Some central banks have maintained overvalued official exchange rates, while unable to ensure that supply of foreign exchange meets legitimate demand for current account transactions at that price. A parallel exchange rate market develops, in such circumstances; and when the spread between the official and parallel rates is both substantial and sustained, price levels in the economy typically reflect the parallel market exchange rate. “Recognizing reality” by allowing economic agents to use a market clearing rate benefits economic activity without necessarily leading to more inflation. But a unified, market-clearing exchange rate will not stabilize without a supportive fiscal and monetary context. A number of country case studies are included; my thanks to Jie Ren for pulling together all the data for the country case studies, and the production of the charts.

Abstract

Some central banks have maintained overvalued official exchange rates, while unable to ensure that supply of foreign exchange meets legitimate demand for current account transactions at that price. A parallel exchange rate market develops, in such circumstances; and when the spread between the official and parallel rates is both substantial and sustained, price levels in the economy typically reflect the parallel market exchange rate. “Recognizing reality” by allowing economic agents to use a market clearing rate benefits economic activity without necessarily leading to more inflation. But a unified, market-clearing exchange rate will not stabilize without a supportive fiscal and monetary context. A number of country case studies are included; my thanks to Jie Ren for pulling together all the data for the country case studies, and the production of the charts.

I. Introduction

For all legitimate current account transactions, there should be a single exchange rate; but in some countries, there are two (or more) exchange rates for current account transactions—an “official” rate at which demand for FX is not fully satisfied, and a parallel market rate. This may contravene the country’s obligations under the IMF’s Article VIII:1 an exchange restriction or a Multiple Currency Practice (MCP) may arise if the authorities require banks to operate at an exchange rate that does not clear the market, or create separate or segmented FX markets on their territory with excessive spreads between the rates in the different markets. While conceptually, it may be “difficult to treat the spreads arising in illegal parallel markets as the result of an official action, given that the authorities themselves have prohibited transactions from taking place in that market” (IMF 2019, para 37), the existence of parallel FX markets—and the problems associated with this phenomenon—are very real.

Balance of payments weakness and associated exchange rate pressures, related to COVID-19, have seen an increase in such cases. This note discusses the impact of a spread growing over time between the official and parallel market exchange rates for current transactions purposes, and what happens when it is eliminated by a move to a market-clearing rate.2 “Recognizing reality” by abandoning an “official rate” that is not accessible to a significant part of the economy, and moving to a unified, market-clearing rate for current transactions, removes distortions and inefficiencies imposed on the economy by an official rate that is out of line with economic reality. In most cases the inflation consequences of the move—presumptively to the parallel market rate—are relatively small, as prices already reflect the parallel market rate.3 But unification at a market-clearing rate will not of itself bring an end to an inflation and depreciation cycle: supportive interest rate and fiscal policies are important factors in determining the market-clearing rate, both at the time of adjustment, and in the future.

An “official” exchange rate is here used to mean an exchange rate that commercial banks and other regulated entities are legally required to use, when recording actual transactions, and for instance when calculating customs and tax liabilities. It may also be used for statistical purposes. The official exchange rate should reflect the actual exchange rate used in market transactions, whether because the official rate detemines market rates (supply is sufficient to meet demand), or simply reflects the actual market rate.4 In some cases, authorized FX dealers are legally allowed to set exchange rates freely, but the central bank then uses informal guidance (“immoral suasion”) to keep the official market exchange rate at a desired level.

A market-clearing rate implies an exchange rate at which demand and supply are in balance: those seeking FX for legitimate current account transactions can obtain it freely when demanded, and those holding FX surplus to their immediate needs are willing to sell it. It does not necessarily require the adoption of a free-floating exchange rate policy. The authorities may be able to fully satisfy demand at a fixed exchange rate (e.g., Gulf States with long-term fixed nominal rates against the USD), or under a managed floating exchange rate regime, or use instruments other than FX transactions to influence the exchange rate.5

Where capital controls are in place, the existence of the controls nearly always results in a parallel foreign exchange (FX) market, since some economic agents will be prepared to pay a price to evade the controls—which may range from just a few percentage points under “normal” conditions and if the financial account is not entirely closed, to a much larger spread if socio-economic conditions lead to demand for large movements of funds, and the financial account is fully closed. A parallel FX market may also exist for illegal transactions—e.g., money laundering, narcotics trades, human trafficking—even in the absence of capital controls.

