Article

Dual Markets: The Case of the Syrian Arab Republic

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1975
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PAUL M. DICKIE and DAVID B. NOURSI *

Economists have recently been giving increased attention to dual exchange markets as a result of their use in several industrialized countries.1 However, such arrangements have been applied extensively in less developed countries, but for different objectives. Whereas the predominant purpose of two-tier exchange markets in industrialized countries has been to separate disruptive capital flows from regular foreign trade transactions, the dual and multiple markets in less developed countries have generally been a tool for selective devaluation—leading in many cases to across-the-board devaluations. Nevertheless, there is a broad similarity in that the difficulties encountered regarding implementation and maintenance, particularly with respect to evasion and intermarket arbitrage, are almost identical in both industrialized and less developed countries.

In the Syrian Arab Republic, the dual exchange market is of particular interest because of its lengthy history and its evolution in response to the changing environment and policy. In addition, the availability of statistics permits the testing of alternative hypotheses. The dual market was introduced in January 1964 with the establishment of a “parallel market” and, although the dual market was modified in the intervening years, it was effectively maintained until mid-1971.2 The parallel market covered private capital movements and transactions associated with specified goods and services, and the rate in this market was characterized by a persistent but variable discount from the official rate. While there was no official intervention in the parallel market in the form of central bank purchases or sales of exchange, the definition and scope of the market were modified periodically to increase its effectiveness.

This paper assesses the performance of the parallel market and its contribution to the Syrian Arab Republic’s overall balance of payments position. A model is developed in Section I, followed by a statistical analysis of one major subperiod (1964–66) in the history of the market. The principal conclusion is that a parallel market properly formulated and supported by foreign exchange controls can contribute to an improvement in the balance of payments. However, the costs, which are mainly administrative, are substantial.

I. A Dual Exchange Model

The establishment of a parallel market should decrease pressures on a country’s external sector, if the price elasticities of demand for the goods and services transferred to the market satisfy the Marshall-Lerner conditions.3 It can be presumed with some assurance that these conditions are indeed fulfilled in the case of small countries where the export elasticity alone is likely to be greater than unity.4 A second advantage of establishing a parallel market is that the authorities can regain control over transactions previously carried out in a foreign free market. Historically, the Syrian Arab Republic’s principal external market has been located in Beirut, the major international financial center in the Middle East. Transactions in Beirut were largely a means to circumvent exchange controls on outward remittances and capital and, in view of the depreciated rate for the Syrian pound there, it also was profitable for exporters to convert their foreign exchange earnings in this market.

Given the import and export elasticities of the items transferred to a parallel market, the size of the improvement that can be achieved in the overall balance of payments position depends on the extent of the devaluation attainable in that market. A disadvantage of a dual market arrangement is that forces are at work tending to limit the spread between the two rates. As the differential becomes larger, the incentives for intermarket evasion also increase. The resulting change in supply and demand conditions leads to a reduction in the parallel market discount. Therefore, in order to limit the possibilities for such evasion, it is important to segregate the two markets as effectively as possible with exchange controls. The degree of devaluation on a parallel market may be limited not only by arbitrage with the official market but also by a diversion of transactions from an external foreign exchange market (such as the Beirut market mentioned above).

It should be emphasized that not all aspects of the Syrian parallel market can be quantitatively modeled. In particular, no quantitative method exists for estimating accurately the degree of evasion between the official and parallel markets. However, it is possible to gain some measure of the influence of the external Beirut market and to provide some general assessment of the parallel market’s contribution to the Syrian Arab Republic’s balance of payments equilibrium. To this end, a three-equation model is developed below to explain the demand, supply, and average price of foreign exchange on the parallel market. The model is based on monthly data which are available for all variables with the exception of output, where quarterly estimates are utilized.

demand for foreign exchange

The purchase of foreign exchange relating to the import of goods and services on the parallel market is specified as a linear function:

where

Mt=money supply, broadly defined
RPt=price of foreign exchange in terms of Syrian pounds in the parallel market
Si=seasonal dummy
Ut=error term; assumed normal and independent of time, with zero mean.

