the relationship between the parallel exchange rate and the equilibrium rate. It is determined that ... previously-derived theoretical results. ... the benefit of being determined in a free market, and hence is not obviously contaminated by the distortionary effects of ..... A volume based on the project, âParallel Exchange Rates in.
Board of Governorsof the Federal ReserveSystem
InternationalFinanceDiscussionPapers Number 564 September 1996
THE USE OF THE PARALLELMARKETRATE AS A GUIDE TO SEn~G THE OFFICIALEXCHANGERATE Nita Ghei and StevenB. Kamin
NOTE: InternationalFinanceDiscussionPapers are preliminarymaterialscirculatedto stimulate discussionand critical comment. Referencesin publicationsto InternationalFinanceDiscussion Papers (other than an acknowledgmentthat the writer has had accessto unpublishedmaterial) should be clearedwith the author or authors.
ABSTRACT This paper addressesthe merits of using the parallelexchangerate as a guide to settingthe official exchangerate. Ideally, policymakerswould set the exchangerate at the level that would balancetrade and sustainablecapital flows--thatlevel is referred to as the equilibriumexchangerate. In practice,it is difficultto identi~ the equilibriumexchangerate, particularlyin countriesthat have experiencedmacroeconomicvolatilityand/or structuralchange. In this context,where parallel markets for foreign exchangeexist, it is natural to considerthe parallel rate as a proxy for the equilibrium exchangerate, since it is set directly by the market. The paper developsan analyticmodel to explore the relationshipbetweenthe parallel exchangerate and the equilibriumrate. It is determinedthat only under a fairly narrow set of circumstanceswill the parallel rate be set at a level close to the equilibriumexchangerate. The paper then comparesthe evolutionof official and parallel exchange rates over time, in a large sampleof different countries,to providea feel for the applicabilityof the previously-derivedtheoreticalresults.
TheUse of the ParallelMarketRateas a Guideto Settingthe OfflcialExchangeRate Nita GheiandStevenB. Kamin*
I. Introduction Determiningthe appropriatelevelat whichto set the exchangerate is a challengingproblemfor any countrypursuinga managedor fixedexchange-ratepolicy. Ideally,a countrywouldset itsexchangerate at the realequ.ilibnumra~,thatis, therate consistentwithinternaland externalbalance(tie latterreferringto balance betwmntradeandsustainableeapital-account flows). Evenin relativelystableand matureindustrialeconomies, however,the realequilibriumlevelof theexchangerateis usuallydifficultto identi~. In developingcountries subject to macroeconomicinstabilityand/orstructuralchange,this identificationis evenmoredifficult. The determination of theequilibriumrealexchangerate is especiallyuncertainif theeconomyis in themidstof trade liberalization andotherreformsthatpromiseto changepreviouslyexistingrelationsbetweentradeperformance andtheexchangerate. In a contextwherea parallelmarketfor foreignexchangeexists,it may appearnaturalto considerthe pardel exchangerate as a proxyfor theequilibriumrealexchangerate. Theparalielexchangerateusuallyhas the benefitof beingdeterminedin a free market,andhenceis not obviouslycontaminatedby thedistortionary effecwof government policy.Mdtipleexchangerate managements,formaland informal,legalandillegal,were the norm for developingcountri= until very recently. Even thoughan increasingnumberof countiieshave tiled theirexchangera@, oftenaspartof a largerliberalizationeffort,parallelforeignexchangemarketshave
l~e au~ors Mecomespnden~ me EconomicTimes~d SeniorEconomist,Divisionof ~~rnation~ Finance,Boardof Governorsof theFederalReserveSystemrespectively.We are gratefulto Lawrence Hinkle,Peter Montieland SteveO’Comell for helpti mmmentsand suggestions.Thispaperwasprepared as a chapterin an editedvolume,LawrenceHinkleandPeterMontiel,eds,ficllange RafeManagementin bw InconleCotlntnes:Metlzoblogiesfor EnzpiricalAnalysis,underpreparationby theWorldBank The viewsexpressedin thispaper are oursand do notnecessarilyreflectthoseheldby theBoardof Governors, theWorldBank,TheEconomicTimesor othermembersof theirstaffs.We areresponsiblefor anyandall emors.
Board of Governorsof the Federal ReserveSystem
InternationalFinanceDiscussionPapers Number 564 September 1996
THE USE OF THE PARALLELMARKETRATE AS A GUIDE TO SETTINGTHE OFFICIALEXCHANGERATE Nita Ghei and StevenB. Kamin
NOTE: InternationalFinanceDiscussionPapers are prelimina~ materialscirculatedto stimulate discussionand critical comment. Referencesin publicationsto InternationalFinanceDiscussion Papers (other than an acknowledgmentthat the writer has had accessto unpublishedmaterial) should be cleared with the author or authors.
ABSTRACT This paper addressesthe merits of using the parallelexchangerate as a guide to settingthe official exchangerate. Ideally, policymakerswould set the exchangerate at the level that would balancetrade and sustainablecapitalflows--thatlevel is referred to as the equilibriumexchangerate. In practice,it is difficultto identi~ the equilibriumexchangerate, particularlyin countriesthat have experiencedmacroeconomicvolatilityand/or structuralchange. In this context,where parallel markets for foreign exchangeexist, it is natural to considerthe parallel rate as a proxy for the equilibrium exchangerate, since it is set directly by the market. The paper developsan analyticmodel to explore the relationshipbetweenthe parallel exchangerate and the equilibriumrate. It is determinedthat only under a fairly narrow set of circumstanceswill the parallelrate be set at a level close to the equilibriumexchangerate. The paper then comparesthe evolutionof official and parallel exchange rates over time, in a large sampleof different countries,to provide a feel for the applicabilityof the previously-derivedtheoreticalresults.
TheUse of the ParallelMarketRateas a Guideto Settingthe OfficialExchangeRate Nita GheiandStevenB. Kaminl
I. Introduction Determiningthe appropriatelevelat whichto set the exchangerate is a challengingproblemfor any countrypursuinga managedor fixedexchange-ratepolicy. Ideally,a countrywodd set its exchangerate at the realequilibriumrate,thatis, therate consistentwithinternalandexternalbalance(thelatterreferringto balance betw=ntradeandsustainable~pit.al-account flows). Evenin relativelystableandmatureindustrialeconomies, however,therealequilibriumlevelof theexchangerate is usuallydifficultto identi&. In developingcountries subject to macroeconomicinstabilityand/orstructuralchange,this identificationis evenmoredifficuh. The determination of theequilibriumrealexehangerateis especiallyuncertainif theemnomyis in themidstof trade liberalization andotherreformsthatpromiseto changepreviouslyexistingrelationsbetweentradeperformance andtheexchangerate. In a contextwherea parallelmarketfor foreignexchangeexists,it may appearnaturalto considerthe paralielexehangerateas a proxyfor theequilibriumrealexchangerate. Thepartilelexchangerateusuallyhas the benefitof beingdeterminedin a free market,andhenm is not obviouslycontaminatedby thedistortionary effectsof government policy.Multipleexchangerate arrangements,formaland informal,legalandillegal,were the norm for developingcountriesuntil very recently. Even thoughan increasingnumberof countrieshave tiled theirexehangerab, oftenaspartof a largerliberalizationeffort,parallelforeignexchangemarketshave
l~e auhors ~e cofiespnden~ me EconomicTimesand SeniorEconotist, Divisionof ~~mation~ Finance,Boardof Governorsof theFederalReserveSystemrespectively.We are grateful10Lawrence Hinkle,PeterMontieland SteveO’Comellfor help~ commentsand suggestions.Thispaperwasprepared as a chapterin an editedvolume,LawrenceHinkleandPeterMontiel,eds,&clzangeRafeManagenzentin bw InconleColtntries:A4et)lodologies for EnlpiricalAnalysis,underpreparationby theWorldBank.The viewsexpressedin thispaperare oursand do not necessarilyreflectthoseheldby theBoardof Governors, theWorldBank,TheEconomicTimesor othermembersof theirstaffs.We areresponsiblefor anyand all enors.
2 notdisappearedas~
Nigeria,whichhas neverSUCwssfully unifiedits exchangerate,is a prominentexample
in Africa;in Venezuela,whichunifiedits exchangerate in 1989,a parallelmarketemergedin 1994following thereimpositionof capitalcontrols. Notwithstandingthe appealof a market-determinedexchangerate as a guideto settingthe official exchangerate,however,variousfactorscomplicatethe relationshipbetweentheparallelmarketrateand thereal equilibrium exchangeratein aneconomy.First,whilethe parallelmarketfor foreignexchangemaynot itselfbe controlledbythegovemmen 4 ~nditionsin thatmarketare likelyto be affated by governmentpolicy. Relative supplies and demandsfor foreigncurrencyin tie parallelmarketwillbe alteredby the levelof the official exchangerate,theextentto whichexchangeand&adecontrolsare enforced,andthe government’sformulafor rationingforeignexchangereceiptsto importers. Second,becausethep@lel exchangemarketrepresentsan assetmarketas well as a trade-relatedmarke4theparallelmarketrate is likelyto reflectexpectations,political concerns,capitalfigh~andotherfactorsnotdirectlyassociatedwiththerealequilibriumexchangerate. Hence, only under a relativelynarrow set of circumstanceswill the parallelmarketrate serve as a useti guideto determiningtie equilibriumvalueof theofficialexchangerate. Inthispaper,weexplorethedeterminan~of theparallelmarketrate in orderto ass~s ifi usetiness as a guide to measuringthe equilibriumvalueof the official real exchangerate. The plan of this paper is as follows. In SectionII, parallelexchangemarketsare definedmorespecificallyand variouscharacteristicof parallelexchangemarti aredestibed.2 SectionIII addrmsestheissueof theunificationof exchangemarke@ andtheappropriatetargetfor theofficialexchangerate.In SectionIV wereviewa simpletheoreticalmodelof parallelexchangemarketsto shedlighton howparallelmarketratesaredeterminedin relationto bothofficial exchangerates andequilibriumexchangerates. SectionV comparestheevolutionofparaUelandofficialreal exchanger-
overtimetoprovidea f~l for the applicabilityof the theoreticalresultspresentedin theprevious ..
ZForgener~ smeys of tie issuesassocia~ withp~~el marketsforforeignexchangessee ‘genor (1992)and KiguelandO’Comell(1995).
3 section.SectionVI concludes. II. EssentialCharacteristicsof ParallelExchangeMarkets 11.1Bmic Definitions
A parallel foreignexchangemarketsystemis onein whichtransactionstakeplaceat morethanone exchangerate and at leastoneof theprevailingrates is a tieelyfloating,market-determined rate (theparallel exchangerate). (KiguelandO’Connell, 1995)ParaUelmarketsystemsrepresenta subsetof thebroadercategory of multipleexchangerateregimes,whichreferto anyregimesin whichtwoor moreexchangeratesare applied to thesa,mecurrency, Manydevelopingmuntrieshaveappliedseparate,fixedexchangeratesto differenttypes of transactions, butthispracticeis, in essence,equivalentto a singleexchangeratecoupledwithdifferenttaxa orsubsidi=(depending on thetransaction).Bycontrast,a parallelmarketfor foreignexchangeis distinguished bythefactthattheparallelexchangerateis determinedfreelyin themarke~ Usually,theofficialexchangerate in parallelmarketsystemsis peggedby the authoritiesat a particularfixed (or crawling)rate, althoughin principletheoficialratecouldbe flotig as well, Additionally,it is frequently-dthoughnot always- thecase thattheoficialexchangerateapplimtocurrentaccounttransaction,whiletheparallelmarketrate,whetherlegal or illegal,appliesto capitaIaccounttransactions. Parallelmarketsfmforeignexchangecane~ge onlywhenthegovernmentimposesexchangecontrols, that is, restrictionson the volumeof certainforeignexchangetransactionsor on the price at whichsuch transactionsare made, Trade barriers,quantitativerestrictions,or high tariffs aloneare not in themselves sufficientto giverise to a parallelexchangemarket. Whilesuchcontrolsmayaffectthedemandor supplyof foreign currencies,theywillnot drivea wedgebetweenexchangerates for differenttransactions,as longas foreign exchangeis freelyavailablefor all transactionsat an officialor market-determined exchangerate. A parallelmarketarisa whenthegovernmentlimitstheamountof foreignexchangethatcanbe boughtor sold for particulartransactions,causingexcessdemandor supplyto spilloverintoa parallelmarkegor authorizesthat exchangeratesfor certaintransactionsbe peggedandfor othertransactionsbe floating.
