1. Research objective

This paper will explore the degree of currency substitution in Albanian economy from 1993 to 2008 and naturally the following questions arise: What is the evolution of currency substitution during the last two decades and what direction will take in the near future knowing that it has a high probability to join Euro Monetary Union (EMU). Also, this paper will look at the implications currency substitution has on Albanian monetary policy by firstly identifying the monetary transmission channels and what some possible solutions would be.

2. Introduction

After the communism regime collapsed in Eastern Europe in the late 1980s and early 1990s, many countries could freely move capital and trade internationally. Also the economic crises in the late 1980s in Latin America made many of the countries in the region to adopt the US dollar due to its unique properties as a means of payment and store of value due to high inflation threats. Us dollar together with other currencies were used in Eastern Europe as a market respond to mitigate the risk and safeguard wealth in a situation were their own domestic denominated- currency mediums were not acceptable in the international arena. The main currencies used in Eastern Europe were the US Dollar, German Mark (DM), British Pound (GBP) and later on Euro. Currency substitution, in Albania, started with the transition process in 1991-92 were legal restrictions were removed and agents switched to foreign currency to preserve their wealth. The modernisation and evolution of the banking system and technological processes has also contributed to the degree of currency substitution in Albania over the last two decades.

The large use of foreign currency by many countries has led into a high interest from both academics and policy makers trying to identify the effects of monetary implications in their domestic economy. The phenomenon of using foreign currency to take-over one or more functions of domestic currency (store of value, means of payment and medium of exchange) is known as dollarization. However, in order not to mislead the term currency substitution will be used instead of dollarization to account for all foreign currencies circulating in Albania, but the main two currencies are dollar and euro.

The use of foreign currency to fulfil different functions is associated with different implication on the economy and it affects monetary policies through different direct and indirect channels. IMF uses the proportion of foreign currency deposits to M3 as a way to measure the scale of currency substitution, ignoring the variable of foreign currency circulating outside banks as a mean of payment. Having in mind that the Albanian economy is based mainly in cash transactions, it is necessary to add foreign currency in circulation variable in order to evaluate currency substitution. Although it is expected that the level of cash transactions relative to electronic transactions is reduced in the recent years due to implementation of real-time gross settlement system and other settlement systems in 2005-2006. Currency substitution based on IMF methodology in 2007 is 34% and it has experienced an increase from 1998 (post pyramid scheme collapse) were it was only 18%, demonstrating an increase in the degree of currency substation in Albania. Moreover, the DIIMF for 2008 is over the IMF threshold of 30%, indicating that it affects the monetary policy of Albania and should not be ignored. The result for 2008 using ASI is 43%, way off greater than DIIMF, meaning that FCC and FCD are in fact substitutes, based on Feige et al (2002) and DIIMF performs poorly. Furthermore, during the period under consideration, it is observed that there is an upward trend in ASI, of 1.7% per annum, from 1998-2008 and an increase of 0.7% per annum for the full period under observation. However, if the process of currency substitution of assets for the period of 1993—2008 is considered a good indicator of currency substitution process, being the variable with the biggest weight, there might be a halt of the upward trend.

Some academics Xhepa (2002) and Vika (2003), have discussed the possibility of adopting euro as a national currency in Albania and Muco et al (2006) have evaluated currency substitution in Albania using indirect methods. However, so far a full valuation of currency substitution in Albanian for the full period that Albania has been exposed to international trade has not yet been performed using direct methods for FCC. In order for the Bank of Albania (BoA) to take informed decisions regarding monetary policy it is necessary to have a direct methodology to measure currency substitution, tailored to the country's economic conditions and which provides an accurate evaluation. Therefore it is natural to ask the following questions. What factors are affecting the evolution of currency substation and to what extent? In what direction would the currency substitution take in the future; would it continue with the same growth it has shown during the last decade or would it occur decline? What would the effects be under the two scenarios? What overall conclusions emerge from this assessment? It is expected that the country would join Euro by 2014 and as a consequence it is crucial to observe the development of currency substitution for the period prior joining Euro-Currency Area and the influence it may cause to the effectiveness of monetary policy in Albania. Moreover, a clear indication of the degree of foreign currency in Albania provides great support to monetary union to draw effective policies and maintain its objectives, low inflation and economic growth.

This study is organised in following way: in second section an economic and financial overview of Albania would be provided in order to distinguish the type of currency substitution taking place, followed by section three where a summary of the literature review regarding currency substitution and the array of methods used in valuing currency substitution will be provided. Section four is an explanation of the methodology used in measuring currency substitution and a clear explanation of the method used in calculating foreign currency in circulation. Section five lays down the results of the examination with possible implications in the monetary policy and section six will briefly go through the indirect method for valuing currency substitution known as “Denomination displacement method”. Section seven will briefly go through MTM in Albania and indentify the connections through looking at previous studies between foreign currency and monetary policy implications. Section eight represents the conclusion and final remarks for the research.

