Boardof Governorsof the Federal ReserveSystem

InternationalFinanceDiscussionPapers
Number 564
September 1996
THE USE OF THEPARALLELMARKETRATEAS A GUIDETO
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 usingthe parallel exchangerate as a guideto 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 foreignexchangeexist, it is natural to considerthe parallel rate as a proxy for the equilibrium
exchangerate, since it is set directlyby the market. The paper developsan analyticmodel to explore
the relationshipbetweenthe parallel exchangerate and the equilibriumrate. It is determinedthat only
under a fairly narrowset of circumstanceswill the parallel rate be set at a level closeto 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.
TheUseof theParallelMarketRateas a Guideto Settingthe OfflcialExchangeRate
NitaGheiandStevenB. Kamin*
I. Introduction
Determiningthe appropriatelevelat whichto set theexchangerateis a challengingproblemfor any
countrypursuingamanagedor fixedexchange-ratepolicy. Ideally,a countrywouldset itsexchangerateat the
realequ.ilibnumra~, thatis, therateconsistentwithinternalandexternalbalance(tie latterreferringtobalance
betwmntradeandsustainableeapital-account flows). Evenin relativelystableandmatureindustrialeconomies,
however, thereal equilibriumlevelof theexchangerateis usuallydifficultto identi~. In developingcountries
subject to macroeconomicinstabilityand/orstructuralchange,this identificationis evenmoredifficult. The
determination of theequilibriumrealexchangerateis especiallyuncertainif theeconomyis inthemidstof trade
liberalization andotherreformsthatpromiseto changepreviouslyexistingrelationsbetweentradeperformance
andtheexchangerate.
In a contextwherea parallelmarketfor foreignexchangeexists,it mayappearnaturaltoconsiderthe
pardel exchangerateas a proxyfor theequilibriumreal exchangerate. Theparalielexchangerateusuallyhas
thebenefitof beingdeterminedin a freemarket,andhenceis not obviouslycontaminatedbythedistortionary
effecwof government policy.Mdtipleexchangeratemanagements, formalandinformal,legalandillegal,were
the norm for developingcountri= until veryrecently. Eventhoughan increasingnumberof countiieshave
tiled theirexchangera@, oftenaspartof a largerliberalizationeffort,parallelforeignexchangemarketshave
l~e au~ors Mecomespnden~ me EconomicTimes~d SeniorEconomist,Divisionof ~~rnation~
Finance,Boardof Governorsof theFederalReserveSystemrespectively. We aregratefultoLawrence
Hinkle,Peter MontielandSteveO’Comell for helpti mmmentsandsuggestions. Thispaperwasprepared
as a chapterin aneditedvolume,LawrenceHinkleandPeterMontiel,eds,ficllange RafeManagementin
bw InconleCotlntnes:Metlzoblogiesfor EnzpiricalAnalysis,underpreparationby theWorldBank The
viewsexpressedin thispaper areoursanddonot necessarilyreflectthoseheldby theBoardof Governors,
theWorldBank,TheEconomicTimesor othermembersof theirstaffs.We areresponsiblefor anyandall
emors.
Board of Governorsof the Federal ReserveSystem
InternationalFinanceDiscussionPapers
Number 564
September 1996
THEUSE OF THEPARALLELMARKETRATEAS A GUIDETO
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 clearedwith the author or authors.
ABSTRACT
This paper addressesthe merits of usingthe parallel exchangerate as a guideto settingthe
official exchangerate. Ideally, policymakerswould set the exchangerate at the level that would
balancetrade and sustainablecapital flows--thatlevel is referredto as the equilibriumexchangerate.
In practice, it is difficultto identi~ the equilibriumexchangerate, particularlyin countriesthat have
experiencedmacroeconomicvolatilityand/or structuralchange. In this context,where parallel markets
for foreignexchangeexist, it is natural to considerthe parallel rate as a proxy for the equilibrium
exchangerate, since it is set directlyby the market. The paper developsan analyticmodel to explore
the relationshipbetweenthe parallel exchangerate and the equilibriumrate. It is determinedthat only
under a fairly narrowset of circumstanceswill the parallel rate be set at a level closeto 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.
TheUseof theParallelMarketRateas a Guideto SettingtheOfficialExchangeRate
NitaGheiandStevenB. Kaminl
I. Introduction
Determiningthe appropriatelevelat whichto set theexchangerateis a challengingproblemfor any
countrypursuinga managedor fixedexchange-ratepolicy. Ideally,a countrywodd set itsexchangerateat the
realequilibriumrate,thatis, therateconsistentwithinternalandexternalbalance(thelatterreferringtobalance
betw=ntradeandsustainable~pit.al-account flows). Evenin relativelystableandmatureindustrialeconomies,
however, thereal equilibriumlevelof theexchangerateis usuallydifficulttoidenti&. In developingcountries
subject to macroeconomicinstabilityand/orstructuralchange,this identificationis evenmoredifficuh. The
determination of theequilibriumrealexehangerateis especiallyuncertainif theemnomyis inthemidstof trade
liberalization andotherreformsthatpromisetochangepreviouslyexistingrelationsbetweentradeperformance
andtheexchangerate.
In a contextwherea parallelmarketfor foreignexchangeexists,it mayappearnaturaltoconsiderthe
paralielexehangerateas a proxyfor theequilibriumreal exchangerate. Thepartilel exchangerateusuallyhas
thebenefitof beingdeterminedin a freemarket,andhenmis not obviouslycontaminatedbythedistortionary
effectsof government policy.Multipleexchangeratearrangements, formalandinformal,legalandillegal,were
the norm for developingcountriesuntil veryrecently. Eventhoughan increasingnumberof countrieshave
tiled theirexehangerab, oftenaspartof a largerliberalizationeffort,parallelforeignexchangemarketshave
l~e auhors ~e cofiespnden~ me EconomicTimesandSeniorEconotist, Divisionof ~~mation~
Finance,Boardof Governorsof theFederalReserveSystemrespectively. Wearegrateful10Lawrence
Hinkle,PeterMontielandSteveO’Comell for help~ commentsandsuggestions. Thispaperwasprepared
as a chapterin aneditedvolume,LawrenceHinkleandPeterMontiel,eds,&clzangeRafeManagenzent in
bw InconleColtntries:A4et)lodologies for EnlpiricalAnalysis,underpreparationby theWorldBank.The
viewsexpressedin thispaperareoursanddonot necessarilyreflectthoseheldby theBoardof Governors,
theWorldBank,TheEconomicTimesor othermembersof theirstaffs.We areresponsiblefor anyandall
enors.
2
notdisappearedas~ Nigeria,whichhasneverSUCwssfully unifieditsexchangerate, is a prominentexample
in Africa;in Venezuela,whichunifiedits exchangeratein 1989,aparallelmarketemergedin 1994following
thereimpositionof capitalcontrols.
Notwithstandingthe appealof a market-determinedexchangerate as a guideto settingthe official
exchangerate,however, variousfactorscomplicatetherelationshipbetweentheparallelmarketrateandthereal
equilibriumexchangerateinaneconomy.First,whiletheparallelmarketfor foreignexchangemaynot itselfbe
controlledbythegovemmen 4 ~nditionsin thatmarketarelikelytobe affated bygovernmentpolicy. Relative
supplies and demandsfor foreigncurrencyin tie parallelmarketwill be alteredby the levelof theofficial
exchangerate,theextentto whichexchangeand&adecontrolsareenforced,andthegovernment’s formulafor
rationingforeignexchangereceiptsto importers. Second,becausethep@lel exchangemarketrepresentsan
assetmarketas well as a trade-relatedmarke4theparallelmarketrateis likelytoreflectexpectations, political
concerns, capitalfigh~andotherfactorsnot directlyassociatedwiththereal equilibriumexchangerate. Hence,
only under a relativelynarrowset of circumstanceswill the parallelmarketrate serve as a useti guideto
determiningtie equilibriumvalueof theofficialexchangerate.
Inthispaper,weexplorethedeterminan~of theparallelmarketrateinorderto ass~s ifi usetiness as
a guideto measuringtheequilibriumvalueof the official real exchangerate. The planof thispaper is as
follows. In SectionII, parallelexchangemarketsare definedmorespecificallyandvariouscharacteristicof
parallelexchangemarti aredestibed.2 SectionIII addrmsestheissueof theunificationof exchangemarke@
andtheappropriatetargetfor theofficialexchangerate.In SectionIVwereviewa simpletheoreticalmodelof
parallelexchangemarketsto shedlightonhowparallelmarketratesaredeterminedinrelationtobothofficial
exchangeratesandequilibriumexchangerates. SectionVcomparestheevolutionofparaUelandofficialreal
exchanger- overtimetoprovidea f~l for theapplicabilityof thetheoreticalresultspresentedin theprevious
..
ZForgener~smeys of tie issuesassocia~ withp~~el marketsforforeignexchangessee‘genor
(1992)andKiguelandO’Comell(1995).
3
section. SectionVI concludes.
II. EssentialCharacteristics of ParallelExchangeMarkets
11.1Bmic Definitions
Aparallel foreignexchangemarketsystemis onein whichtransactionstakeplaceat morethanone
exchangerate andat leastoneof theprevailingrates is a tieelyfloating,market-determined rate (theparallel
exchangerate). (KiguelandO’Connell, 1995)ParaUel marketsystemsrepresenta subsetof thebroadercategory
of multipleexchangerateregimes,whichreferto anyregimesinwhichtwoor moreexchangeratesareapplied
tothesa,mecurrency, Manydevelopingmuntrieshaveappliedseparate,fixedexchangeratestodifferenttypes
of transactions, butthispracticeis, inessence,equivalentto a singleexchangeratecoupledwithdifferenttaxa
orsubsidi=(depending onthetransaction).Bycontrast,a parallelmarketfor foreignexchangeis distinguished
bythefactthattheparallelexchangerateis determinedfreelyinthemarke~Usually,theofficialexchangerate
in parallelmarketsystemsis peggedby the authoritiesat a particularfixed(or crawling)rate, althoughin
principletheoficialratecouldbeflotig as well, Additionally, it is frequently-dthoughnot always- thecase
thattheoficialexchangerateapplimtocurrentaccount transaction,whiletheparallelmarketrate, whetherlegal
or illegal,appliestocapitaIaccounttransactions.
Parallelmarketsfmforeignexchangecane~ge onlywhenthegovernmentimposesexchangecontrols,
that is, restrictionson
transactionsare made,
the volumeof certainforeignexchangetransactionsor on the price at whichsuch
Tradebarriers,quantitativerestrictions,or high tariffs aloneare not in themselves
sufficienttogiveriseto a parallelexchangemarket. Whilesuchcontrolsmayaffectthedemandor supplyof
foreigncurrencies,theywillnot drivea wedgebetweenexchangerates for differenttransactions,as longas
foreignexchangeis freelyavailablefor all transactionsat anofficialor market-determined exchangerate. A
ernment limitstheamountof foreignexchangethatcanbeboughtor sold for parallelmarketarisa whenthegov
particulartransactions, causingexcessdemandor supplytospilloverintoa parallelmarkegor authorizesthat
exchangeratesfor certaintransactionsbepeggedandfor othertransactionsbefloating.
