Currency substitution exists widely in the world. According to the Federal Reserve's estimation, 55% of the U.S. dollar circulation is held by foreigners, and before the euro was officially launched, about 1/3 of the mark was circulated outside Germany. The statistics of the International Monetary Fund also show that at least 52 countries have high or moderate foreign currencies to replace their local currencies. With the further deepening of financial globalization, emerging market countries and regions have relaxed their domestic financial controls and allowed free convertibility under current and capital accounts, making the exchange of local and foreign currencies more free and convenient and cheaper. However, the expansion and deepening of a country's currency substitution does not necessarily lead to formal dollarization. For most emerging economies, dollarization is still a new monetary system. With the exception of Panama, which completely replaced its local currency with US dollars in 1904, the dollarization process in El Salvador, Ecuador, Guatemala and other countries has only recently begun.

Analysis on the Policy Effect of Currency Substitution

There have been many analyses on the influence of dollarization on economic development, but a simple analysis of its advantages and disadvantages cannot fully explain whether a country should adopt dollarization as its monetary system. Because currency substitution is the only process of formal dollarization, and the phenomenon that strong foreign currency replaces weak local currency has existed for a long time in emerging economies, it will be more helpful to understand the significance of this new monetary system to emerging economies by analyzing the policy effect of currency substitution and comparing it with the impact of formal dollarization.

(1) Effect of fiscal policy

The substitution of strong foreign currency for local currency will undoubtedly change the amount of local currency held by residents, thus affecting government tax revenue and bond income. Specifically, this influence is mainly reflected in the following aspects:

1. seigniorage. Seigniorage is the purchasing power formed by the government by issuing money. Currency substitution enables a country's currency to be supplied to a certain extent by the issuing country of the replaced currency, thus giving this part of the coinage income to the country. The loss of seigniorage increased with the deepening of currency substitution. When a country is officially dollarized, the government will completely lose its seigniorage income. The loss of seigniorage will bind the government's budget expenditure, and it is difficult to make up the fiscal deficit by issuing currency.

However, when analyzing the dollarization effect of fiscal policy, we should not overemphasize the loss of coinage income. The phenomenon that a country's strong foreign currency replaces its local currency is largely due to the government's excessive dependence on coinage income, which leads to sustained inflation, which makes the residents of the country have strong expectations for the depreciation of their local currency, thus causing the conversion between local currency and foreign currency. From this point of view, the loss of seigniorage can be regarded as a punishment for the government's excessive issuance of money, and the transfer of seigniorage income to a powerful currency issuing country is a compensation for the country to maintain the high quality of money. In addition, because the widespread currency substitution in emerging economies is a fact, it is difficult to avoid the loss of seigniorage whether it is officially dollarized or not, so the cost of officially dollarized seigniorage may be exaggerated. If a country implements bilateral dollarization, that is, it reaches an agreement with the currency issuing country to jointly bear the seigniorage tax, this loss will be reduced. From the perspective of liquidity loss, because electronic money reduces the use of cash, the seigniorage will be less than expected in the process of dollarization.

2. Inflation tax. Inflation tax is a hidden seigniorage levied by the government on the society by issuing additional base currency. Issuing more money will inevitably lead to inflation and currency depreciation, which will shrink the assets of creditors, and the government as a debtor will benefit. Rational economic entities will reduce their local currency and increase their foreign currency for the purpose of preserving their own assets. The decrease in demand for local currency will narrow the tax base of inflation tax and affect the government's financial financing ability. To get the same income, only by increasing the inflation rate will it lead to a higher degree of currency substitution. Dollarization will make the government completely lose inflation tax.

Although dollarization is difficult to increase expenditure or make up the fiscal deficit by levying inflation tax, thus affecting the total social demand, the benefits brought by monetary stability will be more conducive to expanding investment and economic growth. More importantly, the inflation constraint contained in complete currency substitution may make currency substitution a powerful means to curb inflation.

3. Issue government bonds. National debt revenue is an important part of government revenue. When the expectation of local currency depreciation rises and the domestic economic situation is unstable, financial institutions, as the main buyers of national debt, will reduce the demand for national debt from the perspective of reasonable asset portfolio. The decline in the subscription rate of treasury bonds not only affects the transaction tax and income tax of treasury bonds, but more importantly, in order to complete the revenue budget and improve the attractiveness of treasury bonds, the government can only lower the issue price of bonds or raise interest rates, which will inevitably increase the financing cost and fiscal deficit, thus undermining the stability and sustainable development of the economy.