3. Economic and financial overview

In order to identify trends and individual behaviours during the last two decades regarding foreign currency flows (in and out), it is important to do an economic and financial overview of Albania. From the observation it is found that the economic growth, increase in deposit interest rates, depreciation of Lek, developments in the banking sector and increase in remittances have positively affected the increase of foreign currency in Albania.

3.1 Monetary policy and Macro-structural background

The most successful reform in Albania during the transition period (1992-present) is the monetary policy pursued by the Central Bank of Albania (BoA). Albania has a loosely managed floating exchange regime and the monetary policy framework consists of informal inflation targeting through money growth (M3). BoA has practised a cautious monetary policy by controlling M3 and as a consequence the inflation has remained to one digit number. Overall the last two decades the economy has experience a significant growth in real terms and the local currency has appreciated while inflation kept low.

Real GDP growth in Albania has remained strong on average at 5-6% per annum from 2004 to 2008 and it is mainly driven by internal demand like investments and public spending. Also, when looking at the composite of GDP, Services Sector is the largest contributor to GDP and has remained at about 50%, whether agriculture has systematically declined over the last decade (Figure 1). The growth in the services indicates a developing economy, and the fall in agricultural businesses is mainly because of lack of investments (both government and FDI) which has forced many farmers to not plant their land.

The high growth in internal demand has been mostly financed with internal finance, hence quickly increasing internal credit in the economy as well. However, the global crises have reduced growth to only 1% in 2009, and it has forced monetary indicators to deviate significantly. The year-end inflation target is 3% (% of CPI) with a fluctuation band of ± 1% implemented in 2003. As a consequence of global crises together with strong internal demand, inflation rate increased to 3.6 % in 2008 and in May 2009 reached 4.6% the highest point in last five years.

The external sector in Albania continued to record a deficit on current account and surplus in capital accounts in 2008. Budget deficit has varied across the years, it showed improvement between 2000 and 2005 and since then the government is running a bigger deficit peaking in 2009 with 7% of GDP, where in 2007 was only 3% due to high public spendingstrategy pursued by the current government. As a consequence the Public Debt has increased significantly from 37% in 2007 to almost 60% in 2009 (Koleka. B, 2010). The government faces pressure from both IMF and the European Committee to reduce its deficit to a preferred level of only 3% within 2010, which would preserve macroeconomic stability and safeguard foreign investments.

Mainly Albania imports from European countries where Italy is the largest importer (Figure 1). Albania exports mostly minerals, followed by agricultural products like fruits, vegetable, meat, and seeds and the major exporting countries are EU countries with 79% of total exports (Figure 1). The global crisis has affected the imports which have increased 16% from 2007 whereas exports have declined in 2008 due to strong domestic demand. The results indicate that the largest currency that flows in Albania is Euro because of the countries it trades with.

The economy's dependence on remittances has still remained strong at about 15% of GDP for the period of 2004-2007, but the crises have affected remittances which 2008 declined substantially to around 10% when compared with 2007. A reduction in remittances directly affects foreign currency in Albania, because it is a major component and from this is expected that the level of currency substitution for 2008 to be lower than 2007. The local currency, Lek, has remained stable over the period of 1999-2008 with the Euro whether lek/dollar saw a large appreciation in the early 1995 to 1997 where it has since been declining (Figure 4). In 2009 large depreciation of lek was seen against all main currencies, especially against Euro. The decline period has increased the presence of foreign currency in Albania, because individuals did not have any incentives to exchange the foreign currency for lek, because of the exchange rates being very low and in this way foreign deposits increased relative to lek deposits as shown in Figure 2 and 3.

Foreign direct investment (FDI) account for more than half of external liabilities because mainly they are in type of credits and debt creating instruments which therefore add to external liabilities. FDI enhances future competitiveness of Albanian economy and the capacity to earn foreign exchange, because FDI is assumed to be used productively and help the overall economy. Frasheri and Hobdari (2006) have stated that the economy benefits from FDI because integrates transition countries towards a market economy and globalization, increase capital inflows and develops technological systems. During 2004 and 2008 FDI has seen a slight decline due to barriers in Albania market such as insufficient rule of law and governance, significant power cuts, increase in corruption and other issues in infrastructure which have increased imports and restrained growth. The government during the last three years has taken major infrastructure projects in all Albania territory in improving roads and small business facilities. New reforms are expected to create a more pleasant business environment increasing both FDI and economic growth future expectations.