4
11.2kgal andIllegalSystem
Parallelexchangeratesystemsmaybe legalor illegal. Whentheparallelmarketfor foreignexchange
is legal, it is oftenreferredto as a dual exchangerate (DER) system.In thesecases, most currentaccount
transactionstakeplaceat a peggedcommercialrate, andcapitalaccount&ansact.ions at a marketdetermined
financial rate.Anumberof countrieshaveexperimentedwithDERsystemsof varyingduration.Somecountriw
maintainedofficialdual exchangerates for longtimeperiods,suchas Belgium(from1957to 1990)andthe
DominicanRepublic(until 1993).Theparallelmarket,in thesewuntria, wasusedto insulatether=tofthe
-nomy fromshorttermcapitalflows. France(1971-74) andItaly(1973-74)adopteddualratesfor a short
period followingthe mllapseof the BrettonWoodssystemas a transitorymeasure.ArgentinaMexiwand
VenezuelaadoptedDERregimes in the 1980sh the wakeof balanceof paymentscrisesandhugecapital
outflows.
Illegalparallelmarketsystemsemergewhenprivateagenfi attempttoevaderestrictionsonthepriceor
quantityof foreignexchangetransactions. Illegalmarketswerethenormin mostof Afri~ andSouthAsia,as
well in severalLatinAmericanmuntrim, ~pecially throughthe 1980s.The parallelmarketsweregenerally
toleratedby theauthorities,withsomeexceptions.For example,thethreatof enforcementandpenaltieswas
significant inGhanapriorto 1983,but theseeffortsfellby thewaysidelateron, andthecoverageof theparallel
marketgrew,asdidtheparallelpremium(Kiguel andO’Connell,1995).In Sudan,tradingon theparallelmarket
was a capitaloffence,andenforcement was attemptedbetween1970and 1990.But eventhethreatof capital
punishmentdid not totallywipeout the parallelmarket,thoughit mayhavekn a factor in the veryhigh
p~miLlmobservedinSudan.
Inprinciple, thereis littledifference,in termsof macroeconomicimplications, betweenlegalandillegal
systems. In eithercase, free-markettransactionsin foreignexchangetakeplacealongsidecontrolledprice-
transacdons. Thismeanshat ineitherlegalor iliegalsystems,thereareincentivesfor transactionsto spillover
or “leak”horn onemarketintothe other. Theseleakagesmay tendto underminetheparallelexchangerate
5
system,dependinguponhowrigidlyexchangecontrolsareenforced.
11.3:ParallelMarketsin the 1990s
Agreatmanycountri=haveexperimen M withparallelexchangearrangemen~at varioustimes.These
arrangements haveincludedformal,legaldualratesas wellas illegal“black”rata. However,theincidenmof
sud wangernentshasbeendeclininginthe1990s,as anincreasingnumberof developingcountrieshavesought
tounifytheirexchangerati, oftenaspartof a largerstructuralreformeffortwhichincludesliberalizationof the
externalaccounts.Evenpartialconvertibilityof thecurrency,for ment accountpurposes,forexample,leads
toprogresstowardsunifyingtheexchangerate.
Observersfrequentlyviewthe incidenceof restrictionson internationaltransactionsas evidenceof
prevalenmandimportance ofparallel extige marti. AccordingtoIMFrepo~, aboutone-haifof themember
countrimimposer~trictions onpaymen~on transactionon thecurrentaccount;overthree-quartersdo so on
capitalaccountpayments(Table1).However,themereexistenceof restrictionsdoesnotnecessarilyimplythe
existenceof si@lcant parallelmarb~, sincetheseareqtitative data,withtwovalues- yes andno, andsodo
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, whenthe payments
r~trictionsandcapitalcon@olsareeitherminimalor not enford. For example,SouthMnca imposedcapital
controlsin 1985,followingmassivecapitaloutflows,andre-introdud a dualexchangeratesystemat thattime.
Buttheparallelpremiumhasremainedmodest- themedianpremiumwas4.4per centfor theperiod1980-89,
and declinedto 2.3per centduringtheperiod1990-94(Ghei,KiguelandO’ComeU1996)- whichwouldbe
consideredto a unifiedexchangerateregimeunderthedeftition in Section5 below. Thereareseveralother
examplesof countri~withextremelylowpremia,including~ailand, MalaysiaandIndonesia,withmedian
premiavaryingfmm-1.5to3.4percent (Gheiet al, ibid).
6
Table1
Incidenceof PaymentsRestrictionsamongIMFMemberCountries
1980 1994
CurrentAccount 51.77% 51.69%
CaDitalAccount 78.01% 77.53%
Source: Exchange Restrictions andExcbange ArrangcmenU: Annual Report oftheIMF, various issues.
At thepr~ent momen~parallelexchangeratearrangementaretobefoundindevelopingcountriesonly;
Belgium,which wasthelastdevelopedcountrywithdualexchangerates,movedtoa unifid exchangeratein
1990. Parallelexchangerates werea featureof onehalfofour sampleoftwenty-fourdevelopingcountriesat
theendof 1994(seeTable2)3. Parallelexchangeratearrangemen&wereevenmorewidespreadindeveloping
countriesin the 1980s- everycountryinour samplehadmorethanoneexchangerate in 1985. Our sample
includescountrieswheresignificantparallelmarkefi existedfor sometime, and includesmost of the more
importantdevelopingcountries,outsideeasternand=ntral EuropeandtheformerSovietUnion.
Parallelmarkefihavehaddifferentdegreesof longevity.ArgentinaMexicoandVenezuelahadlegal
dualrates that wereexpectedto be temporary.All threecreateddualratesandthenunified withintheperiod,
1980to 1994,thougha parallelmarketdidre-emergein Venezuelain 1994,as discussedabove.OtherLatin
Americancountriesmovedto multiplerates or unifiedwithinthe sameperiod.In the fican and Asian
muntri=,bycontras~paraLlel rnar~ weremorelonglivd Afewof thesecountriesunifiedtheirexchangeratw
inthe 1990s,but majorexceptionsremain- 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
ExchangeRatesinDevelopingCountriW”.Avolumebasedontheprojec~“ParalielExchangeRatesin
DevelopingCountries,M.A.Kiguel,J.S. LizondoandS.A. O’Comell,eds,is forthcoming.Thedatawere
updatedto theendof 1994for thispaper.
7
Table2
Statusof ParallelMarket/ Levelof ParallelPremium(%)
?
country
1980 1985 1990 lm
htin AmericanandTurkey
Argentina 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
Colombia unified 11.42 9.24 6.12
DominicanRep. 38.00 7.69 68.01 u n ified
Ecuador 11.45 76.90 23.53 5.45
Mexico unified 28.46 7.41 Un ifld
Peru 36.25 29.53 104.80 unified
Uru~ay unified 9.41 10.93 16.51
Venezuela unified 104.00 unified 4.73
Turkey 9.98 -7.17 unified unified
AflicaandAsia
gena 193.25 375.23 248.81 253.95
Egypt 7.77 122.90 89.47 unified
Ethiopia 35.02 127.66 192.75 113.2
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
Tanzania 174.00 271.89 56.36 Unified
Zambia 70.27 65.39 279.56 -6.15
India 9.58 15.12 9.10 Unifl
Pakistan 26.26 -0.67 8.72 Unifi
1
.
NOM:Premiumisdefinedas(&/e”-l)* IW. Exchange w k expressedas local currency/US$. Dataareannualaveragescalculatedusing
endingof quartervalum.
Source:IFSandWorldCurrencyYearbook, CurrencyAnalysis,variousissues
8
of highpremiumcountri=4,Ghei,KiguelandO’Comell (1996)fmdthat themedianpremiumfor theperiod
1990to 1994was49perm~ comparedwithafigureof 100percentfortheperiod1980-89.Similartrendshave
beenobsexvedfor moderateandlowpremiummuntri= as well.
Ovmti, thereareindicationsthatdevelopingcountriesue movinginthedirectionof unifiedexchange
rates.Thenumberofcountrimwithsignificantparallelmmke~hasdeclined,and thegapbetwun theofficial
andtheparallelrateis steadilydecreasinginmost of thecountriesthatstillhaveparallelratm.
11.4Rationalefor ParallelMarht Systems
Parallel marketsystemsemergefor differentreasonsin differentcountri=. Thereis onelegitimate
rationalefor a systeminwhichcment accounttransactionsareconductedat a peggedrateandcapitalaccount
transactions areconductedat a floatingrate:toinsulatedo-tic pricesandeconomicactivityfromexchangerate
fluctuationsderivingtim transitoryshocksin thefinancialmarket.
In practice,the implementationof parallelmarketsystemsin developingmuntrim rarelyhas been
consistentwiththis rationale. In certainLatinAmericancountries,dual exchangerate systemswereindeed
adoptedinrmponsetostrong,temporarycapitaloutiowsr=uitingfrombtiance-of-payments crisesin the 1980s,
andthisdi&toa@ ex~ protecttheireconomiesfiornexcessive,transitorydepreciationsof theexchange
rate. However,thedualmarketswereretainedlongafterthefmancidcriseshadpassed. Moreover,evenafter
the criseshadpassed,thepdel rates continuedto be moredepreciatedthantheo~cial rates; in a dualrate
syskmtiigned topm~ thewnomy tim exchangeratevariability-asopposedto a systemdesignedtotarget
theofficial rateat a levelpe~iskntlymoreappreciakdthanwhatthemarketwodd set--theparallelratewould
beexpectedtofluctuatebothaboveandbelowtheofficialrate.
InMean countri~,p~el marketswereevenlessconsistentwiththebestradonalefor theexistence
4A~@ pre~um coun~ iswherethemedianp~tium eX=dS 50 per ~n~ The te~ “m~era~
premium”is appliedtocountrieswithmedianpremiumbetween10and50percen~Amedianlevelof less
than10percent putsa muntryintothelowpremiumcategory.Thetimeperiodexaminedin 1970-1994.
9
of suchs~terns. Frequently, exchangecontrolsweretightenedinth=e countriesas a gradualovervaluationof
theofficialexchangerate ledto ex~ss demandfor foreignexchangeat tie officialrate. This, in turn,ledto
creationof parallelmarketsto evadesuchcontrols,evenin the absenceof strongcapitalaccountpressures.
Hence, exchangecontrolswereused to prop up persistently misalignedexchangerates, not to insula~the
domesticeconomyfromtransitoryfluctuations.
11.5EconomicFunctionof ParallelMarkets
Wehaveidentiledtwocentraleconomicfunctionsof parallelexchangemarkets.Whenparallelrates
emergedfollowinga balanceof paymentscrisis,aswasthecaseinmuchof LatinAmerica,theparallelmarket
wasusedprimarilytofinancecapitalflowsinandoutof thecountry.Therewasverylittlerationinginthemarket
for trade transactions,as foreignexchangesupplywas usuallyenoughto satisfydemand. On average,the
premiumof theparallelraterelativeto theofficialrate wasquitemoderatein thesecases- thoughtherewere
occasional spilces whenthepremiumwasveryhigh.But thesespikesreflectedtemporarymacroeconomic cnsm,
not a drasticandpersistentmisalignment of thereal exchangerate.
Preciselytheoppositewas trueinthecaseof mostAfricancountrim.In theprototypical case,foreign
exchangerationinggrewmorestringent overtimeas theofficialexchangeratebecameincreasinglyovervalued.