The discussion in this note refers only to the existence of a parallel market where FX is purchased/sold for legitimate current account transactions. Where a parallel exchange rate exists for legitimate current account transactions, the same (parallel) market will likely be used for some capital account and other illegal transactions. This note recognizes that there will be an impact on the parallel rate of the inclusion of capital account and illegal transactions, but does not attempt to estimate it.

Case studies of countries that have, over the past 10 years, unified the exchange rate at a market-clearing level, suggest that moving to a market-clearing official rate is not in itself likely to lead to a sharp increase in inflation, since prices in the real economy tend to reflect the parallel market exchange rate already. There is also some evidence that eliminating the distortions can give a substantial boost to economic development, by removing uncertainty as to the availability of FX and strengthening competitiveness. Moreover, if it is true that, in some cases, the benefits of transacting at the official (over-valued) exchange rate accrue to a relatively small number of those with privileged access, moving to a unified exchange rate should mean that those benefits are much more widely spread, thus reducing inequality to some extent.

This paper looks at the question: what happens when the central bank “recognizes reality” and moves to a unified, market-clearing exchange rate. Section II discusses why parallel FX markets emerge, and section III follows with the economic distortions to which substantial and persistent spreads give rise. Section IV examines the motivations of central banks and ministries of finance in addressing the issue, and section V summarizes a number of short case studies. Section VI considers the timing of a move to a market-clearing rate; section VII touches on the importance of good communication of such a move, and section VIII outlines issues concerning the post-unification exchange rate policy. Section IX concludes.

II. Why Does a Parallel Market Rate Emerge?

Many central banks operate a managed exchange rate policy: this is in most cases a peg against a single currency (normally the USD or EUR), or against a basket of currencies, and typically with a narrow trading range (e.g., +/-30 basis points); or a stabilized real effective exchange rate. Maintaining a single exchange rate market—so that the official exchange rate is relevant to the real economy, and legitimate current account transactions can be undertaken easily at or near the official rate—means the central bank needs to ensure that demand and supply for FX against the domestic currency are balanced over time.6 If the central bank has ample FX reserves, and FX inflows at least equal outflows, managing such an exchange rate policy may be relatively straightforward (though it will have consequences for other policy actions and the economy that may be more challenging).7 The central bank in this case is the price maker.

In other cases, the central bank’s official rate will simply be a reflection of the (flexible) market-clearing rate, and the central bank is a price taker. Official FX reserves can of course act as a short-term buffer if the FX market is thin (demand and supply will clearly not be in balance from day to day). A number of central banks operate an FX intervention (FXI) policy that aims to lean against excessive short-term price volatility.

From time to time, a central bank may find that it is no longer able to maintain a managed exchange rate for current transactions—where the central bank is the price maker—because it can no longer ensure that supply of FX is sufficient to meet demand at that price. This tends to happen when the authorities are reluctant to allow the exchange rate to adjust fully in response to excessive fiscal stimulus—perhaps “supported” by monetary financing—that leads to high inflation and balance of payments weakness. It may also reflect shocks to the economy, for instance where a commodity-exporting country suffers from a substantial and persistent decline in the global price of that commodity. In a number of countries, the COVID-19 crisis has led to balance of payments weakness, associated with a fall in remittances, or a sharp decline in tourism revenues, in addition to commodity price shocks.

