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References

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*

The author would like to thank, without implication, Jagdeep Bhandari, Dean DeRosa, Joshua Greene, Steven Kamin, Mohsin Khan, Saul Lizondo, Peter Montiel, and Carlos Végh for many helpful comments on a previous draft of this paper.

1/

According to data presented in the World Currency Yearbook, 1987, parallel currency markets exist in all developing countries, except the high-income oil exporters. The evidence available suggests that parallel currency markets have recently increased in size and sophistication in many countries, in relation with capital movements.

2/

As such, magnitudes mentioned here should be treated with a certain amount of caution.

3/

The expressions “parallel”, “fragmented”, “informal”, “black” (which has an illicit connotation), and “curb” markets have been used interchangeably in the literature. Lindauer (1989) provides an analytical distinction between these alternative descriptions of market structure. He defines a parallel market (p. 1873) as “…the structure generated in response to government interventions which create a situation of excess supply or demand in a particular product or factor market”. Government price fixing (through taxes, regulations, and prohibitions) plays, therefore, a prominent role in the creation of excess demand at official prices and in the emergence of a parallel market. See also Feige (1989).

4/

The nature of these restrictions is well documented in the Annual Report on Exchange Restrictions published by the Fund.

5/

Parallel exchange rates are taken from the World Currency Yearbook (formerly Pick’s Currency Yearbook), and official exchange rates are from the IMF database. Data are end-of-period exchange rates relative to the US Dollar.

6/

Figure 1 also suggests the existence of a clear seasonal pattern for some countries (Malaysia and Morocco, for instance). At a more formal level, Akgiray, Booth and Seibert (1988) provide a statistical analysis of the distribution properties of parallel market exchange rates for 12 Latin American currencies. See also Akgiray, Aydogan, and Booth (1990).

7/

In some countries, however, capital controls (often motivated by recurrent balance-of-payments difficulties) were the primary factor leading to the emergence of an informal market in foreign exchange. See, for instance, Kamin’s (1990) account of Argentina’s experience in the 1930’s.

8/

For a general description of illegal transactions, see Bhagwati (1978, pp. 64-81). An interesting case study of Indonesia is described by Cooper (1974).

9/

The imposition of a tariff, by itself, creates incentives for smuggling but does not create incentives for the emergence of a parallel currency market. Such a market will usually emerge only if foreign exchange controls are in place. In the particular case where legal trade requires the sale or purchase of legal foreign exchange, the existence of a positive tariff will also be sufficient to induce illegal trade activities and foreign currency transactions (Pitt, 1984).

10/

Restrictions on capital flows may take the form of taxes or discriminatory reserve requirements on non-resident bank deposits, etc. Phylaktis and Wood (1984) provide an analytical framework for classifying, and appraising the impact of, various forms of exchange controls. Swidrowski (1975) provides an extensive discussion of various aspects of foreign exchange and trade restrictions.

11/

Greenwood and Kimbrough (1986) motivate the existence of a parallel currency market with a cash-in-advance requirement that forces individuals to accumulate foreign currency (either officially or illegally) before they can consume.

12/

A strictly illegal market often develops into a tolerated one —or becomes officially recognized and legitimized, as in Bangladesh in 1972, in the Dominican Republic in 1982 or in Guyana in 1987— as its scope of operations expands and the authorities recognize its inevitable character and relative benefits.

13/

This does not preclude substantial variations within countries. For instance, in Guyana, the exchange rates offered in border towns are significantly more depreciated relative to those quoted in the “Wall Street” area of Georgetown (Thomas, 1989).

14/

This may be the result of the “convenience” of the US dollar in international transactions or a “safe haven” effect. The use of US currency notes may also result from the importance of non-trade-related sources of supply and demand for foreign exchange in the parallel market.

15/

Government officials may also allow diversion foreign exchange from the official to the parallel market in return for bribes and favors.

16/

Smuggling may take place with regards to legal or prohibited goods. Cocaine exports, for instance, is considered to account for a large share of the unofficial inflow of US dollars in certain Latin American countries. In Brazil, illegal trade (gold and coffee exports, in particular) is believed to account currently for nearly 30 percent of foreign currency supply in the parallel market (Novaes, 1990).