Importerswholackeda-s toeverscarcerforeignexchangethroughtheo~cial channels,turnedtotheparallel
marketto obtainforeignexchangefor tradetransactions, Theparallelpremiumgrewto very highlevels,and
stayedthere,astheofficial rate* moreandmoreovervalued. Ghanais thekxtbookexamplefor 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 ExchangeRatestoa SingleEquilibriumRate
Observa haveidentiledvariousnegativeconsequencesof exchangecontrolsandtheparallelmarkets
that they engender. A non-exhaustivelist wodd include,fns~ the fact that exchangecontrolsallowthe
—--
10
authoritiatomaintainapersistentlymisalignedofficialexchanger~-perhaps coupledwithinappropriatefiscal,
monetary,andcommercialpolicies--without losingall their internationalreserves,therebydistortingrelative
prices in the wonomyand inhibitingthe growthof exports. Second,Wause parallelmarketregimesof~n
involvetherationingof foreignexchangeat subsidizedratesto thosewithpreferentialaccessto theauthoriti~,
exchangecontrolsencouragethedevelopment of rent-seekingbehavioramongpriva~ entrepreneurs.Finally,
theintroduction ofexchangecontrols,whichby theirnaturearehardtoenforceandprofitabletoevade,tendsto
promotea cultureof lawevasionamongprivateentrepreneursthat mayspill over intootherareassuchas tax
complianceor adherencetootherwonomicandfiancial regulations.
Inrmponsetotheseandoth~adverseeff~ of exchangecontrols,anincreasingfractionof developing
countrimhavemovedtodismantleexchangecontrolsandunifytheirexchangemarkets. Someparallelmarkets
wmeabandonedeitherbecausetheywerenolongerneeded(whenthecrisiswasover)or becausetheywereno
longereffmtive, thatis,rampantevasionofextiangecontrolsunaed thesystem.Otherdevelopingcountries
(includingTanzania,GhanaandIndia)movedtolegalizetheirparallelmarketsas a transitionalmeasurewhile
easingrestrictions oncment accounttransactions- as a steponthepathto Mlcation of theexchangerate. In
thosecases,unificationhas beenpart of a largerstructuralreformeffortaimedat liberalizingmarketsoverall.
Becausetheemergaceof aparallelmarketusuallyrefl~ theexistenceof anexcessdemandfor foreign
exchangeat theprevailingofficialexchangerate(sothatforeignexchangemustbe rationedbytheauthorities),
successfulunificationof theexchmgemarketsgenerallyrequiresthat theofficialexchangerate be devalued
stilcientlytoe” “ ~ excessdemandsfor foreignexchange.Put anotherway,successfulWlcation requirw
thatthereal officialexchangeratebe set at its “realequilibrium”level.
Definitionsof the “realequilibriumexchangerate”aboundin the literature. Herewe focuson two
equilibriumconcepts, the“short-run” and“long-run”equilibriumexchangerates,whicharemorefullyd~cribed
inanotherchapterin thisvolumes Thelong-runequilibriumexchmgerateis thatratewhichequatesthetrade
.
bpekrMontiel,“me maw of tie ~ng-R~ EquilibriumRealExch~ge ‘a~”*
11
balancewithsustainablenet capiti flOWS,when fisc~, mOne@, mcl commercial polici= are “normal”and
sustainable, whenforeignassetholdingsareequalto theirdesiredlevels,andwhennoexchangecontrolsarein
place. Theshort-runequilibriumexchangerate, by contras~is thelevelof theexchangerate that equatesthe
tradebalanceto net capitalflows--thatis, equatesthesupplyanddemandforforeignexchange--givencwent
settings of economicpolicyandcment demandsfor foreigncapiti, regardlessof whethereitherare at their
normal levels;as in thecaseof the long-runequilibriumrate, the short-runequilibriumreal exchangerate is
definedas thatwhichinducesbalance-of-payments equilibriumwhennoexchangecontrolsareinplace.
Theshort-runquilibriumrd exchangeratemaydiffertim itslong-runvaluefor innumerablereasons.
Forexample, startingoutinaneconomywhereboththeexchangera~ andothergovernmentpoliciesareat their
sustainable, long-runsettings, theimpositionof extraordinaryimportbarriers,byreducingtheeffwtivedemand
fmforeignexchangeintheforeignexchangemarke~willcausetheshort-runequilibriumreal exchangerateto
appreciaterelativetoits iong-runlevel. Conversely, expectationsofa futuredevaluationor politicaldisruption
will leadto a temporaryheighteneddemandfor foreignassets that will lead the short-runequilibriumreal
exchangeratetodepreciateinrelationto thelong-runequilibriumra~.
Bydeftition, as longastheoff~cial exchangerateis at its short-runequilibriumlevel,therewillbeno
imbalancebetweendemandsandsuppliesfor foreignexchange.Thereforeparallelexchangemarkets,to tie
extentthattheyreflectanexcessdemandforforeignexchangeunderuent economicpolicim,areassociated
with real officialexchangerates that are overvalued--that is, apprwiated--withrespectto the short-runreal
equilibriumexchangerate. However,successfullysustaininga unificationof theexchangemarketprobably
requirmthatthereal officialratebe set to its long-runequilibriumvalue,not itsshon-run value. Moreover,it
probablyrequiresthatotherelementsof government policy,inadditionto theexchangerate,bechangedas well.
Toseethis,consider anexampleinwhichtheauthorities haveimposedveryhighquantitativerestrictions
(QRs)onimports, therebyreducingtheeffectivedemandfmforeignexchangeandappreciatingtheshofi-runreal
equilibriumexchangeraterelativeto its long-runlevel. At thesametime,assumethattheauthoritieshaveaiso
12
w theofficial ex-ge rateatalevelthatis evenmoreappreciatedthantheshort-runequilibriumrate, so that
in response to an excessdemandfor foreignexchange,the authoritiesrationdollarsand a parallelmarket
ernerg=. Inthisexample, devaluingtheofficialexchangerateto itsshort-runequilibriumlevelwouiduni~ the
extiangemarkets, butwouldleavemuchof thedistortionassociatedwiththeQRsuntouched.A~lly successful
tilcation thereforewouldentaildismantlingtheQRsanddevaluingthereaIofficialexchangerateall theway
to its long-runequilibriumlevel.
k practice, somecountri=mightnotregardit as feasible,withina shortperiodof time,bothtodevalue
theirexchangeratetoitslong-runequilibriumlevelandto 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, theauthoritiesmightatmmptto
implement a gradualprocessof unificadon,movingtheofficialratetowardits long-runequilibriumvalueeven
as theyadjustassociatedeconomicpoliciesin theappropriatedirectionas well.
Whetherthe authoritiesintendto implementeithera gradualor a rapidtilcation, theywillneedto
iden~ thelong-runequilibriumvalueof thereal exchangerate, and,asnotedintheintroduction, thistaskwill
be fraught withmnsiderableuncertainty. Underthesecircumstances, the prevailingparallelexchangerate
W-M anobvio~PmXYfmthe~uilibriumrate,andtheauthoritiesmightnaturallyconsidertheparallelrate
tobe m appropria~targettowardwhichtomovetheofficialrate, eithergraduallyor all at once. As shownin
thefollowingsection,however,therearemanyfactorsthatcodd causetheparallelra~ todivergesignticantly
hornitslong-runequilibriumvalue,makingiginmanyinstan~, aninappropriatetargetfor theofficialexchange
rate.
IV. ASimpleModelof ParallelExchangeRateDetermination
Thisstion presentsa simplepartialequilibriummodeltoillustratehowtheparallelwket exchange
rateisdeterminedinrelationbothtotheoKlcial exchange rateandtothelong-runequilibriumexchangerate,that
13
is, the rate that wouldproduceequilibriumin the balanceof paymen~under normal, sustainablepolicy
conditions!Thereisnoconsensus regardingthemostappropriatemodeltouseinexplainingtie parallelmarket
rate, just as thereis no agreementas to whichmodelbest explainsthemovementof floatingexchangerates
amongindustrialcountries.Themodelillustratedbelowhas theadvantageof beingrelativelystraightforward
andintuitive,whilehopefillyhighlightingthemostimportantfeatur=influencingtheparallelmarketrate.
N.1 BasicSetup
Considerasmallopeneconomytradingintwogoods,a nondomesticallyconsumedexportgoodanda
non-domestictiy producedimport;the worldpricesof bothgoodsare fixedandset to unity. To focuson
developmentsin theexternalsector,we assumeit to be smallrelativeto thedomesticeconomy,so that the
analysis&cribes theoperationof theparallelexchangemarketinpartialequilibriumTherefore,theoutputof
anon-tradedgoodanditi priceareconsideredf~ed as well. We assumefor conveniencethattheUSdollaris
theonlyforeigncurrencytraded.
Turningto theparametersof government policy,it is assumedthatmonetaryandfiscalpoliciwareat
theirlong-~ sustainable levels,andmoreovm, fortiytid convenience, thereareno tariffs,subsidies,or other
commercial policyintervention.(Theroleof importbarrierswillbeexaminedlater.) Therefore,intermsof the
deftitionsintrodud intheprecedingsectiontheshort-runrealequilibriumvalueof theexchangerateis, at least
initially, thesameas its long-runvalue. TheofficialexchangerateE(measuredintermsof domesticcwency
per dollar) is peggedat an overvaluedlevelrelativeto the equilibriumrate. Therefore,at that levelof the
exchangerate, theflowdemandfor dollars(tobe elaboratedbelow)exc~ theirflowsupply. Exportersare
requiredto surrendertheirdollarearningstothecentralbankat theofficialrateE. Importerspurchasedollars
fromthecentralb~ whichrationsdollarsalesOS, basedontheamountof exportrevenuessurrenderedtothe
centralbankOX, accordingtothecentralbankrationingfunction:
%e modelanditsexpositionarebasedontheanalysispresentedinKamin(1993,1995).
14
0s = os(o~,osf()>0
(1)
Inraponsetotheprevailingexms demandfordollarsat theofficialrateE, a parallelmarketfor dollars
pricedat theparallelmartirate Epemerges. Wefollowtheconventional stock/flowapproachtoexchangerate
determinationin positingthat inthelongrun, theparallelratemovesso as @equateflowdemandsfor dollars
byimporterswithflowsuppliesfor dollarsbyexporters. That is, ti thelongrun Epis set so as to balancetie
privatesector’scurrentaccount In theshortrun, ontheotherhand,theparallelmarketrateis assumedtomove
exclusively toset theportfoliodemandfor dollarsequalto thestockof dollarsoufitanding,so thatat anygiven
momen~theprivatecwnt accountmaybe out of balance.
IV.2me ParallelMarketRateinhng RunCurrentAccountEquilibrium
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)
Thecment account(or flow)demandfor dollarsis a deriveddemandfor importedgoods. Arbitrage
ensures that thepriceof theimportwillbe thesame,whetherpurchasedhorn a legalimporterwithaccmsto
officialforeignexchangeor horn a smugglerusingdollarspurchasedintheparallelmarket.’ Ineithercase,the
priceof importswillbesetqual toi~ marginal ms~theparallelmarketrateEP(sin@by assumption, tie foreign
currencyprice is set to unity). Therefore,theprivatedemandfor imports,as indica~ in equation3 below,
TWe~sme hat theremen. t~ffs andthatrestrictionsonsmugglhg~ cosfl~slYevad~” ‘e ‘at&r
assumptionis relaxedbelow.
15
depends (negatively) uponthedom=ticcmency primof importsEPrelativetothepriceof non-tradeablmPm.8
D = D(Ep/Pn) =D(ep), D/( ) <0
(3)
where&is therealparallelexchangerate.
