International Research Journal of Finance and Economics

ISSN 1450-2887 Issue 21 (2008)

EuroJournals Publishing, Inc. 2008
http://www.eurojournals.com/finance.htm

Currency Substitution: Evidence from Turkey

Muhittin Kaplan
FEAS, Department of Economics, Nigde University, Nigde, Turkey
E-mail: mkaplan@nigde.edu.tr
Huseyin Kalyoncu
FEAS, Department of Economics, Nigde University, Nigde, Turkey
E-mail: hkalyoncu@nigde.edu.tr
FatihYucel
FEAS, Department of Economics, Nigde University, Nigde, Turkey
E-mail: fatihyucel@nigde.edu.tr
Abstract
This paper investigates whether currency depreciation in Turkey has resulted in
currency substitution away from the Turkish Liras (TL). By conducting cointegration test
we have tested for a long-run relationship between M1, real income, nominal interest rate
and nominal effective exchange rate over the period January 1987 to August 2006.
Empirical results suggest that depreciation of the TL has resulted in a decline in holding of
M1 indicating the presence of currency substitution in Turkey.
Keywords: Currency substitution, Cointegration, Turkey.
JEL Classification Codes: E41, F31, C22

1. Introduction
In developing and developed countries currency substitution is a widely observed phenomenon and
represents a shift away from domestic to foreign currencies. The notion of currency substitution is
important particularly for developing countries because the extent of currency substitution is closely
associated with underdeveloped financial markets and high and volatile inflation rates. In the periods
of high and variable inflation, currency substitution is viewed as a safety precaution and its extent is
determined by the level of financial development.
Currency substitution has important implications for the macroeconomic performance of
countries, financing government deficit, determining an appropriate foreign exchange regime, and
conducting the monetary policy. Currency substitution, leading to the decline in domestic money
holdings, could cause an economic slowdown and hence worsen the economic crisis (BahmaniOskooee and Techaratanachai, 2001). Following currency substitution, an increase in the size of
foreign currency deposits leads to a decline in the amount of credits in domestic currency forcing
domestic private firms to borrow in foreign currencies. This increases the currency and default risks of
firms making them more vulnerable to speculative activities. In addition, borrowing in foreign
currency leads to an increase in the domestic currency value of foreign currency debt obligations in the
face of devaluation. This causes an increase in the demand for foreign currency and, in turn, may result
in a downward spiral in the price of domestic currency (Hausmann, 1999). These will of course

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weaken the macroeconomic stability in the overall economy (Ortiz, 1983; Prock et. al, 2003). Currency
substitution could also cause widening in budget deficits since seigniorage income is the main source
of income for the government, particularly in high inflation economies. In case, this loss of income is
not compensated by increasing taxes or reducing government spending, currency substitution may
further increase the rate of inflation (Fisher, 1983).
Currency substitution is also important implications for conducting effective monetary and
exchange rate policies. Destabilizing the domestic money demand, currency substitution makes
monetary targeting more difficult and restricts the ability of central banks to run an independent
monetary policy. This will increase the volatility of the exchange rate and weakens the impact of fiscal
instruments (Miles, 1978; Boyer and Kingston, 1987; Bergstrand and Bundt, 1990).
Currency substitution is also investigated in the empirical literature. In their study on Thailand,
Bahmani-Oskooee and Techaratanachai (2001) examined whether currency depreciation has resulted in
currency substitution away from the Thai baht. Using cointegration approach, they found that
depreciation of the baht has resulted in a decline in bath holding in Thailand. Using a similar
methodology, Prock et al (2003) investigated whether currency depreciation in some of Latin America
countries (namely Argentina, Brazil and Mexico) has resulted in currency substitution. Using the
vector error correction (VEC) model, they found that currency substitution occurs to a greater extent in
Argentina and Brazil than Mexico. Akay et al (1997) investigated currency substitution and its effect
on exchange rate instability in Turkey. Using an exponential GARCH (E-GARCH) model, they found
evidence of currency substitution and also found that exchange rate instability increases with the
degree of currency substitution. Selcuk (1994) investigated the dynamics of currency substitution.
Dynamics impulse responses show that the residents have a preference for substituting foreign
currencies for domestic currency because of real exchange rate depreciations.
Investigation of the validity of currency substitution is especially interesting in the Turkish
case. After a financial liberalization program in 1987, the Turkish economy has experienced moderate
to high levels of inflation and learned to live with above-average inflation for a long time. Inflation is
averaged yearly about 68% between 1987 and 1994 and about 77% between 1995 and 2000. Following
the financial crisis of 2001, inflation is dropped radically to 25% in 2003 and gradually dropping since
then. It is about 10% in 2006. It is also worth mentioning that since the 1987 financial liberalization
program, the Turkish financial markets have been substantially developed. In this paper we will
investigate whether currency depreciation in Turkey has resulted in currency substitution away from
the Turkish Liras (TL) over the period January 1987 to August 2006 using cointegration approach.
Using a different methodology that employed in our study, Akay et all (1997) and Selcuk (1994) have
shown that currency substitution occurred in Turkey.
The rest of this paper is organized as follows. Section two provides analytical framework and
econometric methodology employed in the empirical analysis of currency substitution. Section three
introduces the data employed in the empirical analysis and presents the results. Section four concludes.

