This paper analyzes the currency substitution (CS) process in a country of the former Soviet Union (henceforth called BRO1), the Kyrgyz Republic, from the introduction of the national currency in May 1993 to October 1998, three months after the Russia crisis hit the Kyrgyz economy.2 The Kyrgyz Republic is an interesting case since the ratio of foreign currency deposits to total deposits has risen sharply and hovered at around 40 percent since early 1997, notwithstanding considerable progress in macroeconomic stabilization during this period. The Kyrgyz case is symptomatic of similar developments in other BRO transition economies, which despite the restoration of growth and rapid disinflation have generally experienced persistently high and, in some cases, rising CS ratios.
Such developments seem to be consistent with evidence from Latin American and other countries where factors that are typically considered conducive to a decline in the CS ratio—moderate inflation, resumption of growth, stability of the exchange rate, and a relatively calm political situation—have generally led to a reduction in the CS ratio only after long lags. However, the BRO experience appears to run counter to the developments in some Central and Eastern European transition economies, which after successful macroeconomic stabilization have experienced a decline in their CS ratios, such as Poland.
Against this background, this paper identifies the determinants that have driven the CS process in the Kyrgyz Republic during the five years leading to the onset of the Russia crisis, including such factors that have traditionally been used in CS studies, i.e., the interest rate differential and the expected depreciation rate. However, based on Mueller (1994), the econometric analysis goes beyond the conventional CS literature by explicitly addressing the persistence in the use of foreign currency. This hysteresis is modeled through the inclusion of a ratchet variable, which implies an asymmetric substitution process between domestic and foreign currency. The persistence in the use of foreign currency is explained by the fixed costs of introducing “inflation-beating” money management techniques; once these fixed costs are overcome, there are few incentives for agents to switch back to the domestic currency even after macroeconomic stability is regained.
A second feature of this paper is that it experiments with a second, more comprehensive, definition of currency substitution by using a broader definition of the CS ratio that includes the estimated amount of foreign and domestic cash circulating in the Kyrgyz Republic, based on flow data and a recent survey undertaken by the National Bank of the Kyrgyz Republic (NBKR). By including cash, the CS ratio rises from just above 10 percent in May 1993 to slightly above 20 percent in October 1998. exhibiting a continuous, albeit less pronounced, upward trend than the deposit-based CS ratio.
The econometric results indicate that the interest rate differential and the depreciation of the exchange rate are significant CS determinants in the Kyrgyz economy. Moreover, while there may be a ratchet effect in the currency allocation of deposits, such an effect cannot be detected in the broader CS definition including cash. This suggests that the economy as a whole has not yet reached a degree of CS that would make the process asymmetric and difficult to reverse, implying that monetary policy may still have an impact on the portfolio decisions of the private sector. However, given the significance of the ratchet variable for the deposit-only CS ratio, particularly strong policies would need to be pursued over an extended period of time so as to convince deposit holders to switch back to som-denominated assets.
The paper is structured as follows. Section 1 illustrates the extent of CS in the BRO transition economies, pointing to the possible presence of a ratchet effect and providing a brief theoretical background for, and an overview of, its use in other empirical studies. Section II focuses on the CS process in the Kyrgyz Republic and describes the two CS definitions used in this paper. Section III describes the econometric model and the estimation results, while Section IV provides some general conclusions and policy implications.
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Joannes Mongardini and Johannes Mueller are Economist and Senior Economist, respectively, in the European II Department of the IMF. The authors would like to thank, without implication, Oleh Havrylyshyn, Julian Berengaut, Hugh Bredenkamp, Thanos Catsambas, Jens Dalsgaard, and two anonymous referees for helpful comments on earlier drafts. Sepideh Khazai also provided invaluable research assistance.
Baltics, Russia, and other countries of the former Soviet Union.
Given the central role of the ratchet effect in the present study, the analysis does not go beyond October 1998, as the Russia crisis has temporarily halted the process of macroeconomic stabilization in the Kyrgyz Republic and induced a renewed phase of currency substitution. A major banking crisis added further distortions in early 1999.
Only anecdotal evidence is presented, based on Figures 1 to 3, so as to put the developments in the Kyrgyz Republic into perspective. The general statements in this section would warrant a more detailed, country-specific analysis in a different forum.
Notwithstanding significant macroeconomic stabilization in Latvia in line with its Baltic neighbors, the CS ratio in Latvia remained high, which could be explained by its very liberal foreign exchange regulations, making it a safe haven for residents from other BRO countries. See Sahay and Végh (1996).
As pointed out by Savastano (1992 and 1996), some authors tried to estimate the amount of foreign currency bills in circulation in certain LDCs, e.g., Melvin and Afcha de la Parra (1989) or Kamin and Ericsson (1993). However, according to Savastano, the usefulness of these estimations is doubtful, given the extremely restrictive assumptions on the velocity of circulation of domestic money balances and other variables.
As there are no reliable monthly inflation data available especially for the first few years of the observation period, it was decided to use the monthly depreciation of the exchange rate as a proxy. The use of both the exchange rate and the inflation variables in the estimation leads to serious multicollinearity problems.
All dummy variables in the regression for both the CS1 and CS2 ratios were statistically significant.
All econometric results were computed using the Microfit 4.0 software package for Windows, designed by M. H. Pesaran and B. Pesaran (1997).
The tests for mean-stationarity were all rejected. LCS2 was also tested against the null hypothesis of a second order integration. The resulting test statistic was -5.738, clearly indicating that LCS2 is integrated of order 1.
This test is similar in kind to testing the significance of the ECM variable in an error correction model. For details, see Pesaran and Pesaran (1997).
A table of critical values for this nonstandard F-statistic is available in Pesaran and Pesaran (1997).
This result is also common to the regressions using the LCS2 ratio as a dependent variable, suggesting that this represents a more generalized phenomenon.