3.2 Financial Sector

Financial sector is considered generally safe and no risk spill-over from the troubled banking systems in the West, due to the nature of banks in Albania. In addition new reforms regarding prudential regulations and bank supervision were undertaken in 2007 in the financial sector were the capital requirement was increased to those financial institutions that provide credit facilities. Moreover, the financial system still is in its infancy, where very limited activity, even though it has improved since 1992, where only the Central Bank existed. There were 16 in 2008 with 507 branches and increase of 27% from 2007, but the majority of banks are foreign.

Interest rates for deposits (local and foreign currency) have increased during 2008, narrowing the spread between the two rates as well (Figure 6), however lek-deposits have a higher interest rate which is a tentative of central bank to reduce the level of foreign currency in Albania in order to reduce the vulnerability of Albanian economy to external factors.

4. Dollarization and Currency Substitution

Money has three roles, unit of account, store of value and mean of payments. The use of foreign currency for deposit purposes relates to the role of money has as a store of value, because deposits in foreign currency are used to avoid the danger of inflation and depreciation of the local currency. Foreign deposits are widely spread in developing and transmission countries where the economic stability is uncertain and in most of the cases is accompanied with political insecurity.

Calvo and Vegh (1992) define currency substitution as the use of different currencies as medium of exchange and this represents one extreme of the literature review. On the other extreme, McKinnon (1985) defines currency substitution as direct and indirect. Direct currency substitution is when two or more currencies compete among each other to replace the role of the local currency as a means of payment within the same “commodity domain” and indirect is when the investors are freely to switch between “non-monetary financial assets”. Based on McKinnon definition, currency substitution in Albania is categorised as indirect and this is observed in private investors having the choice to hold any type of asset denominated in currencies that is not the local currency, Lek. Fiege et al (2002) defines it as the “choice that individuals and firms have to use foreign currency to substitute for some monetary services of the domestic currency”.

There are three types of currency substitution, based on the role that money has and these are financial, payments and real substitution. Financial substitution is otherwise known as asset substitution and relates to the assets denominated in foreign currency kept from the private sector. Asset substitution arises when the country faces economic instability and asset substitution is necessary to preserve and safeguard wealth. Payment substitution is otherwise known as currency substitution and it is when transactions in the private sector are denominated in foreign currency. Real substitution is when key prices are indexed to a foreign currency even though the actual payments may take place in local currency (Escolano et al, 2005).

Asset substitution is clearly visible and can be identified by using foreign deposit held both home and abroad whereas currency and real substitution is difficult value and to distinguish from each other due to foreign currency in circulation variable and the nature of transactions in Albania. If the transactions are small then local currency is preferred to foreign currencies, however large transaction such as property, cars and manufacturing equipment are bought in foreign currency, where Euro is the dominant currency. Also the financial sector has recently used Euro currency wages payments to their employees but the rest of the sectors use Lek to pay for wages and other transactions. Moreover, individuals deposit in foreign currency but on day to day activities they hold local currency in form of cash. Therefore it is difficult to distinguish between the currency and real substitution in Albania. In order to overcome this issue, based on the reasoning of Escolano et al (2003) financial and currency substitution would be used to evaluate the degree of substitution, and the real substitution would be categorised under currency substitution.

Moreover, it is important to recognize the difference between currency substitution and dollarization/euroization. Currency substitution is defined by Komarek and Melecky (2201) as: “a process of substitution in the economy which is symmetric and reversible”, otherwise meaning that any amount of substitution can cause a parallel increase or decrease in the use of foreign currencies. Dollarization is defined as: “an asymmetric reaction to changeable determinants of the substitution process in the usage of foreign currency”. As a consequence the demand for foreign currency overshoots by increasing more than depreciating when the exchange rate starts to appreciates.

5. Literature review

Dollarization is related to Latin American region when many countries such as Argentina, Uruguay, Peru, and Mexico adopted US dollar as their official or unofficial currency tender. As a consequence most of the early literature review is focused on Latin American countries. Later on with the collapse of communism systems in Eastern Europe (EE) in the early 1990s, literature review was developed looking at countries in transition focusing more on the EE countries. Also other currencies, apart from US dollar, like German Mark (DM), British Pound (GBP) and at a later stage Euro were used by other countries parallel with their local currency. Porter & Judson (1996) found that 40-60 percent of US dollar was outside US borders and Feige and Dean (2002) 50% of US currency in circulation was held abroad, and according to Seitz (1995) and Doyle (2000) around 35-70 per cent of German Mark (DM) was outside Germany.