After dollarization, the stability of currency value and domestic economic situation can improve the income of national debt, thus alleviating the influence of currency substitution on fiscal revenue in the national debt market to some extent.

4. Securities market tax. In countries with large-scale currency substitution, their securities markets are often underdeveloped, so the proportion of securities market tax revenue in these countries is relatively small. The main purpose of investors entering the market is to earn the difference income from securities trading. Therefore, the government's tax revenue in the securities market is mainly stamp duty, which is related to the activity of stock market trading and depends on the amount of local currency funds invested in the securities market. Currency substitution will directly reduce the amount of local currency funds in the securities market, thus weakening the government's ability to raise funds with stamp duty.

(B) the effect of monetary policy

The influence of currency substitution and dollarization on a country's macro-economy is first reflected in the effect of monetary policy, and the influence of currency substitution on monetary policy is mainly concentrated in the following aspects:

1. Independence of monetary policy. The "ternary paradox" in international economics determines that if it is difficult for a country to carry out strict capital control, it will inevitably lose the independence of monetary policy. The loss of the right to issue money will make the central bank unable to implement the function of lender of last resort when the banking system is in a liquidity dilemma; What's more, in the economic recession of dollarization countries, it is difficult to use fiscal policy to stimulate the economy because of the limited domestic financing ability of the government and the fragile international debt. The loss of independence makes the monetary policy of the country subordinate to the United States and not suitable for its national conditions, thus greatly weakening the macro-control function of the government.

According to Mundell-Fleming model, only by adopting floating exchange rate system can a country maintain the independence and effectiveness of its monetary policy. However, under the background of the gradual relaxation of financial control, because a country's currency is not necessarily irreplaceable from the demand side, currency substitution will occur even under the floating exchange rate system. If most people and enterprises in a country hold scattered asset portfolios, the independence of its monetary policy will no longer be established. In addition, the financial opening under financial globalization makes the operation of macroeconomic policies more difficult and costly, and it is difficult to achieve the expected regulatory effect by implementing independent monetary policies. As for the lender of last resort, we should not overemphasize the negative impact of dollarization. In fact, the ability of the central bank to deal with the crisis only by issuing money is limited. On the contrary, because dollarization countries will allow foreign financial institutions to freely enter their own countries, they can not only improve the competitiveness of domestic financial institutions and stabilize the financial situation, but more importantly, loans from foreign banks can play the role of lender of last resort. At the same time, a stable dollar can also reduce the possibility of bank runs.

2. Money supply and demand. The substitution of foreign currency for local currency in different degrees will not only weaken the controllability of money supply, but also increase the instability of domestic money demand, thus affecting the effect of a country's monetary policy. First of all, when a country's monetary authorities increase the base currency, the cost of holding local currency will be reduced due to the lower interest rate, so the demand for local currency will increase accordingly. If foreign countries do not implement the same monetary policy at the same time, part of the demand for local currency will flow abroad, then the price increase in this country is lower than that without currency substitution. The continuous introduction of money will strengthen people's expectation of local currency depreciation and increase the opportunity cost of holding local currency, so the residents of this country will increase their holdings of foreign currency and reduce their demand for local currency. In this case, there will be a deviation between the actual money supply and the nominal money supply, which makes it difficult for expansionary monetary policy to achieve the expected goal. Secondly, when the monetary authorities adopt a tight monetary policy, despite the decline in inflation, the degree of currency substitution will not decrease and the demand for local currency will not increase rapidly due to the time lag of currency substitution and the established cost of conversion between local currency and foreign currency, thus affecting the tightening effect of monetary policy. In addition, even if the country's money supply has not changed, due to the existence of currency substitution, when the monetary policy of the replaced country shrinks or expands, it will also affect the supply and demand of local currency, and then affect the realization of the country's monetary policy objectives. For emerging economies, because currency substitution is asymmetric, that is, when there is the possibility of converting local currency into foreign currency, foreign residents have no demand for local currency. Therefore, the impact of currency substitution on the supply and demand of the country's currency is mainly reflected in the fact that when the local currency has a strong expectation of depreciation or the rate of return on foreign assets is significantly higher than that of the country, residents' demand for currency changes from local currency to foreign currency, so it is difficult to achieve the goal of increasing employment and expanding production through expansionary monetary policy.

