Focus on Central, Eastern and South-Eastern Europe
Edited by Ewald Nowotny, Peter Mooslechner and Doris Ritzberger-Grünwald
Chapter 9: Currency Substitution in the Economies of Central Asia: How Much Does it Cost?
Asel Isakova INTRODUCTION Currency substitution, or the use of foreign currency to finance transactions, by domestic residents has been a widespread phenomenon in emerging market and transition economies. This chapter investigates the importance of currency substitution in a group of transition economies in Central Asia and estimates the degree of substitutability between domestic currency and foreign currency in these economies. This empirical analysis contributes to an understanding of the economic importance of currency substitution in three economies – Kazakhstan, the Kyrgyz Republic and Tajikistan. Moreover, the study examines the implications of currency substitution for seigniorage revenues of central banks and its welfare cost. The countries of Central Asia have experienced important structural socio-economic and political transformation related to the demolition of old administrative systems and building new institutions of the free market (Gürgen et al., 1999). Building a market economy required economic liberalization, including price liberalization and gradual capital markets decontrol. Price liberalization resulted in an accelerated pace of inflation and rapid depreciation of newly introduced national currencies. The weak positions of domestic legal tenders and their decreasing purchasing power led to a flight from national money and to an increase in foreign currency holdings by residents. Currency substitution was a result of the general economic instability and undermined the credibility of the domestic money. Moreover, the rudimentary financial sector institutions were not able to provide households with reliable financial instruments for saving in domestic currency. Holding foreign currency (mostly US dollars) thus became a way to hedge against the...
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