The reasoning underlying this formulation is that the demand for imports depends on the availability of domestic liquidity (a1 > 0) and on the price of foreign exchange (a2 < 0). Because of the lack of representative price series, it is not possible to reflect the change in relative domestic prices between the exporting countries and the Syrian Arab Republic. As a result, relative domestic prices are implicitly assumed to be constant, and changes in relative prices occur only as a result of exchange rate movements. In order to capture seasonality, monthly dummy variables (Si) were incorporated.

As actual purchases of foreign exchange adjust to demand with a lag, an adjustment function is specified:

where Δlog Zt = log Zt - log Zt-1, and α is the adjustment coefficient. As ± approaches unity, actual imports adjust to demand almost instantaneously while as ± approaches zero, the duration of the adjustment process approaches infinity.

By substituting equation (1) into equation (2) and solving for Zt the estimating equation is determined as:

supply of foreign exchange

The supply of foreign exchange from proceeds of the export of goods and services on the parallel market is specified as follows:

where

Y=real output variable
RBt=price of foreign exchange in terms of Syrian pounds in the Beirut market
Wt=error term

and the other variables are as defined above.

The formulation reflects the effect of changing levels of output and, in particular, of agricultural output on the parallel market exports (b1 > 0). In addition to the rate variable (RP) with an expected positive sign (b2 > 0), the price of foreign exchange in Beirut relative to that in the parallel market (RBRP) is also incorporated in the export equation. The (RBRP) variable is indicative of the profitability of diverting transactions from the Beirut to the Syrian market or vice versa (b3 < 0).

Comparable to the formulation of the import demand equation, the adjustment of actual supply to the desired supply of foreign exchange is as follows:

By substituting equation (4) into equation (5), the estimating equation becomes:

rate determination

The price of foreign exchange on the parallel market (RPt) is specified as a behavioral function of the change in foreign exchange balances held by the commercial banks and the assumed exogenous value of the Syrian pound in the Beirut market:

given log Bt = log Xt - log Zt

Using the Koyck transformation, the estimating equation becomes

where

Ωt = Vt - ΩVt-1

Thus, the model is composed of equations (3), (6), and (8). It is a simultaneous system of equations in that Xt, Zt and RPt must be jointly determined. All other variables are assumed to be exogenous.

II. Experience in the 1964–66 Period

The parallel market was established in January 1964. Initially, it applied to all private imports from neighboring countries, including Lebanon; to imports of some luxury goods irrespective of the country of origin; to all private invisible transactions, except those related to trade effected through the official market and expenditures for study abroad; to exports to neighboring countries of items other than major export products (wheat, barley, corn, cottonseed, lentils, chick-peas, pistachios, raw hides, raw wool, raw cotton, and raw lint); and to all private capital movements. Because of delays in allocating exchange in the official market, the Exchange Control Office was authorized to approve importers’ requests for payment for current imports through the free exchange market. All other exchange transactions, consisting principally of private trade and trade-related invisibles and all official transactions in foreign exchange, were included in the official market.

The fact that the parallel market proved sustainable may be attributed to the supporting framework of exchange controls and the careful selection of the basket of goods and services transacted in the market. Prior to 1964, the Syrian authorities had a broad experience in both the exchange control mechanism and the functioning of a dual exchange market. In 1961, when the free market was abolished, comprehensive exchange controls were introduced, quantitative limits were placed on payments for visible and invisible imports, and dealings in foreign exchange became subject to authorization by the Ministry of Economy. Moreover, most export proceeds were made subject to surrender at the official rate. In 1962 a slight liberalization was introduced, but restrictions were reimposed in 1963 along the same pattern of 1961.

The 1962 liberalization was accompanied by reinstatement of the free foreign exchange market. Although this market was abandoned at the time of reunification of rates in March 1963, it provided useful experience to the authorities. The composition of the parallel market wa similar to that of the 1962 market, although there was a substantia reduction in exports covered; whereas the earlier market included al trade with neighboring countries, the parallel market excluded major export commodities to these countries.

