In recent years, demand by residents of developing countries for foreign currency deposits has grown rapidly. This process of currency substitution has received considerable attention because of its implications for the conduct of macroeconomic policies, in particular monetary, interest rate, and exchange rate policies. The results obtained from estimating models of currency substitution confirm that relative rates of return, measured in a variety of ways, determine the choice between domestic and foreign currency assets in the composition of portfolios.
This paper re-examines the issue of the relative demands for domestic and foreign currency deposits in developing countries. Three particular advances beyond the conventional approaches to currency substitution are made. First, at the theoretical level, the optimizing model developed incorporates forward-looking rational expectations, as well as dynamic adjustment of domestic and foreign money holdings. Second, the model is specified in a way that excludes the domestic interest rate from the final estimation form; information about this variable in many developing countries is hard to come by. Finally, data on foreign currency deposits held abroad by residents are directly utilized.
The model is estimated on a quarterly basis for a diverse group of ten developing countries—Bangladesh, Brazil, Ecuador, Indonesia, Malaysia, Mexico, Morocco, Nigeria, Pakistan, and the Philippines. The results tend to support the theoretical specification, indicating that the foreign interest rate and the expected rate of depreciation of the parallel market exchange rate influence the choice made by individuals between holding domestic and foreign deposits. Furthermore, the forward-looking rational expectations model also outperforms empirically the standard currency substitution model.