Academy of Economic Studies Doctoral School of Finance and Banking CURRENCY SUBSTITUTION IN ROMANIA...

Academy of Economic StudiesDoctoral School of Finance and Banking

CURRENCY SUBSTITUTION

IN ROMANIA

MSc Student: Ciprian Dascalu

Supervisor: Professor Moisa Altar

THEORETICAL BACKGROUND

Definitions

- Currency substitution

- Currency substitutability

Dollarisation or Currency Substitution

Theoretical models:

- cash-in-advance models

- transaction-costs models

- ad-hoc models

EMPIRICAL BACKGROUND

Money demand functions for domestic and foreign currency are part of a sequential portfolio balance model;

Two-period portfolio balance model;

Models dealing with representative agent dynamic optimization problem;

Money demand models including ratchet effect to account for hysteresis;

Pros and Cons of currency substitution

DEPENDENT VARIBLES

Total stock of money in domestic currency (M_ROL1); The total stock of domestic money in banking system (M_ROL2), since there is no reliable data on foreign currency in circulation;The ratio of foreign currency deposits and brad money (CS1);The proportion of foreign deposits in total term deposits (CS2), considering that foreign currency deposits are primarily hold for store of value proposes;The ratio between domestic and foreign currency (CS3) to inspect the substitution between domestic and foreign currency deposits.

All dependent variables are in logarithms.

9.5

10.0

10.5

11.0

11.5

12.0

12.5

1996 1997 1998 1999 2000 2001 2002

M_ROL1

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

1996 1997 1998 1999 2000 2001 2002

M_ROL2

-1.6

-1.5

-1.4

-1.3

-1.2

-1.1

-1.0

-0.9

-0.8

-0.7

1996 1997 1998 1999 2000 2001 2002

CS1

-.8

-.6

-.4

-.2

.0

.2

.4

1996 1997 1998 1999 2000 2001 2002

CS2

-.8

-.6

-.4

-.2

.0

.2

.4

1996 1997 1998 1999 2000 2001 2002

CS3

EXPLANATORY VARIABLES

A scale variable, the industrial production (IPI), in logarithm;The own return (marginal) of domestic money, the deposit interest rate for non-banking clients (DR);The opportunity cost of holding money, the return on treasury bills (TBR);The inflation rate since real assets represent an alternative to money holding (INFLATION);Exchange rate depreciation against a basket comprised of (60% EURO and 40% USD) (D_BASKET) as the relative cost of holding domestic money instead of foreign currency;The past peak values of the exchange rate (R_BASKET) and the past peak values of currency substitution ratios (R_CS), to account for the ratchet effect, both expressed in logarithms.

0

1

2

3

4

1996 1997 1998 1999 2000 2001 2002

INFLATION

-.8

-.7

-.6

-.5

-.4

-.3

-.2

1996 1997 1998 1999 2000 2001 2002

IPI

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1996 1997 1998 1999 2000 2001 2002

DR

0.0

0.4

0.8

1.2

1.6

2.0

1996 1997 1998 1999 2000 2001 2002

TBR

-.1

.0

.1

.2

.3

.4

1996 1997 1998 1999 2000 2001 2002

D_BASKET

7.5

8.0

8.5

9.0

9.5

10.0

10.5

1996 1997 1998 1999 2000 2001 2002

R_BASKET

MODEL USED

Portfolio Balance Model – a version of Branson and Henderson (1985) to investigate currency substitutability, this model implies a negative sign associated to depreciation rate as an evidence that domestic currency could be substituted by a foreign currency:

Analysis of the currency substitution as a ratio without imposing restriction reflecting a particular money demand theory, since foreign deposits have a significant store of value role;The possibility of an asymmetric reaction of foreign currency holdings to its main determinants.

TBRINFLATIONDRBASKETDIPIROLM ***_**_ 54321

METHODOLOGY

ECM’s proved to be a useful tool for estimation of money demand functions, along with the long run relation given by cointegration using Johansen procedure;

Data span is 1996:01 – 2002:12;

Data is not seasonally adjusted (such pre-filtering may affect the short-run dynamics);

Except the depreciation rate and the rate of inflation which are probably I(0), the rest of variable are I(1), they shouldn't be excluded of the cointegration vector (Dickey and Rossana (1994), Harris (1995)).