The model developed in the preceding section was estimated by the full-information maximum-likelihood method.5 In the results presented, the ratio of the estimated coefficient to its standard error is shown in parentheses below the coefficient. This ratio can be interpreted as a “quasi-t” statistic, although its distribution is asymptotic normal. The quoted values for the coefficient of determination (R2) differ from those calculated on the basis of least squares in that the coefficient of determination is bound (–∞, 1 rather than 0, 1) and its distribution is not strictly F. Therefore, relatively low R2 values should not be a matter of great concern. The data definitions and sources are described in the Appendix.

The results obtained for the 1964–66 period are detailed in Table 1. In the import equation, domestic liquidity (M) shows a strong positive effect on the demand for foreign exchange. The coefficient is significant and indicates that for every percentage increase in liquidity the demand for foreign exchange in the parallel market expands by over 2 per cent. The coefficient for the price of foreign exchange (RP) has the expected negative sign but is not significantly different from zero. If intermarket arbitrage was an important factor, it would have reinforced the strength of the rate variable. The absence of such an effect can be taken as a strong indication that evasion either did not occur or was minimal; this can be attributed, in addition to stringent exchange controls, to the formation in 1965 of a state agency given exclusive rights to import many of the “nonessential goods” transacted in the parallel market.6 The estimated coefficient of lagged imports has the expected positive sign and is significantly different from zero. Since this coefficient is (1-α), it implies that about 95 per cent of the adjustment of imports to demand takes place within three months.

Table 1.Structural Model of the Syrian Parallel Market, 1964-66
logZt=4.0360+0.3670(5.86)logZt1+2.1154(3.72)logMt1.5452(0.54)logRPt+a3a13Si1R2 = 0.833
R2 = 0.833
logXt=43.3355+0.4095(2.86)logXt1+7.5240(2.32)logRPt3.3695(1.27)log(RBRPt)+b4b14Si1R2=0.858
logRPt=+0.5112+0.5825(5.57)RPt10.0241Bt(2.31)+0.3327logRBt(4.11)R2=0.799

The coefficients and their “quasi-t” values are not detailed in the interest of brevity. Although there is significant seasonality in these series as tested by the X-11 program over the extended time span of 1964–71, many of the coefficients for the seasonal dummies in the shorter 1964–66 period were not significant.

The coefficients and their “quasi-t” values are not detailed in the interest of brevity. Although there is significant seasonality in these series as tested by the X-11 program over the extended time span of 1964–71, many of the coefficients for the seasonal dummies in the shorter 1964–66 period were not significant.

With respect to the sale of foreign exchange receipts, the rate (RP) is highly positive and significant. For a 1 per cent increase in the rate, export receipts increased by 7.5 per cent in the short run and, given the adjustment lag, by over 12 per cent in the longer run. The magnitude of this coefficient suggests that intermarket arbitrage was taking place—for example, exporters were transshipping from neighboring countries to obtain the parallel market rate. The relation between the Beirut and parallel market rates (RBRP) has the expected sign, although the coefficient is not significantly different from zero. The general indication is that, as this ratio increases, foreign exchange receipts would be settled in Beirut rather than in the parallel market. As indicated by the model formulation, an attempt was made partly to explain exports by a supply variable; although several such variables were tried, none was found significant, perhaps because of data limitations and the lack of variation in supply over this time period. The lagged value of exports has the expected positive sign and indicates that adjustment was somewhat slower than that for imports.

