Written By: Dr. Zafar Mahmood
Recent media reports suggest that China proposed to Pakistan that it may be allowed to use Chinese Yuan Renminbi (CNY) as a legal tender in the Gwadar Economic Zone (GEZ). This proposal that would amount to a limited currency substitution was reportedly not accepted by Pakistan.
Let us first see what currency substitution means? It means the use of a foreign currency in parallel to or as a substitute for domestic currency.
Full currency substitution occurs when a country adopts a foreign currency as its sole legal tender, and stops issuing the domestic currency. It takes place when a country faces some major economic crises. For instance, during the financial crises of the late 1990s, currency substitution became a very serious policy issue in Latin America and Southeast Asia.
A partial currency substitution occurs when local residents opt to hold a significant share of their financial assets denominated in foreign currencies to minimize the risk of revaluation of exchange rate changes on their assets. Residents maintain deposits in foreign currencies because of weak domestic currency, or as a hedge against high inflation. Once a partial substitution of currency is allowed then there remains a possibility of a gradual substitution of local currency with a stronger foreign currency, provided that the structural problems in the economy persist for a longer time period. Pakistan has allowed foreign currency accounts to its citizens since 1992, which is a partial currency substitution.
Besides, informal currency substitution occurs when residents make local transactions (e.g., rents) in foreign currency and keep foreign currencies in private holdings, despite the foreign currency not being a legal tender there.
How can one find out that the currency substitution is taking place and to what extent? Two measures are often used to identify this: (i) the share of foreign currency deposits (FCD) in the domestic banking system in the broad money including FCD (it was 6.16% in the end June 2016 for Pakistan), and (ii) the share of all foreign currency deposits held by domestic residents at home and abroad in their total monetary assets (data not available).
The pattern of the currency substitution procedure also varies with different domestic exchange and capital controls. For instance, in a situation of strict foreign exchange regulations, the demand for foreign currency in the absence of currency substitution can be met by holding foreign currency assets abroad (capital flight) and outside the domestic banking system. This foreign currency demand usually puts pressure on the parallel (black) market of foreign currency and on the country's international reserves. In contrast, by allowing the domestic residents to maintain foreign currency accounts as in Pakistan, it has to a certain degree mitigate the capital flight and strengthen the foreign exchange reserves in exchange for a partial currency substitution.
Several countries do not use their domestic currencies and instead adopt a stronger currency for transactions. Panama adopted the U.S. dollar as legal tender after independence as a result of a constitutional ruling, the so-called de jure currency substitution. Ecuador became fully dollarized economy in the year 2000 following a widespread political and financial crises resulting from massive loss of confidence in its political and monetary institutions. Ecuador adopted U.S. dollar to impose strict fiscal discipline, but in the process gave up control over its financial sovereignty.
Effects of Currency Substitution
Currency substitution helps to promote fiscal and monetary discipline. As a result, greater macroeconomic stability in terms of lower inflation rates, lower real exchange rate volatility, and deepening of the financial system are achieved. Currency substitution provides a firm commitment to stable monetary and exchange rate policies by introducing a passive monetary policy. Adopting a strong foreign currency as a legal tender can help to eliminate the inflation-bias problem of discretionary monetary policy. Currency substitution imposes stronger financial constraint on the government by eliminating deficit financing, i.e., eliminating issuing of domestic money. Studies show that inflation has been significantly lower in economies with full currency substitution than nations with domestic currencies. The expected benefit of currency substitution is the elimination of the risk of exchange rate fluctuations.
One of the main advantages of full currency substitution is to reduce the transaction costs of trade among countries using the same currency. It has been found that countries sharing a common currency often engage in significantly increased trade among them and that the benefits of currency substitution for trade may be quite large. Consequently, economic integration with the rest of the world becomes easier.
Countries with full currency substitution can also stimulate greater confidence among foreign investors, thus inducing increased investments. The resultant elimination of the currency crisis risk due to currency substitution leads to a reduction of country’s risk premiums, which helps in maintaining lower interest rates, consequently leading to a higher level of investment.
Currency substitution also leads to the loss of seigniorage revenue. Seigniorage revenues are the profits generated when monetary authorities issue a currency. When adopting a foreign currency as a legal tender, a monetary authority gives up its powers to print domestic currency and hence its power to collect seigniorage revenue. The country also loses the rights to its independent monetary and exchange rate policies, even in times of financial emergency. The cost of losing an independent monetary policy is that domestic monetary authorities can no longer use counter-cyclical monetary policy to stabilize the business cycle. Domestic monetary authorities diminish the liquidity assurance to their banking system, thus they cannot act as lender of last resort to commercial banks by printing domestic money.