4 11.2kgal andIllegalSystem Parallelexchangeratesystemsmaybe legalor illegal. Whentheparallelmarketfor foreignexchange is legal, it is often referredto as a dual exchangerate (DER) system.In these cases, most currentaccount transactionstakeplaceat a peggedcommercialrate, and capitalaccount&ansact.ions at a marketdetermined financialrate.Anumberof countrieshaveexperimentedwithDER systemsof varyingduration.Somecountriw maintainedofficialdualexchangerates for longtimeperiods,such as Belgium(from 1957to 1990)and the DominicanRepublic(until 1993).The parallelmarket,in thesewuntria, was used to insulatether=tofthe -nomy fromshorttermcapitalflows. France(1971-74) and Italy(1973-74)adopteddualratesfor a short period followingthe mllapse of the BrettonWoodssystemas a transitorymeasure.Argentina Mexiw and VenezuelaadoptedDER regimes in the 1980sh the wakeof balanceof paymentscrises and huge capital outflows. Illegalparallelmarketsystemsemergewhenprivateagenfiattemptto evaderestrictionson thepriceor quantityof foreignexchangetransactions.Illegalmarketswerethenormin mostof Afri~ andSouthAsia,as well in severalLatinAmericanmuntrim, ~pecially throughthe 1980s.The parallelmarketsweregenerally toleratedby the authorities,withsomeexceptions.For example,the threatof enforcementandpenaltieswas significantinGhanapriorto 1983,but theseeffortsfellby thewaysidelateron, andthe coverageof theparallel marketgrew,asdidtheparallelpremium(KiguelandO’Connell,1995).In Sudan,tradingon theparallelmarket was a capitaloffence,and enforcementwas attemptedbetween1970and 1990.But eventhe threatof capital punishmentdid not totallywipeout the parallelmarket,thoughit may have kn
a factor in the veryhigh
p~miLlmobservedin Sudan. Inprinciple,thereis littledifference,in termsof macroeconomicimplications,betweenlegaland illegal systems. In eithercase, free-markettransactionsin foreignexchangetake placealongsidecontrolledpricetransacdons.Thismeanshat in eitherlegalor iliegalsystems,thereare incentivesfor transactionsto spillover or “leak”horn one marketinto the other. These leakagesmay tend to underminethe parallelexchangerate
5 system,dependinguponhowrigidlyexchangecontrolsareenforced. 11.3:ParallelMarketsin the 1990s Agreatmanycountri=haveexperimen M withparallelexchangearrangemen~at varioustimes.These arrangementshaveincludedformal,legaldualratesas wellas illegal“black”rata. However,theincidenmof sud wangernentshasbeendecliningin the1990s,as an increasingnumberof developingcountrieshavesought tounifytheirexchangerati, oftenaspartof a largerstructuralreformeffortwhichincludesliberalizationof the externalaccounts.Evenpartialconvertibilityof thecurrency,for ment accountpurposes,forexample,leads to progresstowardsunifyingtheexchangerate. Observers frequentlyviewthe incidenceof restrictionson internationaltransactionsas evidenceof prevalenmandimportanceofparallelextige marti. Accordingto IMFrepo~, aboutone-haifof the member countrimimposer~trictions on paymen~on transactionon thecurrentaccount;overthree-quartersdo so on capitalaccountpayments(Table1).However,themereexistenceof restrictionsdoesnotnecessarilyimplythe existenceof si@lcant parallelmarb~, sincetheseare qtitative data,withtwovalues- yes andno, andso do notcaptureeithertheintensityof restrictionsor theeffectivenessof enforcementTherefore,usingtheexistence on paymentsrestrictionswodd r~ult in an overestimateof the prevalenceof parallelmarketsfore foreign exchange. Parallel marketsare likelyto be unirnportan~and the parallelpremiumlow, when the payments r~trictionsandcapitalcon@olsareeitherminimalor notenford. For example,SouthMnca imposedcapital controlsin 1985,followingmassivecapitaloutflows,andre-introdud a dualexchangeratesystemat thattime. Buttheparallelpremiumhasremainedmodest- themedianpremiumwas4.4per centfor theperiod 1980-89, and declinedto 2.3 per centduringtheperiod 1990-94(Ghei,Kigueland O’ComeU1996)- whichwouldbe consideredto a unifiedexchangerate regimeunderthedeftition in Section5 below. Thereare severalother examplesof countri~ with extremelylowpremia,including~ailand, Malaysiaand Indonesia,withmedian premiavaryingfmm-1.5 to 3.4 percent (Gheiet al, ibid).
6
Table1 Incidenceof PaymentsRestrictionsamongIMF MemberCountries CurrentAccount
1980
1994
51.77%
51.69%
78.01% CaDitalAccount 77.53% and Excbange ArrangcmenU: Annual Report oftheIMF,various issues. Source: Exchange Restrictions At thepr~entmomen~parallelexchangeratearrangementareto befoundin developingcountriesonly; Belgium,which wasthe lastdevelopedcountrywithdualexchangerates,movedto a unifid exchangeratein 1990. Parallelexchangerates werea featureof onehalfofour sampleoftwenty-fourdevelopingcountriesat theendof 1994(see Table2)3. Parallelexchangeratearrangemen&wereevenmorewidespreadin developing countries in the 1980s- everycountryin our samplehad morethanoneexchangerate in 1985. Our sample includes countrieswheresignificantparallelmarkefiexistedfor some time,and includesmost of the more importantdevelopingcountries,outsideeasternand=ntral EuropeandtheformerSovietUnion. Parallelmarkefihavehaddifferentdegreesof longevity.ArgentinaMexicoandVenezuelahad legal dualrates that wereexpectedto be temporary.All threecreateddualrates and thenunified withintheperiod, 1980 to 1994,thougha parallelmarketdid re-emergein Venezuelain 1994,as discussedabove.OtherLatin Americancountriesmovedto multiplerates or unifiedwithinthe same period.In the fican
and Asian
muntri=,bycontras~paraLlel rnar~ weremorelonglivd A fewof thesecountriesunifiedtheirexchangeratw in the 1990s,butmajorexceptionsremain- mostlyin MCZ includingNigeri~KenyaandZambia. Thelevelof theparallelpremiumhasdeueased,on average,in thecountrieswiti parallelexchangerate wangements.Wefindlowerprerniain 1994reladveto 1985inrnanycases,for our sample. For a selectedgroup
.
me sampleis drawntim a WorldBankresearchproject,“Macroeu)nomicImplicationsof Multiple ExchangeRatesin DevelopingCountriW”.A volumebasedon theprojec~“ParalielExchangeRatesin DevelopingCountries,M.A.Kiguel,J.S.LizondoandS.A.O’Comell,eds,is forthcoming.Thedatawere updatedto theend of 1994for thispaper.
7
Table2 Statusof ParallelMarket/ Levelof ParallelPremium(%)
?
1980
1985
1990
Unified
30.79
29.93
unified
Bolivia
19.85
223.60
unified
unified
Brazil
8.90
30.12
14.28
Unifi
Chile
6.03
25.39
16.78
8.67
unified
11.42
9.24
6.12
DominicanRep.
38.00
7.69
68.01
unified
Ecuador
11.45
76.90
23.53
5.45
Mexico
unified
28.46
7.41
Unifld
36.25
29.53
104.80
unified
Uru~ay
unified
9.41
10.93
16.51
Venezuela
unified
104.00
unified
4.73
9.98
-7.17
unified
unified
193.25
375.23
248.81
253.95
7.77
122.90
89.47
35.02
127.66
192.75
Ghana
485.92
143.48
9.84
Utifi
Kenya
9.38
4.51
3.11
19.78
Malawi
92.27
49.51
17.51
14.62
Nigeria
67.67
306.22
19.40
231.87
Sudan
92.40
27.14
955.45
53.13
174.00 70.27
271.89 65.39
56.36 279.56
Unified -6.15
9.58
15.12
9.10
Unifl
26.26
-0.67
8.72
Unifi
country
lm
htin Americanand Turkey Argentina
Colombia
Peru
Turkey Aflica andAsia gena Egypt Ethiopia
Tanzania Zambia India Pakistan .
unified 113.2
1 NOM:Premiumisdefinedas(&/e”-l)* IW. Exchangew k expressedas local currency/US$. Dataareannualaveragescalculatedusing endingof quartervalum. Source:IFSandWorldCurrencyYearbook,CurrencyAnalysis,variousissues
8 of high premiumcountri=4,Ghei,Kigueland O’Comell (1996) fmdthatthe medianpremiumfor the period 1990to 1994was49 perm~ comparedwitha figureof 100percentfortheperiod 1980-89.Similartrendshave beenobsexvedfor moderateandlowpremiummuntri= as well. Ovmti, thereareindicationsthatdevelopingcountriesue movingin thedirectionof unifiedexchange rates.Thenumberofcountrimwithsignificantparallelmmke~has declined,and thegap betwun theofficial andtheparallelrate is steadilydecreasinginmost of thecountriesthatstillhaveparallelratm.
11.4Rationalefor ParallelMarht Systems Parallel marketsystemsemergefor differentreasonsin differentcountri=. Thereis one legitimate rationalefor a systemin whichcment accounttransactionsare conductedat a peggedrate andcapitalaccount transactionsareconductedat a floatingrate:to insulatedo-tic
pricesandeconomicactivityfromexchangerate
fluctuationsderivingtim transitoryshocksin thefinancialmarket. In practice,the implementationof parallelmarketsystemsin developingmuntrim rarelyhas been consistentwith this rationale. In certainLatin Americancountries,dualexchangerate systemswereindeed adoptedinrmponseto strong,temporarycapitaloutiowsr=uitingfrombtiance-of-paymentscrisesin the 1980s, andthisdi&to a @
ex~
protecttheireconomiesfiornexcessive,transitorydepreciationsof theexchange
rate. However,thedualmarketswereretainedlongafterthefmancid criseshad passed. Moreover,evenafter the criseshad passed,thepdel
rates continuedto be moredepreciatedthan theo~cial rates; in a dualrate
syskmtiigned topm~ thewnomy tim exchangeratevariability-asopposedto a systemdesignedto target theofficialrateat a levelpe~iskntly moreappreciakdthanwhatthemarketwodd set--theparallelratewould be expectedto fluctuatebothaboveandbelowtheofficialrate. InMean countri~,p~el
marketswereevenlessconsistentwiththebestradonalefor theexistence
4A~@ pre~um coun~ iswherethemedianp~tium eX=dS 50 per ~n~ The te~ “m~era~ premium”is appliedto countrieswithmedianpremiumbetween10and50 percen~ A medianlevelof less than 10percent putsa muntry intothelowpremiumcategory.The timeperiodexaminedin 1970-1994.