The rate determination equation indicates, as expected, that the Syrian authorities fixed the parallel market rate with two main considerations: the existing stock of foreign exchange and the level of the Beirut rate. The coefficient for the Beirut rate, both positive and significantly different from zero, suggests that the authorities responded to the longer-term trend; the adjustment on month-to-month changes was only one third but it increased to about 80 per cent over a longer period. The lagged value of RB incorporated in the model formulation was dropped because it was insignificant, undoubtedly due to multicollinearity. The change in the stock of foreign exchange (Bt) has the expected negative sign and the coefficient is significant. The lagged value of the rate is significant and the value of the adjustment coefficient (0.5825) indicates a much slower adjustment process than might have occurred if the rate had been completely free to fluctuate with market forces. The relatively long lag is undoubtedly associated with the fact that the rate changes were based on perceptions of month-to-month trends rather than on the shorter-term fluctuations.

As indicated in Chart 1, the model appears to track reasonably well. The simulated parallel market rate shows a slight tendency to lag the actual rate. However, the correspondence is generally good, except perhaps at the peaks and troughs of the curve. The lack of successful duplication in those areas reflects the difficulties faced by the authorities in setting the rate at turning points in the underlying economic situation.

Chart 1.The Exchangge Rate in the Syrian Parallel Market, 1964–66

A rough overall assessment of the parallel market’s performance can be made by utilizing the estimated elasticities and calculating the change in the balance of payments if the official rate had applied to this basket of goods and services over the 1964–66 period. On average, the parallel market rate was 410 Syrian piasters per U. S. dollar. With an appreciation of 7.4 per cent to attain the official rate of 380 Syrian piasters per U. S. dollar, imports of goods and services in the parallel market would have increased by 11 per cent [(– 1.5) X (– 7.4)], while exports would have declined by 56 per cent [7.5 X (– 7.4)]. Taking the respective volumes involved, the balance of payments would have deteriorated by the equivalent of 500 million Syrian pounds or US$132 million at the official rate.7 This would have been a relatively large amount for the Syrian Arab Republic, given that the Central Bank’s gross reserves at the end of 1966 were equal to US$79 million. It should be noted that if the parallel market had been eliminated in this way, export settlements would have increased in Beirut by an amount on the order of 70 million Syrian pounds or US$18 million.

As a quasi-efficiency test of the rate-setting behavior of the authorities in the parallel market, the model was run to simulate the effect of equating the parallel market rate with the Beirut rate. No significant differences were detected with respect to import and export volumes. It should, therefore, be concluded that the parallel market rate was established with reasonable effectiveness with a view to achieving a maximum contribution to the balance of payments.

III. Economic Forces from 1967 to Mid-1971

An attempt to model the economic factors influencing the volumes of exports and imports as well as the rate-making behavior for the period 1967 to mid-1971 gave unsatisfactory results. Economic forces had less explanatory power when compared with the preceding period of 1964–66; the hypothesized adjustment process, demonstrated for the earlier period, was not evident—due, undoubtedly, to the disturbances introduced by a number of factors, including the use of nonmarket controls not only to segregate the two markets but also to influence the volume of transactions.

Initially, substantial changes were made in the scope and operation of the market. At the end of 1966, the regional element in the distribution of trade between the official and parallel markets was eliminated and the allocation was thereafter purely on a commodity basis.8 This resulted in a simplification of the exchange control system, as the problem of transshipments was eliminated (for example, an exporter transshipping from a neighboring country to obtain the parallel market rate). Moreover, the mixing of rates was somewhat reduced, since it was decided that the advance deposit required for effecting imports at the official rate would no longer be purchased in the parallel market. However, the Exchange Control Office could allow importers who had bills overdue on the official market to purchase exchange in the parallel market. The net effect of the reallocation of trade and other measures was to expand the scope of the parallel market.

In the two years ended in 1968, the parallel market rate was maintained in line with the Beirut rate, although month-to-month changes in the latter were not followed. The parallel market recorded overall surpluses in both 1967 and 1968, due in part to the expansion of allowable exports and other measures in mid-1968.9 Moreover, following the June 1967 Middle East conflict and its aftermath, the exchange and payments system was modified by numerous restrictive measures, most of which were later rescinded.10 In addition, an increasing share of foreign trade came under the control of public agencies11 while the agencies were being reorganized.