17/

The extent to which traders engage in fake invoicing is typically measured by partner country trade-data comparisons. To investigate the scale of under-invoicing or over-invoicing of exports, for instance, one would need to look at the ratio of exports to major partner countries, as shown by domestic data, to the corresponding imports as recorded in partner country data. When this ratio is less than unity, the evidence points to under-invoicing of exports. To be able to make these partner-country comparisons, however, it is important to adjust the trade data for transport costs, timing of transactions, and classification of transactions. See McDonald (1985), Gulati (1988), and Arslan and van Wijnbergen (1989) for recent attempts to use these procedures to estimate the degree of under- and over-invoicing in foreign trade transactions.

18/

See Arslan and van Wijnbergen (1989) for econometric evidence supporting this proposition in the case of Turkey.

19/

This view suggests the existence of a trade-off between the premium and the rate of inflation in financing a given real fiscal deficit. The implications of this trade-off for unification strategies is examined below.

20/

Montiel (1990) provides an analytical discussion of the role of parallel foreign currency markets (as well as informal credit markets) in the transmission mechanism of monetary policy.

21/

The welfare effects of foreign exchange restrictions have been analyzed by Greenwood and Kimbrough (1986). Using a choice-theoretic cash-in-advance general equilibrium model, they examine how the imposition of foreign exchange controls affects decision making by private agents, notably the decision to evade the restrictions by purchasing foreign currency illegaly in the parallel market. They show that while foreign exchange controls may improve the trade balance and the balance of payments of an economy with parallel markets, they unambiguously lower economic welfare. This is because foreign exchange controls essentially place a quota on imports, thus raising their domestic relative price in the same manner as a tariff would.

22/

Policies of active repression of parallel markets have been attempted by some countries (Guyana in 1980, Tanzania in 1983, or Algeria in May 1990). It has proved difficult to maintain an agressive or punitive stance against well-entrenched informal activities.

23/

See Quirk et al. (1987, 1989).

24/

In addition to the approaches discussed here, there have been some recent attempts to integrate informal markets in goods and foreign currencies in Computable General Equilibrium models; see Franco (1985), Azam and Besley (1989), and Nguyen and Whalley (1989). See also Charemza and Ghatak (1990) for a disequilibrium approach.

25/

The treatment of risk in real trade models of smuggling is critically examined by Sheikh (1989).

26/

In Blejer’s model, flow monetary disequilibrium is measured as the difference between the expansion of the domestic-credit component of the base (and variations in the money multiplier) and the changes in the demand for real cash balances.

27/

The Dornbusch et al. formulation (and also that of Frenkel, 1990) is not particularly adequate for the majority of developing countries with underdeveloped financial systems. Moreover, the process of currency substitution —whereby foreign-currency denominated money balances increasingly substitute for domestic money as a store of value, unit of account, and medium of exchange— has gained importance in many countries over the past few years.

29/

Edwards and Montiel (1989) for instance consider a three-good economy and develop a fairly general analytical framework, but they assume that foreign currency holdings remain constant —excluding therefore an important source of dynamics.

30/

In addition to its impact on the propensity to under-invoice exports, an increase in the premium —without an equivalent increase in domestic prices— may generate a positive wealth effect on aggregate demand, which may further deteriorate the current account of the balance of payments.

31/

In some models of dual exchange markets with leakages discussed below —in particular those of Gros (1988) and Bhandari and Végh (1990)— arbitrage flows between markets eliminate the exchange rate differential through time, so that the steady-state value of the premium is zero. This result, however, derives from the implicit assumption that arbitrage activity is subject to negligible transaction costs.

32/

The unification issue is discussed below.

33/

Nowak’s (1984) result, according to which an official devaluation will be associated with an appreciation of the parallel exchange rate, depends critically on the assumption that the central bank does not accumulate foreign exchange (Kamin, 1988b, pp. 8-9).

34/

An increase in the parallel market rate, given the official exchange rate, increases the share of exports channeled through the unofficial market for foreign currency via under-invoicing or smuggling, and thus increases the flow supply of foreign exchange. Conversely, import demand will fall, as well as the share of imports channeled through the parallel market (as a result of over-invoicing or smuggling), which will in turn decrease the flow demand for foreign currency.