Thement account(or flow)supplyof dollarsderiva bothfromunder-invoiceddollarearnings--that
is,exportreceiptsnotturnedovertothecentralbank--andfromofficialdollarsalesto importersOS. Notethat
whileholdersofimportii~~ haveanincentivetoover-invoice, thisdoesnot addto thetotalsupplyof dollars
to theprivatesector,whichis fixedby thecentralbank’srationingtiction (equation1). Let Xrepresentthe
quantityof totalexportsandtotaldo~arrevenues aswell(sincetheworldpriceis set tounity),while$ represents
theshareof totalexportproceedsdivertedto theparallelmarke~Then
s = ox + Os(oxi = $x + 0s((1 -(#)x)
(4)
Exporters~ domesticcurTency profi~subjecttorisingmarginalcostsof production--which we
assumetoberelatedtothepriceofnon-tradedgoods--aswell asrisingcostsassociatedwiththeunder-invoicing
share~. Wecanderivethesupplycurvefor totalexportsas a functionof theweightedaverageof thereal (non-
tradeablespricedeflated)official(e) andparallelmarketexchangerates(eP):g
X = X(@eP + (1 -@)e), X’( ) >0 (5)
Theunderinvoicingshare$ canbe showntopositivelydependupontherealparallelmarketpremium:
(6)
8~ p ~cip le, imwfi demmd is a ~ction of in~me as well. Sin~, in tis p~~ ~~ibrium ‘Odel$

incomeis consideredtobe fixed,wedonot includeit explicitlyin thedemandtiction.
9SW K- (1993)for ‘ews’
16
For a givenvaiueof the real oficid rate e, a uniquereal pdlel marketrate & will equatedollar
demandsandsuppliminequilibrium:
D(e~ =@X + OS(O~ (7)
Thisequationw beMer simplifiedif wepositth~ onaverageandovera longenoughtimeperiod,thecentral
bankwillhaveroughlystable international reserves. Therefore,wecanassumethatovera longtimeperiod,the
centralbankwillresellall surrenderedexportreceiptsOX= (1+)Xtolicensedimporters,afterit extrac~any
foreignexchangeneedsof thegovernment(assumedtobe invariantto theexchangerate)D~10
OS(O~ = OX - Dg = (1 -$)X - Dg (8)
Therefore,equadon7 canbe rewrittenas
D(ep) = +X + (1-+)X - Dg =X - D$ =x((#)ep+(l -@)e) - D8 (9)
Figure1belowdepictsvariousdifferentequilibriaintheparallelexchangemarke~dependinguponthe
valueof e set bytheauthoriti~. TheDDcurvedepictsequation3, theprivatedemandfor foreignexchangeas
a tiction of thereal parallelrate&. TheSScurvedepictsthesupplyof foreignexchangeto themarketas a
titionof ~; itslocationalsoisatitionof e, sinmboth &ande affectthetotalquantityof exportssupplied.
e*is thelong-m equilibriumrealexchangerate, thatis, thelevelof therealexchangeratethatwodd cl~ the
market- set toti de~ds for foreignexchangeequalto totalsupplies-in aunifiedforeignexchangemarket.
Notethatwhatheofficial exchangerateissetequaltoe*, theparallelratealsomustequale*.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
epl
e*
D
. . . . . . . . . . .
+
......... .....................
s
D,S
Figure 1
17
whenthe officialexchangerate is set at its equilibriumvalue, thereis no current-accountmotivefor the
emergenceof a parallelforeignexchangemarket,sincethereis no excessdemandfor foreignexchangeat tie
officialrate.
Wenowcomidertheeffecfion thereal parallelrateof a real appreciationof theofficialrate. Assume
thattheauthoritiesallowtheofficialratee to appreciatetoanovervaluedlevelel<e*. Becausethislowersthe
profiti-ilityof exports,thesupplycurveSSshiftsinwards,creatinganexmssdemandfor foreignexchangeat
thatrate. Thisputsupwardpressureon theforeignexchangevalueof thedollarin the(nowemergent)par~el
marke~causingthep@el exchangerateto depreciatefrome* to &l .12
Hence,in cases wheretheemergenceof the parallelmarketreflectstheovervaiuationof theofflcia.1
commercial exchangerate,theparallel-ket rate,on average,is likelynotonlyto be moredepreciatedthanthe
commercialrate, but it probablyis moredepreciatedthan the long-runequilibriumexchangerate ~ well.
Various factors are likelyto determinethe extent to whichthe parallelrate is more depreciatedthat the
equilibriumexchangerate. As Figure1makesobvious,themoreovervaluedtheofficialexchangerate, andso
thegreatertheextenttowhichtheSScurveshiftsinwards,thegreaterwillbe thegapbetweentheparallelrate
and the equilibriumrate. It alsois straightforwardto showthat thegapwillbe greater,themoreelasticare
exportsandthelesselasticareimportswithrespectto theexchangerate.
Theex~t towhichexportsurxender requiremts areenforcedplaysa keyroleindetermini.n g thevalue
of theparallelexchangerate, as well. Recallthattotalexportsarea functionof a weightedaverageof thereal
officialandparallel exchangerates. If foreignexchangeregulationsaretightlyenforced,exportunderinvoicing
willbe limited,reducingthe underinvoicingratio$ and therebyincreasingthe weightplacedon theofficial
exchangerate. Inthiscase, theovervaluationof theofficialexchangeratedepressestotalexportssigtilcantly,
reducingthesupplyof foreignexchangetotheparallelrnar~ anddepreciatingthereal parallelmarketexchange
thenit is obviousby inspectionthatthesecondequationis satisfiedfor ep=e*.
l~s resdt is ~mis~nt wit h t ilatfoundby NOW*(1984)”
18
ratesubstantiallyrelativetotheequilibriumrate.
Conversely, i.fforeignexchangere@ations arepoorlyenforcedandwidelyevaded,theunderinvoicing
ratiowillbe higher,theweightedaverageexchangeratewillbe morefavorablefor exporters,andtoti exports
will not be as severelydepressed. ~s willleadto lesspressureon theparallelmarketexchangerate anda
smallergaprelativetotheequilibriumrate. At anextreme, as tosomeextentoccurredinsomeWean countries,
theo~cial exchangeratebecomessowidelyevadedas tobecomeirrelevantto mosteconomicdecisions.In this
context,mosttradeis routedthroughtheundergroundeconomy,andtie parallelexchangeratemaybecomea
reasonablyaccurateguidetothelong-runequilibriumra~.
Finally,thevalueof theparallelexchangerateinlong-runequilibriumis likelytobeinfluencedby the
ex~nttowhichbarrierstoimports(aboveandbeyondmerelyrationingofficialsalesof foreignexchangethrough
exchangecontrols)areenforced. The aboveanalysisassumesthat onceimportersacquireforeignexchange,
Whethmofflcially orfiomtheblackmarke~theymayusethatfinancingtofreelyimportgoods. However,if the
authoritiesimposehighimportbarriersandtheyarewell-enforced, so thatsmugglingis costly,thiswillact to
redumthedemandforforeignexchangeintheblackmarket--that is, theDDcurveshowninFigure1wodd shift
inwardsandtothelek Thisreduceddemand,inturn,wouldcausetheshort-runreal equilibriumexchangerate
to appreciaterelativeto its long-runvalue,sincethe long-runequilibriumvalueof thereal exchangerate is
predation theabsenceof extraordinarycommercialpolicimof thissofi Theimpositionof thebarriersalso
wouldleadtherealparallel exchangeratetoappreciate relativetothecasewhereimportbarriersarenot enforced.
Forstilcientlytightcontrolsonimports,therealparallelratecouldalsobemoreappreciatedthanthelong-run
equilibriumrealrate.
IV.3TheParallelMarketRatein Short-RunPortfolwEquilibrium
Theresultsdescribedabovearelikely,at bes~toholdon averageoverrelativelylongperiodsof time.
Intheveryshort~ thestockof dollarsheldby tie privatesectoris consideredtobe fixed,sinceit ti time
toaccumulate ordecumulate dollarsthroughaent account imbalan~; duringthisshortrun, thepardel market
19
rateconventionally is modeledas behgde~tied bytie portfolio-bued demandfor dollars. Thisportfolio
demanddependsuponthe relativeexpectedrates of returnto holdingdollarsanddomesticassets,whichare
Muend by anticipatedinflation,otheraspectsof maaoeconornicperformance,andpoliticalevens as well.
Thevolatilityof suchexzons largelyexplainsthehighvolatilityexhibitedbymostfreelyfloatingexchange
rates,includingparallelmarketexchangerat=.
Forasimpletheoretical exposition,assumethatprivatesectoragentsholdtwoasse~in theirportfolio,
dollarsanddomesticcurrency.FollowingDombuschet. al. (1983),thedesiredratioof thedomesticcurrency
valueofprivatesectordollarholdingstothenominaldomesticmoneysupply(M) is modeledas a tiction of the
expectedrateof depreciationof theblackmarketrate(theAdeno~ percentagechange):
or, dividingtiough by non-tradedgoodsprices,
(1 1 )
Thenotationfor therateof depreciation, ;P, ornitsanexpectationaltermtoreflecttheassumptionof perfect
foresight. Theportfoliodemandfor dollars(whenthe parallelmarketrate is stable)tracesout a downward
slopingcurvein ( 4, B) spaw as showninFigure2. GiventhatBis consideredfixedat anyonemomen~the
levelof Bdeterminesthelevelof &at thatmomen~
In thelongrun, theparallelmarketrate andtheprivatestockof dollarholdingsaredeterminedby the
require~ts ofbothportfolioandcurrentaccount equilibrium.In additiontotheportfolioequilibriumcondition
hdbed above,Figure2 depictsthelocusof poinfifor whichtheprivatecurrentaccountis inequilibrium, so
thatthestockofdollarsBheldbytheprivatesectoris unchanging.This curve, denoteddBsO,is vertical,since
19a
B
o
ep
dB=o
Figure 2
20
for anygivenofflcid exchangerate, a singlevalueof the parallelmarketrate epclears the privatecment
account.13 Thepointwherethetwocurv= cross--thesteady-stateequilibrium--istheonlypointwhereboththe
currentaccountis inequilibriumandthestockof dollarsheldby theprivatesectorequalsitsportfoliodemand.
Finally, theverticalandhorizontal mows repraent thedirtion of movementof Bandepoukideof equilibrium,
while the diagonalline-the “stablesaddlepath’’ --indicatestie path by whichB and # convergetoward
equilibrium,shodd theystartout ou~ideof equilibrium.
Wenowconsidertheeffectsontheparallelmmketrateof a risein inflation--say, fromOto20percent--
leadingtohigherratesofnorninaldepreciationof theofficialandparallelexchangerates. Thisis animpo~t
example, sincemanycountri~ that imposedexchangecontrolsexperiencedincreasesin inflationand other
measuresof macroeconomicvolatilityat aboutthesametime,particularlyinLatinAmerica(andTurkey).