In 1969 the parallel market recorded a large deficit. Early in the year, import restrictions were relaxed, and import payments on the parallel market increased substantially. Moreover, parallel market exports did not respond favorably, despite satisfactory levels of production,12 and a gradual depreciation of the rate from 4.20 to 4.27 Syrian pounds per U. S. dollar between April and December.

In April 1970 the exchange and payments system became more restrictive following the introduction of a foreign exchange budget encompassing quotas for most commodities (about 400 tariff items). As these quotas applied to the year as a whole, imports for which the quota was filled were suspended for the rest of the year. Exports on the parallel market declined, mainly because of the reduced agricultural output, and the market recorded a small deficit. During most of 1970, the parallel market rate was held at 4.32 Syrian pounds per U. S. dollar; it therefore diverged increasingly from the Beirut rate, which gradually depreciated to 4.51 Syrian pounds per U. S. dollar.

The new Syrian Government, which took office at the end of 1970, liberalized the import trade appreciably in the early months of 1971,13 and imports increased markedly. Although agricultural output and overall production increased substantially in 1971, exports showed no growth and the parallel market recorded increasing month-to-month deficits in the first half year. While the parallel market rate was held at 4.32 Syrian pounds per U. S. dollar, the Beirut rate continued to depreciate and the spread between these two rates widened. Finally, in mid-1971, foreign exchange transactions being effected in the official market were gradually transferred to the parallel market, and the dual rate arrangement was eliminated.

IV. Conclusions

Provided that the Marshall-Lerner conditions are met, a dual exchange rate arrangement contributes to an improvement in the balance of payments because of the devaluation it achieves in the parallel market. The statistical analysis covering the period 1964-66 confirmed that this improvement was indeed substantial in the Syrian case, reflecting the relatively high export and import elasticities for items transferred to the parallel market. Other interesting findings of the analysis include the strong effect of the domestic liquidity variable on the demand for foreign exchange and also the successful rate-setting performance of the Syrian authorities in light of their objectives. It is unfortunate that the statistical methods used could not yield satisfactory results in the subsequent period beginning in 1967; this, however, is understandable, given the exchange control practices and extensive state trading in that period.

APPENDIX: Data Definitions and Sources

Parallel Market Rate (RP): Monthly averages of daily rates in Syrian piasters per U.S. dollar. Source: Central Bank of Syria. A series covering recent periods is published in The Central Bank of Syria Bulletin.

Beirut Rate (RB): End-of-month rate in Syrian piasters per U. S. dollar. Source: Bulletin Statistiques Mensuel, Direction Centrale des Statistiques, Lebanon (various dates). Daily rates and/or monthly averages are not currently being published.

Volume of Purchases and Sales in the Parallel Market (Z and X): Monthly volumes in millions of Syrian pounds. Source: Central Bank of Syria.

Money Supply (M): End-of-month data, with broad definition of money in millions of Syrian pounds. Source: International Monetary Fund, International Financial Statistics, various issues.

Industrial Origin Output Data (Y): Annual data, in millions of Syrian pounds, at 1963 prices. Source: Central Bureau of Statistics, Statistical Abstract (Damascus, 1971). Quarterly estimates utilized in the analysis are derived as follows (i = quarters):

Mr. Dickie, Assistant Division Chief in the Middle Eastern Department, has degrees from the University of British Columbia (Canada) and from the University of Southern California. He has been a member of the faculty of the George Washington University and Director, Economics Branch, National Energy Board, Ottawa. He has also contributed a number of articles to professional journals and is coauthor of Multinational Corporations and Eastern European Socialist Economies.

Mr. Noursi, a senior economist in the Middle Eastern Department, was educated at San Francisco State College, the American University of Beirut, and the University of Iowa. Before joining the Fund, he was Deputy General Manager of a commercial bank in Jordan and prior to that was Director, Research Department, Central Bank of Jordan. He also worked for the Central Planning Commission of Jordan, contributing to the formulation of the Seven-Year Development Plan of Jordan, 1963–1970.