The causes and consequences of dollarization have on the monetary politics and the adoption of dollar as the official currency has an extensive literature work. Tobin (1980) argued that excessive variability created through floating exchange rates is the key factor that encouraged dollarization of developed countries. During the 1980s the main focus was official dollarization and mainly looking at the determinants and characteristics mainly in developed countries (Ortiz, 1983; Canto, 1985; etc). With the advances in technology, many researches shifted their focus from just purely identification of causes to evaluation of the degree of currency substitution. However many just concentrated in finding volumes outside the issuing countries (Feige, 1996, 1997; Porter and Judson, 1996). Others considered currency substitution as unobservable (Calvo and Vegh, 1992) arguing that foreign currency in circulation (FCC) is unobservable due to unreported data regarding small stock of foreign currency flows in and out of a country.

As a response to evaluate the degree of currency substitution in a country or group of countries, many researchers used alternative routes to evaluate the degree of currency substitution. Some researches looked at the currency substitution through analysing demand function for domestic money and foreign variables. Some of the variable are foreign inflation (Rogers, 1990), nominal interest rates (Madhavi and Kazemi, 1996), and real return differential (Thomas, 1985). Moreover, Prock et al (2003), tested for currency substitution in Latin American countries by looking at changes taking place in money demand for domestic currency allowing at the same time for capital mobility and currency substitution. Other authors applied similar demand models to different countries and regions (Darral et al (1996); Sharma et al (2004); Rodriguez and Turner (2003), etc).

In developing countries money in circulation is greater than developed countries and a majority of transactions are made in cash and the foreign money used for the transaction is hard to be valued. As a consequence, the majority of literature review concentrates in measuring the currency substitution level as a proportion of foreign deposits over M3. Based on IMF, the level of substitution that is supposed to not have an effect the monetary policy is 30 per cent and this threshold is supported from et al (1999) which considers 30% the threshold that separates highly dollarized economies with those not highly dollarized. However, IMF ignores the money in circulation; as a consequence it does not represent the true level of substitution, because it fails to capture the differences in dynamics which this model tries to capture. If FCC is used in the calculation then the money substitution can be divided into two categories, asset substitution and currency substitution. Asset substitution represents the store of value effect and is calculated as a proportion of foreign deposits and total deposits (foreign and local). Money substitution represents the role that currency has as a mean of payment and is calculated as proportion of foreign currency in circulation over total money (foreign and local) outside banking system.

Calvo and Vegh (1992) have argued that foreign currency circulating in an economy is “unobservable” and the degree of currency substitution is therefore unobservable. It is understood that foreign currency in circulation is the most difficult variable to be calculated from the rest of the variable that make up the money substitution index. For this reason many researches have proposed several methods in measuring FCC, mainly focusing on the money transfers, net exchanges (local currency to foreign and foreign currency to local) and macroeconomic factors. Feige et al (2000, 2002) have evaluated FCC in several countries using the records from Customs of USA Borders, were the dollar amount leaving the country and their destination is reported by individuals and also the official transfers of dollars outside US. However, the true destination of the dollar is difficult to obtain because it can circulate from a country to another without being recorded. To measure the Euro in circulation Feige et al (2000 and 2002) used Austrian Bank records during 1997-2001 periods. Therefore this method represents a weak methodology which is critised by the author itself and it would not be a good approach in measuring the FCC in Albania because many of the money inflows and outflows through customs are not recorded. One factor that helps towards the informality of the system is the high degree of corruption which allows individuals to bring and take money from Albania without obeying to the law regarding maximum amount of capital that should be reported and the bribed officers not properly doing the job.

Mongardini and Mueller (2000) have used net conversions of exchange offices to value the amount of FCC in Kyrgyzstan. Based on their approach, money exchange offices are the main entity for small currency exchanges carried from individuals and small businesses, and the net conversion is the FCC in the domestic economy.

Reinhart et al (2003) classifies currency substitution of a country through macroeconomic variables like: foreign deposits/M3 (used from IMF as well), external debt to GDP and debt denominated in foreign currency to total debt. The two ratios that involve debt are used to calculate the currency substitution in loans. Based on the combination of these reports they build four groups where the degree of substitution is categorised in each group. However not an accurate valuation of the degree or evolution of currency substitution is reached. Albania was investigated from some previous studies and the results obtained indicate that the substitution of currency is not very high. According to Feige (2002) the foreign currency in circulation as a proportion of money outside banks in Albania in 2001 was 14%, whereas the money substitution index was 22.4%. Reinhart et al (2003) categorises Albania in second group, where the currency substitution is considered internal meaning that the level of foreign denominated loans is relatively low. Balino et al (1999) concluded that the ratio of foreign deposits to M3 was 18% in 1994.

