What is Currency Substitution?

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

Key Takeaways

  • Currency substitution is when a country uses a foreign currency in lieu of, or in addition to, their domestic currency, primarily due to the greater stability of that foreign currency.
  • 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 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 and as legal tender. The foreign currency thus serves as the de facto medium of exchange. Usually, a country which uses currency substitution will not have its own central bank or 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 as its currency.

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. 

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 some cases, a nation might circulate common cash, but decide to use another country’s currency in specific instances such as for international trade. Usually, full currency substitution will happen only after a significant event, whether it be political or economic.

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. For 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, currency substitution gives them credibility that will open up access to global trade. However, currency substitution also means that the domestic country will give up some economic control to the nation that owns the substituted currency.

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 is needed in the substituting country. 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 that use a great deal of currency substitution and also a flexible exchange rate can encounter problems. They have no authority over the exchange rates 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 foreign currency's exchange rate.

The higher the rate of currency substitution, the higher the likelihood that the adopting country will experience monetary disturbances. Zimbabwe is one such example of a nation that uses several currencies. Since 2009, Zimbabwe has used the South African rand (ZAR), British pound (GBP), Botswana pula (BWP), Chinese yuan (CNY), U.S. dollar (USD), and many others. Needless to say, volatility has been ever-present.

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, its political makeup, and the country's industry, natural resources, and exports.