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Monetary substitution in developing countries: Why people prefer foreign to their own currency; how to counter this

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
June 1986
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C.L. Ramirez-Rojas

Residents of any country may hold foreign currency for use in certain kinds of transactions, such an international trade and tourism. In some developing countries, however, the demand for foreign money by domestic residents, especially for hard currencies and most often for the US dollar, has far surpassed the requirements for these transactions. These countries, including notably Argentina, Bolivia, Israel, Mexico, Uruguay, and Yugoslavia, are characterized by different economic structures. Yet despite these differences, all have experienced a significant shift away from their domestic currencies to foreign currencies, particularly during periods of high and variable inflation rates and great uncertainty about domestic policies. In some of these countries the use of foreign money has become so widespread that even purely domestic sales and contracts are transacted in foreign currency.

Monetary or currency substitution is defined as the demand for foreign money by domestic residents. While in some cases monetary substitution takes place between residents and nonresidents that hold domestic and foreign money simultaneously, in others there is no demand for domestic money by nonresidents. The latter condition is most prevalent in developing countries. This article discusses the determinants of this type of monetary substitution and presents some empirical estimates of its extent. In addition the implications of monetary substitution for economic management and the policy options available in light of this process are discussed.

A detailed paper on this subject, entitled “Currency Substitution in Argentina, Mexico, and Uruguay,” was published in the March 1985 issue of IMF Staff Papers.

Determinants

The demand for foreign money can take various forms, including foreign-currency notes circulating domestically and foreign-currency deposits held either abroad or domestically. The determinants of monetary substitution are certain institutional factors, real wealth, and the difference between the expected real rate of return on domestic and foreign financial investments. The institutional factors that explain the phenomenon of monetary substitution in developing countries are the volume of international transactions, the limited availability of domestic financial investments, and the transaction costs incurred in the exchange of currencies.

Foreign money is likely to be held in a stable proportion to the volume of international transactions. In addition, foreign money constitutes an attractive means of liquidity and financial savings, when there are only few available domestic alternatives for holding wealth. In the absence of severe exchange controls or other deterrents to the holding of foreign money, the transaction costs incurred in the exchange of domestic for foreign money will be relatively small, compared with the other means of holding wealth, thereby creating a further bias in these economies toward the holding of foreign money. Changes in real wealth affect the demand for domestic as well as foreign financial instruments. An increase in real wealth may increase the demand for both domestic and foreign currencies.

While the previously mentioned factors help one to understand the holding of foreign currency in developing countries, the most important factor that helps explain monetary substitution is the difference between the expected real rate of return on domestic and foreign financial investments. To a large extent this differential rate of return can be approximated by the expected rate of depreciation of the domestic currency. If the domestic and foreign interest rates on financial instruments are freely determined, the difference between the two rates—adjusted for country risk—will tend to be closely associated with the expected change in the exchange rate. In some developing countries, however, a policy of maintaining a fixed nominal interest rate for long periods, regardless of the level of inflation, exacerbates monetary substitution, because the real return on domestic financial assets declines relative to the one obtained on foreign assets.

Extent

In recent years the extent of monetary substitution has been quite large in developing countries. The reason for this trend can be found in domestic macroeconomic imbalances which have resulted in high and variable inflation rates; and in the technological advances in communication and financial management, which make it possible to transfer funds at a low cost. Table 1 presents a rough partial estimate of the magnitudes involved, using data on foreign-currency deposits kept in banks abroad (excluding official and interbank deposits) by residents of a sample of developing countries.

Table 1.Foreign bank deposits of nonbanks1 at year end, 1982–84

(In billions of dollars)

Residence of depositor198219831984
Argentina7.107.897.62
Brazil4.088.078.17
Cameroon0.310.230.41
Chile1.492.111.95
Greece5.125.004.74
Israel2.722.852.62
Côte d’Ivoire0.380.300.31
Kenya0.930.870.83
Mexico10.4012.6614.31
Pakistan0.730.860.87
Peru1.021.191.42
Philippines0.520.781.10
Turkey2.172.101.83
Uruguay1.111.511.74
Venezuela10.0110.8511.69
Yugoslavia0.340.270.28
Total48.4357.5459.89
Source: IMF. International Financial Statistics

Nonbanks are defined as residents plus state enterprises. Excludes deposits by domestic commercial banks

Source: IMF. International Financial Statistics

Nonbanks are defined as residents plus state enterprises. Excludes deposits by domestic commercial banks

The magnitudes involved are very large and vary considerably according to the countries considered. In the case of Greece, Israel, Turkey, and Yugoslavia, deposits in foreign banks by residents of these countries have been relatively stable. This has also been the case for the sample of African countries (Cameroon, Cote d’lvoire, and Kenya). Most of the remaining countries have experienced a substantial growth of foreign-currency deposits and, with the exception of Venezuela, the rate of accumulation has been very fast. This process has become particularly entrenched in Latin America where the amounts transferred abroad have been considerable.

