**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.

**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.

**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.

**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)).

**Variable** M_ROL1 Eq. 2 M_ROL1 Eq. 1 IPI 2.278764 (0.87578) [-2.60199] 2.623697 (1.39953) [-1.87470] - 2.898162 (0.41354) [ 7.00822] D_EXBASKET -1.181348 (0.33638) [ 3.51196] 1.739506 (0.36544) [-4.76009] DR 0.744964 (0.16083) [-4.63206] -1.380286 (0.40548) [ 3.40406] INFLATION -1.090635 (0.28317) [ 3.85156] -0.262162 (0.20235) [ 1.29557] TBR *** -0.048624 (0.01287) [-3.77869] -0.017941 (0.00412) [-4.35809] SPEED OF ADJUSTMENT CURRENCY SUBSTITUTABILITY Standard errors in ( ) & t-statistics in [ ].

**STABILITY TESTS**

**STABILITY TESTS**

**Variable** IPI D_EXBASKET DR INFLATION TBR SPEED OF ADJUSTMENT 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] M_ROL2 Eq. 1 CURRENCY SUBSTITUTABILITY Standard errors in ( ) & t-statistics in [ ].

**STABILITY TESTS**

**STABILITY TESTS**

**MODEL1** Eq.1 MODEL1 Eq.2 MODEL2 Eq.1 MODEL2 Eq.2 Χ2(1) p-value 28.21274 32.95289 31.13666 28.99550 0.000000 0.000000 0.000000 0.000000 EVIDENCE THAT DOMESTIC CURRENCY HAS THE ABILITY OF BEING SUBSTITUTED The null hypothesis is that the coefficient associated to exchange rate depreciation is zero.

**MODEL1** MODEL2 Χ2(1) 0.142438 0.026553 p-value 0.705869 0.870557 RESTRICTION IN LINE WITH THE QUANTITATIVE THEORY OF MONEY The null hypothesis is that the coefficient associated to the scale variable is one.

**ΔMROL2** ΔMROL1 ΔIPI ΔIPI ΔD_EXBASKET ΔD_EXBASKET ΔDR ΔDR ΔINFLATION ΔINFLATION ΔTBR ΔTBR Χ2(1) 14.06821 0.002699 13.41405 11.59228 2.277853 3.478700 Χ2(1) 11.29531 0.044568 14.01270 11.86642 1.315177 3.533511 p-value 0.000176 0.958567 0.000250 0.000662 0.131233 0.062164 p-value 0.000777 0.832801 0.000182 0.000572 0.251459 0.060140 WEAK EXOGEINITY 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.

**Variable** 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 CURRENCY SUBSTITUTION Standard errors in ( ) & t-statistics in [ ].

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

**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).

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