But sometimes central banks maintain an [overvalued] official exchange rate at which supply does not meet demand and instead attempt to restrict demand administratively. They may do so by prioritizing certain transactions; rationing FX; allowing queues to develop; or setting ceilings for, or even prohibiting, certain current payments.8 In some cases, the central bank detemines two or more “official” rates. A range of preferential exchange rates may be used for different sectors or items e.g., one rate for fuel imports, a second for basic foodstuffs and so on. A multiplicity of official exchange rates is likely to give rise to a multiple currency practice (MCP) under Article VIII of the IMF’s Articles of Agreement.

The approach of using of one or more official rates may be supported by a belief that a strong currency will mean higher growth and lower inflation, while ignoring the underlying problems—such as excessive fiscal stimulus and/or monetary financing—that cause exchange rate weakness and inflation. It may also be promoted by those who can profit from privileged access to FX at the official exchange rate (rent seeking behavior). Some may initially have hoped that an exogenous shock causing exchange rate weakness will quickly be reversed, thus avoiding the need for policy changes, but fail to adjust when the situation is prolonged.

In such cases, a parallel market for current transactions will develop as many economic agents will, if possible, move transactions to the parallel market, whether to obtain a better price if selling FX, or because they cannot obtain FX at the official price.9,10 The wider the spread between the official and parallel rates, the greater will be the incentive to channel FX to the parallel market. At the extreme, the “parallel” market may be the only reliable source of FX for the majority of participants in the economy. The central bank is then acting as if it were a price maker, but without the “fire-power” (FX that is available and it is willing to use) to implement its chosen price effectively.11 Arguably, the parallel market represents economic agents’ solution to a problem created by the central bank. Price levels in the economy are likely to reflect the parallel market rate, either because that is the rate most people and companies have to use, or because those with access to the official rate can benefit by taking excess profits, or expect the possibility of a significant depreciation in the near future and set prices accordingly. The figures in the South Sudan and Sudan case studies (below) illustrate this: the consumer price index and the parallel exchange rate move in tandem (causality is likely bi-directional).

The parallel market represents a market-clearing rate but may not be “the” market-clearing rate for current account transactions. Since the parallel market will be used not only for some current account transactions, but also for illegal transactions e.g., evasion of capital controls, or criminal activities, it may be weaker than a market-clearing rate solely for legitimate current account transactions.12

III. A Large Spread Between Official and Parallel Market Rates Creates Distortions

When an official exchange rate diverges persistently and substantially from a market-clearing rate, this reflects underlying macroeconomic policies and imbalances. Maintaining de jure an exchange rate policy that de facto is neither sustained nor sustainable tends to lead to a range of distortions in the economy, and to lower GDP growth.13

An official rate that is markedly stronger than a market-clearing rate means by definition that demand will always exceed supply.14 If a central bank cannot manage the exchange rate— that is to say, the actual rate that impacts the economy, rather than an official rate at which a limited amount of FX is sold to “priority sectors” or those with privileged access—then the alternative may be a disorderly market: an official rate but with a backlog of demand, delays in access, and a parallel market rate over which the central bank has no control.15 This is problematic for economic agents—particularly for large amounts needed by businesses— who have to obtain FX from banks, for instance, because of the need for an audit trail, and therefore cannot reliably access FX, whether from the official or the parallel market, when needed. Moreover, an overvalued exchange rate always generates excess demand (sometimes referred to as an “overhang” of demand); but this cannot be cleared as long as the exchange rate remains overvalued.16 It is not obvious that the real economy benefits from maintaining the ‘convenient fiction’ of the official rate.

The distortions that are apparent from discussions in IMF member countries include:

  • Banks may struggle to find good projects for lending, in significant part because of the uncertain availability of FX. Most businesses are likely to need some imported inputs, and since they cannot reliably obtain FX when needed, it is always uncertain whether the business will be able to operate effectively and profitably.17 Some companies with a viable business may have to cease operating, or reduce operating capacity, because they cannot maintain machinery, if spare parts need to be imported.

  • Similarly, potential new business ventures may be reluctant to start up, given the uncertainties of being able to obtain FX for necessary imports, even if the bulk of their inputs is domestically sourced.