CURRENCY SUBSTITUTABILITY

Variable IPI D_EXBASKET DRINFLATION

TBR SPEED OF

ADJUSTMENT

M_ROL1

Eq. 1

2.623697 (1.39953) [-1.87470]

- 2.898162 (0.41354) [ 7.00822]

1.739506 (0.36544) [-4.76009]

-1.380286 (0.40548) [ 3.40406]

-0.262162 (0.20235) [ 1.29557]

-0.017941 (0.00412) [-4.35809]

M_ROL1

Eq. 2

2.278764 (0.87578) [-2.60199]

-1.181348 (0.33638) [ 3.51196]

0.744964 (0.16083) [-4.63206]

-1.090635 (0.28317) [ 3.85156]

*** -0.048624 (0.01287) [-3.77869]

Standard errors in ( ) & t-statistics in [ ].

Unrestricted Cointegration Rank Test

Hypothesized Trace 5 Percent 1 Percent No. of CE(s) Eigenvalue Statistic Critical Value Critical Value

None * 0.387338 88.06117 87.31 96.58 At most 1 0.307559 49.35576 62.99 70.05 At most 2 0.157769 20.32073 42.44 48.45 At most 3 0.080597 6.756317 25.32 30.45 At most 4 0.001491 0.117889 12.25 16.26

*(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 1 cointegrating equation(s) at the 5% level Trace test indicates no cointegration at the 1% level

Hypothesized Max-Eigen 5 Percent 1 Percent No. of CE(s) Eigenvalue Statistic Critical Value Critical Value

None * 0.387338 38.70540 37.52 42.36 At most 1 0.307559 29.03503 31.46 36.65 At most 2 0.157769 13.56442 25.54 30.34 At most 3 0.080597 6.638428 18.96 23.65 At most 4 0.001491 0.117889 12.25 16.26

*(**) denotes rejection of the hypothesis at the 5%(1%) level Max-eigenvalue test indicates 1 cointegrating equation(s) at the 5% level Max-eigenvalue test indicates no cointegration at the 1% level

Lags interval (in first differences): 1 to 4

Sample(adjusted): 1996:06 2002:12 Included observations: 79 after adjusting endpoints Trend assumption: Linear deterministic trend (restricted) Series: M2_ROL1 IPI D_BASKET INFLATION DR TBR

-.15

-.10

-.05

.00

.05

.10

.15

.20

1997 1998 1999 2000 2001 2002

Recursive Residuals ± 2 S.E.

-30

-20

-10

0

10

20

30

1997 1998 1999 2000 2001 2002

CUSUM 5% Significance

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1997 1998 1999 2000 2001 2002

CUSUM of Squares 5% Significance

.00

.05

.10

.15

-.2

-.1

.0

.1

.2

1997 1998 1999 2000 2001 2002

One-Step Probability Recursive Residuals

.00

.05

.10

.15-.2

-.1

.0

.1

.2

1997 1998 1999 2000 2001 2002

N-Step Probability Recursive Residuals

STABILITY TESTS

STABILITY TESTS

-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

1997 1998 1999 2000 2001 2002

Recursive C(1) Estimates ± 2 S.E.

-.04

-.02

.00

.02

.04

.06

.08

1997 1998 1999 2000 2001 2002


-.28

-.24

-.20

-.16

-.12

-.08

-.04

.00

.04

1997 1998 1999 2000 2001 2002


-.01

.00

.01

.02

.03

.04

.05

.06

1997 1998 1999 2000 2001 2002


-.05

-.04

-.03

-.02

-.01

.00

.01

.02

.03

1997 1998 1999 2000 2001 2002


CURRENCY SUBSTITUTABILITYVariable IPI D_EXBASKET DR INFLATION TBR SPEED OF

ADJUSTMENT

M_ROL2

Eq. 1

1.535829 (1.18773) [-1.29308]

-2.534164 (0.35427) [ 7.15324]

1.274687 (0.30092) [-4.23600]

