels ob- demand provoked by the doubling of prices. served prior to stabilization. The dollarization This line of argument is only strictly correct if processes seem to exhibit "hysteresis," or irre- both monies are perfect substitutes. This Carlo A. Vegh versibility, in the sense that dollarization would be the case if there were no legal barri- from Uruguay, is an ratios do not fall once inflation has been in the IMF's ers to the use and free exchange of the two reduced. For the same level of inflation, the Research Department. He monies, and the two monies were fully and received his PhD from the public holds less domestic money than before. equally recognized as means of payment by University of Chicago. This irreversibility in the process of cur- everybody. Thus, once the exchange rate be- rency substitution is most likely related to the tween the two monies is fixed, their risk char- role played by financial adaptation. High infla- acteristics are the same and the two monies tion forces the gradual development of new fi- become perfect substitutes. In this extreme nancial instruments and institutions (foreign case, the system has no nominal anchor. currency deposits being one of the manifesta- An example may help to clarify the central tions of this process) that decrease the demand issue. Suppose the US government erased the for domestic money for a given level of domes- number "10" from $10 bills and let the tic nominal interest rates. Creating new finan- determine the price of the ex-10-dollar bills given domestic money supply determines a cial products is costly and requires a learning (that is, their exchange rate) against all other unique . However, currency substi- process. Once this "" has taken dollar bills. A moment's reflection shows that, tution still plays a key role in a money-based place, the public will continue to use these new given an exchange rate, total money supply is stabilization. By lowering expected inflation, a financial instruments even if inflation falls. determined, which, in turn, pins down the reduction in the rate of growth of the money A similar explanation has been advanced to price level. But if such an exchange rate dou- supply reduces the domestic nominal interest explain the secular decline in the demand for bles, the price level will increase to a new equi- rate, thus inducing the public to switch from currency in the . Clearly, once au- librium. Hence, if the exchange rate is not foreign to domestic currency. The public's de- tomated teller machines (ATMs) have been fixed, the price level is totally undetermined; sire to sell foreign currency leads to an appre- put into place on almost every corner, one that is, the system is left with no nominal ciation of the domestic currency. Moreover, the would hardly expect a fall in the opportunity anchor. attempt by the public to increase real domestic cost of holding money to a given level to cause In practice, of course, foreign currency is money balances provokes a recession because, currency demand to go back to pre-ATM-lev- not a perfect substitute for domestic currency. to the extent that domestic prices and els. Hence, to the extent that the "hysteresis" If it were, a small increase in domestic infla- are sticky, the real domestic money supply associated with currency substitution reflects tion over foreign inflation should immediately cannot increase, so that output must fall to such considerations, there is little that policy- provoke a total replacement of the domestic equilibrate the . The higher the makers can or should do to reduce foreign for the foreign currency, which has not been of substitution between domestic currency holdings.

36 Finance & Development / March 1993

©International Monetary Fund. Not for Redistribution Inflationary finance inflation rate required to finance a given bud- mean that currency substitution "causes" infla- get deficit is higher. This is because the avail- tion. Rather, the implication is that the ready The popularity of the inflation tax in devel- ability of foreign currency reduces the de- availability of sound currencies makes the use oping countries is hardly surprising. Unlike mand for domestic money for a given level of of the inflation tax less attractive than it would conventional taxes, the inflation tax is costless inflation. Since the stock of domestic money be otherwise. Measures designed to prevent the to collect, easy to enforce, and hits low-income constitutes the tax base for the inflation tax, use of foreign currencies enjoy, at most, tempo- groups with no political clout the hardest. The the same amount of revenues can only be col- rary success, and are often counterproductive. inflation tax thus provides a convenient lected with a higher inflation rate. Moreover, Such measures provide a clear signal to the means of financing public spending in the the closer foreign currency substitutes for do- public that the government has no intention of face of inefficient and costly tax administra- mestic money, the higher the inflation rate, be- taking serious fiscal measures, which can only tion systems. Unfortunately for the - cause a given increase in inflation will provoke exacerbate the flight from the currency. Hence, hungry politician, the presence of a foreign a larger reduction in domestic money demand. the policy prescription in this area is simple (al- currency provides an inexpensive and effi- Since both the speed with which the public ad- though in practice it might not be easy to im- cient way of evading the tax on domestic justs its money portfolio and the degree of plement for political reasons): attack the cause money balances. Hence, when the inflation tax substitution between the two currencies are of inflation (the fiscal deficit) rather than the becomes the main source of revenue—as best likely to increase with a higher inflation rate, symptoms (currency substitution). Ironically, exemplified by the post-World War I by making it more costly for a government to currency substitution may well lead to an ex- European hyperinflations—governments go monetize its deficit, currency substitution may plosive inflationary path. Currency substitu- to extremes to ban the use of foreign curren- bring forward the day of reckoning. If that is tion may also lead to more volatile inflation. cies in a desperate attempt to salvage the last the case, currency substitution might have Sudden spikes or inflationary explosions are source of revenue. During the Austrian hyper- played a beneficial role after all. bound to result from any exogenous shift in inflation, for instance, the government estab- the demand for real money demand as a result lished widespread exchange controls aimed at of, say, changes in the availability of foreign increasing the amount of domestic currency currency or in transaction patterns. held by the public. The incentives to evade This article is based on the authors' IMF Working were so enormous, however, that even Paper WP/92/40, "Currency Substitution in In sum Developing Countries: An Introduction," which was widespread controls could not prevent flight prepared as the introductory chapter for a special from the currency. The fact that currency substitution may issue on currency substitution, edited by the The possibility of switching from the do- lead to higher and more volatile inflation for a authors, of Revista de Analisis Economico, pub- mestic to the foreign currency implies that the given budget deficit should not be taken to lished in June 1992.

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