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Currency substitution facts for kids

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Imagine a country where people use money from another country to buy things or save their earnings. This is called currency substitution. It means using a foreign currency either alongside or instead of the country's own money.

Currency substitution can be full or partial. Full currency substitution can occur after a major economic crisis, such as in Ecuador, El Salvador, or Zimbabwe. Some small economies, like Liechtenstein, find it easier to use the money of a bigger neighbor, such as the Swiss franc, because it's hard for them to manage their own currency.

Partial currency substitution occurs when residents of a country choose to hold a significant share of their financial assets in a foreign currency. They might do this because they trust the foreign currency more. For example, in the 1990s, Argentina and Peru started using the U.S. dollar more and more.

What is Currency Substitution?

Foreign currency uses and pegs
Worldwide official use of foreign currency or pegs:      United States dollar users, including the United States      Currencies pegged to the United States dollar      Euro users, including the Eurozone      Currencies pegged to the euro
     Australian dollar users, including Australia      Indian rupee users and pegs, including India      New Zealand dollar users, including New Zealand      Pound sterling users and pegs, including the United Kingdom      Russian ruble users, including Russia and other territories      South African rand users (CMA, including South Africa)
     Three cases of a country using or pegging the currency of a neighbor

When people talk about "dollarization," it doesn't always mean using the United States dollar. It's just a common term for when a country uses a foreign currency. The most popular foreign currencies used this way are the U.S. dollar and the euro.

Why Do Countries Use Foreign Money?

Main article: Bretton Woods system

After big world events like World War I and World War II, countries wanted to make the global economy more stable. They looked for ways to keep their money's value steady. One way was to link their currency to a major, trusted foreign currency.

Some countries choose a "hard peg," which means they are very committed to keeping their money's value fixed to another currency. This can even mean giving up control over their own money, like when countries join a currency union. Other countries use "soft pegs," which are more flexible ways to link their money.

In the late 1990s, many "soft pegs" failed in places like Southeast Asia and Latin America. This made countries think seriously about using foreign currencies.

Exchange rate arrangements map
Map of current exchange rate regimes (2018). De facto exchange-rate arrangements in 2018 as classified by the International Monetary Fund:      Floating (floating and free floating)      Soft pegs (conventional peg, stabilized arrangement, crawling peg, crawl-like arrangement, pegged exchange rate within horizontal bands)      Hard pegs (no separate legal tender, currency board)      Residual (other managed arrangement)

Before 1999, countries usually adopted foreign currencies for historical or political reasons. For example, Panama started using the U.S. dollar after it became independent.

More recently, countries like Ecuador (in 2000) and El Salvador (in 2001) switched to the U.S. dollar for different reasons. Ecuador did it to fix a big political and financial crisis. People had lost trust in their government and money system. El Salvador, however, made the switch after careful discussions, even though its economy was already stable.

The Eurozone is another example. Many European countries decided to use the euro (€) as their common money in 1999. This is like a full currency substitution, but with countries working together.

Different Ways Countries Use Foreign Money

Unofficial currency substitution is the most common type. This happens when people in a country choose to keep a lot of their savings in foreign money, even if it's not the official money. They might do this if their local money has a history of losing value or to protect themselves from inflation (when prices go up).

Official currency substitution happens when a country completely adopts a foreign currency as its only official money. It stops printing its own money. When a country does this, it also gives up the power to change its money's value compared to other currencies. This has happened a lot in Latin America, the Caribbean, and the Pacific, where countries see the United States Dollar as a very stable currency. For example, Panama officially adopted the U.S. dollar in 1904. This is also called de jure currency substitution.

Sometimes, currency substitution can be semiofficial. This means the foreign currency is used as official money alongside the country's own currency.

How Does Using Foreign Money Affect a Country?

Impact on Trade and Investment

One big benefit of using a strong foreign currency is that it can make trade between countries easier and cheaper. When countries use the same money, they don't have to worry about changing money back and forth, which saves time and costs. This can help a country connect better with the global economy.