As showninFigure3, theincreasedexpectedlevelof ~ation-and henceof nominaldepreciationof
theparallelmarketrate-leadsagentstodesiretoholda higherratioof dollarstodom~tic currency,causingthe
Portfoliobalanmcurvetoshifiupwards. Equilibriumdollarholdingssh.ifttim BOto Bl, whiletheequilibrium
real parallelmarketrate remainsunchanged.However,in orderto accumulateadditionaldollars,theprivate
currentaccountmustshiftintosurplustemporarily, whichin turnrequiresa temporarydepreciationof thereal
parallelexchangerate. Hence,at themomentof increasedinflationexpectations, theparallelmarketratejumps
tiominitialquilibriumat(l) tothenewstablesaddlepathat (2). Afterthis,theaccumulationofdollm through
thecurrentaccountsurplusreversesthedepreciationof thereal parallelmarketrateuntilthesystemreturnsto
equilibriumat (3).
h theexampledepictedabove,thed parallel exchangeratebecomes,for a time,moredepreciatedthan
i~ ownequilibriumlevel(conditional onthevalueof therealofficialrate). (As a resultof thesetemporarycapiti
ltForsimplicity,~s ~~ysis abs~ac~horn theinterestpaymentsassociatedwi~ net as~t holdings?U
wellas horn thewealtheffectsof assetholdingsonimportdemand. In thepresenceof interat paymentsor
wealtheffec~, thedB=Ocurvewouldnotbe vertical,sincethevalueof theparallelmarketexchangeratethat
clearedtheprivawcurrentaccountwouIddependuponthestockof dollarholdingsB.
20a
B
dB=o
BI
........................
~p=zo
BO
........................
Ep=o
ep
Figure3
21
outflows, theshort-runequilibriumexchangerateinaunifiedmarketalsowodd depreciaterelativetoitslong-run
equilibriumlevel.) Sincetie equilibriumlevelof theparallelexchangerateis likely,asshownin Section111.2,
to be moredepreciatedthanthe long-runequilibriumrate in a unifiedexchangemarket,this meansthat the
parallelrate duringperiodsof macroeconomicvolatilityandcapitaloutflowswill be moredepreciatedsti~.
Hence,duringperiodsof macroeconomicvolatilityandheavycapitaloutflows,theparallelrateis likelytobe a
particularlybiasedguidetosettingtheappropriatelevelof theofficialexchangerate.
Infa~ becauseof theassetmarketfunctionof theparallelexchangemarket,theparallelmarketratecan
trade at a largepremiumovertheofficialrate, evenwhentheofficialrateis closeto its long-runequilibrium
value,thatis, thevaluethatequilibra~thebalanceof paymentsin “normal”macroeconomiccircumstances.As
notedabove,his is becauseduringperiodsof heavycapitaloutflows,theshort-runequilibriumrealexchange
rate in a unifiedexchangemarketmaydepreciaterelativeto i~ long-runlevel;if the officialexchangerate
remainsat that ( i.e. equilibrium)long-runlevel,anexcessdemandfor foreiWexchangewilldevelopthatwill
causea parallelmarketpremiumtoemerge. TheLatinAmericancountries’ experienceswithexchangecontrols
mayfitthisscenario.Aswillbediscussedfurtherbelow,in variousof th=e countries,a combinationof factors
ledto a balance-of-payment crisisin the 1980s. Thegovernmentsrespondedtothiscrisisbydepreciatingthe
official exchangerate,but becauseof thesizeof thecapi~ outflowstriggeredby thecrism,theparallelmarket
ratesin thesecountriesdepreciatedstillfurther.
Finally, weshouldunderscorethef= thatevenif therealparallelmarketexchangerate,onaverageover
longperiodsof time,werea goodindicatorof thelong-runequilibriumred exchangerate,thevalueof thereal
parallelmarketrateat anysinglepointinh wodd likelybe anextremelyunreliableproxyfor thatequilibrium
rate. Thisisbecausetheparallelmarketexchangerate, likeanyotherassetprice,dependsuponhighlyvolatile
@otio&-&, adham&i&eMti@y volatile. Thisvolatilitymaybe seenquiteeasilyin thechartsof the
officialandparallelexchanger~ presentedat theendof thispaper. Hen&, asidehornthefact thattheparallel
rateis likelytobea biasedindicatorof thelong-runequilibriumexchangerate, it is also,unlessaveragedover
22
very long periods,likelyto be a highlyuncertainor inaccurateindicatorof theequilibriumrate as we11.14
V. TrendsinOficial andParallelRealExchangeRates
Thetheoreticalmodeldescribedabovesuggeststhat theparallelexchangerate is likelyto be more
depreciated thanthelong-runequilibriumrealexchangerate,unless(1) macroeconomicfactorsinducingcapital
flightarenot presen~(2) exchangecontrolsarepoorlyenformd,and/or(3) therearehighimportbarriersthat
arewellenforced.Toevaluatethesehypotheses, wewould,ideally,comparethepathof theparallelexchange
rate in variouscountri~to thatof thelong-runequilibriumreal exchangerate inorderto gaugetheextentto
wtichtheparaIlel ratemayserveas a use~ guidetodetermining g theequilibriumexchangerateand, therefore,
insettingtheofficialrate.
Unfortunately, theequilibriumrealexchangerateis a thwreticalconstructwhichmustbeestimati, not
a measuredquantityfor whichdataexis~ Mor@ver,evenin a ~ed markegtheempiricalestimationof the
equilibriumreal exchangerate is no easytask Estimatingthe equilibriumrate is a highlyinvolvedprocess
requiringstrongassumptionsabouttheoperationof thecurrentandcapitalaecounti,as well as theestimation
of stabletradeandpaymentsrelationshipsovertime15.
Estimationofthelong-runequilibriumrd exchangeratefor a wideset of countries,inordertocompare
thoseexchangerates to actualparallelrates, wodd go beyondthelimitedscopeof thispaper. As a f~st step
toward identifyingwhereparallelmarketra~s standin relationto long-runequilibriumreal exchangerates,
lqBmedon ~ opti~z~g mo~l of tie parallel marketexchangerate,MontielandOStrY(1994)~me to
muchthesameconclusion.Theyfmdthatin thetransitionbetweensteady-stateequilibriainresponsetoa
productivityshock,theparallelmarketpremiummaymovebothaboveandbelowzero,andhenceis “an
unreliableindicatorof thesignandmagnitudeof real exchangeratemisalignment.”
lbAnm~r of ~proachedhaveb~n triedin thelitera~e. Devarajaran(1995)~es a gener~
equilibriummodelthatfactorsinchangesintermsof tradetoestimatetheequilibriumrealexchangerateand
theextentof overvaluationin theCFACountrieS; Baffeset al (1995)constructaneconometricmodelusinga
varietyof macroeconomictidament,als for severalof thesecountries;AhlersandHi.nkle(1995)followa
tradeelasticitiesapproachintheirestimation.
23
however,it makessenseto comparelevelsof theparallelrate 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 maybeusefulto comparethelevelof the
rd officialexchangerateduringperiodswhenexchangeConwols areh effec4andhenceparallelmarketsexist,
toperiodswhenexchangemarketsareunified. Suchcomparisonsmayshedlighton thefactorsthatmotivated
theimpositionofexchangecontrols, whichintummayhaveimplicationsfor therelationshipbetweentheparallel
andequilibriumreal exchangeratm.
Acomplicatingfactorinusingaveragesof actualexchangeratesas proxiesfor equilibriumexchange
rates is that for most countrim,the processof developmentand structuralchangewill cause the long-run
equilibriumexchangeratetochangeovertime. In thatsense,along periodaverageof actualreal exchangerates
mayyiel~at bes~anaverageof long-runreal equilibriumexchangeratesoverthatperiod. Withthiscaveatin
mindhowever, westillbelievethatempirical comparisons of actualofficialandparallelexchangeratescanyield
usefi insights.
First, our analysiswillfocuson averagesof exchangerates acrossa largeset of differentcountria.
Therefore,evenif long-runrealequilibriumexchangeratesfollowparticulartrendsineachindividualcountry,
theaveragelong-runrealequilibriumexchangeratefor thesampleas a wholemaybe morestation~. Second,
ouranalysisfm~ uponcomparisonof~mnt typesof exchangerates--official andparallel-duringdifferent
regimes–withandwithoutexchangecontrols. Therefore,our resultswill be ~erable to misinterpretation
mainlyif thetimingof exchangecontrolperiodsin thesamplecoincidewithparticdar movementsinlong-run
equilibriumreal exchangeratm. Whilewebetieve,asd.iscussedabove,thatexchangecontrolperiodsarelikely
tocoincidewithsystematicmovementsin shorf-runequilibriumreal exchangerates, as a resultof tempor~
shockstocapitalflowsor thetermsof trade,wehavemuchlesscausetobelievethatexchangecontrolshavebeen
associatedwithparticulartrendsin Zong-runequilibriumreal exchangerates.
.
Y1 DataandMethodology
24
To makethesecomparisons, wegathereddataontheofficialandparallelexchangeratesfor a sample
of24 developing countri=(SeeAppendix1for thecompletelist). Of these,twelvearefromLatinAmerica,ten
are AfricanandtwoareSouthAsian.Thesampleis basedononechosenfor anearlierWorldBankresearch
projecton themacroeconomicimplicationsof multipleexchangerates (seefootnote3 above).The sampleis
consideredto be fairlyrepresentative- geographically ancl withrespectto thealternativepathsof evolutionof
theparallelrnarke~Thesampledoesincludemostof themoreprominentdevelopingcountrieswithsignificant
parallelmarkets,outsideeasternandcentralEuropeandtheformerSovietUnion.Thebasicdataset is theone
usedinGheiandKiguel(1992).WeaddedthreeAfricancountries- Algeri~MalawiandSudan; andextended
thedataset tothelast quartero f 1994.
Tomeanin~y comparelevelsof exchangeratesovertime,wefmt correctedthedataforchangesin
prim bydculating realexchangerates. Thereareanumberof empiricaldeftitions of the real exchangerate
(seeHinkleandNsengiyumva (1995)for adetaileddiscussion). Weusethebilateralreal exchangeratebetween
thecountrywe areexaminingandtheUnitedStates(localcurrencyper USdollar-anincreaseintheexchange
rateindicatesdepreciation). Theconsumerprimindexis usedas a proxyfor domesticprices;theUSproducer
priceindexfor worldprices.
. E. Pus
e—
P
(12)
wheree is thereal exchangera~, E, thenominalexchangerate,is the Iocd currencyvalueof U.S. dollar,Pus
is the USproducerpriceindexandP is thedom~ticCPIlb.
lbIt is conceivablethattheuseof a bilateralexchangerate,usingtheUSproducerpriceindexas a proxy
for worldpricesmaybiasourresults,in viewof thesi~lcant movementsof tie USdollarvis-a-visother
industrialcountriesduringthe 1980s.Resultsof tesk for sensitivitywithrespecttochoiceof foreignprice
indexarepresentedin Appendix3, for a sub-sampleof countriesfor theperiod1979-94.
25
Thedatausedareendof quarter,for theperiodfrom1970through199417. Thereal officialexchange
rateisindexedsothat 1985Q1isequalto 100. Therealparallelmarti exchangerateis indexedso thatitsvalue
in 1985Q1 is equti to 100plus thepremium(inpercent)of theparallelrateovertheofficialratein thatbase
quarter. For eachcountry,meanandthemedianaveragevaluesarecalculatedfor thefollowing:e, theofficial
real exchangerate for theentireperiod;ep,theparallelreal exchangeratefor theentireperiodof i~ existence,
that is, whenexchangewntrols werein eff~t; en.,theofficialnon-tiled real exchangerate, for theperiods
whmexchangecontrolswereineffectandexchangemarketswerenot Mled; ande’, theofficialreal exchange
rateduringperiods,if anyexisted,whenexchangemarketiwereunified. Aunificationof exchangemarketsis
definedtohave* placeif theabsolutevalueof theparallelratedeviateslessthan3 per wnt fromtheofficial
rateforat least4 q~. Thenon-zeronumberistotakeintoaccountmeasurement errors,sincetheoficial and
parallelratesarehorndifferentsour= (seetablm).