9 of suchs~terns. Frequently,exchangecontrolsweretightenedin th=e countriesas a gradualovervaluationof the officialexchangerate led to ex~ss demandfor foreignexchangeat tie officialrate. This, in turn,led to creationof parallelmarketsto evadesuch controls,evenin the absenceof strongcapitalaccountpressures. Hence, exchangecontrolswereused to prop up persistently misalignedexchangerates, not to insula~ the domesticeconomyfromtransitoryfluctuations. 11.5EconomicFunctionof ParallelMarkets We haveidentiled twocentraleconomicfunctionsof parallelexchangemarkets.Whenparallelrates emergedfollowinga balanceof paymentscrisis,as wasthecasein muchof LatinAmerica,theparallelmarket wasusedprimarilytofinancecapitalflowsin andoutof thecountry.Therewas verylittlerationingin themarket for trade transactions,as foreignexchangesupplywas usuallyenoughto satisfydemand. On average,the premiumof theparallelrate relativeto theofficialrate was quitemoderatein thesecases- thoughtherewere occasionalspilceswhenthepremiumwasveryhigh.But thesespikesreflectedtemporarymacroeconomiccnsm, nota drasticandpersistentmisalignmentof therealexchangerate. Preciselytheoppositewas truein thecaseof mostAfricancountrim.In theprototypicalcase,foreign exchangerationinggrewmorestringentovertimeas theofficialexchangeratebecameincreasinglyovervalued. Importerswholackeda-s
toeverscarcerforeignexchangethroughtheo~cial channels,turnedto theparallel
marketto obtainforeignexchangefor tradetransactions,Theparallelpremiumgrewto very highlevels,and stayedthere,astheofficialrate*
moreandmoreovervalued.Ghanais the kxtbookexamplefor this,when
by the end of the 1980s,tie o~lcial exchangerate was so overvaluedthat it karne irrelevantfor most transactions; evendomesticpricesandMation reflectedtheparallel,not theofficialrate (ChibberandShtilk, 1991). III. Unificationof ExchangeRatesto a SingleEquilibriumRate Observa haveidentiledvariousnegativeconsequencesof exchangecontrolsandtheparallelmarkets that they engender. A non-exhaustivelist wodd include,fns~ the fact that exchangecontrolsallow the
—--
10 authoritiato maintaina persistentlymisalignedofficialexchanger~-perhaps coupledwithinappropriatefiscal, monetary,andcommercialpolicies--withoutlosingall their internationalreserves,therebydistortingrelative prices in the wonomyand inhibitingthe growthof exports. Second,Wause parallelmarketregimesof~n involvetherationingof foreignexchangeat subsidizedratesto thosewithpreferentialaccessto theauthoriti~, exchangecontrolsencouragethedevelopmentof rent-seekingbehavioramongpriva~ entrepreneurs.Finally, theintroduction ofexchangecontrols,whichby theirnaturearehard to enforceandprofitableto evade,tendsto promotea cultureof lawevasionamongprivateentrepreneursthat mayspillover intootherareassuchas tax complianceor adherenceto otherwonomicandfiancial regulations. Inrmponseto theseandoth~adverseeff~ of exchangecontrols,an increasingfractionof developing countrimhavemovedtodismantleexchangecontrolsandunifytheirexchangemarkets. Someparallelmarkets wmeabandonedeitherbecausetheywereno longerneeded(whenthecrisiswasover)or becausetheywereno longereffmtive,thatis,rampantevasionofextiangecontrolsunaed
thesystem.Otherdevelopingcountries
(includingTanzania,GhanaandIndia)movedto legalizetheirparallelmarketsas a transitionalmeasurewhile easingrestrictionson cment accounttransactions- as a stepon the pathto Mlcation of theexchangerate. In thosecases,unificationhas beenpart of a largerstructuralreformeffortaimedat liberalizingmarketsoverall. Becausetheemergaceof a parallelmarketusuallyrefl~ theexistenceof anexcessdemandfor foreign exchangeat theprevailingofficialexchangerate (so thatforeignexchangemustbe rationedby the authorities), successfulunificationof the exchmgemarketsgenerallyrequiresthat the officialexchangerate be devalued stilcientlyto e” ~ “
excessdemandsfor foreignexchange.Put anotherway,successfulWlcation requirw
thattherealofficialexchangeratebe set at its “realequilibrium”level. Definitionsof the “realequilibriumexchangerate” aboundin the literature. Herewe focuson two equilibrium concepts,the“short-run” and“long-run”equilibriumexchangerates,whichare morefullyd~cribed .
inanotherchapterin thisvolumes The long-runequilibriumexchmgerate is thatrate whichequatesthetrade bpekrMontiel,“me maw of tie ~ng-R~ EquilibriumRealExch~ge ‘a~”*
11 balancewith sustainablenet capiti flOWS,when fisc~, mOne@, mcl commercialpolici= are “normal”and sustainable, whenforeignassetholdingsareequalto theirdesiredlevels,andwhenno exchangecontrolsarein place. The short-runequilibriumexchangerate,by contras~is thelevelof theexchangerate that equatesthe tradebalanceto net capitalflows--thatis, equatesthe supplyanddemandforforeignexchange--givencwent settings of economicpolicyand cment demandsfor foreigncapiti, regardlessof whethereitherare at their normal levels;as in the caseof the long-runequilibriumrate, the short-runequilibriumreal exchangerate is definedas thatwhichinducesbalance-of-payments equilibriumwhenno exchangecontrolsarein place. Theshort-runquilibriumrd exchangeratemaydiffertim its long-runvaluefor innumerablereasons. Forexample,startingoutin aneconomywhereboththeexchangera~ andothergovernmentpoliciesare at their sustainable, long-runsettings,theimpositionof extraordinaryimportbarriers,by reducingtheeffwtivedemand fmforeignexchangein theforeignexchangemarke~willcausetheshort-runequilibriumreal exchangerateto appreciaterelativeto its iong-runlevel. Conversely,expectationsofa futuredevaluationor politicaldisruption will lead to a temporaryheighteneddemandfor foreignassets that will lead the short-runequilibriumreal exchangerateto depreciatein relationto thelong-runequilibriumra~. Bydeftition, as longas theoff~cialexchangerate is at its short-runequilibriumlevel,therewillbe no imbalancebetweendemandsand suppliesfor foreignexchange.Thereforeparallelexchangemarkets,to tie extentthattheyreflectanexcessdemandforforeignexchangeunderuent economicpolicim,are associated with real officialexchangerates that are overvalued--thatis, apprwiated--withrespectto the short-runreal equilibriumexchangerate. However,successfullysustaininga unificationof the exchangemarketprobably requirmthattherealofficialratebe set to its long-runequilibriumvalue,not its shon-run value. Moreover,it probablyrequiresthatotherelementsof governmentpolicy,in additionto theexchangerate,be changedas well. Toseethis,consideranexamplein whichtheauthoritieshaveimposedveryhighquantitativerestrictions (QRs)onimports,therebyreducingtheeffectivedemandfmforeignexchangeandappreciatingtheshofi-runreal equilibrium exchangeraterelativeto its long-runlevel. At thesametime,assumethattheauthoritieshaveaiso
12 w theofficialex-ge
rateata levelthatis evenmoreappreciatedthantheshort-runequilibriumrate, so that
in response to an excessdemandfor foreignexchange,the authoritiesration dollars and a parallelmarket ernerg=. Inthisexample,devaluingtheofficialexchangerate to its short-runequilibriumlevelwouiduni~ the extiangemarkets,butwouldleavemuchof thedistortionassociatedwiththeQRsuntouched.A ~lly successful tilcation thereforewouldentaildismantlingthe QRsanddevaluingthereaIofficialexchangerate all theway to its long-runequilibriumlevel. k practice,somecountri=mightnotregardit as feasible,withina shortperiodof time,bothto devalue theirexchangerateto itslong-runequilibrium levelandto adjustinappropriatefiscal,monetary,andcommercial policiesas well. They may fear the inflationaryad distribution consequencesof a very large “maxi” devaluation,andmayfacestrongpoliticalpressuresagainstchangingparticularaspectsof governmentpolicy, particularlytradebtiers that benefitcertainvated interests. In sucha case,the authoritiesmightatmmptto implementa gradualprocessof unificadon,movingtheofficialrate towardits long-runequilibriumvalueeven as theyadjustassociatedeconomicpoliciesin the appropriatedirectionas well. Whetherthe authoritiesintendto implementeithera gradualor a rapidtilcation, theywillneedto iden~ thelong-runequilibriumvalueof thereal exchangerate, and,as notedin the introduction,thistaskwill be fraught with mnsiderableuncertainty. Underthesecircumstances,the prevailingparallelexchangerate W-M
anobvio~PmXYfm the~uilibriumrate,andthe authoritiesmightnaturallyconsidertheparallelrate
to be m appropria~targettowardwhichto movetheofficialrate,eithergraduallyor all at once. As shownin thefollowingsection,however,thereare manyfactorsthatcodd causetheparallelra~ to divergesignticantly hornitslong-runequilibrium value,makingig in manyinstan~, aninappropriatetargetfor theofficialexchange rate. IV.A SimpleModelof ParallelExchangeRateDetermination Thisstion presentsa simplepartialequilibriummodelto illustratehowthe parallelwket exchange rateisdeterminedinrelationbothtotheoKlcialexchange rateandto the long-runequilibriumexchangerate,that
13 is, the rate that wouldproduceequilibriumin the balanceof paymen~ under normal, sustainablepolicy conditions!Thereisnoconsensusregardingthemostappropriatemodelto use in explainingtie parallelmarket rate, just as thereis no agreementas to whichmodelbest explainsthe movementof floatingexchangerates amongindustrialcountries.Themodelillustratedbelowhas theadvantageof beingrelativelystraightforward andintuitive,whilehopefillyhighlightingthe mostimportantfeatur= influencingtheparallelmarketrate. N.1 BasicSetup Considera smallopeneconomytradingin twogoods,a nondomesticallyconsumedexportgoodanda non-domestictiy producedimport;the worldpricesof both goodsare fixed and set to unity. To focuson developmentsin the externalsector,we assumeit to be smallrelativeto the domesticeconomy,so that the analysis&cribes theoperationof theparallelexchangemarketin partialequilibrium Therefore,theoutputof anon-tradedgoodanditi priceareconsideredf~ed as well. We assumefor conveniencethattheUSdollaris theonlyforeigncurrencytraded. Turningto theparametersof governmentpolicy,it is assumedthatmonetaryandfiscalpoliciwareat theirlong-~ sustainablelevels,andmoreovm,fortiytid
convenience, thereareno tariffs,subsidies,or other
commercial policyintervention.(Theroleof importbarrierswillbe examinedlater.) Therefore,in termsof the deftitionsintrodud in theprecedingsectiontheshort-runrealequilibriumvalueof theexchangerateis, at least initially,the sameas its long-runvalue. TheofficialexchangerateE (measuredin termsof domesticcwency per dollar) is peggedat an overvaluedlevelrelativeto the equilibriumrate. Therefore,at that levelof the exchangerate, theflowdemandfor dollars(to be elaboratedbelow)exc~
theirflowsupply. Exportersare
requiredto surrendertheirdollarearningsto thecentralbankat theofficialrate E. Importerspurchasedollars fromthecentralb~
whichrationsdollarsalesOS, basedon the amountof exportrevenuessurrenderedto the
centralbankOX, accordingto thecentralbankrationingfunction:
%e modelanditsexpositionarebasedon the analysispresentedin Kamin(1993,1995).
14 0s = os(o~,osf() >0
(1)
Inraponse to theprevailingexms demandfordollarsat the officialrate E, a parallelmarketfor dollars pricedat theparallelmartirate Epemerges. We followthe conventionalstock/flowapproachto exchangerate determinationin positingthat in the longrun, theparallelrate movesso as @equateflowdemandsfor dollars by importerswithflowsuppliesfor dollarsby exporters. Thatis, ti the longrun Epis set so as to balancetie privatesector’scurrentaccount In the shortrun, on theotherhand,theparallelmarketrate is assumedto move exclusively tosettheportfoliodemandfor dollarsequalto the stockof dollarsoufitanding,so thatat anygiven momen~theprivatecwnt accountmaybe out of balance.
IV.2me ParallelMarketRate in hng Run CurrentAccountEquilibrium Wenowanaiyzethedete*
“onof theparallelmartirate inprivatecurrentaccountequilibrium.The
private sector currentaccountis defied as the differencebetweenprivatedollarinflowsor suppliesS and outflowsor demandsD. We assumethat foreignersholdno domesticassets,so that changesin the stockof dollarsheldbytheprivatesector,B,-
exclusivelythroughimbalancesin theprivatesector’scurrentaccount: dB = S - D
(2)
The cment account(or flow)demandfor dollarsis a deriveddemandfor importedgoods. Arbitrage ensures that thepriceof the importwillbe the same,whetherpurchasedhorn a legalimporterwithaccmsto officialforeignexchangeor horn a smugglerusingdollarspurchasedin theparallelmarket.’ In eithercase,the priceof importswillbesetqual toi~ marginalms~ theparallelmarketrateEP(sin@by assumption,tie foreign currencyprice is set to unity). Therefore,the privatedemandfor imports,as indica~ in equation3 below,
TWe~sme hat theremen. t~ffs andthatrestrictionson smugglhg ~ cosfl~slYevad~” ‘e ‘at&r assumptionis relaxedbelow.