Countries that fully adopt a foreign currency might also attract more international investors. This is because investors feel more confident that their money will be safe. It can lead to more investments and economic growth. When there's no risk of a currency crisis, countries might also get lower interest rates on loans.

Impact on Money Management

Official currency substitution can help a country manage its money and economy better. It can lead to more stable prices and lower inflation. By using a foreign currency, a country commits to a stable money policy. It also means the government can't just print more money to pay its debts, which encourages careful spending. Studies show that countries with full currency substitution often have lower inflation rates. It also removes the risk of sudden changes in the exchange rate.

However, there are downsides. A country loses the ability to earn money by printing its own currency (called seigniorage). It also gives up control over its own money policies. For example, the U.S. central bank (the Federal Reserve) makes decisions based on the U.S. economy, not on countries that use the U.S. dollar. This means a country using a foreign currency can't change its money's value to help its economy during tough times.

Impact on Banks

In a country that fully uses a foreign currency, the central bank can't easily help commercial banks by printing money if they run into trouble. This role, called "lender of last resort," is important for keeping banks stable. However, there are other ways to help banks, like through taxes or government loans.

Banks in countries that use foreign currency might face risks. For example, if they take deposits in foreign currency but lend in local currency, they could have a "currency mismatch." But using a foreign currency can also reduce the chance of a big currency crisis that could harm banks. Research suggests that official currency substitution has helped banks in Ecuador and El Salvador become more stable.

What Makes Countries Use Foreign Money?

When Local Money Loses Value

When a country has very high and unexpected inflation (prices rising quickly), people start to lose trust in their local money. They look for other ways to save their wealth, often by buying foreign currency. This is sometimes called a "flight from domestic money."

First, people stop using their local money to save. Then, they might start listing prices for goods and services in foreign currency. If inflation continues for a long time, people might even start using foreign currency for everyday shopping.

Studies show that currency substitution increases when inflation is unstable.

How Rules and Systems Play a Role

How much a country uses foreign money also depends on its rules and systems. If a country has a strong and well-developed financial market, it might offer many ways for people to save in local currency. This can reduce the need for foreign money.

Rules about foreign exchange and capital can also play a part. If a country has strict rules, people might keep their foreign money outside the country or use unofficial markets. But if a country has more foreign currency reserves, it might be able to manage the shift to foreign money better.

Countries Using Other Currencies

Many countries around the world use foreign currencies, either fully or partially. Here are some examples of the main "anchor currencies" they use:

Australian dollar

Euro

Indian rupee

New Zealand dollar

Pound sterling

British Overseas Territories using the pound, or a local currency pegged to the pound, as their currency:

The Crown Dependencies use a local issue of the pound as their currency:

Under plans published in the Sustainable Growth Commission report by the Scottish National Party, an independent Scotland would use the pound as their currency for the first 10 years of independence. This has become known as sterlingisation.

Other countries:

South African rand

Main article: Common Monetary Area

United States dollar

Main articles: United States dollar and International use of the U.S. dollar
Used exclusively
  •  British Virgin Islands (also issues non-circulating British Virgin Islands collector coins pegged to the U.S. dollar)
  • Caribbean Netherlands (since 1 January 2011)
  •  Marshall Islands (issued non-circulating collector coins of the Marshall Islands pegged to the U.S. dollar since 1986)
  •  Micronesia (since 1944)
  •  Palau (since 1944; issued non-circulating Palauan collector coins pegged to the U.S. dollar since 1992)
  •  Turks and Caicos Islands (issued non-circulating Turks and Caicos Islands collector coins denominated in "Crowns" and pegged to the U.S. dollar since 1969)
Used partially

Others

See also

  • Currency union
  • Currency board
  • Dedollarisation
  • Domestic liability dollarization
  • Petrocurrency
  • Bitcoin, a cryptocurrency
  • World currency
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