A~S-COUntI’y Summaryof our calculationsof thefourreal exchangeratecategoriwdescribedabove,
basedonmeanaveragesof theexchangeratedatafor eachseparatecountry,is prmentedincolumns1through
4 of Table3. ResultsarepresentedinTable3 for thewholesample,as wellas twosubsets. For thecountri~
in each subset, wepresentthemean,median,andstandarddeviationof thereal exchage rate. In columns5
though9 ofTable3, wecalculmvariousratiosof thedatashownincolumns1through4, andperfoxmbinomial
signhts to~e whethertheseratiosdiffersignificantlyfromone. ThePr (Ho is true) rowindicatesthe
probabilitythattheob~ed configuration ofratioswouldbeobsemed,if thenu~hypothesis- thattheratiowere
equalto 1-weretrue.
Theregional groupingswerechosenin orderto testourhypoth~s concerningthedifferentmotivation
and functionof parallelmarketsin differentregions. In LatinAmericaandTurkey,exchangemntrols were
imposed,particularlyin the 1980s,in situationsof ~nornic andbalance-of-payments crisisleadingto
ITTheoffici~exchangera~s andprim arefromII’vIF, InternationalFinanciaZStatistic. Thep~allel
exchangerat= arefromWorldCurrencyYearbookandInternationalCurrencyAnalysis,Inc.
Z6
strongcapitaloutflows.Inthesecountriw, pressurmtim capitalflightarelikelytohavecausedtheparallelrate
todepreciatewellabovethelong-runequilibriumreal rate,evenif theofficialexchangera~ wmnotespecially
overvaluedrelativeto its long-runequilibriumvalue. tican andSouthAsiancountri~, on theotherhand,
experienced muchlessmacroeconomic distress. Inthosecountries,exchangecontrolsweremorelikelytohave
arisen as a meansof rationingforeignexchangereceiptsin thecontextof a progressiveovervaluationof the
officialexchangerate. As describedin SectionIV.2,theparallelrateis likelytobe moredepreciatedthanthe
long-runequilibriumrate in this mntext as well,unlessexchangecontrolsare poorlyenforcedand/orwell-
enforcedimportbarrierseffectivelycurtailthedemandfor foreignexchange.
K2 Comparisonsof PeriodAverages
Wenowcomparetherealparallelrateeptovariousproxiesof theequilibriumreal exchangerate. The
fmt possibleproxyfortheequilibriumRERwewnsideris e, theaverageRERfor a periodof twentyfiveyem.
Asmaybeseenincolurnn5,&/e,onavaage,isgreaterthan1,witha meanof 1.64for theentifesample.In fact,
thereisnocountryinoursamplefor whichtheaveragerealparallelmarketexchangeratewasmoreappreciated
thantheaveragerealofficialrate(calculatedfor periodswhentheexchangemarketwasunifiedas wellasnon-
unified). To theextentthat theaverageofficialrate, whenaveragedovera stilciently longperiod,is a good
proxyfortheequilibriumrealrate,thissugg~~thattheparallelrateis a biasedindicatorof theequilibriumrate.
However, usingtheaverageRERfor theentireperiodmaybe misleading, sinceit includ~periodswith
exchangecontrolsas wellas whentheexchangemarketis unified.Whenexchangemntrolsare in place,the
nominalprice of foreignexchangeis set by the authorities,andaccessto foreignexchangeis determinedby
quantitativerationing.Hence,theofficialreal exchangerateduringperiodsof exchangecontrolis likelytobe
more appreciatedthantheequilibriumreal rate, It maybe moreappropriateto use theRERaveragedover
periodsof un~ledexchangemarke~- thatis, em- as a proxyfor thelong-runequilibriumRER.
For thewholesample,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 andAsia,witha meanvalueof
1.05(whichis not si@lcantly differentfrom1). Hence,to tie extentthate“is a goodproxyfor thelong-run
equilibriumrealexchangera~, epappears,onaverage,to havebeencloseto thelong-runequilibriumexchange
rate in AfricaandAsia but muchmoredepreciatedthanthelong-runequilibriumlevelin LatinAmericaand
Turkey.Thismayseemsurprising, giventhefarhigheraverageparallelpretia thathavebeenobservedinmuch
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”,theratioof theparallelrate to theunifiedofficialrate, betwwnLatin
Americaandficaappear to berelatedtoequallymarkeddifferencesin the evolutionof theofficialexchange
ratebetweenthetworegions.As indicati incolumn9, inLatinAmericaandTurkey,thereal officialexchmge
ratetendedto bemoredepreciatedduringperiodsof exchangewntrols thanduringperiodswhentheexchange
marketsweretiled; themeanratioof e“-/e”was 1.12,with9 of the 12countrieshavingratiosgreaterthan1.
This is consistentwith our view that in Latin America and Turkey, unsustainablepoliciesresultedin
macroeconomicdisequilibrium, which,in turn, triggeredcapiti outflowswhichdepreciatedthe short-run
equilibriumrealexchangerate(arelationshipthatwouldholdin a unifiedexchangemarket)relativetoi~ 1ong-
run level. The governmentdid depreciatethe official exchangerate, but not by as muchas the short-run
equilibriumratedepreciated. Therefore,anex~s demandfor foreignexchangedeveloped, causingtheparallel
ratetodepreciateaswell.Asmacrop=urm _ capitaloutflowsmoderatedandreversedthemselves, leading
toanappreciation of theshort-runequilibriumexchangerateandfacilitatingtheunificationof exchangemarkets.
IncontrasttoLatin~ca andTurkey,intheMean andSouthAsiancountriesinour sample,thereal
official exchangeratetendedtobe moreappreciatedwhenexchangecontrolswereinplacethanwhenexchange
marketsw=unified. As shownincolumn9, for ~ca andSouthAsia,theratioof eB9/emwasonly.65,with
al15countriesinthisgroupingshowingratioslessthan 1. This evidence,whilequ~ledby thelownumberof
observationsinthesub-sample,supportsour speculationthattheemergenceof a parallelmarketinMca 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 extent of overvaluationinaeased, oftenforeignexchangerationing
tightened,andtheparallelmarketgrew,asdidthepremium.
Consideringhowovervaluedthereal officialexchangerate wasin manyAfricanandtheSouthAsian
countries, relativetoitslong-runequilibriumvaiue,it is surprisingthatrealparallelratesin thosecountrieswere
not more deprwiatedcomparedwithaveragereal officialexchangerates duringtheperiodswhenexchange
marketswereunified. SectionIV.2showedthat,all elseequal,themoreovervaluedwastheofficialexchange
rate, the moreundervaluedwouldbe the parallelrate relativeto the long-runequilibriumrate. Therefore,
unificationpresumablywouldhaverequiredtican andAsiangovernment to devaluetheirofficialexchange
ratesto a leveltiat wasnot asdepreciatedas thepriorlevelof theparallelrate.
Inaddressingthisissue,it is importanttopointout thatwehavea verysmallsampletoexamine- only
5 ~untriminoursamplein thesubse~AfricaandSouthAsia,unifiedtheirexchangera~. Intwoof thesefive
cases(EgyptandT~ania), theratioisgreaterthan1. Additionally, as wepointedout inSectionIV.2,thereare
factorsthatmaylowertheparallel raterelativetothelevelpredictedby thebasicmodel. Firs~considerthecase
whenunderinvoicing, +, ishighbecauseexchangecontrolsarenot effective- whenenforcement is lackadaisical
andevasionwikprd Th~ for allpracticalpurposes,therelevantratefor theemnomybecomestheparallel
rate, whichmay,in thiscase,be closeto theequilibriumrate. Then,whenexchangemarketsareunified,the
official ratewouldneedtobedepreciatedto thelevelof theformerparallelrate, and&/eUwouldbeclosetoone.
Ghanais anexullent illustrationfor this (ChibberandShaffii (1991)).
As~nd factorthatmightappreciatetheparallelmarketraterelativeto thelevelpredictedby thebasic
modelmightbethestrongenforcemt of importcontrols.Thiswouldcausethepremiumtobe low,evenif the
official exchangerateis maintainedat a substantiallyovervaluedlevelcomparedwiththelong-runequilibrium
.
exchangerate,sinceeffectiveimport~ntrolsreducethedemandfor foreignexchangeandtherebyappreciatethe
29
short-runequilibriumexchangerate. Then, if tilcation is associatedwith import liberalization,thereby
depreciating short-runreal equilibrium
alargeamountifexms demandsforforeign
exchange
exchange
rate, theofficialexchangeratewillhavetodepreciateby
areto beeliminated.Thisscenariowouldleadtoa ratio,
&/e”,tiat wouldbelowcomparedwiththepredictionsof thebasicmodeloutlinedin SectionIV.2. Indiais the
ht examplefmthis-tilcation oftheexchangeratetookplacein 1993as pm of a largerliberalizationeffort,
requiring greaterdevaluationof theofficialexchangerate thanwouldhavekn the casein the absenceof
importliberalization.
Table3: Full PeriodStatistics,RatiosandBinomialSi~ Tests
1 2 3 4 5 6 7 8 9
Offlciai Parallel Official Official Ratio, Ratio, Ratio Ratio, Ratio,
RealER RealER ERwith ERwhen #/e e’”le #/e””
Country
@/e” e-lea
1970-94 Par. mkt Unifjed 2fl 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 1.24 1.06 1.36 1.32 1.10
StdDev 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 0.98 1.85 1.05 0.65
Median 103.56 186.64 101.56 267.03 1.78 1.00 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 0 12 0 3 5
Number>1 12 0 12 2 0
Pr (HOis true)
0.0002 0.0002 0.0002 0.500 0.031
All countries
Mean 101.28 171.92 101.53 111.71 1.64 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
StdDev 41.60 99.81 40.40 74.67 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) O.000 0.153 0.000 0.006 0.50C,
Source: ES,WorldCurrency Yearbook, Currency Analysis Inc,various issues, authors ~culations.
30
K3 TheOficial ExchangeRateafierExchangeMarht Unification
The issuesrelatedto unificationcanbe tier examinedbyconsideringwhathappenstothe official
exchangerate at that time. We havetwentyobservationsof unifications.In somecases, a countryhas two
episti of dualexchangerat~, witha periodof unifiedexchangeratesintheinterim;thesearetreatedas two
separateobservations. Somecountrimhavenevertiled, andthereforearenot represented(seeAppendix2 for
thecompletelist).Thecomposition of thetilcation dataset is quitedifferentfromthatusedinTable1.Firstly,
threequartersoftheobservationsarehorn theexperienceof unificationinLatinAmerica;onlythreeoutof the
twentyobservationsarefor Africa,withthetwoSouthAsiancountriu completingthecoun~Theverysmall
samplemeansthatthesubsetsresultsaretobe interpretedwithcautionfor theAfricaandSouthAsiasubset.