-1.328478 (0.34871) [ 3.80972]

-0.117193 (0.17108) [ 0.68501]

-0.019251 (0.00513) [-3.75288]

M_ROL2

Eq. 2

3.164238 (1.53578) [-2.06034]

-2.279694 (0.38367) [ 5.94174]

1.347877 (0.25102) [-5.36967]

-1.474063 (0.41126) [ 3.58429]

***

-0.013053 (0.00392) [-3.33061]



None ** 0.574716 127.4611 87.31 96.58 At most 1 0.297137 58.20621 62.99 70.05 At most 2 0.213194 29.64614 42.44 48.45 At most 3 0.115477 10.22448 25.32 30.45 At most 4 0.003515 0.285207 12.25 16.26

*(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 1 cointegrating equation(s) at both 5% and 1% levels



*(**) denotes rejection of the hypothesis at the 5%(1%) level Max-eigenvalue test indicates 1 cointegrating equation(s) at both 5% and 1% levels

Sample(adjusted): 1996:04 2002:12 Included observations: 81 after adjusting endpoints Trend assumption: Linear deterministic trend (restricted) Series: M2_ROL2 IPI D_BASKET INFLATION DR TBR

Lags interval (in first differences): 1 to 2

-.15

-.10

-.05

.00

.05

.10

.15

.20

1997 1998 1999 2000 2001 2002


-30

-20

-10

0

10

20

30

1997 1998 1999 2000 2001 2002


-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1997 1998 1999 2000 2001 2002


.00

.05

.10

.15

-.2

-.1

.0

.1

.2

1997 1998 1999 2000 2001 2002


.00

.05

.10

.15

-.2

-.1

.0

.1

.2

1997 1998 1999 2000 2001 2002


STABILITY TESTS

-.8

-.6

-.4

-.2

.0

.2

.4

1997 1998 1999 2000 2001 2002


-.04

-.02

.00

.02

.04

.06

1997 1998 1999 2000 2001 2002


-.25

-.20

-.15

-.10

-.05

.00

.05

1997 1998 1999 2000 2001 2002


-.01

.00

.01

.02

.03

.04

.05

.06

1997 1998 1999 2000 2001 2002


-.04

-.03

-.02

-.01

.00

.01

.02

.03

1997 1998 1999 2000 2001 2002


STABILITY TESTS

EVIDENCE THAT DOMESTIC CURRENCY HAS THE ABILITY OF

BEING SUBSTITUTED

MODEL1Eq.1

MODEL1Eq.2

MODEL2Eq.1

MODEL2Eq.2

Χ2(1) 28.21274 32.95289 31.13666 28.99550

p-value0.000000 0.000000 0.000000 0.000000

The null hypothesis is that the coefficient associated to exchange rate depreciation is zero.

RESTRICTION IN LINE WITH THE QUANTITATIVE THEORY OF MONEY

The null hypothesis is that the coefficient associated to the scale variable is one.

MODEL1 MODEL2

Χ2(1) 0.142438

0.026553

p-value 0.705869

0.870557

WEAK EXOGEINITY ΔMROL1 ΔIPI ΔD_EXBASKET ΔDR ΔINFLATION ΔTBR

Χ2(1) 14.06821

0.002699 13.41405

11.59228 2.277853

3.478700

p-value0.000176

0.958567 0.000250

0.000662 0.131233

0.062164

ΔMROL2 ΔIPI ΔD_EXBASKET ΔDR ΔINFLATION ΔTBR

Χ2(1)11.29531

0.044568 14.01270

11.86642 1.315177

3.533511

p-value0.000777 0.832801 0.000182 0.000572 0.251459 0.060140

The null hypothesis is that there is weak exogeneity.

The deposit rate (after the sharp decline in money demand after 1997, the NBR stimulated its recovery through a rise in the level of interest rates) and the depreciation basket (demonetisation of the economy raise the demand for foreign currency) adjust to the disequilibria in the cointegration vector.

