Currency Substitution, Speculation and Crises: Theory and Empirical Analysis

We extend the "fundamentals model" of currency crisis by incorporating the currency substitution effects explicitly. In a regime of free foreign exchange markets and free capital movements the reserve (hard) currencies are likely to substitute for the local soft currency in agents' portfolia that include currency as an asset. Our model shows that, controlling for the fundamentals of an economy, the more pronounced the currency substitution is in a country, the earlier and the stronger is the tendency for the local currency to devalue. The model is implemented by constructing a currency-softness index. Two empirical findings emerge. First, there is a negative relationship between the currency-softness index and the degree of nominal-exchange-rate devaluation. Second, there is a systematic negative relationship between the softness of a currency and the level of economic development. The empirical and policy implications of the model can prove germane in approaching "speculative attacks" on currencies and in evaluating proposed dioramas of the "new architecture" of the international financial system.