Currency Substitution in High Inflation Countries GUILLERMO A. CALVO AND CARLOS A. VEGH relatively successful in maintaining their pur- real value of the domestic currency. Even urrency substitution—the chasing power over time. Not surprisingly, though during most of these hyperinflations, then, the public turns to a foreign money 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 currencies as tution—the use of a foreign currency as a currency, the public managed to circumvent C medium of exchange—is pervasive in high in- these controls and resorted to foreign cur- media of exchange— flation countries. In many Latin American rency to satisfy most of their needs. raises major and often contro- countries, for instance, the US dollar is widely The presence of currency substitution 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 interest 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 local currency, 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 store of value. currency as the only legal tender (as in impact on the level and Unfortunately, the extent of currency sub- Panama). variability of the inflation tax? stitution is difficult to quantify since there are • The presence of foreign money implies usually no data on foreign currency circulat- that the relevant money supply—which in- Unfortunately, there are ing in an economy. Only some rough, and ad- cludes the domestic value of foreign currency few clear-cut answers to these mittedly crude, estimates exist. In Uruguay, 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 dollars 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 unit of account, 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, Peru, and Uruguay, and re- government to raise revenues from money unpredictable manner, is ill suited to serve as mains very high, as documented in numerous creation? a store of value. Nominal prices 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 economies stitution tends to be favored by governments Unlike an organism that is unique and can- that suffered hyperinflation after the two that rely heavily on revenues from money cre- not be replaced, substitutes for a sick cur- world wars. In Germany, 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 Monetary System certainly support cause the lack of a lender of last resort will im- tries—most notably Brazil—consists of paying this view. pose stricter discipline on the domestic bank- 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. Liberia, 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 exchange rate 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 stock 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, seigniorage constitutes over 20 percent of use of foreign currencies. Hence, except under duce the demand for dollars and increase the total revenues. From a public finance 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 capital flight and driven conventional taxes 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- larization 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.