  • FDI will also be discouraged, if non-residents are concerned that constraints in accessing FX needed for operational inputs may make a venture unviable, or if they expect a substantial depreciation in the near future will make the FDI much cheaper, so that they postpone decisions and investments, or possibly choose an alternative location. In some cases, they get specific exemption from the FX regime, and can retain and use freely the FX they earn abroad.

  • Statistics and corporate accounts will be distorted: in addition to under- and over-invoicing by exporters and importers, banks that have to book transactions at the official, non-market rate may add other fees and costs to cover the real exchange rate used, complicating corporate accounts. Corporates may post lower than actual profits (reflecting under-and over-invoicing), thus reducing government tax revenues.

  • Where remittances from/to individuals abroad represent a significant share of FX inflows, an overvalued official exchange rate will tend to motivate some people to use informal channels for remittances—whether the use of cash, or other channels such as hawalla— and this can lead to a widening of the spread between the official and parallel markets.

  • More generally, AML/CFT controls may be hard or impossible to impose on the parallel market, which also lacks an audit trail.

  • The interbank FX market will be thin or non-existent: banks have a strong incentive to hoard FX to service their own customers, and economic agents have an incentive to keep FX out of the market (for instance by under-and over-invoicing exports and imports).

  • Rent-seeking and dishonest practices are in effect encouraged. Large and persistent parallel premiums create numerous microeconomic distortions. Some economic agents will respond to the incentives by seeking to profit from privileged access to FX at the official rate, or mis-state accounts to offset the impact of mis-aligned official rates on business activities.

  • There may be spill-over to the property market, where investors postpone entry into the market in part because they are waiting for the expected further real depreciation of the domestic currency. One consequence of the further downwards pressure on the property market is that the valuation of collateral held by banks is reduced, making banks reluctant or unable to extend further credit.

  • In general, the uncertain availability of FX may be more of an impediment to business development than the price of FX, or the level of interest rates. The notionally cheap official exchange rate is of little value if supply at that price is substantially insufficient to meet needs.

While the macroeconomic distortions and problems are evident, and the macroeconomic gains from moving to a market-clearing exchange rate potentially significant, the macroeconomic benefits are harder to identify—though clearly those with privileged access to FX at the official rate will obtain some advantage.

IV. Central Banks and Ministries of Finance

The authorities may not want to move to a unified exchange rate. They may believe that a strong (in practice, this means stable) official rate, or multiple rates, can be an effective way to achieve (multiple) goals. Multiple official exchange rates may be seen as a way of providing differential subsidies to critical or vulnerable sectors of the economy, effectively taxing exporters (and other recipients of FX e.g., from remittances), though the impact of such a tax tends to reduce the tax base by damaging the economy’s ability to export, and leads to significant evasion. Problems in assessing the real cost of such subsidies, difficulties in targeting them, and—importantly—susceptibility to corrupt practices, also suggest that this is not an efficient approach.18 A stable exchange rate can indeed bring benefits, including stabilizing inflation expectations and supporting financial stability. But to deliver real benefits, the exchange rate needs to represent a price at which economic agents are willing and able to transact, both buying and selling. If FX is not readily available at this price— because supply of FX at the official rate is significantly lower than demand—the benefits may be fictitious, and the uncertainties may even deliver the opposite results to those desired.

Central banks and ministries of finance may be reluctant to make a “necessary” exchange rate move because of concerns about the transition process and its impact. They may know what they want to achieve—a functioning and sustainable FX market that serves the needs of the economy—but do not make the move because of a lack of clarity about the path to that goal. They may be concerned the transition will be so bumpy/volatile that social or political considerations will derail the move before it can deliver the hoped-for benefits.19 Governments will be uncertain about the net impact on the budget: this will depend on the government’s need for FX (including for debt service); whether imported goods (typically, fuel and some foodstuffs) are and will remain government-subsidized; the extent to which taxable profits are hidden because of the distortionary official rate; and likely benefits to the tax base from a stronger future economy. There may be short-term net costs that change to net benefits in the medium term.