2. Analytical framework and econometric methodology

In this study we follow Arango and Nadiri (1981) and Bahmani-Oskooees (1996) model. In the
empirical analysis we estimated the following money demand function:
log M 1t = a + b log Yt + c log I t + d log neert + et
(1)
where, M1, is the real money stocks, Y is the real income, I is nominal domestic interest rate and neer
is the nominal effective exchange rate.
In equation (1), the elasticity of income b is expected to be positive and the elasticity of interest
c is expected to be negative. As argued by Arango and Nadiri (1981), a depreciation of the domestic
currency (or appreciation of the foreign currency) raises the domestic currency value of foreign assets
held by domestic individuals. If this increase is perceived as an increase in wealth, demand for
domestic cash balances may increase. The link between exchange rates and money demand can also be

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used to define currency substitution. According to the currency substitution literature, when the
exchange rate is expected to depreciate, the expected return from holding foreign money increases, and
the demand for domestic currency falls (as individuals substitute foreign money for domestic
currency). Thus, if depreciation of the TL reflected by a decrease in effective exchange rate induces a
decline in money holdings by domestic residents, the estimate of d should be positive.

3. Methodology
A necessary condition for testing for a long-run relationship among variables is that these variables are
I(1), i.e., stationary in first differences. We, therefore, use the classical unit root tests, namely, the
Augmented Dickey-Fuller (ADF) test (see Dickey and Fuller, 1981; Said and Dickey, 1984). ADF test
is based on the null hypothesis that a unit root exists in the time series.
Once it is established that series are I(1), we can proceed to test for a long-run relationship
between the series. If such a relationship exists, the series are cointegrated. We tested cointegration
using the two cointegration techniques devised by Johansen and Juselius (JJ) (1990).
In the JJ method, two tests are used to determine the number of cointegrating vectors (r): the
trace test and the maximum eigenvalue test. In the trace test, the null hypothesis is that the number of
cointegrating vectors is less than or equal to r, where r is 0, 1, or 2. In each case, the null hypothesis is
tested against a general alternative. In the maximum eigenvalue test, the null hypothesis r = 0 is tested
against the alternative that r = 1, r = 1 against the alternative r = 2, etc.

4. Data and Empirical Results

4.1. Data
Monthly time series data are used, and the sample period is from January 1987 to August 2006. All
data has been taken from the International Financial Statistics (IFS), Eurostat Online database and the
Central Bank of the Republic of Turkey (CBRT) electronic data delivery system.
M1 is the real money stock. Countrys nominal M1 is deflated by its CPI to obtain real money
supply. Y is the real the gross domestic product (GDP). Nominal GDP is deflated by CPI to obtain real
GDP. Interest rate (I) is the nominal domestic interest rate. neer is nominal effective exchange rate
defined as units of foreign currency per unit of the Turkish Liras. All the data series are seasonally
adjusted and transformed to logarithmic form.
4.2. Empirical Results
We first perform unit root tests in levels and first differences in order to determine univariate properties
of the series used in this study. The results are presented in Table 1. Test results indicate that the
hypothesis of a unit root in level series cannot be rejected at the 5% level of confidence, suggesting
that the variables are not level stationary. Table 1 also shows that the ADF statistics for the four
variables imply first-difference stationary.
Table 1:

