Summary of WP/92/99
“Money and Credit Under Currency Substitution” by Carlos A. Rodriguez
In an economy operating under currency substitution, macroeconomic effects may derive from either shifts between denominations of currency holdings or shifts in the locational composition of foreign currency holdings. A shift from dollar deposits abroad to deposits in the local system increases the credit supply of the financial system without increasing money demand. Given an initial situation of credit constraint, the extra credit results in an equivalent accumulated current account deficit that is also associated with temporary real currency appreciation, which is expected to be hard to reverse. In contrast, when there is an excess demand for money, one would expect a general reduction in expenditure leading to both capital inflows and current account surpluses.
Data from Argentina and Peru following the stabilizations after hyperinflation show that the capital inflows have been associated with significant worsening in the current account. They therefore support the hypothesis that the inflows were induced by portfolio reallocations or by foreign investors responding to the lower interest rates in the United States.
Higher temporary marginal reserve requirements (nonremunerated) are one alternative for slowing down domestic credit expansion caused by the repatriation of foreign assets. In the case of dollar deposits in the local financial system, the higher reserve requirements should apply only to that part that is locally lent. For overseas operations, reserve requirements should be at rates compatible with international competition. Moreover, local taxes should not be imposed on the profits earned from financial intermediation based on dollar deposits that are reinvested overseas by local banks. Otherwise, deposit rates for local dollar deposits will not be able to compete internationally and, in consequence, the repatriation of assets could be hampered. The marginal reserve requirements should be lowered as monetization advances or as the ability of the economy to adapt to trade deficits without substantial relative price swings improves.