InTable4, welookat themean,medianandstandarddeviationof threevariables:theaverageofficial
RERfortheyearbeforethetication (10),theaverageofficialRERin theyearfollowingMlcation (11) and
the averageparallelrate for the year precedingthe unification(12). We calculatetwo ratios, of the post-
tilcation official RERtothepre-unificationRER,egt+l/emmt.l; andtheratioof thepostunificationofficial(and
sole) RERto thepre-unificationparallelrate, eot+l/&t.l. As before,wereportthemean,medianandstandard
deviationfor all variablmas wellas ther~ults of binomialsigntest for tie ratios.
Theresultsareconsiskntwiththefindingsreportedintable3. Theratioof thepost-to pre-untication
officialexchangerate, ew,+l/em9i.1, is approximatelyequal to one for the wholesample.Again,aggregation
obscurathedifferenminresul~betweenthetwosubsefi.Theratio, eut+l/e’gt.l is (very)slightlylessthan1for
LatinAmericaandTurkey,suggwtinga smallappreciationintheRERfollowingunification. Thisis consistent
with the ideathancapitalWows resumedas themacrocrisiswas alleviated,appreciatingtheshort-runreal
equilibriumexchangerate and allowingthe authoritiesto appreciatethe real offlcid exchangerate while
simultaneously unifyingtheexchangemti. Theratioisslightlygreaterthan1onaveragefor AfricaandAsia,
as theexchangeratewasdevaluedfollowingunification. Again,thisis consistentwiththeobservationthat in
.
threecountria,official exchanger- duringtheexchangewntrol periodwereovervaluedrelativetotheirlong-
n
31
runequilibriumraks, so thatunificationrequiredthedevaluationof theofficialrate.
Therelationship betweenthetild officialrateandthepriorparallelratealsodifferssomewhat
thesub-samples.Theratio eO,+l/ept.l clearlyis lessthan 1for theentiresample,indicatingthatin general,the
offlcirdrateis not depreciatedall theway@thelevelof theformerparallelrate. Withtheexceptionof Ghana
and Bolivia,the averageratio is less tian 1 for all countrim. ~S rault also is unambiguousfor theLatin
AmericaandTurkeysubs& Ontheotherhand,berat.io egt+l/&,.l doesnot appeartobe significantlydifferent
fromonefor the~can andAsiansample,whichis consistentwithresultsd=cribed above-averagetiled
officialexchangeratesappeartobecloseto theaveragelevelof theparallelratein AsiaandMea. -
Table 4: UnificationEpisodes- Statistics,RatiosandBinomialSignTests
10 11 12 13 14
OfficialRER, OfficialRER, Parallel RER, e8~+1/eaut.1 e“*+l/#~.l
Country Year,unif-1 Year,unif+l 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
Aft ia &Ash
Mean 183.67 201.5~ 203.81 1.08 0.98
Median 172.71 155.21 180.99 1.11 0.94
StciDev 71.92 87.56 85.81 0.12 0.13
Numbers 1 1 4
Number>1 4 1
Pr (HOis true) 0.188 0.188
All countries
Mean 108.61 113.21 131.81 1.02 0.86
Median 99.42 83.77 118.08 1.00 0.90
StdDev 60.60 71.42 75.28 0.11 0.16
Numbers 1 10 19
Number>1 11 2
Pr (~ is true) 0.500 0.0001
Source: IFS, WorldCmencyYearbook, Currency ~ysis Lnc, various issues, authors calcu~ons.
32
VI. Conclusion
Wenows~ themostimportantfindingspresentedinourpaper. Tobeginwith,ourtheoretical
analysisindicatedthatwhentheemergenceof a parallelexchangemarketis motivatedby theovervaluationof
theofficial exchangeraterelativetothelong-runequilibriumred exchangerate, theparallelmarketrateis likely,
onaverage, tobemore@reciatedthanthelong-runequilibriumrealextiangerate. Thegapbetweentheparallel
rate and the long-runequilibriumrate is likelyto be smaller,to the extent that export receipt surrender
requiremen~arenutwelldor~ andto theextentthatbarriersto importsandothercommercialpoliciesthat
tendto appreciatetheshort-runequilibriumreal exchangerate arewell-enforced.
Moreover, our theoreticalanalysisindicatedthatevenif tie officialexchangerateis set at i~ long-run
equilibriumlevel,a parallelmar~ mayariseinordertomeetthedemandsof residentsseekingtoaugmenttheir
holdingsof foreignassets. Duringtheperiodwhenforeignassetsarebeingaccumulated--that is, whencapital
mghtis~g-the parallelexchangeratewillbemoredepreciatedthanitsownequilibriumvalue,andhence
probablymoredepreciated thanthelong-runequilibriumextige~ fmtheeconomyas a whole. Additionally,
becausetheparallelmarketrateisanasw price,andexhibitsthevolatilitythatis characteristicof all assetprices,
the valueof theparallelrate at anygivenmomentis likelyto be a particularlypoor indicatorof thelong-run
equilibriumexchangerate.
Th~e considerations suggestthatonbalance,theparallelrateis likelytobe moredepreciatedthanthe
long-runequilibriumreal exchangerate, andhencetheofficialexchangeratein a unifiedexchangemarketwill
ingeneral ht besetat alevelthatismoreappreciatedthanthepriorparallelrate(averagedovera suitablylong
period).Inthisp~, wedidnotcomparea parallelexchangeratestoestimatesof thelong-runequilibrium
rateindifferentcountries,owingto thed~lculty of estimatingequilibriumratesfor a largesample. However,
wecomparedmulti-year averagaofrealparallel ~ torealofficial ratesina sampleof 24developingcountries,
andmadeanumberof useti findings.
First, we foundthat for the sampleas a whole,the real partiel marketrate was uniformlymore
33
depreciatedthantheofficialexchangerate,evenwhentheofficialratewasmeasuredonlyduringperiodswhen
the exchangemarketswereunified. Duringperiodswhenthe exchangemarketis unified,and thereare no
exchangecontrolstobridgethegapbetweensuppliesanddemandsfor foreignexchange,theofficialexchange
rateis morelikelytobeclosetotie long-runequilibriumrateon average. Hence,thisrepresen~partialevidence
thattheparallelrateten~ to beundervaluedrelativeto thelong-runequilibriumexchangerate.
Secondwefoundimportant differencesin therelationshipbetweenparallelandofficialexchangerates
amongdifferentsubsefi of our countrysample. In LatinAmericaand in Turkey,the emergenceof parallel
exchangemarketsappears~ havereflecteda sharpdepreciationof the short-runequilibriumexchangerate
relativeto its long-runvalue,not the appreciationof theofflciaiexchangerate horn its long-runequilibrium
value.Inthose~untri~, theparallel ratewasclmly depreciatedcomparedwiththeofficialexchangerateduring
periodswhentheexchangemarketswereunified. However,theundervaluednatureof theparallelratedoesnot
ap~ tOhavereflect~ fie overvaluat.ion of theofficialexchangeraterelativeto thelong-runequilibriumreal
exchangerateduringperiodsofexchangecontrols,sincetheofficialexchangeratein thissubsetwason average
moredepreciated duringtheperiodswhenexchangecontrolsw=eineffectthanin theperiodswhenmarketswere
unified.
We surmisethat a combinationof internalandexternalshocksledto macrmnomic turbulenceand
capitalflightinLatinAmericaandTurkey,mainlyin the 1980s. Thesedevelopments, in turn,depreciatedthe
short-runequilibriumreal exchangeraterelativeto its long-runlevel. Whiletheauthoritiesdepreciate their
officialexchange~-possibly eventolevelsmoredepreciatedthanthelong-runequilibriumrate--theydidnot
dosobyenought.or~olveex~s demandsfor foreignexchange.Thatis, evenifofflcialexchangeratesduring
the exchangewntrol periodwereundervaluedrelativeto thelong-runequilibriumrate, theywereovemalued
relative to the short-runequilibriumrate, therebygivingrise to parallelexchangemarkets. As a resulgthe
parallel ra~ probablywereeva moreundervalued relativetothelong-runequilibriumratethanweretheofficial
rates.
34
Third,wefoundthattheAfricanandSouthAsia countriesinour samplebetterfit our preconception
thattheemergenceof parallelexchangemarketsreflectstheovervaluationof theofficialexchangeraterelative
to its long-runequilibriumvalue. Amongthefewcou.ntrimin this subsetthat experiencedperiodsof tiled
exchangerates, the real officialexchangerate clearlywas moreappreciatedduringperiodswhenexchange
controlswereineffwtthaninperiodswhenexchangemarketswereunified. Thissuggeststhatincontrasttothe
LatinAmericaandTurkeycase,therealappreciation ofofficialexchangeratesinAfticaandSouthAsia,relative
tolong-runequilibriumvalues,wasthemainfactorunderlyingtheemergenceof parallelmarkets.
On the other hand, in AfricaandSouthAsia theparallelexchangerate was not si~lcantly more
depreciatedthantheofficialexchangerateduringperiodswhenmarketswereunified--putanotherway,when
exchangemarketswereunified,theauthoritieshadto depreciatetheofficialrateall thewaytothelevelof the
formerparallelrate. Therelativesimilarityof parallelandunifiedofficialexchangeratesunderscor~thefact
thatinthecaseof someMean countries,exchangecontrolsmayhavebeensopoorlyenforcedthattheparallel
rateeff~vely mimickedtheroleof theofficialratein a unifiedexchangemarke~Additionally, insomeAsian
countries,well-enforcedimportbarriersconstrainedthedemandfor foreignexchangewhenexchangecontrols
wereineffec~therebyappreciatingboththeshort-runequilibriumexchangerateandtheparallelrate;exchange
marketsweretiled at aboutthesametimeas importbarrierswerelowered,makingit necessarytodepreciate
theofficialexchangeratesubstantiallyinordertomaintainthebalan~ of paymentsin aunifiedmarke~
Our findingsfor someWean andAsiancountriessuggestthatinsomecases,theparallelratemight
notbean inappropriti proxyfor thelong-run~uilibriumexchangerate, andhencecouldbe a guideto setting
the officialrate. Somewhatspecialfactorswereoperativein thesecountrieshowever--verypoorlyenforced
exchangecontrolsinsomeAfricancountri~,verywell-enforcedimportcontrolsinsomeAsiancountries.More
gen~y, theparallelmarketratewouldseemtorepresentanupperbound,in termsof localcurrencyperdollar,
ontheappropriatelevelof theofficialexchangerate.