CURRENCY SUBSTITUTIONVariable IPI D_BASKET INFLATION DR CONSTANT

CS1

Eq. 1

1.393081 (0.58447) [-2.38352]

1.997812 (0.30438) [-6.56346]

1.033161 (0.24987) [-4.13479]

-0.341896 (0.10067) [ 3.39616]

-0.686649

CS2

Eq. 2

2.055270 (0.56903) [-3.61190]

2.473727 (0.26466) [-9.34698]

1.339928 (0.22015) [-6.08642]

-0.196935 (0.10357) [ 1.90152]

-1.228833

CS3

Eq. 3

3.417434 (1.05484) [-3.23977]

4.297071 (0.48402) [-8.87779]

2.400730 (0.41233) [-5.82229]

-0.498750 (0.19278) [ 2.58714]

-0.378053




None ** 0.660543 145.0839 76.07 84.45 At most 1 * 0.298704 58.65132 53.12 60.16 At most 2 0.197953 30.26526 34.91 41.07 At most 3 0.137912 12.61818 19.96 24.60 At most 4 0.009286 0.746347 9.24 12.97

*(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 2 cointegrating equation(s) at the 5% level Trace test indicates 1 cointegrating equation(s) at the 1% level



*(**) denotes rejection of the hypothesis at the 5%(1%) level Max-eigenvalue test indicates 2 cointegrating equation(s) at the 5% level Max-eigenvalue test indicates 1 cointegrating equation(s) at the 1% level

Sample(adjusted): 1996:05 2002:12 Included observations: 80 after adjusting endpoints Trend assumption: No deterministic trend (restricted constant) Series: CS IPI D_BASKET INFLATION DR Lags interval (in first differences): 1 to 3

Sample(adjusted): 1996:05 2002:12 Included observations: 80 after adjusting endpoints Trend assumption: Linear deterministic trend (restricted) Series: CS2 IPI D_BASKET INFLATION DR Lags interval (in first differences): 1 to 3




*(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 2 cointegrating equation(s) at the 5% level Trace test indicates 1 cointegrating equation(s) at the 1% level



*(**) denotes rejection of the hypothesis at the 5%(1%) level Max-eigenvalue test indicates 2 cointegrating equation(s) at the 5% level Max-eigenvalue test indicates 1 cointegrating equation(s) at the 1% level

Sample(adjusted): 1996:05 2002:12 Included observations: 80 after adjusting endpoints Trend assumption: Linear deterministic trend (restricted) Series: CS3 IPI D_BASKET INFLATION DR Lags interval (in first differences): 1 to 3




*(**) denotes rejection of the hypothesis at the 5%(1%) level Trace test indicates 1 cointegrating equation(s) at both 5% and 1% levels



*(**) denotes rejection of the hypothesis at the 5%(1%) level Max-eigenvalue test indicates 1 cointegrating equation(s) at both 5% and 1% levels

-.12

-.08

-.04

.00

.04

.08

.12

1996 1998 1999 2000 2001 2002


-30

-20

-10

0

10

20

30

1996 1998 1999 2000 2001 2002


-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1997 1998 1999 2000 2001 2002


.00

.05

.10

.15

-.2

-.1

.0

.1

.2

1996 1998 1999 2000 2001 2002


.00

.05

.10

.15-.2

-.1

.0

.1

.2

1996 1998 1999 2000 2001 2002


-.8

-.6

-.4

-.2

.0

.2

.4

.6

1997 1998 1999 2000 2001 2002


0.4

0.8

1.2

1.6

2.0

2.4

2.8

1997 1998 1999 2000 2001 2002


-.04

-.02

.00

.02

.04

.06

.08

1997 1998 1999 2000 2001 2002


-.3

-.2

-.1

.0

.1

.2

.3

.4

.5

1997 1998 1999 2000 2001 2002


-.12

-.08

-.04

.00

.04

.08

.12

1996 1998 1999 2000 2001 2002


-30

-20

-10

0

10

20

30

1997 1998 1999 2000 2001 2002


-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1996 1998 1999 2000 2001 2002


