Theoretical And Empirical Analysis Of Currency Substitution

Currency substitution rate in China is relatively low with less flexible RMB exchange rate, less developed domestic financial market and lack of full convertibility of RMB on the capital account. However with the liberalization of RMB capital account and steadily advancing of reform in foreign exchange administration system, China cannot avoid from increasing currency substitution either. With our special economic mechanism, we have to do theoretical and empirical research about currency substitution by ourselves, rather than simply use western theory.Many domestic economists insist that currency substitution can only take place in floating exchange rate system and those countries with full convertibility currency. While I consider that currency substitution can also take place in fixed exchange rate system but in a different way. As for the currency convertibility, I consider that the accrual currency substitution rate in China is less than the potential level because part of the currency substitution demand is restrained by the capital control and the less flexible exchange rate of RMB. While China open capital account and realize full convertibility, the currency substitution rate will increase with the restrained part being released.Based on the western currency theory and the specific condition in China, I build a model of currency substitution. Besides exchange rate of RMB, interest rate of RMB and USD, I also choose inflation rate of those two currencies and M2 amount of USD which denotes the currency supply in US as explaining variables, and I also put a dummy variable D in the model to denote the reform in foreign exchange administration system in 1994. The regression result shows that currency substitution rate of USD to RMB is mostly influenced by the exchange rate of RMB and the gap between the inflation rate in China and that in US.