A large number of factors make domestic residents substitute away from the domestic currency, namely, the foreign trade transactions, the domestic transactions, the portfolio diversification, and the avoidance of excessive financial losses from inflationary taxation[1] (Brand, 1993). Country where currency substitution is prevalent, interest rate (both real and nominal) changes would be uncertain due to the instability of the money demand. Foreign nominal interest rate if currency substitution exists in those economies. Other researchers used optimizing framework with both domestic currency and foreign currency as assets to identify currency substitutions[3] (Selc¸uk, 2003; Age´nor and Khan, 1996). The presence of currency substitution has been also tested by examining the stability of the money demand function as the presence of currency substitution

increases the volatility of money demand (Darrat et al., 1996; Sharma et al., 2004).


The degree of currency substitution in Albania will be measured by building indexes based on Feige (2002) approach because same ASI, CSI and MSI indexes would be used, however this approach differs in accounting for foreign currency in circulation.

Due to lack of data related to both un-computerised recording systems in Albania and the short period of time that Albania has been trading in open market (post-communism period), the period under observation is restricted to 1993-2008 and all results will refer to this period. Moreover to be consistent the data used are annual data, because some of the variables used in building the indexes (M3 and Foreign Currency in Circulation) are only reported annually by the BoA for the period in consideration. Therefore it is not possible to carry this study with high frequency data, even though is a better measurement. However, annual data would be a good indicator for the purpose of this evaluation. All calculations are expressed in local currency (Lek) and the data used for calculations would be expressed in Lek. The main reason is to keep the consistency with all the data required to build this report, because prior euro all accounts were published in dollars and once euro was introduced then statistics were reported in euro terms. Bank of Albania was the main resource of information were most of the data was withdrawn primarily from annual reports, balance of payments and financial stability reports over the last fifteen years. Also National Institute of Statistics (INSTAT) was used to collected information relating to unemployment rate, real GDP growth and other macroeconomic factors. Moreover, International Statistics Database of IMF was used regarding transfers and to verify that all data collected consisted with the other sources.

In order to measure and value the currency substitution three indexes will be built and they are Asset Substitution Index (ASI), Currency Substitution Index (CSI), both of which make up Money Substitution Index (MSI). On top of these, the IMF Dollarization Index (DIIMF) will be build using the approach adopted from IMF to compare with previous results and be able to see the dynamics of currency substitution evolution in Albania.

6.1 Asset Substitution Index (ASI)

ASI is calculated as the proportion of foreign currency deposits over total deposits. Total deposits include time and demand deposits, for both foreign and domestic deposits. All information is easy to find, as it is published in Central Bank of Albania website. ASI (equation 1) would be compared with DIIMF (equation 2) because both indexes have a common variable, foreign currency deposit (FCD). FCD includes all type of deposits in foreign currency, time and demand deposits.

6.2 Currency substitution index

Currency substitution index (CSI, equation 3) present more challenge when building, because of the foreign currency in circulation (FCC) variable which is considered unobservable and alternative methods need to be adopted to calculate FCC. The other variable is currency outside banks, which is reported by INSTAT and IMF. Money substitution index (MSI) is just the sum of the two other indexes and this is represented in equation 4, were all variables are used. Therefore the MSI result should stretch out between ASI and CSI.

It is important to explain the method used for calculating FCC- component of both CSI and MSI indexes and the first crucial step is to identify the sources of FCC in Albania. As it is seen in figure 2, foreign currency has many sources of entry and exit in the economy. The main sources of entry are, cash entry through customs points, export payments, transfers of emigrants from abroad and credit issued in foreign currency (FC). Moreover, the conversion from Lek to foreign currency would be considered as an entry of foreign currency in the economy, which adds to foreign currency in circulation and substitute local currency with foreign currency. In order to calculate the net foreign currency in Albanian economy, exit routes need to be considered as well, which are made of import payments, transfers out of the country and cash leaving through custom borders that leave the country. Also the conversion from foreign currency to Lek would be subtracted and finally foreign currency would be net amount, where some is deposited in banks and the rest is considered FCC.

Net transactions (export-imports) are made through two ways; cash transactions and bank transactions. Based on the in 2004 BoA's Balance of Payment Report only 40% of transactions were made using bank accounts. As a result the rest of transactions made in cash are unobservable, hence difficult to quantify. Therefore, for the period under consideration, it is supposed that transactions for net exports are done through bank accounts, which are included into time and demand foreign deposits. To conclude, the payment for exports are already incorporated into the foreign deposits held by private banks in Albania and reported to BoA regularly, so it would not be used when calculating FCC.