15 depends (negatively) uponthedom=ticcmency prim of importsEPrelativeto thepriceof non-tradeablmPm.8 D = D(Ep/Pn) = D(ep), D/( ) 0
(5)
Theunderinvoicingshare$ canbe shownto positivelydependupontherealparallelmarketpremium: (6)
8~
“
p~ciple,
imwfi demmd is a ~ction of in~me as well. Sin~, in tis p~~
incomeis consideredto be fixed,we do not includeit explicitlyin thedemandtiction. 9SW
K-
(1993)for ‘ews’
~~ibrium ‘Odel$
16 For a given vaiueof the real oficid rate e, a uniquereal pdlel
marketrate & will equatedollar
demandsandsupplimin equilibrium: D(e~ = @X + OS(O~
(7)
Thisequationw be Mer simplifiedif wepositth~ on averageandovera longenoughtimeperiod,thecentral bankwillhaveroughlystable internationalreserves. Therefore,we can assumethatovera longtimeperiod,the centralbank willresellall surrenderedexportreceiptsOX= (1+)Xtolicensedimporters,afterit extrac~any foreignexchangeneedsof thegovernment(assumedto be invariantto theexchangerate)D~10 OS(O~ = OX - Dg = (1 -$)X - Dg
(8)
Therefore,equadon7 can be rewrittenas D(ep) = +X + (1-+)X - Dg = X - D$ = x((#)ep+(l -@)e) - D8
(9)
Figure1belowdepictsvariousdifferentequilibriain theparallelexchangemarke~dependinguponthe valueof e set by the authoriti~. TheDD curvedepictsequation3, theprivatedemandfor foreignexchangeas a tiction of thereal parallelrate &. The SS curvedepictsthe supplyof foreignexchangeto the marketas a titionof
~; itslocationalsois atitionof
e, sinmboth & ande affectthe totalquantityof exportssupplied.
e* is thelong-m equilibriumrealexchangerate, thatis, thelevelof therealexchangerate thatwodd cl~ the market- set toti de~ds
for foreignexchangeequalto totalsupplies-in a unifiedforeignexchangemarket.
Notethatwhatheofficial exchangerateis setequalto e*, theparallelrate alsomustequale*.11In otherwords,
llwe bow thiS ‘w
u
D(e*)= X(e*). Dg in a unifiedexchangernarke~andif in a parallelmarketsystem, D(ep)= X(W + (1-@~*)- Dg,
16a
ep D
epl . . . . . . . . . . . e*
+ ......... .....................
s
D,S Figure 1
17 when the officialexchangerate is set at its equilibriumvalue, there is no current-accountmotivefor the emergenceof a parallelforeignexchangemarket,sincethereis no excessdemandfor foreignexchangeat tie officialrate. Wenowcomidertheeffecfion therealparallelrateof a real appreciationof theofficialrate. Assume thattheauthoritiesallowtheofficialratee to appreciateto an overvaluedlevelel< e*. Becausethislowersthe profiti-ilityof exports,thesupplycurveSS shiftsinwards,creatingan exmssdemandfor foreignexchangeat thatrate. Thisputsupwardpressureon theforeignexchangevalueof thedollarin the (nowemergent)par~el marke~causingthep@el exchangerate to depreciatefrome* to &l .12 Hence,in cases wherethe emergenceof the parallelmarketreflectsthe overvaiuationof the offlcia.1 commercial exchangerate,theparallel-ket
rate,on average,is likelynotonlyto be moredepreciatedthanthe
commercialrate, but it probablyis more depreciatedthan the long-runequilibriumexchangerate ~ well. Various factors are likely to determinethe extent to which the parallelrate is more depreciatedthat the equilibriumexchangerate. As Figure1makesobvious,the moreovervaluedtheofficialexchangerate,andso thegreatertheextentto whichthe SS curveshiftsinwards,thegreaterwillbe the gapbetweentheparallelrate and the equilibriumrate. It also is straightforwardto showthat the gap willbe greater,the moreelasticare exportsand thelesselasticareimportswithrespectto theexchangerate. Theex~t to whichexportsurxender requiremts areenforcedplaysa keyrolein determini.n g thevalue of theparallelexchangerate, as well. Recallthattotalexportsarea functionof a weightedaverageof thereal officialandparallelexchangerates. If foreignexchangeregulationsaretightlyenforced,exportunderinvoicing willbe limited,reducingthe underinvoicingratio $ and therebyincreasingthe weightplacedon the official exchangerate. Inthiscase, theovervaluationof theofficialexchangeratedepressestotalexportssigtilcantly, reducingthesupplyof foreignexchangeto theparallelrnar~ anddepreciatingtherealparallelmarketexchange thenit is obviousby inspectionthatthe secondequationis satisfiedfor ep=e*. l~s
resdt is ~mis~nt with tilatfoundby NOW*(1984)”
18 rate substantiallyrelativeto the equilibriumrate. Conversely, i.fforeignexchangere@ations arepoorlyenforcedandwidelyevaded,theunderinvoicing ratiowillbe higher,theweightedaverageexchangerate willbe morefavorablefor exporters,andtoti exports will not be as severelydepressed. ~s willlead to less pressureon theparallelmarketexchangerate and a smallergaprelativeto theequilibrium rate. At anextreme,as to someextentoccurredin someWean countries, theo~cialexchangeratebecomessowidelyevadedas to becomeirrelevantto mosteconomicdecisions.In this context,mosttradeis routedthroughtheundergroundeconomy,and tie parallelexchangeratemaybecomea reasonablyaccurateguideto thelong-runequilibriumra~. Finally,thevalueof theparallelexchangeratein long-runequilibriumis likelyto be influencedby the ex~ntto whichbarriersto imports(aboveandbeyondmerelyrationingofficialsalesof foreignexchangethrough exchangecontrols)are enforced.The aboveanalysisassumesthat onceimportersacquireforeignexchange, Whethmofflcially orfiomtheblackmarke~theymayusethatfinancingto freelyimportgoods. However,if the authoritiesimposehighimportbarriersand theyare well-enforced,so thatsmugglingis costly,thiswillact to redumthedemandforforeignexchangeintheblackmarket--thatis, theDDcurveshownin Figure1wodd shift inwardsandto thelek Thisreduceddemand,in turn,wouldcausetheshort-runrealequilibriumexchangerate to appreciaterelativeto its long-runvalue,sincethe long-runequilibriumvalueof the real exchangerate is predation
theabsenceof extraordinarycommercialpolicimof thissofi Theimpositionof thebarriersalso
wouldleadtherealparallelexchangerateto appreciaterelativeto thecasewhereimportbarriersarenot enforced. Forstilcientlytightcontrolson imports,therealparallelratecouldalsobe moreappreciatedthanthelong-run equilibriumrealrate. IV.3TheParallelMarketRate in Short-RunPortfolwEquilibrium The resultsdescribedaboveare likely,at bes~to holdon averageoverrelativelylongperiodsof time. Intheveryshort~
thestockof dollarsheldby tie privatesectoris consideredto be fixed,sinceit ti
to accumulate ordecumulate dollarsthroughaent
time
accountimbalan~; duringthisshortrun,thepardel market
19 demandfor dollars. This portfolio rate conventionally is modeledas behgde~tied bytie portfolio-bued demanddependsuponthe relativeexpectedrates of return to holdingdollarsand domesticassets,whichare Muend
by anticipatedinflation,otheraspectsof maaoeconornicperformance,andpoliticalevens as well.
Thevolatilityof suchexzons
largelyexplainsthehigh volatilityexhibitedby mostfreelyfloatingexchange
rates,includingparallelmarketexchangerat=. Fora simpletheoreticalexposition,assumethatprivatesectoragentshold two asse~ in theirportfolio, dollarsand domesticcurrency.FollowingDombuschet. al. (1983),thedesiredratioof thedomesticcurrency valueofprivatesectordollarholdingsto thenominaldomesticmoneysupply(M) is modeledas a tiction of the expectedrateof depreciationof theblackmarketrate (the Adeno~ percentagechange):
or, dividingtiough by non-tradedgoodsprices,
(11)
Thenotationfor therate of depreciation,;P, ornitsan expectationaltermto reflectthe assumptionof perfect foresight. The portfoliodemandfor dollars(whenthe parallelmarketrate is stable)tracesout a downward slopingcurvein ( 4, B) spaw as shownin Figure2. GiventhatB is consideredfixedat anyone momen~the levelof B determinesthelevelof & at thatmomen~ In thelongrun, theparallelmarketrate and the privatestockof dollarholdingsare determinedby the require~ts ofbothportfolioandcurrentaccountequilibrium.In additionto theportfolioequilibriumcondition hdbed
above,Figure2 depictsthelocusof poinfifor whichthe privatecurrentaccountis in equilibrium,so
thatthestockofdollarsB heldby theprivatesectoris unchanging.This curve, denoteddBsO,is vertical,since
19a
B dB=o
o
ep Figure 2
20 for any givenofflcid exchangerate, a singlevalueof the parallelmarketrate ep clears the privatecment account.13 Thepointwherethe twocurv= cross--thesteady-stateequilibrium--istheonlypointwhereboththe currentaccountis in equilibriumandthestockof dollarsheldby theprivatesectorequalsits portfoliodemand. Finally,theverticalandhorizontalmows repraentthedirtion of movementof B andepoukideof equilibrium, while the diagonalline-the “stablesaddle path’’--indicatestie path by which B and # convergetoward equilibrium,shodd theystartout ou~ideof equilibrium. Wenowconsidertheeffectsontheparallelmmketrateof a rise in inflation--say,fromOto 20 percent-leadingtohigherratesofnorninaldepreciationof theofficialandparallelexchangerates. Thisis an impo~t example,sincemanycountri~ that imposedexchangecontrolsexperiencedincreasesin inflationand other measuresof macroeconomicvolatilityat aboutthesametime,particularlyin LatinAmerica(andTurkey). As shownin Figure3, the increasedexpectedlevelof ~ation-and henceof nominaldepreciationof theparallelmarketrate-leadsagentsto desireto holda higherratioof dollarsto dom~tic currency,causingthe Portfoliobalanmcurvetoshifiupwards. Equilibriumdollarholdingssh.ifttim BOto Bl, whiletheequilibrium real parallelmarketrate remainsunchanged.However,in orderto accumulateadditionaldollars,the private currentaccountmustshiftintosurplustemporarily,whichin turnrequiresa temporarydepreciationof thereal parallelexchangerate. Hence,at themomentof increasedinflationexpectations,theparallelmarketratejumps tiominitialquilibriumat(l) tothenewstablesaddlepathat (2). Afterthis,theaccumulationofdollm through thecurrentaccountsurplusreversesthedepreciationof therealparallelmarketrateuntilthesystemreturnsto equilibriumat (3). h theexampledepictedabove,thed parallelexchangeratebecomes,for a time,moredepreciatedthan i~ ownequilibrium level(conditional onthevalueof therealofficialrate). (As a resultof thesetemporarycapiti
ltForsimplicity,~s ~~ysis abs~ac~horn the interestpaymentsassociatedwi~ net as~t holdings?U wellas horn thewealtheffectsof assetholdingson importdemand. In thepresenceof interat paymentsor wealtheffec~,thedB=Ocurvewouldnotbe vertical,sincethevalueof theparallelmarketexchangerate that clearedtheprivawcurrentaccountwouIddependuponthestockof dollarholdingsB.
