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47-434: Historically, soldiers serving overseas had been paid in local currency rather than in their "home" currency. Most cash drawn by soldiers would go directly into the local economy, and in a damaged economy the effects of a hard currency such as the dollar circulating freely alongside weaker local currencies could be very problematic, risking severe inflation . There were other problems as well. Once dollars were circulating in

94-658: A central bank may attempt to increase confidence in the local currency by pegging it against a hard currency , as is this case with the Hong Kong dollar or the Bosnia and Herzegovina convertible mark . This may lead to problems if economic conditions force the government to break the currency peg (and either appreciate or depreciate sharply) as occurred in the 1998–2002 Argentine great depression . In some cases, an economy may choose to abandon local currency altogether and adopt another country's currency as legal tender . Examples include

141-468: A combat region, the opposing side could freely use its own stocks of dollars as currency, or acquire stocks for use elsewhere. The high purchasing power of the dollar, and its easy transference back to the United States, also posed a significant incentive to black-marketeering . However, whilst the use of local currencies was effective where they were provided in cooperation with the local authorities, it

188-405: 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. They hold deposits in the foreign currency because of a bad track record of the local currency, or as a hedge against inflation of the domestic currency. Official currency substitution or full currency substitution happens when a country adopts

235-474: A currency that is considered weak at one time may become stronger, or vice versa. One barometer of hard currencies is how they are favored within the foreign-exchange reserves of countries: The percental composition of currencies of official foreign exchange reserves from 1995 to 2022. The US dollar (USD) has been considered a strong currency for much of its history. Despite the Nixon shock of 1971, and

282-602: 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 . There are a small number of countries adopting a foreign currency as legal tender . Full currency substitution has mostly occurred in Latin America, the Caribbean and the Pacific, as many countries in those regions see

329-512: 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.S. dollar during the 1990s. "Dollarization", when referring to currency substitution, does not necessarily involve use of the United States dollar . The major currencies used as substitutes are the US dollar and the euro . After

376-521: A hard currency for much of its short history. However, the European sovereign debt crisis has partially eroded that confidence. The Swiss franc (CHF) has long been considered a hard currency, and in fact was the last paper currency in the world to terminate its convertibility to gold on 1 May 2000, following a referendum . In the summer of 2011, the European sovereign debt crisis led to rapid flows out of

423-824: A hard currency. However, it is now regarded as a junk currency due to the sharp decline in the currency's value since 2022. For this reason, many exchange offices don’t handle the Japanese yen. The impact of this junk currencyisation has also led to a series of moves by even Japanese companies to cease trading in Japanese yen. Investors as well as ordinary people generally prefer hard currencies to soft currencies at times of increased inflation (or, more precisely, times of increased inflation differentials between countries), at times of heightened political or military risk, or when they feel that one or more government-imposed exchange rates are unrealistic. There may be regulatory reasons for preferring to invest outside one's home currency, e.g.

470-502: A major economic crisis, such as in Ecuador , El Salvador , and Zimbabwe . Some small economies, for whom it is impractical to maintain an independent currency, use the currencies of their larger neighbours; for example, Liechtenstein uses the Swiss franc . Partial currency substitution occurs when residents of a country choose to hold a significant share of their financial assets denominated in

517-581: A monetary authority needs to withdraw the domestic currency and give up future seigniorage revenue. The country loses the rights to its autonomous monetary and exchange rate policies, even in times of financial emergency. For example, former chairman of the Federal Reserve Alan Greenspan has stated that the central bank considers the effects of its decisions only on the US economy. In a full currency substituted economy, exchange rates are indeterminate and monetary authorities cannot devalue

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564-458: A reduction of country risk premiums and then to lower interest rates. These effects result in a higher level of investment. However, there is a positive association between currency substitution and interest rates in a dual-currency economy. 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

611-473: A result of internal debates and in a context of stable macroeconomic fundamentals and long-standing unofficial currency substitution. The eurozone adopted the euro (€) as its common currency and sole legal tender in 1999, which might be considered a variety of full-commitment regime similar to full currency substitution despite some evident differences from other currency substitutions. There are two common indicators of currency substitution. The first measure

658-579: Is also even less trusted than soft currency and have a very low currency value. These countries experience sharp falls in value all the time. The paper currencies of some developed countries have earned recognition as hard currencies at various times, including the United States dollar , euro , British pound sterling , Japanese yen , Swiss franc and to a lesser extent the Canadian dollar , New Zealand dollar , Swedish krona , Singapore dollar , Hong Kong dollar and Australian dollar . As times change,