See, for example, Vittorio Barattieri and Giorgio Ragazzi, “An Analysis of the Two-Tier Foreign Exchange Market,” Banca Nazionale del Lavoro, Quarterly Review, No. 99 (December 1971); and J. Marcus Fleming, “Dual Markets and Other Remedies for Disruptive Capital Flows,” Staff Papers, Vol. 21 (March 1974), pp. 1-27.

Officially the parallel market continued until July 1973 when it was subsumed in an overall reform of the exchange system. However, from mid-1971 to the end of 1971, most transactions were transferred to the parallel market; from December 1971 to July 1973 only the exports of petroleum and cotton and the inward transfers of pipeline transit dues were maintained at the official rate. All of these transactions were under the jurisdiction of public agencies, and the requirement for domestic budget adjustment was the apparent basis for the reluctance to unify the rate.

This ignores capital transactions in which the effect of yield differential should be taken into account, but capital movements, other than those for the settlement of trade accounts, were relatively small during the relevant period. Nevertheless, there was some outward capital transfer in response to exchange controls, as well as substantial inward remittances from Syrians working abroad, but neither of these is very responsive to interest rate differentials.

Moreover, if, as expected, the covered goods and services recorded a deficit prior to transference, the sum of the export and import elasticities can be less than unity and yet a net improvement on devaluation would occur. See, for example, Charles P. Kindleberger, International Economics, Irwin Series in Economics (Homewood, Illinois, rev. ed., 1958), pp. 610–12.

The estimation technique was developed by C. R. Wymer, London School of Economics, and adapted by Niranjan S. Arya and Mohsin S. Khan of the International Monetary Fund staff.

The Import and Export Company of the Public Sector (SIMEX) was formed February 18, 1965. Nationalized exports (cotton, wheat, barley, and their derivatives) accounted for 75 per cent of total exports, and they were almost exclusively transacted on the official market. Nationalized imports accounted for 55 per cent of total imports and included both basic and nonessential commodities.

The magnitude of contribution would be even greater if the long-term elasticities had been utilized in the calculation. However, even at the indicated level, there is undoubtedly some overstatement due to the suspected presence of inter-market evasion with respect to exports.

The official market applied to (a) export of major commodities and other items, such as raw cotton and by-products, wood, leather, cereals, and crude petroleum; (b) import of essential consumer goods, basic raw materials, and capital equipment; (c) invisible transactions relating to trade settled in the official market, remittances for study abroad, servicing of government debt, and pipeline royalties; and (d) government capital transactions.

The parallel market applied to (a) exports of other specified items, including most processed and manufactured goods, such as yarn, woven fabrics, clothing, iron and steel products, soap, cement, cattle, and poultry; (b) all other invisible transactions; and (c) private capital transactions.

Substantial export volumes (for example, animal offal, woodboard, and jute) encompassing eight tariff items were shifted from the official to the parallel market. On the other hand, some exports were shifted to the official market, and part of the remittances for students studying abroad was shifted to the parallel market.

For example, the exports of many foodstuffs and other prime necessities were banned from July 23 to September 27, 1967, and the stringent exchange controls regarding import payments imposed on July 13, 1967 and overseen by a Special Foreign Exchange Commission were partially relaxed on January 20, 1968 and eliminated in February 1969.

For example, exports of cottonseed cake (January 9, 1967), export and import of medical and pharmaceutical products (May 7, 1967), exports and imports of sunflower seeds (February 8, 1968), imports of alcoholic beverages (March 9, 1968), export of cotton waste and lint (March 9, 1968), and imports of synthetic yarn (April 18, 1968) were nationalized.

This may be due to the reorganization of SIMEX, on September 1, 1969.

For example, as of January 9, 1971, importation was permitted of a large number of agricultural goods previously prohibited or suspended; and as of February 25, 1971, importation was allowed for a number of previously prohibited or suspended foodstuffs.

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