20a
B dB=o
BI ........................ ~p=zo BO ........................ Ep=o ep Figure3
21 outflows,theshort-runequilibrium exchangeratein a unifiedmarketalsowodd depreciaterelativeto its long-run equilibriumlevel.) Sincetie equilibriumlevelof theparallelexchangerateis likely,as shownin Section111.2, to be more depreciatedthan the long-runequilibriumrate in a unifiedexchangemarket,this meansthat the parallelrate duringperiodsof macroeconomicvolatilityand capitaloutflowswill be more depreciatedsti~. Hence,duringperiodsof macroeconomicvolatilityandheavycapitaloutflows,theparallelrate is likelyto be a particularlybiasedguideto settingthe appropriatelevelof theofficialexchangerate. Infa~ becauseof theassetmarketfunctionof theparallelexchangemarket,theparallelmarketratecan trade at a large premiumoverthe officialrate, evenwhenthe officialrate is closeto its long-runequilibrium value,thatis,thevaluethatequilibra~ thebalanceof paymentsin “normal”macroeconomiccircumstances.As notedabove,his is becauseduringperiodsof heavycapitaloutflows,theshort-runequilibriumrealexchange rate in a unifiedexchangemarketmay depreciaterelativeto i~ long-runlevel;if the officialexchangerate remainsat that( i.e. equilibrium)long-runlevel,an excessdemandfor foreiWexchangewilldevelopthatwill causea parallelmarketpremiumto emerge. TheLatinAmericancountries’experienceswithexchangecontrols mayfitthisscenario.Aswillbe discussedfurtherbelow,in variousof th=e countries,a combinationof factors led to a balance-of-payment crisisin the 1980s. The governmentsrespondedto thiscrisisby depreciatingthe officialexchangerate,butbecauseof thesizeof the capi~ outflowstriggeredby thecrism,the parallelmarket ratesin thesecountriesdepreciatedstillfurther. Finally,weshouldunderscorethef= thatevenif therealparallelmarketexchangerate,on averageover longperiodsof time,werea goodindicatorof thelong-runequilibriumred exchangerate,thevalueof thereal parallelmarketrateat anysinglepointin h
wodd likelybe anextremelyunreliableproxyfor thatequilibrium
rate. Thisis becausetheparallelmarketexchangerate, likeanyotherassetprice,dependsuponhighlyvolatile @otio&-&,
adham&i&eMti@y volatile.This volatilitymaybe seenquiteeasilyin thechartsof the
officialandparallelexchanger~ presentedat theend of thispaper. Hen&, asidehorn the factthattheparallel rateis likelyto be a biasedindicatorof thelong-runequilibriumexchangerate,it is also,unlessaveragedover
22 very long periods,likelyto be a highlyuncertainor inaccurateindicatorof the equilibriumrate as we11.14
V. Trendsin Oficial and ParallelRealExchangeRates Thetheoreticalmodeldescribedabovesuggeststhat the parallelexchangerate is likelyto be more depreciated thanthelong-runequilibriumrealexchangerate,unless(1) macroeconomicfactorsinducingcapital flightarenot presen~(2) exchangecontrolsare poorlyenformd,and/or(3) therearehighimportbarriersthat are wellenforced.To evaluatethesehypotheses,we would,ideally,comparethepathof theparallelexchange rate in variouscountri~ to thatof thelong-runequilibriumreal exchangerate in orderto gaugetheextentto wtichtheparaIlelratemayserveas a use~ guideto determining g theequilibriumexchangerateand, therefore, in settingtheofficialrate. Unfortunately, theequilibrium realexchangerateis a thwreticalconstructwhichmustbe estimati, not a measuredquantityfor whichdataexis~ Mor@ver,evenin a ~ed
markegtheempiricalestimationof the
equilibriumreal exchangerate is no easy task Estimatingthe equilibriumrate is a highlyinvolvedprocess requiringstrongassumptionsabouttheoperationof thecurrentandcapitalaecounti,as wellas theestimation of stabletradeandpaymentsrelationshipsovertime15. Estimationofthelong-runequilibrium rd exchangeratefor a widesetof countries,in orderto compare those exchangerates to actualparallelrates,wodd go beyondthe limitedscopeof thispaper. As a f~st step toward identifyingwhereparallelmarketra~s stand in relationto long-runequilibriumreal exchangerates,
lqBmedon ~ opti~z~g mo~l of tie parallelmarketexchangerate,MontielandOStrY(1994)~me to muchthesameconclusion.Theyfmdthatin thetransitionbetweensteady-stateequilibriain responseto a productivityshock,theparallelmarketpremiummaymovebothaboveandbelowzero,andhenceis “an unreliableindicatorof thesignandmagnitudeof realexchangeratemisalignment.” lbA nm~r of ~proached haveb~n triedin thelitera~e. Devarajaran(1995)~es a gener~ equilibriummodelthatfactorsin changesin termsof tradeto estimatetheequilibriumrealexchangerate and theextentof overvaluationin theCFACountrieS; Baffeset al (1995)constructan econometricmodelusinga varietyof macroeconomictidament,als for severalof thesecountries;AhlersandHi.nkle(1995)followa tradeelasticitiesapproachin theirestimation.
23 however,it makessenseto comparelevelsof the parallelrate to levelsof theofficialrate, averagedoverlong periods of time.This comparisonmay be informative,since over stilciently long periods,the balanceof paymentsmuston averagebe at a sustainablelevel. Additionally,it may be usefulto comparethelevelof the rd officialexchangerateduringperiodswhenexchangeConwolsare h effec4andhenceparallelmarketsexist, to periodswhenexchangemarketsareunified.Suchcomparisonsmayshedlighton thefactorsthatmotivated theimpositionofexchangecontrols,whichin tummayhaveimplicationsfor therelationshipbetweentheparallel andequilibriumrealexchangeratm. A complicatingfactorin usingaveragesof actualexchangerates as proxiesfor equilibriumexchange rates is that for most countrim,the process of developmentand structuralchangewill cause the long-run equilibrium exchangeratetochangeovertime. In thatsense,along periodaverageof actualrealexchangerates mayyiel~at bes~an averageof long-runrealequilibriumexchangeratesoverthatperiod. Withthiscaveatin mindhowever,westillbelievethatempiricalcomparisonsof actualofficialandparallelexchangeratescan yield usefi insights. First, our analysiswillfocuson averagesof exchangerates acrossa largeset of differentcountria. Therefore,evenif long-runrealequilibriumexchangeratesfollowparticulartrendsin each individualcountry, theaveragelong-runrealequilibriumexchangeratefor the sampleas a wholemaybe morestation~. Second, ouranalysisfm~
uponcomparisonof~mnt
typesof exchangerates--officialandparallel-duringdifferent
regimes–withand withoutexchangecontrols. Therefore,our results willbe ~erable
to misinterpretation
mainlyif thetimingof exchangecontrolperiodsin thesamplecoincidewithparticdar movementsin long-run equilibriumreal exchangeratm. Whilewe betieve,asd.iscussedabove,thatexchangecontrolperiodsare likely to coincidewithsystematicmovementsin shorf-runequilibriumrealexchangerates, as a resultof tempor~ shocksto capitalflowsor thetermsof trade,wehavemuchlesscauseto believethatexchangecontrolshavebeen .
associatedwithparticulartrendsin Zong-runequilibriumreal exchangerates. Y1 Dataand Methodology
24 To makethesecomparisons,we gathereddataon theofficialandparallelexchangeratesfor a sample of24 developing countri=(SeeAppendix1for thecompletelist). Of these,twelveare fromLatinAmerica,ten are African and twoare SouthAsian.The sampleis basedon onechosenfor an earlierWorldBankresearch projecton the macroeconomicimplicationsof multipleexchangerates (see footnote3 above).The sampleis
anclwithrespectto thealternativepathsof evolutionof consideredto be fairlyrepresentative- geographically theparallelrnarke~Thesampledoesincludemostof themoreprominentdevelopingcountrieswithsignificant parallelmarkets,outsideeasternandcentralEuropeandtheformerSovietUnion.Thebasicdataset is theone usedinGheiandKiguel(1992).We addedthreeAfricancountries - Algeri~MalawiandSudan; andextended thedataset to the lastquartero f 1994. To meanin~y comparelevelsof exchangeratesovertime,we fmt correctedthedataforchangesin prim bydculating realexchangerates. Thereare a numberof empiricaldeftitions of the realexchangerate (seeHinkleandNsengiyumva (1995)for a detaileddiscussion).We use thebilateralrealexchangeratebetween thecountrywe areexaminingandtheUnitedStates(localcurrencyper USdollar-an increasein theexchange rateindicatesdepreciation).Theconsumerprim indexis usedas a proxyfor domesticprices;theUS producer priceindexfor worldprices. . E. Pus e— P
(12)
wheree is therealexchangera~, E, thenominalexchangerate,is the Iocd currencyvalueof U.S.dollar,Pus is the US producerpriceindexandP is thedom~tic CPIlb.
lbIt is conceivablethattheuse of a bilateralexchangerate,usingtheUSproducerpriceindexas a proxy for worldpricesmaybiasourresults,in viewof thesi~lcant movementsof tie US dollarvis-a-visother industrialcountriesduringthe 1980s.Resultsof tesk for sensitivitywithrespectto choiceof foreignprice indexarepresentedin Appendix3, for a sub-sampleof countriesfor theperiod 1979-94.
25 The datausedare end of quarter,for theperiodfrom 1970through199417. Therealofficialexchange rateis indexedsothat1985Q1 isequalto 100. Therealparallelmarti exchangerate is indexedso thatits value in 1985Q1 is equti to 100plus thepremium(in percent)of the parallelrateoverthe officialratein thatbase quarter. For eachcountry,meanand themedianaveragevaluesarecalculatedfor thefollowing:e, theofficial real exchangerate for theentireperiod;ep,theparallelrealexchangeratefor theentireperiodof i~ existence, that is, whenexchangewntrols werein eff~t; en.,the officialnon-tiled real exchangerate, for theperiods whmexchangecontrolswerein effectandexchangemarketswerenot Mled; ande’, theofficialrealexchange rateduringperiods,if anyexisted,whenexchangemarketiwereunified. A unificationof exchangemarketsis definedtohave*
placeif theabsolutevalueof theparallelrate deviateslessthan3 per wnt fromtheofficial
rateforat least4 q~.
Thenon-zeronumberis to takeintoaccountmeasurementerrors,sincetheoficial and
parallelrates are horn differentsour= (seetablm). A~S-COUntI’y Summaryof our calculationsof thefourrealexchangeratecategoriwdescribedabove, basedonmeanaveragesof theexchangeratedatafor eachseparatecountry,is prmentedin columns1 through 4 of Table3. Resultsarepresentedin Table3 for thewholesample,as wellas twosubsets. For the countri~ in each subset, we presentthe mean,median,andstandarddeviationof therealexchage rate. In columns5 though9 ofTable3, wecalculmvariousratiosof thedatashownin columns1through4, andperfoxmbinomial signhts to ~e
whethertheseratiosdiffersignificantlyfromone. The Pr (Ho is true) rowindicatesthe
probabilitythattheob~ed configuration ofratioswouldbeobsemed,if thenu~hypothesis- thattheratiowere equalto 1-weretrue. Theregionalgroupingswerechosenin orderto testourhypoth~s concerningthedifferentmotivation and functionof parallelmarketsin differentregions. In Latin Americaand Turkey,exchangemntrols were imposed,particularlyin the 1980s,in situationsof ~nornic
and balance-of-payments crisisleadingto
ITTheoffici~exchangera~s andprim are fromII’vIF, InternationalFinanciaZStatistic. The p~allel exchangerat= are from WorldCurrencyYearbookandInternationalCurrencyAnalysis,Inc.