Foreign denominated loans are another element that add to FCC amount in the economy and are normally provided on demand to individuals being used for certain purposes, from buying a property to cars, etc. If the individuals would not needed foreign currency, they would demand local currency loans instead of foreign. Moreover, foreign denominated loans are given from the foreign deposits held from banks, given that foreign deposits are already incorporated into the indexes (MSI and ASI) foreign denominated loans would not be included to avoid double counting of the data. Therefore it is suggested that FCC to be calculated as: (5)

FCC would be calculated for the period between 1993 and 2008 would be divided into two sections. The period from 1998 to 2008 would be calculated using the methodology given in equation 5. The conversion from the exchange offices prior 1998 are hard to secure, because the majority of conversions were made in cash, therefore in order to account for this period it is supposed that the level of FCC is a result of accumulation of transfers from the Financial Union (FU) which started its operation in 1996. Before FU, transfers were made mainly through banking system or cash (unobservable) from individuals. Therefore it is assumed that for this period

To calculate net conversions, conversions from the exchange offices data are used, which are institutions mainly used from individuals, apart from the informal market, to exchange currencies, due to the narrow spread that they charge for exchanges. Also exchange office do transactions with the informal market, therefore a part of the black market is included in their conversions. Moreover, the conversions carried through banks accounts are included into foreign deposits which are reported from the BoA and INSTAT and already incorporated in the ASI, therefore only cash conversions would be used for conversions to avoid double counting of the data.

The last variable, customs, represent entries and exits that do not pass- through the banking system, but are made in cash through customs, and are believed to be high in value. Unfortunately, this information is not available, but can be added to the equation if is obtained from the Customs Directory personal by manually recording each amount of cash crossing the borders, however it is not done so far. Even though customs personnel would record all the amounts, given that Albanian customs is associated with high degree of corruption, so data would be biased. A good proxy for cash, which goes through customs, would be the difference between exports and imports reported from Customs Office and the net exports payments done through the banking system. Therefore by taking the difference we would be able to indirectly attain the cash element that would be added to the FCC variable.

Furthermore, the interest rate spreads on deposits in Albania relative to the European countries is very small, so it is logical that individuals would deposit their savings in the country they work, avoiding the costs of transferring. So, the benefits deriving from keeping domestic deposit would be higher than foreign deposits mainly because of the interest rate differential. Deposits in Lek have a higher interest rate than deposits in foreign currency and this is illustrated from the graph Y. The interest rate for foreign denominated deposits should be high to account for arbitrage and exchange risk, so it results that interest rates for foreign deposits are much lower when compared with interest rates for local deposits. As a consequence, it is supposed that foreign money entering the country it is used for transaction purposes or it is deposited in Lek, but it is not deposited in foreign currency deposits. The exchanges from foreign to Lek value attained from exchange offices is subtracted from FCC, in order to eliminate that part of transfers that it is consumed or deposited in Lek.

7. Results (critical appraisal, compare results with previous studies)

This section lays down the results obtained, for the evaluation of currency substitution, using the methodology described in section 5, and to provide a good comparison with previous researches the IMF approach will be employed. It is believed that all the indexes of currency substitution withholds special interests therefore each of them would be separately analysed, in order to see the evolution of ASI and CSI for the period under observation, which might help to explain the evolution MSI. Overall, for the period 1993-2008, it is seen that all indexes have an upward trend, apart from 1997 where all indexes declined due to the Albanian civil war happening during that time. If we believe that the history repeats itself, it is possible that the evolution of currency substitution in Albania might be stopped, and start again therefore moving around a mean. Fifteen years is a considerable period to analyse for the degree of currency substitution, due to the difficulty of finding data.

7.1 Money substitution index (MSI)

Graph 13, presents the evolution of MSI calculated as:

It is seen that there is an increasing trend since 1997 to 2007, and the degree of MSI is doubled achieving the maximal value of 40% in 2007. The index seems to grow linearly with a coefficient of 0.95 percent per annum, and this fact is also confirmed by the linear regression of MSI against the time and autoregressive factors. Time effect and index value of 1 lag explain 99.4% of movements and are statistically significant. From these observations it is concluded that the factors that have lead to the increase of MSI are lack of individuals to carry-out exchange transactions, use of domestic currency and the increase of use of foreign currency. Another factor that might have helped to increase the level of foreign currency in Albania is the movement towards financial systems and towards formal economy (deposits), leading to the increase of foreign deposits.

Graph 7

7.2 Asset substitution index (ASI)

Asset substitution is one of the two elements of MSI, and is the closest index to DIIMF, hence making them comparable. The results obtained from using DIIMF (FCD/M3) are shown in graph 9, where can be seen that the index has increased steadily over the last fifteen years. However, during 1996-97, 2002-03 and 2007-08 where the index has declined, overall keeping the index's growth to 4% p.a. which is a significant growth.

Meanwhile, ASI is much higher than DIIMF (graph 10). On average 35% of deposits are in foreign currency and increasing after 1998, achieving the maximal level in 2007 and 2008 with 43%.

