Currency Substitution, Speculation, and Financial Crises: Theory and Empirical Analysis

We extend the "fundamentals model" of currency crisis by incorporating the currency substitution effects explicitly. In a regime of free foreign exchange markets and free capital movements the reserve (hard) currencies are likely to substitute for the local soft currency in agents' portfolia that include currency as an asset. Our model shows that, controlling for the fundamentals of an economy, the more pronounced the currency substitution is in a country, the earlier and the stronger is the tendency for the local currency to devalue. This is especially true if indebtedness, public and private, fail to decrease as currency substitution occurs. Moreover, the use of the required reserve ratio is indicated as an adjustment device to moderate short-term capital inflows and control the level of indebtedness. The model is implemented by constructing a currency-softness index. Two empirical findings emerge. First, there is a negative relationship between the currency-softness index and the degree of nominal exchange rate devaluation. This indicates that soft currency countries have a systematic tendency to have under-valued currency. Second, there is a systematic negative relationship between the softness of a currency and the level of economic development. The policy recommendations of the paper refer to the means of achieving "moderately repressed exchange rates," and thus helping diffuse the pressure for devaluation of soft currencies that is exogenously determined through the opportunities afforded for currency substitution in a globalization environment.