Z6
strongcapitaloutflows.Inthesecountriw,pressurmtim capitalflightarelikelyto havecausedtheparallelrate todepreciatewellabovethelong-runequilibriumrealrate,evenif theofficialexchangera~ wm notespecially overvaluedrelativeto its long-runequilibriumvalue. tican
and SouthAsiancountri~, on the otherhand,
experienced muchlessmacroeconomicdistress. In thosecountries,exchangecontrolsweremorelikelyto have arisen as a meansof rationingforeignexchangereceiptsin the contextof a progressiveovervaluationof the officialexchangerate. As describedin SectionIV.2,theparallelrateis likelyto be moredepreciatedthanthe long-runequilibriumrate in this mntext as well,unlessexchangecontrolsare poorlyenforcedand/orwellenforcedimportbarrierseffectivelycurtailthedemandfor foreignexchange. K2 Comparisonsof PeriodAverages Wenowcomparetherealparallelrate epto variousproxiesof theequilibriumrealexchangerate. The fmt possibleproxyfortheequilibrium RERwe wnsideris e, theaverageRERfor a periodof twentyfiveyem. Asmaybeseenincolurnn5,&/e,onavaage,is greaterthan1,witha meanof 1.64for theentifesample.In fact, thereisnocountryinoursamplefor whichtheaveragerealparallelmarketexchangerate wasmoreappreciated thantheaveragerealofficialrate (calculatedfor periodswhentheexchangemarketwasunifiedas wellas nonunified). To theextentthat the averageofficialrate, whenaveragedovera stilciently longperiod,is a good proxyfortheequilibrium realrate,thissugg~~ thattheparallelrate is a biasedindicatorof the equilibriumrate. However,usingtheaverageRERfor theentireperiodmaybe misleading,sinceit includ~ periodswith exchangecontrolsas wellas whenthe exchangemarketis unified.Whenexchangemntrols are in place,the nominalprice of foreignexchangeis set by the authorities,and accessto foreignexchangeis determinedby quantitativerationing.Hence,theofficialreal exchangerate duringperiodsof exchangecontrolis likelyto be more appreciatedthan the equilibriumreal rate, It may be moreappropriateto use the RER averagedover periodsof un~ledexchangemarke~- thatis, em- as a proxyfor thelong-runequilibriumRER. For the wholesample,theparallelrateis, on average,moredepreciatedthantheunifiedofficialRER; asindicatedincolumn8,themeanof theratio,&/e”, is 1.43for all wuntries.However,thisresultmash strong
27 @erenm Nw=
LatinAmericaandTurkey,witha meanof 1.58,andMca and Asia,witha meanvalueof
1.05(whichis not si@lcantly differentfrom 1).Hence,to tie extentthate“is a goodproxyfor thelong-run equilibrium realexchangera~, epappears,on average,to havebeencloseto thelong-runequilibriumexchange rate in Africaand Asia but muchmoredepreciatedthan the long-runequilibriumlevelin LatinAmericaand Turkey.Thismayseemsurprising,giventhefarhigheraverageparallelpretia thathavebeenobservedin much of Africa; as shown in column7, the ratio of the parallelmarketrate to the officialrate duringperiodsof exchangecontrolaveraged1.85for AfricaandAsiabut only 1.42for LatinAmericaandTurkey. The strong~erenc~ in &/e”,theratio of the parallelrate to the unifiedofficialrate, betwwnLatin Americaandficaappear to berelatedto equallymarkeddifferencesin the evolutionof theofficialexchange ratebetweenthetworegions.As indicati in column9, in LatinAmericaandTurkey,thereal officialexchmge ratetendedto be moredepreciatedduringperiodsof exchangewntrols thanduringperiodswhentheexchange marketsweretiled; themeanratioof e“-/e”was 1.12,with 9 of the 12countrieshavingratiosgreaterthan 1. This is consistentwith our view that in Latin America and Turkey, unsustainablepoliciesresulted in macroeconomicdisequilibrium,which,in turn, triggeredcapiti outflowswhich depreciatedthe short-run equilibrium realexchangerate(a relationshipthatwouldholdin a unifiedexchangemarket)relativeto i~ 1ongrun level. The governmentdid depreciatethe officialexchangerate, but not by as much as the short-run equilibrium ratedepreciated.Therefore,anex~s demandfor foreignexchangedeveloped,causingtheparallel ratetodepreciateaswell.Asmacrop=urm _
capitaloutflowsmoderatedandreversedthemselves,leading
to anappreciation of theshort-runequilibrium exchangerateandfacilitatingtheunificationof exchangemarkets. IncontrasttoLatin~ca
andTurkey,in theMean andSouthAsiancountriesin our sample,thereal
officialexchangeratetendedto be moreappreciatedwhenexchangecontrolswerein placethanwhenexchange marketsw=unified. As shownin column9, for ~ca
andSouthAsia,theratioof eB9/em wasonly.65,with
al15countriesin thisgroupingshowingratioslessthan 1. This evidence,whilequ~ledby thelownumberof observationsin thesub-sample,supportsour speculationthatthe emergenceof a parallelmarketin Mca and
Lo
Asia was typicallythe result of an appreciationof the real officialexchangerate relativem the long-run equilibriumrate. Authoritieschose,for a varietyof reasons,to rationforeignexchangewhilemaintainingan overvaluedreal exchangerate. As the extentof overvaluationinaeased, often foreignexchangerationing tightened,andtheparallelmarketgrew,as did thepremium. Consideringhowovervaluedtherealofficialexchangerate wasin manyAfricanandtheSouthAsian countries,relativeto itslong-runequilibriumvaiue,it is surprisingthatrealparallelratesin thosecountrieswere not more deprwiatedcomparedwith averagereal officialexchangerates duringthe periodswhenexchange marketswereunified. SectionIV.2showedthat,allelseequal,themoreovervaluedwastheofficialexchange rate, the moreundervaluedwouldbe the parallelrate relativeto the long-runequilibriumrate. Therefore, unificationpresumablywouldhaverequiredtican
and Asiangovernmentto devaluetheirofficialexchange
ratesto a leveltiat was not asdepreciatedas thepriorlevelof theparallelrate. Inaddressingthisissue,it is importantto pointout thatwe havea verysmallsampleto examine- only 5 ~untriminoursamplein thesubse~AfricaandSouthAsia,unifiedtheirexchangera~. In twoof thesefive cases(EgyptandT~ania), theratiois greaterthan 1. Additionally,as wepointedout in SectionIV.2,thereare factorsthatmaylowertheparallelraterelativeto the levelpredictedby thebasicmodel. Firs~considerthecase whenunderinvoicing,+, ishighbecauseexchangecontrolsarenoteffective- whenenforcementis lackadaisical andevasionwikprd
Th~ for allpracticalpurposes,therelevantratefor theemnomybecomestheparallel
rate, whichmay,in thiscase,be closeto theequilibriumrate. Then,whenexchangemarketsareunified,the officialratewouldneedtobedepreciatedto thelevelof theformerparallelrate,and&/eUwouldbe closeto one. Ghanais anexullent illustrationfor this (ChibberandShaffii (1991)). A s~nd factorthatmightappreciatetheparallelmarketraterelativeto thelevelpredictedby thebasic modelmightbethestrongenforcemt of importcontrols.Thiswouldcausethepremiumto be low,evenif the .
officialexchangerateis maintainedat a substantiallyovervaluedlevelcomparedwiththelong-runequilibrium exchangerate,sinceeffectiveimport~ntrols reducethedemandfor foreignexchangeandtherebyappreciatethe
29 short-run equilibriumexchangerate. Then, if tilcation depreciating
is associatedwith import liberalization,thereby
short-runreal equilibriumexchangerate, theofficialexchangerate willhaveto depreciateby
a largeamountifexms demandsforforeignexchangeareto be eliminated.Thisscenariowouldleadto a ratio, &/e”,tiat wouldbelowcomparedwiththepredictionsof thebasicmodeloutlinedin SectionIV.2. Indiais the ht examplefmthis-tilcation oftheexchangerate tookplacein 1993as pm of a largerliberalizationeffort, requiring greaterdevaluationof the officialexchangerate than wouldhavekn the case in the absenceof importliberalization.
Table3: FullPeriodStatistics,Ratiosand BinomialSi~ Tests 3 5 1 2 4 6 7 8
9 Offlciai Parallel Official Official Ratio, Ratio, Ratio Ratio, Ratio, RealER RealER ERwith ER when #/e e’”le #/e”” @/e” e-lea 2fl Country 1970-94 Par. mkt Unifjed 3/1 2f3 W4 3/4 ~tin Americaand Turkey Mean 82.52 121.02 85.13 76.91 1.46 1.03 1.42 1.58 1.12 Median 69.10 115.01 69.43 64.66 1.06 1.24 1.36 1.32 1.10 Std Dev 26.17 24.29 47.71 27.28 0.36 0.26 0.34 0.39 0.16 Numbers 1 0 3 0 0 3 Number>1 12 9 12 12 9 Pr (HOis true) 0.0002 0.019 0.0002 0.0002 0.019 A~“ca &Asia Mem 120.04 222.82 117.94 195.24 1.82 1.85 0.98 1.05 0.65 Median 103.56 186.64 101.56 267.03 1.00 1.78 1.81 0.97 0.57 StdDev 45.99 111.76 45.03 85.81 0.58 0.02 0.58 0018 0.12 Numbers 1 12 0 0 5 3 Number>1 12 12 0 2 0 Pr (HOis true) 0.0002 0.0002 0.0002 0.500 0.031 All countries 1.64 Mean 101.28 171.92 101.53 111.71 1.01 1.64 1.43 0.99 Median 91.38 131.33 91.10 86.24 1.52 1.00 1.54 1.36 1.07 41.60 99.81 40.40 74.67 Std Dev 0.50 0.04 0.51 0,38 0.25 Numbers 1 15 0 3 8 Number>1 24 9 24 14 9 Pr (~ is true) 0.000 0.006 0.50C, O.000 0.153 Source: ES,WorldCurrency Yearbook, Currency Analysis Inc,various issues, authors ~culations.
30
K3 The Oficial ExchangeRate afierExchangeMarht Unification The issuesrelatedto unificationcan be tier
examinedby consideringwhathappensto the official
exchangerate at that time. We havetwentyobservationsof unifications.In somecases,a countryhas two episti of dualexchangerat~, witha periodof unifiedexchangeratesin theinterim;theseare treatedas two separateobservations. Somecountrimhavenevertiled,
andthereforearenotrepresented(seeAppendix2 for
thecompletelist).Thecomposition of thetilcation dataset is quitedifferentfromthatusedin Table 1.Firstly, threequartersoftheobservationsarehorn theexperienceof unificationin LatinAmerica;onlythreeoutof the twentyobservationsare for Africa,withthe twoSouthAsiancountriu completingthe coun~The verysmall samplemeansthatthesubsetsresultsare to be interpretedwithcautionfor the AfricaandSouthAsiasubset. InTable4, we lookat themean,medianandstandarddeviationof threevariables:theaverageofficial RERfortheyearbeforethetication (10),theaverageofficialRERin theyearfollowingMlcation (11) and the averageparallelrate for the year precedingthe unification(12). We calculatetwo ratios, of the posttilcation officialRERto thepre-unificationRER,egt+l/emmt.l; andtheratioof thepostunificationofficial(and sole) RER to thepre-unificationparallelrate, eot+l/&t.l. As before,we reportthe mean,medianand standard deviationfor allvariablmas wellas ther~ults of binomialsigntestfor tie ratios. Theresultsareconsiskntwiththefindingsreportedin table3. Theratioof thepost-to pre-untication officialexchangerate, ew,+l/em9i.1, is approximatelyequal to one for the wholesample.Again,aggregation obscurathedifferenmin resul~betweenthe twosubsefi.Theratio, eut+l/e’gt.l is (very)slightlylessthan 1for LatinAmericaandTurkey,suggwtinga smallappreciationin theRERfollowingunification.Thisis consistent with the ideathancapitalWows resumedas the macrocrisiswas alleviated,appreciatingthe short-runreal equilibriumexchangerate and allowingthe authoritiesto appreciatethe real offlcid exchangerate while simultaneously unifyingtheexchangemti.