.00

.05

.10

.15

-.10

-.05

.00

.05

.10

1996 1998 1999 2000 2001 2002


.00

.05

.10

.15-.10

-.05

.00

.05

.10

1996 1998 1999 2000 2001 2002


-.3

-.2

-.1

.0

.1

.2

.3

.4

1997 1998 1999 2000 2001 2002


.012

.016

.020

.024

.028

.032

.036

.040

.044

.048

1997 1998 1999 2000 2001 2002


.00

.01

.02

.03

.04

.05

.06

.07

1997 1998 1999 2000 2001 2002


-.025

-.020

-.015

-.010

-.005

.000

.005

1997 1998 1999 2000 2001 2002


-.15

-.10

-.05

.00

.05

.10

.15

1996 1998 1999 2000 2001 2002


-30

-20

-10

0

10

20

30

1996 1998 1999 2000 2001 2002


-0.2

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1996 1998 1999 2000 2001 2002


.00

.05

.10

.15

-.2

-.1

.0

.1

.2

1996 1998 1999 2000 2001 2002


.00

.05

.10

.15-.2

-.1

.0

.1

.2

1996 1998 1999 2000 2001 2002


-.6

-.4

-.2

.0

.2

.4

.6

1997 1998 1999 2000 2001 2002


.02

.03

.04

.05

.06

.07

.08

1997 1998 1999 2000 2001 2002


.00

.02

.04

.06

.08

.10

.12

1997 1998 1999 2000 2001 2002


-.04

-.03

-.02

-.01

.00

.01

1997 1998 1999 2000 2001 2002


HYSTERESISVariable D_BASKET INFLATION DR R_CS

R_BASKET

CS1

0.230260 (0.06829) [-3.37196]

0.354158 (0.05358) [-6.61020]

-0.093167 (0.02712) [ 3.43583]

***

0.328494 (0.02543) [-12.9165]

CS1

1.515158 (0.24022) [-6.30731]

0.773906 (0.17694) [-4.37376]

-0.169877 (0.07405) [ 2.29419]

0.544877 (0.25696) [-2.12044]

***

CS2

0.393951 (0.14169) [-2.78032]

0.553937 (0.10266) [-5.39601]

- 0.231276 (0.05256) [ 4.40039]

***

0.203886 (0.04726) [-4.31418]

CS3

1.036575 (0.33192) [-3.12292]

1.328823 (0.24507) [-5.42230]

-0.560334 (0.12433) [ 4.50696]

***

0.310811 (0.11121) [-2.79484]


CONCLUSIONS

The demand for domestic currency is sensitive to exchange rate depreciation, thus the national money could be replaced by foreign currency.

Raising the interest rate on deposits would be a solution for reverting the currency substitution process. But there were periods with negative real interest rate.

In Romania the substitution process was rather encouraged since the reserve requirements established a lower rate for foreign currency deposits until November 2002 (when the rate of reserve requirements was set at 25% for deposits in foreign exchange and 18% for deposits in national currency, with a view to effectively discourage further dollarisation).

