Currency substitution in Bangladesh

Currency substitution/ dollarization is the process whereby foreign currency substitutes for domestic money as a store of value, unit of account, and medium of exchange. What are the underlying reasons for developing countries like Bangladesh to adopt currency substitution? Tamanna Shabnam reports.

1.Inflation

In countries where high and variable inflation rates and uncertainty about domestic policies have prevailed for a substantial period of time, a large proportion of domestic sales and contracts are transacted in foreign currency. Foreign direct investment has dropped from $1054 to $720 million in the 2020-21 fiscal year as the pandemic continues to ravage the global economy. As per the real exchange rate, taka is undervalued which is hurting the country’s exports sector. 

2. Poor communication and financial management

An additional factor that may help explain the increase in currency substitution relates to technological advances in communication and financial management, which have substantially reduced the cost of transferring funds across country borders. Also if transaction costs incurred in switching from domestic-currency assets to foreign-currency assets are low, the degree of currency substitution tends to be high.

3. Absence of Social and Political stability

Uncertainty about social and political developments, fear of expropriation of assets denominated in domestic currency, and the potential need to leave the country also tend to encourage holdings of foreign currency. Absence of social and political stability of leads to economic crimes generating huge illegal incomes, such as default of bank loans, corruption in tax administration, manipulation in stock exchanges, over-invoicing and under-invoicing in trade settlements, leakage in public development expenditure, or illegal financial deals in the running of state-owned enterprises which people often convert to foreign currency held either in the form of cash “under the mattress,” as deposits in the domestic banking system, or as deposits in banks abroad.

4. Balance of Payment Crisis

When a country faces the possibility of a balance-of-payments crisis and immediate corrective policy action is not taken, residents of the country, foreseeing an eventual devaluation and higher inflation or the imposition of exchange controls, are likely to increase transfers abroad.

Currency substitution is undesirable because it reduces monetary independence and may thus endanger the ability of policymakers to implement stabilization programs. It restricts the capacity and ability of the affected country to mobilize its domestic assets and access foreign resources and thus should be by all means should be restricted.