Theratiois slightlygreaterthan 1on averagefor AfricaandAsia,
as theexchangerate wasdevaluedfollowingunification.Again,this is consistentwiththeobservationthat in . threecountria,officialexchanger- duringtheexchangewntrol periodwereovervaluedrelativeto theirlong-
n 31 runequilibriumraks, so thatunificationrequiredthedevaluationof theofficialrate. Therelationship betweenthetild
officialrateandthepriorparallelrate alsodifferssomewhat
the sub-samples.The ratio eO,+l/ept.l clearlyis lessthan 1 for the entiresample,indicatingthatin general,the offlcirdrateis not depreciatedall the way@the levelof the formerparallelrate. Withthe exceptionof Ghana and Bolivia,the averageratio is less tian 1 for all countrim. ~S rault also is unambiguousfor the Latin AmericaandTurkeysubs& On the otherhand,berat.io egt+l/&,.ldoesnot appearto be significantlydifferent fromone for the~can
and Asiansample,whichis consistentwithresultsd=cribed above-averagetiled
officialexchangeratesappearto be closeto the averagelevelof theparallelrate in Asiaand Mea. Table 4: UnificationEpisodes- Statistics,Ratiosand BinomialSign Tests 10 11 12 13 14 OfficialRER, OfficialRER, ParallelRER, e8~+1/eaut.1 e“*+l/#~.l Year,unif+l Country Year,unif-1 Year,unif-1 11/10 11/12 America& Turby Mean 85.15 85.62 109.31 1.00 0.83 Median 81.99 75.74 101.98 0.98 0.87 StdDev 29.89 33.19 54.88 0.09 0.15 Numbers 1 9 15 Number>1 7 1 Pr (~ is true) 0.576 0.001 Aftia & Ash
Mean 183.67 201.5~ 203.81 1.08 Median 172.71 155.21 180.99 1.11 71.92 StciDev 87.56 85.81 0.12 Numbers 1 1 Number>1 4 Pr (HOis true) 0.188 All countries Mean 108.61 113.21 131.81 1.02 Median 99.42 83.77 118.08 1.00 StdDev 60.60 71.42 75.28 0.11 Numbers 1 10 Number>1 11 Pr (~ is true) 0.500 Source: IFS,WorldCmencyYearbook, Currency ~ysis Lnc, various issues, authors calcu~ons.
0.98 0.94 0.13 4 1 0.188 0.86 0.90 0.16 19 2 0.0001
32 VI.Conclusion themostimportantfindingspresentedin ourpaper. To beginwith,ourtheoretical
Wenows~
analysisindicatedthatwhentheemergenceof a parallelexchangemarketis motivatedby theovervaluationof theofficialexchangeraterelativeto thelong-runequilibriumred exchangerate,theparallelmarketrateis likely, on average,tobemore@reciatedthanthelong-runequilibrium realextiangerate. Thegap betweentheparallel rate and the long-runequilibriumrate is likelyto be smaller,to the extent that export receipt surrender requiremen~arenutwelldor~
andto theextentthatbarriersto importsandothercommercialpoliciesthat
tendto appreciatetheshort-runequilibriumrealexchangerate are well-enforced. Moreover,our theoreticalanalysisindicatedthatevenif tie officialexchangerate is set at i~ long-run equilibrium level,a parallelmar~ mayarisein orderto meetthedemandsof residentsseekingto augmenttheir holdingsof foreignassets. Duringtheperiodwhenforeignassetsare beingaccumulated--that is, whencapital mghtis ~g-the
parallelexchangeratewillbe moredepreciatedthanitsownequilibriumvalue,andhence
probablymoredepreciated thanthelong-runequilibriumextige~
fm theeconomyas a whole. Additionally,
becausetheparallelmarketrateis anasw price,andexhibitsthevolatilitythatis characteristicof all assetprices, the valueof theparallelrate at anygivenmomentis likelyto be a particularlypoor indicatorof the long-run equilibriumexchangerate. Th~e considerations suggestthaton balance,theparallelrate is likelyto be moredepreciatedthanthe long-runequilibriumrealexchangerate,andhencetheofficialexchangeratein a unifiedexchangemarketwill in generalht besetat a levelthatismoreappreciatedthanthepriorparallelrate (averagedovera suitablylong period).Inthisp~,
wedidnotcomparea
parallelexchangeratesto estimatesof thelong-runequilibrium
rateindifferentcountries,owingto thed~lculty of estimatingequilibriumratesfor a largesample. However, wecomparedmulti-yearaveragaofrealparallel~
to realofficialratesin a sampleof 24 developingcountries,
andmadea numberof useti findings. First, we found that for the sampleas a whole,the real partiel marketrate was uniformlymore
33 depreciatedthantheofficialexchangerate,evenwhentheofficialratewas measuredonlyduringperiodswhen the exchangemarketswere unified. Duringperiodswhen the exchangemarketis unified,and thereare no exchangecontrolsto bridgethegapbetweensuppliesanddemandsfor foreignexchange,theofficialexchange rateis morelikelytobecloseto tie long-runequilibriumrate on average. Hence,thisrepresen~partialevidence thattheparallelrateten~ to be undervaluedrelativeto the long-runequilibriumexchangerate. Secondwefoundimportantdifferencesin therelationshipbetweenparallelandofficialexchangerates among differentsubsefi of our countrysample. In Latin Americaand in Turkey,the emergenceof parallel exchangemarketsappears~ havereflecteda sharp depreciationof the short-runequilibriumexchangerate relativeto its long-runvalue,not the appreciationof the offlciaiexchangerate horn its long-runequilibrium value.Inthose~untri~, theparallelratewasclmly depreciatedcomparedwith theofficialexchangerateduring periodswhentheexchangemarketswereunified. However,theundervaluednatureof theparallelratedoesnot ap~
tOhavereflect~ fie overvaluat.ion of theofficialexchangeraterelativeto the long-runequilibriumreal
exchangerateduringperiodsofexchangecontrols,sincetheofficialexchangerate in thissubsetwason average moredepreciated duringtheperiodswhenexchangecontrolsw=e in effectthanin theperiodswhenmarketswere unified. We surmisethat a combinationof internaland externalshocksled to macrmnomic turbulenceand capitalflightin LatinAmericaandTurkey,mainlyin the 1980s. Thesedevelopments,in turn,depreciatedthe short-run equilibriumrealexchangerate relativeto its long-runlevel. Whilethe authoritiesdepreciate their officialexchange~-possibly
evento levelsmoredepreciatedthanthelong-runequilibriumrate--theydidnot
dosobyenought.or~olveex~s demandsfor foreignexchange.Thatis, evenifofflcialexchangeratesduring the exchangewntrol periodwereundervaluedrelativeto the long-runequilibriumrate, theywereovemalued relative to the short-runequilibriumrate, therebygivingrise to parallelexchangemarkets. As a resulg the parallelra~ probablywereeva moreundervalued relativetothelong-runequilibriumrate thanweretheofficial rates.
34 Third,we foundthattheAfricanand SouthAsia countriesin our samplebetterfit our preconception thattheemergenceof parallelexchangemarketsreflectstheovervaluationof theofficialexchangeraterelative to its long-runequilibriumvalue. Amongthe fewcou.ntrimin this subsetthatexperiencedperiodsof tiled exchangerates, the real officialexchangerate clearlywas moreappreciatedduringperiodswhenexchange controlswereineffwtthaninperiodswhenexchangemarketswereunified. Thissuggeststhatin contrastto the LatinAmericaandTurkeycase,therealappreciation ofofficialexchangeratesin Afticaand SouthAsia,relative to long-runequilibriumvalues,was themainfactorunderlyingtheemergenceof parallelmarkets. On the other hand, in Africaand SouthAsia the parallelexchangerate was not si~lcantly more depreciatedthanthe officialexchangerate duringperiodswhenmarketswereunified--putanotherway,when exchangemarketswereunified,the authoritieshad to depreciatethe officialrate all theway to thelevelof the formerparallelrate. The relativesimilarityof parallelandunifiedofficialexchangeratesunderscor~thefact thatinthecaseof someMean countries,exchangecontrolsmayhavebeenso poorlyenforcedthattheparallel rateeff~vely mimickedtheroleof theofficialratein a unifiedexchangemarke~ Additionally,in someAsian countries,well-enforcedimportbarriersconstrainedthedemandfor foreignexchangewhenexchangecontrols wereineffec~therebyappreciatingboththe short-runequilibriumexchangerate andtheparallelrate;exchange marketsweretiled at aboutthesametimeas importbarrierswerelowered,makingit necessaryto depreciate theofficialexchangeratesubstantiallyin orderto maintainthebalan~ of paymentsin a unifiedmarke~ Our findingsfor someWean and Asiancountriessuggestthatin somecases,theparallelratemight notbean inappropriti proxyfor thelong-run~uilibriumexchangerate,andhencecouldbe a guideto setting the officialrate. Somewhatspecialfactorswereoperativein thesecountrieshowever--verypoorlyenforced exchangecontrolsinsomeAfricancountri~,verywell-enforcedimportcontrolsin someAsiancountries.More gen~y, theparallelmarketratewouldseemto representan upperbound,in termsof localcurrencyperdollar, on the appropriatelevelof theofficialexchangerate.
35 REFERENCES:
Countries:~eory, Evi&nce, and Agenor,Pierre-Richard(1992), parallelCurrencyMarketsin Developing PolicyImplications,PrincetonEssaysin In@mationalFinanceNo. 188,Princeton,N.J. AhlersT.O.,andL.E.He (1995),“Estimatingtheequilibriumrealexchangerate:an updatedresourcebalance target/tradeelasticitiesapproach”,WorldBank WashingtonDC,fotihcoming. Bties, J., I.A.Elbadawiand S.A. O’Connell(1995),“Econometric~timates of theequilibriumRER”,World Bank,WashingtonDC,fo~hcoming. Chibber,A, andN.S(1991),“Extige ref~ parallelmarti andinflationin Wca: the caseof Ghana”, in A.Cribberand S. Fischer,eds, EconomicRefom in Sub-Sabran Afi”ca,WorldB& WashingtonDC. Devaraju S. (1995),“Estimationof RERmisalignmentusingthe 1-2-3model”,WorldB* forthcoming.
WashingtonDC,
Dombusch,R., D.V.Dantos,C. Pechman,R.R RochaandD. Simoes(1983),“Theblackmarketfor dollarsin Brazil”,QuarterlyJournalof Economics,Vol98, pp. 25-40. Ghei, N., and M.A. Kiguel,(1992), “Dualand multipleexchangerate systemsin developingcountrim:some empiricalevidence”,PolicyResearchWortingPaperNumber881,The WorldB* WashingtonDC. and S.A. O’Connell(1996),“ParWelexchangerates in developingcountrim:lessonstim eightw’e studies”inA4.AKiguel,J.S.h“zondoand S.A O’Connell,e&,ParallelExchangeRatesin Developing Countries,MacMillan,bndon andSt. Martin’sPress,NewYork. Hinkle, L.E., and F. Nsengiyumva(1995), “Realexchangerate indexes:a user’s guideto their theoretical definition,empiricalmeasurementandinterpretadon”,WorldB*, WashingtonDC,processed,May 8, 1995. Kamin,S.B.(1995),“Contractionarydevaluationswithblackmarketsfor foreignexchange”,Journalof Policy Modeling,Vol.17,number 1,pp. 39-57 Karnin,S.B. (1993), “Devaluation,exchangecontrolsand black marketsfor foreignexchangein developing countri~, Journalof Developmentkonomics, Vol40$pp. 151-169. Kiguel , M.A., and S.A. O’Comell (1995), “Parallelexchangerates in developingmuntries”, WorZdBank ResearchObserver,Vol 10,numbr 1,pp 21-52. Montiel,PeterJ. andJonathanD. Ostry(1994), “Theparallelmarketpremium:is it a reliableindicawrof real exchangeratemisalignmentin developingcountries?”IMF StaffPapers41, pp.55-75. Montiel,PeterJ. (1996),“Thetheoryof thelong-runequilibriumreal exchangerate,”WorldB* DC,forthcoming.
Washington,
NOW*M.(1984),“Quantitative mntrolsandunofficialmarketsfor foreignexchange”,IMFStaff Papers31, pp. 404-31 She~ M.A (1976),“Blackmarketfor foreignexchange,capitalflowsandsmuggling”,Journalof Development Economics,Vol 3, pp. 9-26.
i
*
m
.
