Currency substitution

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

Currency substitution can be full or partial. Full currency substitution can occur after a major economic crisis, such as in Ecuador. Some small economies, for whom it is impractical to maintain an independent currency, use the currencies of their larger neighbours; for example, Liechtenstein uses the Swiss franc.

Partial currency substitution occurs when residents of a country choose to hold a significant share of their financial assets denominated in a foreign currency or use it as exchange currency, as is currently the case in Venezuela. It can also occur as a gradual conversion to full currency substitution; for example, Argentina was in the process of converting to the U.S. dollar during the 1990s.^{[citation needed]}

"Dollarization", when referring to currency substitution, does not necessarily involve use of the United States dollar. The major currencies used as substitutes are the US dollar and the euro.

After the gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II, some countries sought 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 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) while "soft pegs" are more flexible and floating exchange rate regimes. The collapse of "soft" pegs in Southeast Asia and Latin America in the late 1990s led to currency substitution becoming a serious policy issue.

A few cases of full currency substitution prior to 1999 had been the consequence of political and historical factors. In all long-standing currency substitution cases, historical and political reasons have been more influential than an evaluation of the economic effects of currency substitution. Panama adopted the US dollar as legal tender after independence as the result of a constitutional ruling. Ecuador and El Salvador became fully dollarized economies in 2000 and 2001 respectively, for different reasons. Ecuador underwent currency substitution to deal with a widespread political and financial crisis resulting from massive loss of confidence in its political and monetary institutions. By contrast, El Salvador's official currency substitution was a result of internal debates and in a context of stable macroeconomic fundamentals and long-standing unofficial currency substitution. The eurozone adopted the euro (€) as its common currency and sole legal tender in 1999, which might be considered a variety of full-commitment regime similar to full currency substitution despite some evident differences from other currency substitutions.

There are two common indicators of currency substitution. The first measure is the share of foreign currency deposits (FCD) in the domestic banking system in the broad money including FCD. The second is the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets.

Unofficial currency substitution or de facto currency substitution is the most common type of currency substitution. 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. 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.