In response to a proposal from China to use CNY as a legal tender in the GEZ, the State Bank of Pakistan (SBP) has announced that CNY is already an approved foreign currency for denominating foreign currency transactions in Pakistan as per current foreign exchange regulations. The SBP states that the authorized dealers may open foreign currency accounts and extend trade loans under FE-25 Scheme in U.S. dollar, Pound sterling, Euro, Japanese yen, Canadian dollar, UAE dirham, Saudi riyal, Chinese yuan, Swiss franc and Turkish lira.
A Currency Swap Agreement (CSA) was also signed with People’s Bank of China (PBoC, the Chinese central bank) on December 23, 2011 for a tenor of three years, according to which the dues will be payable in local currencies (up to PKR140 billion and CNY10 billion) thus averting the need to settle in foreign currency (e.g., U.S. dollars). It would thus deflect pressure on foreign exchange reserves and mitigate volatility in exchange rate.
Under CSA, the SBP will obtain yuan from PBoC either by taking a loan or by exchanging bonds or exchanging currencies at a pre-determined rate—the SBP borrowed equivalent amount of USD 500 million from China and kept it in its reserves. The SBP has since taken a series of steps to promote the use of CNY in Pakistan for bilateral trade and investment with China. It allowed commercial banks to accept CNY deposits and give CNY trade loans. Specifically, for onward lending the proceeds of CSA, the SBP has put in place the loan mechanism for banks to get the CNY financing from the SBP for onward lending to importers and exporters having underlying trade transactions denominated in the yuan. The SBP stated that both public and private sector enterprises, Pakistanis and Chinese, can freely choose CNY for their bilateral trade and investment activities. Thus, traders can open letter of credits for imports in CNY and investors can avail financing facilities in CNY.
Industrial and Commercial Bank of China Limited-Pakistan Operations has been allowed to establish a local CNY settlement and clearing setup in Pakistan, enabling it to open CNY accounts of the banks operating in Pakistan and to facilitate settlement of CNY based transactions such as remittance to and from China. Moreover, with opening of Chinese banks in Pakistan, the access to onshore Chinese markets will strengthen further. Several banks in Pakistan do maintain onshore CNY nostro accounts.
Despite the measures mentioned above, so far CSA remains ineffective. This is mainly because of trade imbalance in favor of China (90:10 in favor of China), capital controls by PBoC, inconsistency in value of CNY, Pakistani traders’ hesitance in using CNY, disinterest of Chinese traders in accepting payments in Pakistan rupee, etc. Concomitantly, Pakistani banks are not interested in CNY too. For instance, the SBP invited Pakistani commercial banks to participate in an auction for sale of CNY in December 2011; however, none of them participated in the auction. At least at this time, Pakistani commercial banks lack confidence on CNY, and are reluctant to hold CNY deposits and prefer to hold their reserves in U.S. dollars and other major international currencies.
Since China-Pakistan trade is quite disproportional, no swap agreement can alter this situation drastically, so other policy measures are also needed to bridge this gap. CSA normally works where mutually strong and balanced economic ties exist. In this regard, close business to business relations are needed to enhance confidence in each other’s currencies.
It is worth noting that yuan is not a freely convertible currency as other major international currencies; therefore, Pakistan can largely use it in transactions with China. Chinese yuan accounted for 1.68% of global transactions in 2016, while U.S. dollar accounted for 42.1%.
Nonetheless, our policymakers should regularly and carefully watch the impact of CSA-related developments on trade, investment, exchange rate, inflation, growth and balance of payments and take necessary steps to benefit from these developments. This would go a long way in assessing the consequences of transition to new bilateral swap agreements and continuation of the existing ones.
At present, Pakistan is experiencing an all-time low inflation and performance of other economic indicators is satisfactory and continually improving, so there does not seem any reason for currency substitution, even in a zone. Substitution of currency in a zone, if implemented, will send a wrong signal about the health of the economy as well as financial sovereignty. It is, however, understood that informal use of CNY will be practiced but it will be on a limited scale. Rather than considering any currency substitution proposal, Pakistan should focus on the improvement of bilateral financial links with China to strengthen trade and investment relations. A sufficiently developed financial market in Pakistan can offer substitute financial instruments denominated in domestic currency, thus lessening the possibility of currency substitution as a hedge against inflation and exchange rate volatility.
The writer is a Professor of Economics at the School of Social Sciences and Humanities at NUST, Islamabad.