Even if the authorities are convinced of the benefits of moving to a unified, market-clearing exchange rate, short-term, frictional costs of adjustment need to be considered. If the parallel rate is long-standing, economic agents may already have made full adjustment. But the authorities need to consider whether banks and other financial intermediaries are adversely exposed to a large change in the official exchange rate, whether directly or because some customers have borrowed in FX and are not well hedged. Additionally, the impact on the government’s budget, and on any official FX-denominated debt, will need to be taken into account (though both should benefit from longer-term improvements to the economy when distortions are removed).20 Consideration should also be given to the impact on vulnerable sectors in the population. In practice, the most vulnerable in society often gain little or no benefit from an overvalued exchange rate and government subsidies. This needs to be explored on a case by case basis, and an appropriate safety-net to protect the most vulnerable—assuming that they have in practice benefited from the overvalued official exchange rate—should also be factored in.

In the transition to a a market-clearing exchange rate, management of the adjustment process is important. It will be smoother, and the transitional uncertainty minimized, to the extent that fiscal and monetary policies are clearly supportive, and the move is well communicated both to the financial markets, and to the population in general.

But the exchange rate will not stabilize—either in nominal or real terms—unless the underlying causes of the (parallel market) exchange rate weakness are addressed. As suggested by the quote below (from a study on Sudan), exchange rate policy must be viewed within the broader context. Devaluation by itself cannot be a complete solution to wider problems; but an artificially strong official exchange rate does not solve problems either.

“A devaluation policy by itself will not reduce the premium in the long run unless preceded or accompanied by a serious fiscal adjustment. Furthermore, when a large fiscal deficit persists and credibility is low, aggressive devaluation and trade liberalization policies aimed at exchange rate unification and integration of the black market will run the risk of leading to speculation of further devaluations, large scale currency substitution, and a rising premium.” 21

V. Country Experience

The existence, for legitimate current account transactions, of a parallel market exchange rate that is substantially and persistenly weaker than the official exchange rate, is very different to a pegged or tightly-managed exchange rate that is currently market-clearing, but may need to be adjusted. In the former, the real economy has often already made the move and is expecting that the central bank will, at some point, catch up. The price level in the economy will already reflect the parallel market rate. In the latter case, the market may not be expecting a move at all, and so is less likely to be prepared: more price level adjustment (inflation) should therefore be expected. The case studies here cover the former case only.

In the case studies included here, a good time-series for the parallel market rate is available for a few countries, and so is included in the figures. In most, only ad hoc indications are available and are not therefore included in the figures. The focus on the past 10 years means that there are more African countries represented than other regions: as noted in IMF (2018), the geographical focus of the incidence of parallel FX rates “shifted from Latin America, where [they] were prevalent in the 1980s and 1990s due to balance of payments (BOP) difficulties, to other regions, most notably to countries in Africa with BOP difficulties typically resulting from fiscal expansion at the end of the 1990s. Recently, parallel market premia emerged in several commodity-exporting countries that experience terms-of-trade shocks.”

The case studies annexed below aim to address three main questions:

  • Is the parallel market a good indicator of the equilibrium exchange rate? Will the exchange rate fall to the level of the parallel market, or only move part-way e.g., if the parallel rate reflects a premium to evade capital controls?22

  • If the exchange rate depreciates sharply, will it quickly find a new level, or might it carry on weakening well beyond an estimated “equilibrium” rate? If the exchange rate overshoots initially, how quickly will it revert to an equilibrium level?

  • What will happen to inflation? Will interest rate levers have any effect in stabilizing expectations, and how far might nominal (and real) rates have to rise? 23

The figures compare two different factors:

  • (i) The nominal exchange rate against the USD and the price level. This shows two series for the price index: one (CPI1) that sets the CPI equal to the nominal exchange rate at the start of the period, and a second (CPI2) that sets the index equal to the nominal exchange rate after a significant adjustment. If the price level rises faster than the nominal exchange rate, the implication is that the real effective exchange rate is appreciating.24

    • a. CPI1 provides an indication of whether the exchange rate has, over the period as a whole, moved in line with the CPI and, effectively, the inflation differential with the USA.