The data presented in Table 1 overestimate the funds the private sector of these countries holds abroad, because they include deposits of state enterprises. Yet, the table also underestimates monetary substitution, because it does not include foreign-currency deposits within the domestic banking system, foreign-currency notes circulating domestically, and some deposits not identified by nationality or residence of the depositor. These components of monetary substitution are important in some countries.

Implications of substitution

The increasing degree of monetary substitution has introduced an element of risk in the prediction and estimation of key macro-economic variables by the authorities. Among the more widely noted consequences of monetary substitution are the reduced ability of authorities to control credit and monetary aggregates, and the problems posed in the design of an appropriate monetary program. This is because the monetary authorities do not have perfect control over the amount of dollars demanded by residents.

In the presence of monetary substitution the relevant empirical definition of money becomes more difficult; one may consider a definition that includes domestically issued money plus domestic dollar deposits, or one that only includes domestically issued money. If the broader definition, namely, domestic dollar deposits along with domestically issued money, is used it is important to realize that the crucial assumption, when estimating the demand for money, is that dollar deposits in the domestic financial system are not a very good substitute for dollar deposits held elsewhere. In other words, it is assumed that they cannot be moved abroad easily. However, recent experience, as reflected in Table 1, indicates that this may be a very misleading assumption, since dollars in recent years have become more easily transferable.

Perhaps the most important implication of monetary substitution in developing countries is that, in order to build up foreign-currency deposits abroad, the residents of a country reduce domestic expenditure relative to domestic income. This depresses domestic investment and makes sustained output growth more difficult to achieve.

Monetary substitution in developing countries also limits the ability of the government to successfully finance a fiscal deficit by issuing domestic currency. As the public shifts from domestic to foreign money, the relative importance of the monetary base, and hence of the financing that can be achieved through money creation, is reduced for any given rate of inflation. Table 2 presents estimates of the revenue from the issuance of money as well as the inflation rate for a group of developing countries since 1980.

Table 2.Revenue from money creation1 and inflation rates,2 selected developing countries, 1980–84

(Annual estimates)

19601981198219831984
Argentina3.75.1
(75.4)(109.6)(256.0)(360.9)(573.0)
Brazil1.91.92.01.82.7
(108.3)(108.2)(92.0)(168.3)(236.2)
Cameroon0.81.7031.4−0.1
(9.6)(10.7)(13.3)(16.6)(11.4)
Chile2.4−0.7−1.70.7
(39.6)(9.1)(7.2)(45.5)(24.3)
Greece3.96.74.91.85.0
(28.4)(25.9)(16.0)(19.8)(21.4)
Israel2.12.12.42.13.3
(132.6)(122.7)(125.7)(144.5)(396.5)
Côte d’lvoire0.11.0−060.7
(14.7)(8.8)(7.3)(5.9)(4.3)
Kenya−0.40.31.6•0.208
(13.8)(11.8)(20.4)(11.5)(10.2)
Mexico4.95.510.96.75.6
(24.5)(24.4)(56.1)(107.4)(70.3)
Pakistan2.41.12.31.92.2
(13.4)(10.9)(4.2)(6.9)(8.9)
Peru7.75.35.68.4
(59.2)(75.4)(64.4)(111.2)(110.2)
Philippines0.70.60.32.41.1
(18.3)(14.4)(11.1)(16.2)(66.6)
Turkey3.44.03434
(110.2)(36.6)(25.9)(31.1)(48.3)
Uruguay2.51.93.45.73.5
(41.8)(23.4)(12.9)(73.5)(77.4)
Venezuela0.61.61.83.53.4
(20.1)(13.8)(8.1)(7.0)(17.5)
Yugoslavia6.96.88212.6
(28.8)(43.3)(25.2)(32.7)(57.7)
Source: IMF, International Financial Statistics.… Indicates data not available

The revenue from money creation, including the central banks, is expressed as a percentage of GDP and is defined as (AH,/GDPt); where H is the monetary base; ΔHt is the first difference of H. namely, ΔHt = Ht − Ht−1; and the GDP is expressed in nominal terms. In some cases the estimates of revenue will be biased upward if interest is paid on deposits of commercial banks held at the central bank.

Inflation rates are reported in parentheses and were calculated as the percentage increase in the wholesale price index for ail the countries except Cameroon. Côte d’lvoire, Kenya, Peru, and Turkey, for which the percentage increase in the consumer price index was used.

Source: IMF, International Financial Statistics.… Indicates data not available

The revenue from money creation, including the central banks, is expressed as a percentage of GDP and is defined as (AH,/GDPt); where H is the monetary base; ΔHt is the first difference of H. namely, ΔHt = Ht − Ht−1; and the GDP is expressed in nominal terms. In some cases the estimates of revenue will be biased upward if interest is paid on deposits of commercial banks held at the central bank.

Inflation rates are reported in parentheses and were calculated as the percentage increase in the wholesale price index for ail the countries except Cameroon. Côte d’lvoire, Kenya, Peru, and Turkey, for which the percentage increase in the consumer price index was used.

Revenue from money creation is of considerable importance as a proportion of GDP for most of the countries in the sample. But it shows wide fluctuations over the years and across countries. In general, attempts to increase this type of government financing have resulted in higher inflation rates, further reducing the ability of the authorities to domestically finance the deficit of the public sector.

