What is a Currency Substitution

During currency substitution, a nation will use foreign currency in place of its domestic currency for transactions and as legal tender. The foreign currency thus serves as a medium of exchange. Usually, a country which uses currency substitution will not have its own Central Bank or money with official backing for the financial or foreign exchange (FX). As an example, Panama substitutes the U.S. dollar as its currency.

Currency substitution is also known as dollarization.

BREAKING DOWN Currency Substitution

Currency substitution frequently happens in developing nations, those without a national currency, and countries with weak or unstable governments or economic situations. For example, the citizens of a country within an economy that is undergoing hyperinflation may choose to use a stable currency, like the U.S. dollar or the euro, to conduct transactions. 

How a nation uses its adopted currency varies and is known as a full or partial replacement depending on the currency's use. Some countries may choose to replace their native money with the foreign funds entirely. In some cases, a nation might circulate common cash, but, decide to use another country’s currency in specific instances such as in international trade. Usually, full currency substitution will happen after a significant political or economic upset.

Types of Currency Substitution

The residents of a nation may create an unofficial currency substitution as they exchange their domestic money for foreign currency. Often this will happen in countries experiencing hardships. As an example, the public may hold deposits in the substituted money, or it may be preferable for use in daily transactions. Some governments will place limits on the extent of foreign funds held by its citizens. 

A nation's government may adopt a full currency substitution for use as its legal tender. For small and growing nations using currency substitution, they will have access to globally recognized money which has the backing of a stable economy. However, when a country assumes another currency, it will give up some economic control to the nation that owns the currency. The substituting country cannot control monetary policies which affect the currency, such as the exchange rate or availability. Often, the nation with full currency substitution will lessen the cost of conducting business by eliminating the cost to convert money on the foreign exchange market and may encourage investments.

Partial currency substitution may allow the use of the foreign currency alongside the domestic money. Daily domestic transactions may use the local money, while international commerce may use the substituted currency. Examples of such use include Cambodia who uses both U.S. dollars (USD) and domestic funds and Iraq who uses both the USD and the dinar (IQD)

Risks of Currency Substitutions

An increase in the rate of currency substitution means that the national economy may fall victim to rapid changes in exchange rates, and thus may experience increased monetary shocks from both home and abroad. Countries who use a great deal of currency substitution and also use a flexible exchange rate can encounter problems. They have no authority over the exchange rates on the foreign exchange (FX) of the money they utilize. This lack of control means the adopting nation may see wide swings in the price of goods or services due to the ever-changing nature of the FX. The higher the rate of currency substitution is, the higher the likelihood of the country experiencing monetary disturbances will be. Zimbabwe is an example of a nation who uses several currencies. Since 2009, Zimbabwe uses the South African Rand (ZAR), British pound (GBP), Botswana Pula (BWP), Chinese yuan (CNY), U.S. dollar (USD), and many others.

There are considerations for how currency substitution will affect a country based on internal factors within that country. Internal factors include the size and location of the nation, the structure of its financial system, the political make-up, and the country's industry, natural resources, and exports.