Series
M1
Y
I
neer

Unit Root Test Results

-0.920(0)
-3.124(0)
-2.149(0)
0.485(1)

Level

-0.482(0)
-0.704(0)
-1.151(0)
-2.110(1)

First Difference

-4.722 (12)*
-17.322(0)*
-15.970(0)*
-9.687(0)*

-3.915(12)*
-17.360(0)*
-15.889(0)*
-9.349(0)*

Note: The t statistics refer to the ADF tests. The subscripts and indicates the models that allow for a drift term and both a drift and a deterministic
trend, respectively. Asterisk (*), shows significance at 5% level. Figures in parentheses indicate the lag length.

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After establishing the stationarity of the data, we use Johansen multivariate cointegration tests
to explore any possible long run relationship among the variables. This involves testing the number of
cointegrating vectors.
Before undertaking cointegration tests, let us first specify the relevant order of lags(p) of the
vector autoregression (VAR) model. Lag order was determined using the Schwarz Bayesian Criterion
(SBC) and Akaikes Information Criterion (AIC). Lag in VAR model is 5 for the model. The results
obtained from the JJ method are presented in Table 2 below.
Table 2: Johansen-Juselius Maximum Likelihood Cointegration Tests
Trace Test
Null
Alternative
r=0
r1
r1
r2
r2
r3
r3
r4

Statistic
56.655*
24.214
9.579
1.812

95 % Critical Value
47.856
29.797
15.494
3.841

Null
r=0
r1
r2
r3

Maximum Eigenvalue Test

Alternative
Statistic
95 % Critical Value
r=1
32.440*
27.584
r=2
14.634
21.131
r=3
7.767
14.264
r=4
1.812
3.841

Notes: 1) we have employed SBC and AIC criterion in the determination of lag length in the VAR model.
2) Asterisks (*) denotes statistical significance at 5%. r stands for the number of cointegrating vectors.

The null hypothesis of no cointegration, i.e., r=0 can be rejected either using the maximum
eigenvalue or the trace statistic. They are both greater than their critical value. The null of r=1 can not
be rejected in favor of r=2. Thus, there is only one cointegrating vector in the model. Therefore, our
monthly data from 1987M1 to 2006M8 appear to support the proposition that in Turkey there exist a
stable long-run relationship among the variables.
Table 3:

Estimates of Long-Run Cointegrating Relationship

Dependent variable
M1

Y
0.265 (0.418)

i
-0.733 (0.071)

NEER
0.019 (0.032)

Note: Figures in parentheses indicate the standard error of coefficients.

Long-run cointegrating relationship is given in Table 3. For the model, interest rate and income
elasticities are negative and positive, respectively, as expected. The nominal effective exchange rate
carries a positive coefficient indicating that as the Turkish Liras depreciates, public holding of M1
declines. As we mentioned above there are two competing forces predicting the impact of devaluation
on money demand. In the first one, depreciation of the domestic currency increases the wealth of
people and demand for domestic currency increase. In the second, people substitute foreign currency
for domestic currency to protect themselves against depreciation and therefore hold less domestic
currency. For this reason, the positive sign on nominal effective exchange rate shows that the latter
force is stronger than the former leading to a the decline in domestic money holdings. As mentioned
before, using a different methodology and for different time period, Akay et all (1997) and Selcuk
(1994) have also shown that there is a currency substitution in Turkey.

Conclusion
In this paper we investigated the impact of depreciation on currency substitution in Turkey. The longrun relationship between M1, real income, nominal interest rate and nominal effective exchange rate is
tested by conducting cointegration test over the period January 1987 to August 2006. Empirical results
indicated that an increase in interest rate decreased the money demand; however, an increase in income
increased the demand for money. Empirical result also suggest that depreciation of the TL has resulted
in a decline in holding of M1 indicating the presence of currency substitution in Turkey.

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