Currency Substitution: Monetary Policy’s Effect on International Commerce

By Isaac Signorelli 

Generally speaking, “currency substitution” occurs when one nation (the domestic nation) uses another country’s (the foreign nation’s) currency as their domestic legal tender. Because of this, the domestic nation will generally not have its own central bank, meaning their currency cannot be backed by their government. In turn, the domestic nation cannot borrow money from the international capital markets without having large reserves. This term generally has been coined as “Dollarization” because of the vast amount of countries that use the U.S. dollar as their domestic legal tender.

The benefit to dollarization is that these countries receive the benefits of stability in the foreign exchange markets, but lose control of their own monetary policy. In fact, the U.S. dollar is the most widely used currency in the world. An extreme example of this would be Ecuador. Their adoption of the dollar was a way of imposing fiscal discipline by essentially handing their monetary policy to the United States. Some argue that less stable nations, such as some of those in South America, benefit from dollarization as speculators won’t be able to force devaluation by shorting domestic currency if there is no domestic currency. On the other hand, the Federal Reserve Board of the United States probably doesn’t give any consideration to other nation’s needs when adjusting their monetary policy.

For example, many developing nations rely heavily on raw materials and manufacturing. Trade goods that come from these industries are generally exported. Nations that export goods typically want a low valuation for their currency so they are “less expensive” for the nations buying them. This is why countries like China buy up U.S. dollars in the foreign exchange markets and flood them with their domestic currency to ensure that they remain attractive for exporting goods, a practice known as “pegging.” Therefore, developing nations that use the U.S. dollar are at a disadvantage when trying to export goods, especially when U.S. monetary policy increases the value of the U.S. dollar in the foreign exchange markets.

This longstanding issue has come under the spotlight recently with Scotland’s independence movement over the last several years. Scotland is rich in oil, obviously a commodity that is heavily exported. Scotland also prints its own notes (debt much like U.S. treasury bonds), but uses the British pound, which is of course controlled by the Bank of England. However, if Scotland continues to use the pound, they would need reserves around 25% of their total GDP in order to show the world that it can act as a lender of last resort during a financial crisis. The issue with this of course is that the British pound, a currency that is stronger than both the U.S. dollar and Euro, would not be ideal for exporting oil. While this hasn’t been an issue for Scotland thus far, this is partially due to the economic diversity that being a U.K. member allows them to have. Thus, one main consideration for Scotland in their quest to become an independent nation lies not only in if their economy alone can support their population, but how their choice of currency would affect their outlook.

References

Kabir Chibber, Here are all the countries that don’t have a currency of their own, quartz,(Sept.15, 2014), available at https://qz.com/260980/meet-the-countries-that-dont-use-their-own-currency/ (last visited Oct. 21, 2018).

Larry Rother, Ecuador’s Use of Dollars Brings Dollars’ Problems, NY Times, (Feb. 5, 2001) available at https://www.nytimes.com/2001/02/05/world/ecuador-s-use-of-dollars-brings-dollars-problems.html (last visited Oct. 21, 2018).

Scottish Economy, financial times,available at https://www.ft.com/stream/2504e757-ea97-43af-98b6-922b6dd0e85e (last visited Oct. 21, 2018).