Looking at graph 8, ASI has achieved the maximal levels before the 1997 crisis, subsequently affected by the decline in 1998. During the recent years, the index has returned to its level in 1996. The index experienced a high growth from 2003-2007, however during 2008 stayed constant, and it is believed that it has declined during 2009, to improve back in 2010. If the graph is observed carefully it is seen a pattern that has been repeated twice from 1998 to 2008, and it caused from the 1998 Asian crisis and currently from the global crises. The result indicates the sensitiveness of Albanian economy to the rest of the world, mainly because of remittances as mentioned before. If 1997, is excluded from the sample, it can be said that ASI has moved around a mean of 33%. The behaviour of this index over the period under consideration indicates that the evolution of ASI would be similar, however would grow with the economic development of Albania and upon joining the EU. Moreover, based on Feige et al (2002) reasoning, currency substitution in Albania can be prevented and inversed.

From graph 9, can be seen that both indexes have followed the same movements, but ASI has been more volatile than DIIMF, mainly because the M3 variable that it is used in calculating DIIMF has been more stable that the value deposits (foreign and local currency). Both indexes have grown from 1998, as it is seen at MSI, which are as a result of the increase in the proportion of FCD to LCD and not from the change in exchange rates. FCD has increased with 245.9 % from 1993 to 2008, whether LCD are increased only with 151.4% for the same period. However in 2008 the growth was kept constant for ASI and declined for DIIMF, mainly because of the global crises, affecting directly the amount of remittances send to Albania from the residents living in countries suffering deep recession, like EU, USA and UK.

7.3 Currency Substitution Index (CSI)

As it is seen from graph 10, CSI shows the same trend as the other two indexes for the period 1993-2008, and FCC has achieved the highest level of x% of currency outside banks in 2007.

Coricelli et al (2007) looked at the eurization in South-eastern Europe by looking at foreign deposits to total deposit ratio and found that Albania in 2006 had 37% which was the lowest in the region followed by Rumania. Also they looked at foreign currency to total loans and Albania scored 70%, the highest in the region.

7. Changes in domestic money in circulation

This is an indirect method and it is based on the assumption that the bigger the circulation of foreign money in the economy, the smaller the usage of large domestic notes. If the currency substitution is high, then the domestic notes in circulation tend to move towards small notes. From table 3, it is clear that the largest cut of lek corresponds to the amount of less than $50 or 50 Euros, meanwhile the largest foreign notes are $100 and 500 Euros. Transactions in large foreign notes would be more convenient for individuals then using the large notes in lek. This is a comparative method and the data prepared from Feige (2000) would be used to compare Albania with other countries in the region with similar economic development in 2003.

Table3: Value of Lek's different notes in dollars and euro in 2008 and in 2003.














































From table 3 is clear that US dollar has depreciated faster than Euro for the period 2003 and 2008, as a consequence many individuals in Albania hold euro rather than dollars. Another reason for the large amount of euro in Albania is that many residents of Albania live and work in EU, therefore the foreign capital inflows are denominated mainly in euro.

Source: Author, Data taken from BoA

The series taken from the Emission Department (part of BoA) even though short, allows for a historical analysis of notes distribution, and it is visible that it has been stable during the period of 2000-2003. In 2003, 78% of currency notes lie under $10 and 22% of notes lie between $10 and $50 US dollars (Table 4). The percentage value is very low in comparison with other countries with similar economic development, for the $10-$50 band. However the MSI of Albania for 2003 is nearly 38% which is high, confirming the results obtained for FCC method implemented in this paper.

Table 4: Notes' Structure of selected countries:


% of Notes in Value Class

























Slovak R.






























7. Albanian Monetary Transmission Mechanism (MTM) channels

It is important to identify the transmission channels which effect Albanian monetary policy, before drawing conclusion regarding effects of currency substitution in monetary policies. The excessively high inflation, the increasing rate of unemployment, the loss of confidence in the effectiveness of economic policies and the domestic currency purchasing power decline in the early 1990s led to rapid dollarization of the Albanian economy. As the degree of foreign currency presence in Albania is reasonably high, it has become a real challenge for BoA in conducting the monetary control and managing price stability.

From past literature review on MTM, there is a general consensus that the exchange rate channel continues to be significant in the overall transmission mechanism framework; monetary policy has gained importance after the adoption of indirect monetary policy instruments and there is little evidence to support the existence of a credit channel. Muco et al (2001) have argued that none of the traditional channels-interest rates, exchange rates, credit rationing and inflation expectation- is likely to be an effective tool for monetary control in Albania. At a later paper from Muci et al (2003), they found that remittances influence both money supply and the exchange rate. Money growth is believed to effect exchange rates, and both money growth and exchange rate should affect the rate of inflation. Moreover, inflation and change in relative export/import prices effect trade balances.

