What Drives a Local Currency Away from Banking Markets? Some Southeast Europe Insights

The chapter explores determinants of currency substitution on a sample of countries of Southeast Europe that follow a variety of exchange rate regimes within different monetary frameworks. In the sampled countries, the level of currency substitution remained rather high despite years-long efforts to address the issue. Although the substituting currency (euro) does not undermine the substituted ones in their role of means of payment, it is the pervasive use of foreign currency as the store of value, or choice of currency for financial assets and liabilities, that becomes a persistent feature of all economies in question. Foreign currency loans continue to dominate local loan markets, and broader money aggregates to a large extent consist of foreign currency deposits (financial euroization). The presence of financial euroization makes interest rate channel of monetary transmission inefficient. Moreover, the pervasive level of financial euroization leaves an economy dangerously exposed to external shocks. This is why understanding roots and mechanisms of financial euroization becomes an increasingly important policy issue. We employed multiple panel regression models feed by the official annual data that cover the last decade. In this study, the choice of explanatory variables is firstly based on the so-called portfolio view which considers economic agents’ choice between the classes of domestic and foreign assets driven by risk–return relationship. We have tested the significance of a set of variables pointed out by two international parity conditions, i.e., uncovered interest rate parity and purchasing power parity. The common variable for those international parity relations is exchange rate expectations, or future path of exchange rate. We also included different proxies for external fragility. Those proxies may shape public view of growth and stability prospects, and further on explain puzzling disparities of the international parity relationships, calculated based on current level of exchange rate. Designed that way, econometric models are able to trace wrong policy choices or unsustainable economic policy mix.