North of pegging

North of pegging

This article needs additional citations for verification. Worldwide official use north of pegging foreign currency or pegs. Currency substitution can be full or partial. Most, if not all, full currency substitution has taken place after a major economic crisis, for example, Ecuador and El Salvador in Latin America and Zimbabwe in Africa.

Partial currency substitution occurs when residents of a country choose to hold a significant share of their financial assets denominated in a foreign currency. It can also occur as a gradual conversion to full currency substitution, for example, Argentina and Peru were both in the process of converting to the U. Dollarization”, when referring to currency substitution, does not necessarily involve use of the United States dollar. De facto exchange-rate arrangements in 2013 as classified by the International Monetary Fund. 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. There are two common indicators of currency substitution. 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. Official currency substitution or full currency substitution happens when a country adopts a foreign currency as its sole legal tender, and ceases to issue the domestic currency. Another effect of a country adopting a foreign currency as its own is that the country gives up all power to vary its exchange rate.

Full currency substitution has mostly occurred in Latin America, the Caribbean and the Pacific, as many countries in those regions see the United States Dollar as a stable currency compared to the national one. For example, Panama underwent full currency substitution by adopting the US dollar as legal tender in 1904. In literature, there is a set of related definitions of currency substitution such as external liability currency substitution, domestic liability currency substitution, banking sector’s liability currency substitution or deposit currency substitution, and credit dollarlization. One of the main advantages of adopting a strong foreign currency as sole legal tender is to reduce the transaction costs of trade among countries using the same currency. There are at least two ways to infer this impact from data. Countries with full currency substitution can invoke greater confidence among international investors, inducing increased investments and growth. The elimination of the currency crisis risk due to full currency substitution leads to a reduction of country risk premiums and then to lower interest rates.

These effects result in a higher level of investment. Official currency substitution helps to promote fiscal and monetary discipline and thus greater macroeconomic stability and lower inflation rates, to lower real exchange rate volatility, and possibly to deepen the financial system. On the other hand, currency substitution leads to the loss of seigniorage revenue, the loss of monetary policy autonomy, and the loss of the exchange rate instruments. Seigniorage revenues are the profits generated when monetary authorities issue currency. In an economy with full currency substitution, monetary authorities cannot act as lender of last resort to commercial banks by printing money.

The alternatives to lending to the bank system may include taxation and issuing government debt. The loss of the lender of last resort is considered a cost of full currency substitution. Currency mismatch risk: Assets and liabilities on the balance sheets may be in different denominations. This may arise if the bank converts foreign currency deposits into local currency and lends in local currency or vice versa. Default risk: Arises if the bank uses the foreign currency deposits to lend in foreign currency.

However, currency substitution eliminates the probability of a currency crisis that negatively affects the banking system through the balance sheet channel. Currency substitution may reduce the possibility of systematic liquidity shortages and the optimal reserves in the banking system. High and unanticipated inflation rates decrease the demand for domestic money and raise the demand for alternative assets, including foreign currency and assets dominated by foreign currency. This phenomenon is called the “flight from domestic money”. It results in a rapid and sizable process of currency substitution. Currency substitution increases with inflation volatility and decreases with the volatility of the real exchange rate.

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