35
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i
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I
I
37
Appendix 2
Table2.A: UnificationEpisodes
country
10 11 12 13 14
e(nu,t-l)OfficialRERe(qt+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)
Year,Unification-1 Year,Unifi-tion+l Year,Unification-1 11/10 11/12
Mean IMedian Mean Median Mean Median Mean Median Mean Median
LQtinAmerica and Turkey
Argentina 76.45 69.89 74.17 75.55 147.95 141.42 0.97 1.08 0.50 0.53
Argentina 26.52 26.41 26.03 25.93 29.40 29.04 0.98 0.98 0.89 0.89
Bolivia 126.58 126.10 136.51 136.50 135.79 134.01 1.08 1.08 1.01 1.02
Bolivia 125.96 126.17 128.00 127.70 134.21 134.36 1.02 1.01 0.95 0.95
B- 60.01 59.92 59.30 59.08 64.74 65.17 0.99 0.99 0.92 0.91
Chile 58.23 57.82 64.18 64.31 65.00 65.32 1.10 1.11 0.99 0.98
Colombia 99.42 99.68 83.77 84.26 104.46 104.28 0.84 0.85 0.80 0.81
Dom Rep 57.21 56.98 56.12 56.36 61.18 60.92 0.98 0.99 0.92 0.93
Ecuador 126.11 126.18 126.39 127.84 141.07 140.06 1.00 1.01 0.90 0.91
Mexico 103.69 110.30 106.98 106.10 114.40 115.15 1.03 0.96 0.94 0.92
Mexico 87.53 88.01 76.20 75.50 92.51 93.29 0.87 0.86 0.82 0.81
Pem 64.50 63.99 75.28 75.01 132.37 146.55 1.17 1.17 0.57 0.51
Urumay 68.78 68.40 67.09 67.18 80.93 81.16 0.98 0.98 0.83 0.83
Venezuela 128.77 108.14 149.58 149.64 277.38 272.90 1.16 1.38 0.54 0.55
Turkey 64.49 65.59 57.84 58.19 68.11 68.22 0.90 0.89 0.85 0.85
Turkey 88.19 87.38 82.40 83.32 99.50 97.95 0.93 0.95 0.83 0.85
Afi”caandAsia
Egypt 172.71 171.70 155.21 156.55 180.99 176.55 0.90 0.91 0.86 0.89
Ghana 212.66 212.93 266.21 271.59 217.60 223.52 1.25 1.28 1.22 1.22
Tanzania 305.99 306.85 340.09 334.37 361.34 355.90 1.11 1.09 0.94 0.94
India 120.01 119.88 138.24 138.99 141.04 140.95 1.15 1.16 0.98 0.99
Pakistan 106.97 106.40 107.73 108.31 118.08 116.50 1.01 1.02 0.91 0.93
LatinAmerica&Turkey
Mean 85.15 83.81 85.62 85.78 109.31 109.36 1.00 1.02 0.83 0.83
Median 81.99 78.63 75.74 75.52 101.98 101.12 0.98 0.99 0.87 0.87
StdDev 29.89 28.91 33.19 33.22 54.88 54.17 0.09 0.13 0.15 0.15
AMca & Asia
Mean 183.67 183.55 201.50 201.96 203.81 202.68 1.08 1.09 0.98 0.99
Median 172.71 171.70 155.21 156.55 180.99 176.55 1.11 1.09 0.94 0.94
,StdDev 71.92 72.41 87.56 86.23 85.81 84.65 0.12 0.12 0.13 0.12
All countries
Mean 108.61 107.56 113.21 113.44 131.81 131.58 1.02 1.04 0.86 0.87
Median 99.42 99.68 83.77 84.26 118.08 116.50 1.00 1.01 0.90 0.91
StdDev 60.60 60.74 71.42 71.13 75.28 74.31 (-)-11 0.13 0.16 0.16
38
Appendix3: Sensitivityof Resultstochoiceof RealExchangeRate
Thetrendsin sectionVareestimatedusingtheUSproducerpriceindexas aproxyfor worldprices.
Thismaybiastheresul~,particularlyfor timeperiodswhenmovementsin theUSreal exchangeratediverge
significantlyfromthoseof otherindustrialcountries,as theydidovermuchof the 1980s.Weestimatethe
sameratiosas inTable3, usingtrade-weightedmultilateral real exchangerat= (seeTables3.Aand3.B
below).
Thedatawereavailablein theIn&mational FinancialStatisticsdatabase,of theIMF, foron.lytenof
thetwenty-fourmuntriesinour sample,for thetimeperiod1979to 1994. Whileit wouldbepossibleto
calculatemuldlateralrealexchangeratesfor all thecountriesin thesample,for theperiodunder
consideration, thiswodd be a laboriouspr~s. Further,thisdataset covers a shortertimeperiodthanthe
oneusedinthestudy(1970to 1994).However,thereal US$ bilateralratewouldhavedivergedsi~lcantly
hornthetradeweightedmultilateral rateprimarilyin the 1980s;thisdataset includestheperiodof interest.
Therefore,weusethesmallerdataset readilyavailabletocomparethevaluesobtainedfor tie ratioswe
calculateusingthebilateralrealexchangeratewiththosefor availabletradeweighted,multilateral real
exchangeratm..
Theuseof multilateral exchangeratesyieldestimatesof theratiosunderconsiderationthatare
remarkablysimilarto thoseobtainedusingbilateralresults.Theoneresdt thatis differentis thebinomial
signt~t for theratio,eDa/e’. TheprobabilitythatHois trueis muchhigherwhenthemultilateral rateis used.
Thisimprobablyduetotheverysmallsample:just fiveobsemations. Theordersof magnitudedonot differ
markedlyfor themeasuresof centi tendency.
Thechoiceof a bilateralrealexchangeratewouldnot seemtoimpactontheresultsinanysignificant
way.At thesametime,usingthebilateralrealexchangeratehasotheradvantages. In particular, -usingthe
bila~ralratepermitsanalysisfor a largersampleof countries,for a longertimeperiod. However,thereare
39
someinstanceswherethedifferencesin thevaluesusingthedifferentreal exchangeraw aremoretian triviaI
(seeTable3.B,particularlyUruguay(columns8 and9, andNigeria).If theanalysisis tobedonefor a single
country,theuseof thetrade-weightedmultilateral real exchangerate wouldbe preferable.For a sampleas
largeas theonein thisstudy,theadvantagesof usingthebilateralreal exchangera~ are greater.
A uuab 4u=* u va a n pu a a n n ~ -m m u t wa u s Uamu AT AUS*SSUC - - -- —.--- .--.= - .—.—
1 2 3 4 5 6 7 8 9
mlciai Parallel mlcial omtid Ratio Ratio, Ratio, Ratio, Ratio,
RealER RealER ERW/ ERwhen #le e“’le &/e”” eple” e“’/e-
1979-94 Parmkt -led
Variable e 4 e
08
e“ 2 / 1 3/1 2/3 2/4 3/4
SummaryStatistim
Wean
Bilateral 118.09 191.01 118.69 8’7.68 1.55 1.01 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 35.74 0.37 0.06 0.42 0.25 0.31
Multilateral 120.95 230.58 117.96 104.42 0.37 0.07 0.43 0.30 0.33
BinomialSignTests
Number <=1
Bilateral o 6 0 0 2
Multilateral o 8 0 1 3
Number>1
Bilateral 10 4 10 6 4
Multilateral 10 2 10 5 3
Pr(HOis true)
Bilateral 0.0001 0.377 0.0001 0.0156 0.3438
Multilateral 0.0001 0.055 0.0001 0.1094 0.6563
——.- — — . .
Source:M-S, WorldCurrencyY*Q CurrencyAnalysis,Inc,variousissues,authorscalcula&ions.
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47
International Finance Discussion Papers
IFDP
Number
564
563
562
561
560
559
558
557
556
555
554
553
552
551
Titles
1996
The Use of the Parallel Market Rate as a Guide
to Settingthe Official ExchangeRate
CountryFund Discountsand the MexicanCrisis of
December 1994: Did Local ResidentsTurn
PessimisticBefore InternationalInvestors?
EasternEuropeanExport Performanceduring
the Transition
Inflation-AdjustedPotential Output
The Managementof FinancialRisks at German
NonfinancialFirms: The Caseof Metallgesellschafi
Broad MoneyDemandand FinancialLiberalization
in Greece
StockholdingBehaviorof U.S. Households: Evidence
from the 1983-89Surveyof ConsumerFinances
Firm Size and the Impact of Profit-MarginUncertainty
on Investment: Do FinancingConstraintsPlay a Role?
Regulationand the Cost of Capital in Japan: A Case
Study
The SovereigntyOption: The QuebecReferendumand
Market Views on the CanadianDollar
Real ExchangeRates and Inflation in Exchange-Rate
BasedStabilizations: An Empirical Examination
MacroeconomicState Variablesas Determinants
of Asset Price Covariances
The TequilaEffect: Theory and Evidencefrom
Argentina
The Accumulationof HumanCat)ital: Alternative
Methodsand Why They Matter ‘
Author(s)
Nita Ghei
StevenB. Kamin
Jefiey A. Frankel
SergioL. Schmukler
Nathan Sheets
SimonaBoata
Jane T. Haltmaier
Allen B. Frankel
David E. Palmer
Neil R. Ericsson
Sunil Sharma
Carol C. Bertaut
Vivek Ghosal
PrakashLoungani
John Ammer
MichaelS. Gibson
MichaelP. Leahy
CharlesP. Thomas
StevenB. Kamin
John Ammer
MartinUribe
Murat F. Iyigun
Ann L. Owen
Pleaseaddressrequestsfor copiesto InternationalFinanceDiscussionPapers, Divisionof
InternationalFinance, Stop 24, Board of Governorsof the Federal ReserveSystem,
Washington,D.C. 20551.
\
48
International Finance Discussion Papers
IFDP
Number Titles
1996
550 Alternativesin HumanCapitalAccumulation:
Implicationsfor EconomicGrowth
549 More Evidenceon the Link betweenBank
Healthand Investmentin Japan
548 The Syndromeof Exchange-Rate-Based
Stabilizationand the UncertainDurationof
CurrencyPegs
547 GermanUnification: What Have We Learned
from Multi-CountryModels?
546 Returnsto Scale in U.S. Production: Estimates
and Implications
545 Mexico’sBalance-of-PaymentsCrisis: A Chronicle
of DeathForetold
544 The Twin Crises: The Causesof Bankingand
Balance-of-PaymentsProblems
543 High Real Interest Rates in the Afierrnathof
Disinflation: Is it a Lack of Credibility?
542 PrecautionaryPortfolioBehaviorfrom a Life-Cycle
Perspective
541 Using OptionsPrices to Infer PDF’s for Asset Prices:
An Applicationto Oil Prices Duringthe Gulf Crisis
540 MonetaryPolicy in the End-Gameto Exchange-Rate
BasedStabilizations: The Caseof Mexico
539 Comparingthe WelfareCostsand the Initial Dynamics
of AlternativeTemporaryStabilizationPolicies
538 Long Memoryin InflationExpectations: Evidence
from InternationalFinancialMarkets
Author(s)
Murat F. Iyigun
Ann L. Owen
MichaelS. Gibson
EnriqueG. Mendoza
MartinUribe
JosephE. Gagnon
Paul R. Masson
WarwickJ. McKibbin
SusantoBasu
John G. Femald
GuillermoA. Calvo
GracielaL. Kaminsky
CarmenM. Reinhart
GracielaL. Kaminsky
LeonardoLeiderrnan
Carol C. Bertaut
MichaelHaliassos
WilliamR. Melick
CharlesP. Thomas
StevenB. Kamin
John H. Rogers
MartinUribe
JosephE. Gagnon
49
International Finance Discussion Papers
IFDP
Number Titles
1996
537 UsingMeasuresof Expectationsto Identi@the
Effects of a MonetaryPolicy Shock
536 RegimeSwitchingin the DynamicRelationship
betweenthe Federal Funds Rate and Innovationsin
NonborrowedReserves
535 The Risks and Implicationsof External Financial
Shocks: Lessonsfrom Mexico
534 CurrencyCrashes in EmergingMarkets: An
EmpiricalTreatment
533 RegionalPatterns in the Lawof One Price: The
Rolesof GeographyVs. Currencies
Author(s)
Allan D. Brunner
Chan Huh
Edwin M. Truman
Jeffrey A. Frankel
AndrewK. Rose
Charles Engel
John H. Rogers