3. Intermediate goal of monetary policy. Currency substitution will affect money supply and demand through exogenous factors, so the role of money supply as an intermediary target of monetary policy will be weakened. In addition, because the adjustment of interest rate will cause the change of the holding cost or real rate of return of a country's currency, which will lead to currency substitution, it is difficult for monetary authorities to use the change of interest rate to regulate the economy.

(C) the exchange rate policy effect

The influence of currency substitution on exchange rate policy is mainly reflected in the stability of exchange rate, the effectiveness of exchange rate policy and the balance of international payments.

1. The exchange rate is stable. The exchange rate level mainly depends on the money supply, the difference of nominal interest rate, the difference of expected inflation rate and the degree of currency substitution. When the nominal interest rate is constant, the fluctuation of exchange rate depends on the difference of inflation between the two countries. Higher inflation in this country will reduce residents' demand for local currency and increase their demand for foreign currency. This kind of currency substitution will make the country's inflation level higher, which will lead to greater exchange rate fluctuations. The existence of currency substitution magnifies the influence of inflation difference on exchange rate fluctuation. From the perspective of nominal interest rate, the exchange rate is more sensitive to the change of nominal interest rate because the change of interest rate will promote the conversion of local and foreign currencies. The higher the degree of currency substitution, the more unstable the exchange rate level. Under the floating exchange rate system, due to the existence of currency substitution, the exchange rate will fluctuate more, thus affecting the stable development of trade, investment and even the whole macro-economy. Under the fixed exchange rate system, even if the monetary authorities can hedge the unstable exchange rate through the intervention of the foreign exchange market, because of currency substitution, the exchange rate is very sensitive to changes in interest rates and inflation, so the intervention cost will be high, but the effect is not good, and it is easy to lead to overvaluation or underestimation of the local currency and the impact of speculative capital.

To solve the negative impact of currency substitution on exchange rate, the most fundamental way is to make the expected rate of return of the two currencies consistent, implement sound macroeconomic policies, and reverse the trend of currency substitution. However, due to the inherent defects in the macroeconomic operation of emerging economies, it is difficult to converge the expected returns of local currency and foreign currency, and prohibiting the exchange of local currency and foreign currency will lead to capital flight. In this case, it will be an effective way to solve the influence of currency substitution on exchange rate instability to implement full dollarization and cancel the exchange rate between local currency and foreign currency.

2. The effectiveness of exchange rate policy. Under the floating exchange rate system or the adjustable pegged exchange rate system, a country can improve the competitiveness of its products by devaluation, while under the completely fixed dollarization system, it will be difficult to use flexible exchange rate policy to deal with the unfavorable trade situation.

In the case of currency substitution, it is difficult for emerging economies to stimulate exports by devaluation even if they implement floating exchange rate system. Because the devaluation of the local currency will strengthen residents' expectation of devaluation, cause currency substitution and lead to the rapid occurrence of inflation, thus raising the price of domestic goods, thus offsetting the positive effect of local currency depreciation on exports. Experience shows that a devalued exchange rate policy will be ineffective for a small open economy with a trade deficit. Instead of increasing exports to make up for the deficit, it will easily lead to inflation.

3. Balance of payments. The existence of currency substitution makes it difficult for a country to increase its exports through devaluation. On the contrary, it will lead to the deterioration of the current account of the balance of payments because of the rising import price and excessive foreign exchange expenditure. In addition, the depreciation of local currency and the further increase of inflation rate under the action of currency substitution will also reduce the return on investment, affect investors' confidence in the country's economy, and are not conducive to attracting foreign investment; More importantly, if the government and enterprises hold a large amount of foreign debts, the depreciation of the local currency will increase the burden of debt service and further consume the country's foreign exchange reserves, which will lead to a deficit in the balance of payments capital account. Under the dollarization system, exchange rate fluctuations will also converge with the US dollar because the US dollar is completely used as the national currency. As a key currency, the value of the US dollar is relatively stable, which is conducive to the country's expansion of foreign trade, attracting international direct and indirect investment, and improving the balance of payments.