705-417: Is any globally traded currency that serves as a reliable and stable store of value . Factors contributing to a currency's hard status might include the stability and reliability of the respective state's legal and bureaucratic institutions, level of corruption , long-term stability of its purchasing power , the associated country's political and fiscal condition and outlook, and the policy posture of

752-431: Is the share of foreign currency deposits (FCD) in the domestic banking system in the broad money including FCD. 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

799-601: The United States Bureau of Engraving and Printing , with some were printed by the Soviet Union and by the Japanese Ministry of Finance . Notes today are fairly common, and can be valued anywhere from one dollar (for a common bill) to a couple thousand dollars for a rare series, low printing, or replacement bill. Hard currency In macroeconomics , hard currency , safe-haven currency , or strong currency

846-481: 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. This type of currency substitution is also known as de jure currency substitution . Currency substitution can be used semiofficially (or officially, in bimonetary systems), where the foreign currency is legal tender alongside

893-823: The gold standard was abandoned at the outbreak of World War I and the Bretton Woods Conference following World War II , some countries sought exchange rate regimes to promote global economic stability, and hence their own prosperity. Countries usually peg their currency to a major convertible currency . "Hard pegs" are exchange rate regimes that demonstrate a stronger commitment to a fixed parity (i.e. currency boards) or relinquish control over their own currency (such as currency unions) while "soft pegs" are more flexible and floating exchange rate regimes. The collapse of "soft" pegs in Southeast Asia and Latin America in

940-460: The gravity model of trade and provided empirical evidence that countries sharing a common currency engage in significantly increased trade among them, and that the benefits of currency substitution for trade may be large. 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

987-498: The United States' growing fiscal and trade deficits, most of the world's monetary systems have been tied to the US dollar due to the Bretton Woods system and dollarization . Countries have thus been compelled to purchase dollars for their foreign exchange reserves , denominate their commodities in dollars for foreign trade, or even use dollars domestically, thus buoying the currency's value. The euro (EUR) has also been considered

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1034-544: The adoption of the US dollar in Panama , Ecuador , El Salvador and Zimbabwe and the adoption of the German mark and later the euro in Serbia and Montenegro . Dollarization Currency substitution is the use of a foreign currency in parallel to or instead of a domestic currency. Currency substitution can be full or partial. Full currency substitution can occur after

1081-442: 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. This cost depends on the initial level of unofficial currency substitution before moving to a full currency substituted economy. This relation is negative because in a heavily currency substituted economy, the central bank already fears difficulties in providing liquidity assurance to

1128-449: The banking system. In contrast, by increasing foreign currency reserves, a country might mitigate the shift of assets abroad and strengthen its external reserves in exchange for a currency substitution process. However, the effect of this regulation on the pattern of currency substitution depends on the public's expectations of macroeconomic stability and the sustainability of the foreign exchange regime. British Overseas Territories using

1175-448: The banking system. However, literature points out the existence of alternative mechanisms to provide liquidity insurance to banks, such as a scheme by which the international financial community charges an insurance fee in exchange for a commitment to lend to a domestic bank. Commercial banks in countries where saving accounts and loans in foreign currency are allowed may face two types of risks: However, currency substitution eliminates

1222-464: The correlation between the business cycle of the client country (the economy with currency substitution) and the business cycle of the anchor country. In addition, monetary authorities in economies with currency substitution diminish the liquidity assurance to their banking system. 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

1269-424: The currency. In an economy with high currency substitution, devaluation policy is less effective in changing the real exchange rate because of significant pass-through effects to domestic prices. However, the cost of losing an independent monetary policy exists when domestic monetary authorities can commit an effective counter-cyclical monetary policy, stabilizing the business cycle. This cost depends adversely on

1316-422: 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. In countries with high inflation rates, the domestic currency tends to be gradually displaced by a stable currency. At the beginning of this process,

1363-450: The demand for foreign currency will be satisfied in the holding of foreign currency assets abroad and outside the domestic banking system. This demand often puts pressure on the parallel market of foreign currency and on the country's international reserves. Evidence for this pattern is given in the absence of currency substitution during the pre-reform period in most transition economies, because of constricted controls on foreign exchange and

1410-415: The determinants of deposit and credit currency substitution, concluding that currency substitution is driven by the volatility of inflation and the real exchange rate. Currency substitution increases with inflation volatility and decreases with the volatility of the real exchange rate. The flight from domestic money depends on a country's institutional factors. The first factor is the level of development of

1457-444: The domestic currency. 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 dollarization . External liability currency substitution measures total external debt (private and public) denominated in foreign currencies of

