Currency substitution and financial dollarization

Currency substitution is the case when foreign currencies are used in domestic transactions. For example, many people in Latin America use dollars to buy real estate and cars. In Eastern Europe, people use the dollar and the euro for the same purposes.

Why are dollars used instead of the local currency? The reason is that people do not trust the local currency. Because of high inflation or the depreciation of the local currency , they prefer to keep their money in dollars, which has traditionally been a stable currency, rather than in their own local currency. Therefore, in transactions that involve large sums of money they prefer to receive dollars.

It is interesting that currency substitution is widespread even in countries where inflation is low and has been low for many years. In these countries, a previous incidence of very high inflation prompted the population to start using dollars. When the use of the dollar became widespread, people became accustomed to it, and continued to use it in transactions even after inflation declined. Therefore, high inflation leads to currency substitutions but reducing inflation does not have the reverse effect on currency substitution (by the way, this persistent effect is called hysteresis).

Financial dollarization

Financial dollarization refers to the use of foreign currencies for savings. For example, many people in Latin America and Asia keep their money in dollar bank accounts instead of the local currency. In Eastern Europe, people open bank accounts in dollars, euro, British pounds, and Swiss Franc along with their own currencies.

Similar to currency substitution, financial dollarization is a by-product of low trust in the local money. If one believes that the domestic currency would depreciate and lose purchasing power, then the better option is to save in a more stable foreign currency.

Because people prefer to save in dollars, banks have to offer high interest rates on local currency deposits to motivate people to save in the local currency. As a result there is a currency risk premium on bank deposits denominated in the local currency. The bank deposits in local currency offer a higher interest rate than the bank deposits in dollars to compensate depositors for the currency risk.

Currency substitution and financial dollarization are common across emerging markets as almost all emerging markets had, at one point or another, experienced high inflation.

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