CURRENCY SUBSTITUTION : EVIDENCE FOR SELECTED ASIAN COUNTRIES

Abstract

This exercise examines the question of currency substitution (CS) in four Asian countries -- Singapore, Hong Kong, Malaysia and Thailand. In particular, it analyses whether currencies are substitutable in demand and whether the rate of return on foreign money is a significant argument in the demand for money function. A secondary concern is the possible problems that currency substitution may pose for flexible exchange rate systems. This exercise implicitly questions the traditional "closed" formulations of money demand in these countries. In estimating an "open economy" demand for money function for the four Asian countries, the rate of return on foreign currencies is included as an independent variable in the money demand function. Evidence suggests that the rate of return on foreign money has a significant impact on the demand for money in more open economies -- Singapore and Hong Kong. A generally poor showing of the influence of the foreign return variable on money demand is evident for Malaysia and Thailand. The more open an economy is, the greater the degree of currency substitution between the domestic and foreign currencies. In the presence of currency substitution, exchange rate will be volatile under a flexible exchange rate system. A well-known conclusion in most currency substitution literature is to maintain a fixed exchange rate system if the currencies have a degree of currency substitution. Given the important implications of currency substitution for open economy macro modelling and policy analysis, the question of currency substitution in the framework of money demand formulations cannot be ignored.