35/

Dornbusch et al. (1983) present empirical tests of their model for Brazil, while Phylaktis (1989) considers the case of Chile. The results show a significant impact of the interest rate differential —as well as, for Chile, the degree of capital restrictions— on the parallel market premium. Fishelson (1988), using the actual rate of depreciation of the parallel market rate as a proxy for the expected rate of official devaluation, tests the Dornbusch et al.’s model for a group of for 19 countries over the period 1970-79. More recently, Kaufman and O’Connell (1990) have provided estimates of the model for Tanzania, over the period 1967-88. Portfolio factors are shown to affect the behavior of the parallel market premium mainly in the short run, while flow factors play a predominant role in the long run.

36/

The early strand of literature was based on the assumption that the dual exchange markets were effectively segmented, implying that the freely floating exchange rate would ensure a zero capital account. As a result, a major channel of transmission of external disturbances —via movements in foreign assets— was completely eliminated.

37/

Note that in a dual rate system (with a fixed commercial rate and a freely floating financial rate) an illegal parallel market may persist, owing to the retention of (some) capital controls.

38/

The recent experience of Argentina provides a good illustration of this proposition. Following the devaluation of December 1989, the premium dropped immediately. But, because of the lack of financial discipline, the free market rate rose quickly to 1,230 (continued from page 25) australes, bringing the premium back to 23 percent. See Kamin (1990) for a further analysis.

39/

Bolivia has since moved to a fairly flexible exchange system, based on daily auctions of predetermined amounts of foreign exchange without restrictions on access to participants. Other countries that have recently pursued an exchange rate policy involving the adjustment of the official exchange rate to the parallel market premium include Bangladesh and Ghana.

40/

Policy discussions have often been centered on the idea that the restriction-free equilibrium exchange rate lies “somewhere” between the official exchange rate and the parallel rate —although it has long been recognized that the latter is often subject to erratic movements due to fluctuations in the demand and supply of foreign currency. In fact, as shown by Lizondo (1987), the equilibrium official rate can be either above or below the parallel rate.

41/

The effect will also depend on whether the balance of payments before the unification attempt is in deficit or in surplus. An initial deficit for instance —which implies that the excess demand for foreign exchange was partly accomodated through changes in international reserves— will translate, upon unification, into a higher rate of depreciation of the official exchange rate and a higher inflation rate.

42/

This helps illustrate the difficulty involved in using the parallel market rate as an indicator for the initial level of the official exchange rate in the crawling peg regime. If private agents anticipate the unification attempt, the parallel rate will move immediately —before the reform is implemented— towards the level the authorities are expected to set the official crawling rate. Consequently, setting the initial, post-reform rate at the level the parallel rate is at the time of unification will be consistent with balance-of-payments equilibrium only if expectations are correct.

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Other developing countries that have recently adopted a floating regime include Uruguay (in late 1982), Jamaica and the Phillipines (in 1984), Bolivia and the Dominican Republic (1985). The move occured in most cases at a time of increasing external payments difficulties and increasing arrears (with reserves no longer available to support the fixed exchange rate), extensive parallel currency markets (syphoning off foreign exchange from the official channels) and capital flight. See Quirk et al. (1987, 1989), and Pinto (1989). See also Branson and Macedo (1989) for an analysis of the (failed) attempt by Sudan to unify its exchange system in November 1981-March 1982, and Hausmann (1990) for a review of the Venezuelan experience with multiple exchange rates during 1983-89.

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Faced with the possibility of a future depreciation of the parallel rate, asset holders reallocate their portfolio away from domestic money, thereby causing the free exchange rate to depreciate immediately, and thus the premium to increase prior to the depreciation of the official rate. The pattern depicted in Figure 3 is consistent with the results reported by Kamin (1988b), Edwards (1989), and Edwards and Montiel (1989).

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Distributional implications of parallel currency markets are examined by González-Vega and Zinser (1987), in the context of the Dominican Republic.

Parallel Currency Markets in Developing Countries: Theory, Evidence, and Policy Implications
Author: International Monetary Fund