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1504-415: The domestic financial market. An economy with a well-developed financial market can offer a set of alternative financial instruments denominated in domestic currency, reducing the role of foreign currency as an inflation hedge. The pattern of the currency substitution process also varies across countries with different foreign exchange and capital controls. In a country with strict foreign exchange regulations,

1551-426: The economy. Deposit currency substitution can be measured as the share of foreign currency deposits in the total deposits of the banking system, and credit currency substitution can be measured as the share of dollar credit in the total credit of the banking system. 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

1598-550: The euro and into the franc by those seeking hard currency, causing the latter to appreciate rapidly. On 6 September 2011, the Swiss National Bank announced that it would buy an "unlimited" number of euros to fix an exchange rate at 1.00 EUR = 1.20 CHF, to protect its trade. This action temporarily eliminated the franc's hard currency advantage over the euro but was abandoned in January 2015. The Japanese yen used to be

1645-642: The fall of the Soviet Union in December 1991, the ruble depreciated rapidly, while the purchasing power of the US dollar was more stable, making it a harder currency than the ruble. A tourist could get 200 rubles per US dollar in June 1992, and 500 ruble per dollar in November 1992. In some economies, which may be either planned economies or market economies using a soft currency , there are special stores that accept only hard currency. Examples have included Tuzex stores in

1692-415: The financial system. Firstly, currency substitution helps developing countries, providing a firm commitment to stable monetary and exchange rate policies by forcing a passive monetary policy. Adopting a strong foreign currency as legal tender will help to "eliminate the inflation-bias problem of discretionary monetary policy". Secondly, official currency substitution imposes stronger financial constraint on

1739-579: The former Czechoslovakia , Intershops in East Germany , Pewex in Poland , or Friendship stores in China in the early 1990s. These stores offer a wider variety of goods – many of which are scarce or imported – than standard stores. Because hard currencies may be subject to legal restrictions, the desire for transactions in hard currency may lead to a black market . In some cases,

1786-437: The government by eliminating deficit financing by issuing money. An empirical finding suggests that inflation has been significantly lower in economies with full currency substitution than nations with domestic currencies. The expected benefit of currency substitution is the elimination of the risk of exchange rate fluctuations and a possible reduction in the country's international exposure. Currency substitution cannot eliminate

1833-443: The issuing central bank . Safe haven currency is defined as a currency which behaves like a hedge for a reference portfolio of risky assets conditional on movements in global risk aversion . Conversely, a weak or soft currency is one which is expected to fluctuate erratically or depreciate against other currencies. Softness is typically the result of weak legal institutions and/or political or fiscal instability. junk currency

1880-448: The late 1990s led to currency substitution becoming a serious policy issue. 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. Panama adopted the US dollar as legal tender after independence as

1927-644: The local currency may be subject to capital controls which makes it difficult to spend it outside the host nation. For example, during the Cold War , the ruble in the Soviet Union was not a hard currency because it could not be easily spent outside the Soviet Union and because the exchange rates were fixed at artificially high levels for persons with hard currency, such as Western tourists. (The Soviet government also imposed severe limits on how many rubles could be exchanged by Soviet citizens for hard currencies.) After

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1974-510: 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. Research has shown that official currency substitution has played a significant role in improving bank liquidity and asset quality in Ecuador and El Salvador. High and unanticipated inflation rates decrease

2021-401: The result of a constitutional ruling. Ecuador and El Salvador became fully dollarized economies in 2000 and 2001 respectively, for different reasons. Ecuador underwent currency substitution to deal with a widespread political and financial crisis resulting from massive loss of confidence in its political and monetary institutions. By contrast, El Salvador's official currency substitution was

2068-435: The risk of an external crisis but provides steadier markets as a result of eliminating fluctuations in exchange rates. 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. When adopting a foreign currency as legal tender ,

2115-433: The same currency. There are at least two ways to infer this impact from data. The first is the significantly negative effect of exchange rate volatility on trade in most cases, and the second is an association between transaction costs and the need to operate with multiple currencies. Economic integration with the rest of the world becomes easier as a result of lowered transaction costs and stabler prices. Rose (2000) applied

2162-435: The store-of-value function of the domestic currency is replaced by the foreign currency. Then, the unit-of-account function of the domestic currency is displaced when many prices are quoted in a foreign currency. A prolonged period of high inflation will induce the domestic currency to lose its function as medium of exchange when the public carries out many transactions in foreign currency. Ize and Levy-Yeyati (1998) examine

2209-409: Was impractical in combat zones where the government might be hostile, deliberately ambivalent, or simply non-existent. In these cases, the military authorities issued special "military currency", which was paid out to soldiers at a fixed rate of exchange and simply declared legal tender in occupied areas by local commanders. Five types of currency were issued: The majority of the notes were printed by

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