Instruments and policy options

The correction of capital outflows and monetary substitution can only be made effectively in the context of a comprehensive adjustment package which includes measures or policies to deal with the causes of macroeconomic imbalances, such as the inflationary financing of government expenditure, inappropriate interest and exchange rate policies, and the general lack of consistency and credibility of overall economic policy. The existence of macroeconomic imbalances results in an environment characterized by high and variable inflation, recurrent devaluations, and declining demand for domestic real balances. Under these circumstances the authorities devise certain policies to deal directly with the problem of monetary substitution. These include the promotion of foreign-currency deposits in the domestic financial system, exchange controls, the total replacement of the domestic currency with dollars, more flexible interest rate policies, and domestic currency deposits tied to exchange rate movements.

The promotion of foreign-currency deposits in the domestic financial system is based on the premise that by reducing the transaction costs and increasing the liquidity to the depositor, it may diminish, at least in part, the outflow of resources, and consequently will reduce pressure on international reserves or the exchange rate. Underlying the promotion of foreign-currency deposits is the view that by keeping foreign money within the boundaries of the home country, the monetary authorities avoid and offset outflows of hard currency. Further, foreign-currency deposits in the domestic financial system can be used domestically by the public or the private sector, and are potentially under more control by the authorities than deposits located abroad. Nevertheless, the introduction of foreign-currency deposits in the domestic financial system does nothing to change the extent of monetary substitution in the system. If the basic macroeconomic imbalances are not corrected, foreign-currency deposits, as a percentage of total deposits, will grow and may themselves become a destabilizing force within the domestic financial system. This may happen if the public has doubts about the full convertibility of its foreign-currency deposits in the domestic financial system.

Exchange controls have a long history in many developing countries. Despite numerous attempts to eliminate monetary substitution and capital outflows through the use of exchange controls, evidence has shown that the controls have been largely ineffective, leading to the creation of a black market for foreign exchange, a worsening in the allocation of resources, with negative effects on output growth, and, in general, a reduction in welfare.

Domestic currency holdings can be totally replaced by foreign currency either by a sharp decline in real demand or through the repurchase of the monetary base with foreign currency. On the demand side, residents may choose to reduce their real holdings of domestic money and, in an extreme case, they may not use domestic money at all. This extreme case is likely to arise in a situation of hyperinflation in which the future value of the domestic money declines very rapidly. It should be noted that the total substitution on the demand side is not a policy by itself but one of the results of fundamental macroeconomic imbalances that led to the original hyperinflation.

A policy of substituting domestic for foreign money can be effected through the supply side, with the government surrendering the right to print money and repurchasing the monetary base with foreign currency. Such a total replacement will imply a very strong fiscal adjustment, because a source of domestic financing will be given up, and consequently this means of financing the fiscal deficit will disappear.

Altering the relative return on holdings of domestic and foreign money will reduce the extent of monetary substitution. For example, a more flexible interest rate policy would make domestic currency deposits a competitive alternative to foreign money holdings, because the return on domestic currency deposits would increase. Further, a more flexible interest rate policy would allow domestic currency depositors and commercial banks to hedge against the future value of the exchange rate. The scope for interest rate policy to reduce monetary substitution also depends on the consistency and credibility of the overall economic policy. If a credible and consistent economic policy is implemented it may even induce residents to start moving out of foreign money.

In an open financial system if the exchange rate is freely floating or has very limited intervention (say, limited to offsetting seasonal factors), a way to make more attractive deposits denominated in domestic currency, relative to those in foreign-currency, is to index their returns to exchange rate movements. This may lessen uncertainty over the future value of the domestic currency. The total yield of such deposits should be at least equal to the interest rate paid on foreign currency deposits plus the percentage associated with changes in the exchange rate. This yield is likely to be smaller than the one obtained with the use of a flexible interest rate policy alone, because the risk associated with exchange rate changes has been eliminated by indexing.

In summary, the appearance of monetary substitution in some developing countries can be traced to the high and erratic inflation rates that they have experienced in recent years. This has reduced the options available to policy makers and has resulted in an exacerbation of domestic imbalances, with further adverse consequences for inflation and the balance of payments. In such circumstances it becomes even more important to restore internal and external equilibrium, while at the same time developing mechanisms to regain the confidence of the public and reduce the degree and adverse impact of monetary substitution.

The IMF in a Changing World, 1945–85

by Margaret Garritsen de Vries

Written by the Fund’s Historian, this collection of 18 articles, originally published in Finance &, Development and the IMF Survey, constitute a short history of the highlights of the Fund’s evolution that should be of value both to serious students and to the general reader. A section discussing the evolution of the par value system prior to the adoption of floating of exchange rates is followed by two sections dealing with the turbulent 1970s, the ultimate collapse of the par value system, the sharp increase in inflation, the impact of higher oil prices, and the sudden expansion of balance of payments deficits. A section on the response to the debt crisis of the 1980s follows, and the book concludes with a retrospective review of developments during the Fund’s forty-year history.

* * * *

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