I
I 37
Appendix 2 Table2.A: UnificationEpisodes 13 12 11 14 10 e(nu,t-l)OfficialRERe(q t+l)O~ial RER e(p,t-l)Parallel RER e(u,t+l)/e(nu,t-1) e(u,t+l)/e(p,t-1) 11/10 11/12 Year,Unification-1 Year,Unifi-tion+l Year,Unification-1 Mean Median Mean Median Mean Median Median Mean Mean IMedian LQtinAmerica and Turkey 0.97 1.08 0.50 0.53 76.45 69.89 74.17 75.55 147.95 141.42 Argentina
country
Argentina Bolivia Bolivia BChile Colombia Dom Rep
26.52 26.41 26.03 25.93 126.58 126.10 136.51 136.50 125.96 126.17 128.00 127.70 60.01 59.92 59.30 59.08 58.23 57.82 64.18 64.31 99.42 99.68 83.77 84.26 57.21 56.98 56.12 56.36
126.11 Ecuador 103.69 Mexico 87.53 Mexico Pem 64.50 68.78 Urumay Venezuela 128.77 Turkey 64.49 Turkey 88.19 Afi”caand Asia Egypt 172.71 Ghana 212.66 Tanzania 305.99 India 120.01 Pakistan 106.97
127.84 106.10 75.50
29.40 135.79 134.21 64.74 65.00 104.46 61.18
29.04 134.01 134.36 65.17 65.32 104.28 60.92
0.98 1.08 1.02 0.99 1.10 0.84 0.98
0.98 1.08 1.01 0.99 1.11 0.85 0.99
0.89 1.01 0.95 0.92 0.99 0.80 0.92
0.89 1.02 0.95 0.91 0.98 0.81 0.93
140.06 115.15 93.29 146.55 81.16 272.90 68.22 97.95
1.00 1.03 0.87 1.17 0.98 1.16 0.90 0.93
1.01 0.96 0.86 1.17 0.98 1.38 0.89 0.95
0.90 0.94 0.82 0.57 0.83 0.54 0.85 0.83
0.91 0.92 0.81 0.51 0.83 0.55 0.85 0.85
176.55 223.52 355.90 140.95 116.50
0.90 1.25 1.11 1.15 1.01
0.91 1.28 1.09 1.16 1.02
0.86 1.22 0.94 0.98 0.91
0.89 1.22 0.94 0.99 0.93
1.00 0.98 0.09
1.02 0.99 0.13
0.83 0.87 0.15
0.83 0.87 0.15
1.08 1.11 0.12
1.09 1.09 0.12
0.98 0.94 0.13
0.99 0.94 0.12
1.02 1.00
1.04 1.01
0.86 0.90
0.87 0.91
(-)-11
0.13
0.16
0.16
126.18 110.30 88.01 63.99 68.40 108.14 65.59 87.38
126.39 106.98 76.20 75.28 67.09 149.58 57.84 82.40
67.18 149.64 58.19 83.32
141.07 114.40 92.51 132.37 80.93 277.38 68.11 99.50
171.70 212.93 306.85 119.88 106.40
155.21 266.21 340.09 138.24 107.73
156.55 271.59 334.37 138.99 108.31
180.99 217.60 361.34 141.04 118.08
75.01
LatinAmerica& Turkey Mean 85.15 83.81 85.62 85.78 109.31 109.36 Median 81.99 78.63 75.74 75.52 101.98 101.12 29.89 28.91 33.19 33.22 54.88 54.17 Std Dev AMca & Asia Mean 183.67 183.55 201.50 201.96 203.81 202.68 Median 172.71 171.70 155.21 156.55 180.99 176.55 ,Std Dev 71.92 72.41 87.56 86.23 85.81 84.65 All countries Mean 108.61 107.56 113.21 113.44 131.81 131.58 Median 99.42 99.68 83.77 84.26 118.08 116.50 Std Dev 74.31 60.60 60.74 71.42 71.13 75.28
38 Appendix3: Sensitivityof Resultsto choiceof RealExchangeRate
Thetrendsin sectionV are estimatedusingtheUS producerpriceindexas a proxyfor worldprices. Thismaybiastheresul~,particularlyfor timeperiodswhenmovementsin theUS realexchangeratediverge significantlyfromthoseof otherindustrialcountries,as theydid overmuchof the 1980s.We estimatethe sameratiosas in Table3, usingtrade-weightedmultilateralreal exchangerat= (seeTables3.A and3.B below). Thedatawereavailablein theIn&mationalFinancialStatisticsdatabase,of theIMF, foron.lyten of thetwenty-fourmuntriesin our sample,for thetimeperiod 1979to 1994. Whileit wouldbe possibleto calculatemuldlateralrealexchangeratesfor all thecountriesin thesample,for theperiodunder consideration,thiswodd be a laboriouspr~s.
Further,thisdatasetcovers a shortertimeperiodthanthe
oneusedin thestudy(1970to 1994).However,therealUS $ bilateralrate wouldhavedivergedsi~lcantly horn thetradeweightedmultilateralrateprimarilyin the 1980s;thisdataset includestheperiodof interest. Therefore,we use thesmallerdatasetreadilyavailableto comparethevaluesobtainedfor tie ratioswe calculateusingthebilateralrealexchangeratewiththosefor availabletradeweighted,multilateralreal exchangeratm.. Theuseof multilateralexchangeratesyieldestimatesof theratiosunderconsiderationthatare remarkablysimilarto thoseobtainedusingbilateralresults.Theoneresdt thatis differentis thebinomial signt~t for theratio,eDa/e’.TheprobabilitythatHo is trueis muchhigherwhenthemultilateralrateis used. Thisimprobablydueto the verysmallsample:just fiveobsemations.Theordersof magnitudedo notdiffer markedlyfor themeasuresof centi tendency. Thechoiceof a bilateralrealexchangeratewouldnotseemto impacton theresultsin anysignificant way.At thesametime,usingthebilateralrealexchangeratehasotheradvantages.In particular,-usingthe bila~ralratepermitsanalysisfor a largersampleof countries,for a longertimeperiod. However,thereare
39 someinstanceswherethedifferencesin thevaluesusingthedifferentrealexchangeraw are moretian triviaI (seeTable3.B,particularlyUruguay(columns8 and9, and Nigeria).If the analysisis to be donefor a single country,theuseof the trade-weightedmultilateralrealexchangerate wouldbe preferable.For a sampleas largeas theonein thisstudy,theadvantagesof usingthebilateralrealexchangera~ are greater.
A
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7 4 5 6 2 3 8 9 Ratio Ratio, Ratio, Ratio, Ratio, mlciai Parallel mlcial omtid e“’le &/e”” eple” e“’/eRealER RealER ER W/ ERwhen #le 1979-94 Parmkt -led 3/1 2/3 2/4 3/4 Variable e 4 e08 e“ 2/1 SummaryStatistim Wean 1.01 1.55 Bilateral 118.09 191.01 118.69 8’7.68 1.55 1.62 1.19 Multilateral 175.73 279.88 172.69 149.36 1.53 1.00 1.56 1.50 1.lC Median Bila~ral 106.28 168.57 104.21 72.18 1.36 1.00 1.36 1.60 1.19 Multilawral 132.80 186.09 124.66 103.88 1.38 1.00 1.40 1.54 1.12 StandardDeviation Bilateral 54.66 116.71 54.10 0.06 0.42 35.74 0.37 0.25 0.31 Multilateral 120.95 230.58 117.96 104.42 0.37 0.07 0.43 0.30 0.33 BinomialSign Tests
Number1 Bilateral Multilateral Pr(HOis true) Bilateral Multilateral — — —— .Source:M-S,WorldCurrencyY*Q
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47
International Finance Discussion Papers IFDP Number
Titles
Author(s)
1996 564
The Use of the Parallel Market Rate as a Guide to Setting the Official ExchangeRate
Nita Ghei Steven B. Kamin
563
Country Fund Discountsand the MexicanCrisis of December 1994: Did Local ResidentsTurn PessimisticBefore InternationalInvestors?
Jefiey A. Frankel Sergio L. Schmukler
562
Eastern European Export Performanceduring the Transition
Nathan Sheets Simona Boata
561
Inflation-AdjustedPotentialOutput
Jane T. Haltmaier
560
The Managementof FinancialRisks at German NonfinancialFirms: The Case of Metallgesellschafi
Allen B. Frankel David E. Palmer
559
Broad Money Demand and FinancialLiberalization in Greece
Neil R. Ericsson Sunil Sharma
558
StockholdingBehaviorof U.S. Households: Evidence from the 1983-89Survey of ConsumerFinances
Carol C. Bertaut
557
Firm Size and the Impact of Profit-MarginUncertainty on Investment: Do FinancingConstraintsPlay a Role?
Vivek Ghosal Prakash Loungani
556
Regulationand the Cost of Capital in Japan: A Case Study
John Ammer MichaelS. Gibson
555
The SovereigntyOption: The Quebec Referendumand Market Views on the CanadianDollar
MichaelP. Leahy Charles P. Thomas
554
Real ExchangeRates and Inflation in Exchange-Rate Based Stabilizations: An Empirical Examination
Steven B. Kamin
553
MacroeconomicState Variablesas Determinants of Asset Price Covariances
John Ammer
552
The Tequila Effect: Theory and Evidencefrom Argentina
Martin Uribe
551
The Accumulationof Human Cat)ital: Alternative Methodsand Why They Matter ‘
Murat F. Iyigun Ann L. Owen
Please addressrequestsfor copiesto InternationalFinance DiscussionPapers, Division of InternationalFinance, Stop 24, Board of Governors of the Federal Reserve System, Washington,D.C. 20551.
\
48
International Finance Discussion Papers IFDP Number
Titles
Author(s)
1996 550
Alternativesin Human CapitalAccumulation: Implicationsfor EconomicGrowth
Murat F. Iyigun Ann L. Owen
549
More Evidenceon the Link betweenBank Health and Investmentin Japan
MichaelS. Gibson
548
The Syndromeof Exchange-Rate-Based Stabilizationand the UncertainDurationof CurrencyPegs
Enrique G. Mendoza Martin Uribe
547
German Unification: What Have We Learned from Multi-CountryModels?
JosephE. Gagnon Paul R. Masson WarwickJ. McKibbin
546
Returnsto Scale in U.S. Production: Estimates and Implications
SusantoBasu John G. Femald
545
Mexico’sBalance-of-PaymentsCrisis: A Chronicle of Death Foretold
GuillermoA. Calvo
544
The Twin Crises: The Causesof Bankingand Balance-of-PaymentsProblems
GracielaL. Kaminsky Carmen M. Reinhart
543
High Real Interest Rates in the Afierrnathof Disinflation: Is it a Lack of Credibility?
GracielaL. Kaminsky LeonardoLeiderrnan
542
PrecautionaryPortfolio Behaviorfrom a Life-Cycle Perspective
Carol C. Bertaut MichaelHaliassos
541
Using OptionsPrices to Infer PDF’s for Asset Prices: An Applicationto Oil Prices During the Gulf Crisis
WilliamR. Melick CharlesP. Thomas
540
MonetaryPolicy in the End-Gameto Exchange-Rate Based Stabilizations: The Case of Mexico
StevenB. Kamin John H. Rogers
539
Comparingthe Welfare Costsand the Initial Dynamics of AlternativeTemporaryStabilizationPolicies
Martin Uribe
538
Long Memory in Inflation Expectations: Evidence from InternationalFinancialMarkets
Joseph E. Gagnon
49
International Finance Discussion Papers IFDP Number
Titles
Author(s)
1996 537
Using Measuresof Expectationsto Identi@the Effects of a MonetaryPolicy Shock
Allan D. Brunner
536
RegimeSwitchingin the DynamicRelationship betweenthe Federal Funds Rate and Innovationsin NonborrowedReserves
Chan Huh
535
The Risks and Implicationsof External Financial Shocks: Lessonsfrom Mexico
Edwin M. Truman
534
CurrencyCrashes in EmergingMarkets: An EmpiricalTreatment
Jeffrey A. Frankel Andrew K. Rose
533
RegionalPatterns in the Law of One Price: The Roles of GeographyVs. Currencies
Charles Engel John H. Rogers