References: Berg, A. and E. Borensztein (2000), “The Prons and Cons of Full Dollarization”, IMF Working Paper 50, 2000.Bordo, M. D. and E. U. Choudhri (1982), “Currency Substitution and the Demand for Money: Some evidence for Canada”, Journal of Money, Credit and Banking, 14, 48-57.Bufman, G. and L. Leiderman (1992), Simulating an Optimizing Model of Currency Substitution. Revista de Analisis Economico, vol. 7, No. 1, 1992.Calvo, G.A. (1999), “On Dollarization”, University of Maryland, 1999.Calvo, G.A. and C. A. Rodriguez (1977). A Model of Exchange Rate Determination under Currency Substitution and Rational Expectations, Journal of Political Economy, 85, 617-625.Calvo, G. A. and A. Vegh (1992), A Model of Exchange Rate Determination Under Currency Substitution and Rational Expectations, Journal of Political Economy, vol. 85, No. 3, 1992.Civcir, I. (2003), “Broad Money Demand and Currency Substitution in Turkey”, The Journal of Developing Areas, Volume 36, Number 2, 2003.Cuthbertson, K. and D. Bredin (2001), “Money Demand in the Czech Republic since Transition”, Journal of Policy Reform, 2001.Daniel, B. C. and H. O. Fried (1983), “Currency Substitution, Postal Strikes, and Canadian Money Demand”, The Canadian Journal of Economics, 16, 612-624.De Freitas, M.L. (2000), “Dollarization hysteresis: further empirical evidence”, Universidade de Alveiro, 2000.De Freitas, M.L. (2001), “Revisiting the dollarization puzzle: Evidence from Bolivia, Turkey and Indonesia”, Universidade de Alveiro, 2001.Enders, W. (2000), “Applied econometric time series”, Iowa State University, John Wiley & Sons, Inc.Feige, E. L., V. Sosic, M. Faulend, and V. Sonje (2000), “Currency substitution, Unofficial Dollarization, and Estimates of Foreign Currency held abroad: the case of Croatia”, in Blejer, M. and Skreb M.: “Financial Policies in Emerging Markets”, Cambridge, Mass: The MIT Press. Feige, E. L. (2002), “Empirical evidence on currency substitution, dollarization and euroization in transition economies”, The Eight Dubrovnik Economic Conference.Fisher, S. (1982), “Seniorage and the Case for a National Money”, Journal of Political Economy, 90, 295-313.Giovannini, A. and B. Turtelboom (1992), “Currency substitution”, National Bureau of Economic Research Working Paper Series, No 4232, Cambridge 1992.Girton, L. and D. Roper (1981), “Theory and Implication of Currency Substitution”, Journal of Money, Credit and Banking, 13, 12-30.

Hamilton, D. J. (1994), “Time series analysis”, Princeton University Press.Harris, R.I.D. (1995), “Using Cointegration analysis in Econometric Modeling”, Prentice Hall, 1995. Komarek, L. and M. Melecky (2001), “Currency substitution in the transition economy: a case of the Czech Republic 1993-2001”, Warwick Economic Research Papers, No 613.Lazea, V. and B. Cozmanca (2003), “Currency substitution in Romania” Liviatan, N. (1981), “Monetary Expansion and Real Exchange Rate Dynamics, Journal of Political Economy, 89, 1218-1227.McKinnon, R. I. (1982), “Currency Substitution and Instability in the World Dollar Standard”, The American Economic Review, 72, 320-333.Miles, M. A. (1978), “Currency Substitution, Flexible Exchange Rates, and Monetary Independence”, The American Economic Review, 68, 428-436.Mizen, P. and E. J. Pentecost (1990), “Evaluating Empirical Evidence for Currency Substitution: A Case Study of the Demand for Sterling in Europe”, The Economic Journal, 104, 1057-1069. Mongardini, J. and J. Mueller (1994), “Rachet Effects in Currency Substitution: An Application to the Kyrgyz Republic”, IMF Working Paper 102, 1999.Ortiz, G. (1983). “Currency Substitution in Mexico: The Dollarization Problem”. Journal of Money, Credit and Banking , l. 15, 174-185.Rogers, J. H. (1990), “Foreign inflation Transmission under Flexible Exchange Rates and Currency Substitution”, Journal of Money, Credit and Banking, 22, 195-208.Rogers, J. H. (1992), “The Currency Substitution Hypothesis and Relative Money Demand in Mexico and Canada”, Journal of Money, Credit and Banking, 1992, 300-318.Thomas, L. R. (1985), Portfolio Theory and Currency Substitution. Journal of Money, Credit and Banking, vol. 17, No. 3, 347-357.Sarajevs, V. (2000), Econometric Analysis of Currency Substitution: A Case of Latvia. Bank of Finland Discussion Papers, Institute for Economies in Transition, No. 4, 2000.Sriram, S.S. (1999), “Survey of Literature on Demand for Money: Theoretical and Empirical Work with Special Reference to Error-Correction Models”, IMF Working Paper no 64, 1999.Uribe, M. (1997), “Hysteresis in a simple model of currency substitution”, Journal of Monetary Economics, No 40 185-202, 1997.Van Aarle, B. and N. Budina (1995), “Currency Substitution in Eastern Europe”, Tilburg University Discussion Paper, No 2, 1995.

Academy of Economic Studies Doctoral School of Finance and Banking CURRENCY SUBSTITUTION IN ROMANIA...

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