What Is Currency Substitution?

Currency substitution is when a country uses a foreign currency in lieu of, or in addition to, its domestic currency, primarily due to the greater stability of that foreign currency.

Key Takeaways

  • Currency substitution is when a country uses a foreign currency instead of or in addition to its own.
  • Currency substitution is also known as dollarization when the U.S. dollar (USD) is the currency that is being used as a substitute.
  • Currency substitution is commonly motivated by the need for a more stable monetary unit or in countries that are too small to capture the economies of scale of having their own currency.
  • Currency substitution frequently happens in developing nations, countries without a national currency, and countries with weak, unstable governments or economic climates.

Understanding Currency Substitution

When a country engages in currency substitution, it will use foreign currency in place of its domestic currency for transactions. The foreign currency thus serves as the de facto medium of exchange and the de jure medium of exchange if the foreign currency is also recognized by the local government as legal tender

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

Because the fundamental function of money as a medium of exchange makes it more useful the more widely it is accepted, a natural economy of scale, very small countries may often engage in currency substitution by adopting the currency of a larger neighbor or trading partner. For small and growing nations, currency substitution gives them credibility that will open up access to global trade, without the need to have its own central bank or print money with official backing for financial or foreign exchange (FX) transactions.

Currency substitution is also known as dollarization when the U.S. dollar (USD) is the currency that is being used as a substitute. An example of dollarization would be Panama, which has adopted the USD alongside its local currency.

Types of Currency Substitution

A nation may choose to engage in full or partial currency substitution. Some countries may choose to replace their native money with the foreign funds entirely. In other cases, a nation might circulate common cash, but decide to use another country’s currency in specific instances such as for international trade.

Full Currency Substitution

A nation's government may adopt a full currency substitution for use as its legal tender.  Often, full currency substitution will lessen the cost of conducting business by eliminating the cost to convert money on the FX market and may encourage investments. Usually, full currency substitution will happen only after a significant event, whether it be political or economic.

Partial Currency Substitution

Partial currency substitution permits 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 include Cambodia, which uses both USD and domestic funds, and Iraq, which uses both the USD and the dinar (IQD).

Unofficial Currency Substitution

The residents of a nation may create an unofficial currency substitution as they exchange their domestic money for a more stable foreign currency by the operation of Gresham's Law. Often this will happen in countries experiencing hardships. For example, the public may hold deposits in the substituted money, or it may be preferable for use in daily transactions. Sometimes this may simply be a matter of trivial convenience, such as when small U.S. and Canadian coins circulate at face value in communities near the border.

Risks of Currency Substitutions

Some governments will place limits on the extent of foreign funds held by its citizens in an attempt to force them to use the domestic currency. Currency substitution also means that the domestic country will give up some economic control to the nation that issues the substituted currency, and this means that currency substitution by citizens threatens the local government's ability to control the local economy.

For example, the substituting country will be at the mercy of the foreign country's monetary policy initiatives, which would affect the foreign currency and might be counter to what local politicians and policymakers desire in the substituting country.