In a slightly different approach, Peters (2003) looks into the details of monetary policy transmission mechanism in Albania and testes the hypothesis that the exchange rate is the most important channel in the monetary policy process. He argues that the exchange rate channel is likely to be weak due to the sizable trade openness of the country and that movements in the exchange rate are likely to be influenced by foreign factors rather than domestic monetary policy. Luci and Vika (2005) argued that in the absence of developed money and capital markets, bank credit is the most important and possibly the only external source of financing especially for small-to-medium size firms in Albania.

In Istrefi and Semi (2007), results suggest that the presence of an asymmetry in the pass-through: pass-through is higher in the case of domestic currency depreciation and lower in the case of depreciation. Also they argued that the low inflation, domestic currency stability and increased monetary policy credibility may have contributed to a dampening of the exchange rate pass-through during the last decade. Samiei (2003) concludes that there is some evidence that the bank has followed a systematic approach to monetary policy by reacting both to inflation and output developments-although severe data problems reduce the reliability of results, maintaining a low inflation. The systematic monetary policy has also been helped by a gradual fiscal consolidation and large foreign currency inflows, which have helped maintain a strong exchange rate.

Currency substitution over the last fifteen years has increased lending in foreign currency, which subsequently has reduced the amount of private credit lending in local currency. Even though the credit lending denominated in foreign currency was very low till 2003, it experienced an enormous growth which started in 2004 and continued up to 2008. Domestic denominated loans increased as well, but with not the same growth rate as foreign denominated loans. The majority of growth comes from the private sector for both type of loans which used for consumption and purchase of real estate.

It is concluded that currency substituion has weakened the effectivenes of monetray policy, because the majority of the credit is done in foreign currency which BoA has no direct control. However, BoA can control the amount of foreing credit lending credit by regulating the banking sector and by implementing a maximum ceiling on the amount of foreign denominated loans banks can lend, in this way currency substituion would decrease as many of the FCD would be exchanged for local currency. By reducing the amount of foreign currency in albania BoA can have more control on interst rates and money growth (the only two tools used for monetary policy). By impossing the maximum ceiling, money growth will decline and inflation would be kept low.

Moreover, BoA, will need to draw prudential rules and regulations for banking sector complying with international regulation in order to regulate the financail sector and promote the growth in Albania. However, it is important that the growth in financial sector doesn not present a threat to the monetary stability. In order to promote both it is suggested that BoA should

On the other hand, currency substituion increases the sensivity of exchange rates to interest rates and nominal shock, and monetary policy becomes more efficient in directly controling the prices through the exchange rates.

8. Conclusions and concluding remarks

Currency substitution calculated for the period 1993-2008 is high, 35% in 2008 and 39% in 2007, in comparison with the standards of IMF which considers the 30% as the maximum threshold which currency substitution does not interfere with the monetary policies. However, the number attained from the study is not much higher than the threshold, as a consequence is not alarming. Looking back at the historical, currency substitution, has an upward trend indicating that the degree of currency substitution will be more spread in the following years. Also, the growth in foreign currency in Albanian economy has grown steadily, around a mean, indicates that currency substitution can be stooped and probably irreversible.

The data used in this study, has a short time span, it is suggested that further studies need to be performed by either increasing the frequency of the data used or stretching the period to include next coming years, because it is suspected that the degree of currency substitution would increase significantly more close to EU integration Albania is. Therefore BoA should collect data regarding the foreign money flows focusing in the routes described in the methodology section to see the development of the indexes through time for further analysis. Moreover, the index should be closely watched by government, because over the last fifteen years overall trade deficit has been increasing and its growth has been covered from the transfers of Albanian residents abroad.

Based on the results which indicate a high level of currency substitution in Albanian economy, it is necessary to evaluate the degree of currency substitution in credit lending, as it is the main factor that leads to financial crisis and exchange rate volatility. The increase in the number of foreign currency loans in Albania, forces BoA to consider the effects of exchange rate volatility in monetary policy, because these volatilities can trigger banking crisis which can harm the fragile Albanian economy.

In addition, it is important to continuously see the monetary transmission channels because remittances affect both money supply and inflation which are the two main targets of BoA. Third generation models, suggest that the foreign currency loans was the main cause of the Russian crisis 1997 and Asian crisis 1998. It is important for small businesses that take many loans during economic booms times, and are the first to suffer when the economy is in depression. Foreign currency loans depend on the amount of foreign currency deposits, as a consequence cannot be included in the calculations used for valuing the three indexes ASI, CSI and MSI. The next questions to be answered from other researchers should be: Does the growing foreign currency loan issuance follow the growth of FCD? How dangerous it is the growth of credit lending in foreign currency for Albanian economy?

Source: Essay UK - http://doghouse.net/free-essays/economics/degree-of-currency-substitution-in-albanian-economy.php

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