Currency substitution in Asian countries

The objective of this study is to investigate the importance of the U.S. dollar to six Asian economies, as a substitute or complement to domestic monetary assets. Towards this goal, the Morishima elasticity of substitution is estimated between domestic currency, the U.S. dollar and time and savings deposits at commercial banks in Indonesia, Japan, Korea, Malaysia, Singapore and Thailand over the period 1977 to 1996. We observe that the domestic currency and the U.S. dollar are Morishima substitutes in every country, and the demand for the U.S. dollar relative to the domestic currency appears to respond more to a change in the opportunity cost of holding domestic money (exchange rate depreciation) than the opportunity cost of holding the U.S. dollar (the domestic interest rate). A higher degree of currency substitution is found in Japan, Korea, and Singapore than the rest of the countries. Moreover, there is an indication of an increasing degree of currency substitution over time in every country except for Malaysia. Currency substitution creates a channel for the transmission of exogenous monetary disturbances from abroad. The vulnerability of money demand in the face of foreign shocks increases pressure on the monetary authorities to accommodate these shocks under a pegged exchange rate system. The cost of this accommodation proved to be unsustainable during the Asian crisis as foreign reserves were drawn down. Hence, there is the need to build up an adequate foreign reserves position to accommodate the degree of currency substitution and dollarization. (C) 2005 Elsevier Inc. All rights reserved.