    • b. CPI2 is included, for those cases where there has been a step change in the exchange rate level, to provide ease of comparison with the exchange rate path after the adjustment.

  • (ii) The rate of inflation and the short-term domestic interest rate. This provides an initial indication of whether interest rates have on the whole been positive in real terms; and whether monetary policy was tightened when/if the exchange rate adjusted. The measure of short-term interest rates should ideally capture the effective policy rate. Since in some cases the posted policy rate is not implemented in a way that impacts markets, where possible, both the policy rate and short-term interbank rates are shown.

In the table below, summarizing lessons from the country cases, there is inevitably an element of judgement and approximation.

While in some cases an exchange rate adjustment is rapid and easily identifiable e.g., Myanmar in March, 2012; in others the start and end dates are less clear. In many cases the adjustment has been made in a short period (from overnight up to a few months), but in others is protracted and takes years. Protracted adjustments may involve a policy change: the central bank may try to control a depreciating exchange rate for a period while allowing a parallel market to develop, and then move to a more market-based approach. A few suggest a long-term policy of stabilizing the REER, but in the shorter-term policy alternates between periods of broadly stable nominal exchange rates, interspersed with sharp adjustments (Ghana, Malawi, Myanmar post 2012, Tajikistan), while others appear to make an insufficient initial exchange rate adjustment, followed by a larger and more sustainable change to the exchange rate around a year later (Azerbaijan, Kazakhstan, Uzbekistan).

The inflation rate shown takes the month of the initial adjustment as the start date, and then the highest rate of inflation in the following 12 months. In some cases, the monetary policy response25 was protracted and tended to lag inflation developments (described as “partial”, e.g., Azerbaijan and Egypt), while in others it was quick and sharp e.g., Kazakhstan in 2015. Pakistan did not have a significant parallel market but did lose substantial FX reserves in the lead-up to the depreciation to a sustainable, market-clearing level.

There is significant variation in the pass-through from the depreciation to inflation, but where the official exchange rate was largely irrelevant (Myanmar in 2012, most obviously), or monetary policy tightening with positive real interest rates was clear, the pass-through appears to be relatively muted. However, even when an economy is already functioning with a free-floating exchange rate (the parallel market is certainly not managed by the central bank), a change in the official rate may impact expectations of future currency weakness— and so feed through to the parallel market rate—unless monetary and fiscal policy are clearly supportive of future exchange rate stability, and well communicated. The pass-through varies for a number of reasons, but in all cases is lower than e.g., the average pass-through ratio of 0.4 found by a World Bank paper in cases where the depreciation was over 20 percent.26

The degree of fiscal stimulus, and of monetary financing are clearly relevant. These are harder to quantify in a time-series for all of the countries involved; we have taken into account, where possible, the level and changes in central bank net credit to the government, and the size of and changes in the budget deficit as a percent of GDP. In most cases we know whether the fiscal context was supportive, and/or changed during or after the exchange rate adjustment process.

There are a number of countries where there is currently (December 2020) a parallel market exchange rate that is some 25 percent or more weaker than the official rate. These include: Algeria, Argentina, Burundi, Ethiopia, Lebanon, Nigeria, Sudan, South Sudan, and Venezuela. They are not included in the table below, because the official exchange rate has not yet been moved to a market-clearing level and so there are no “results” to record.

Table 1.

Summary of country case studies where exchange rate has been unified27

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A number of countries over the past 10 years or so have undergone significant adjustments in the official exchange rate. The evidence from case studies included here (mostly cases where there was a clear parallel market rate, and outlined in more detail in the annexed country case studies) suggests that:

  • (i) When the official exchange rate is allowed to move to a market-clearing level, it does not go into freefall—except perhaps if the market-clearing (parallel market) rate was already in freefall and macro policies are not adjusted appropriately (Argentina, Zimbabwe, and Lebanon provide recent examples of rapidly-moving parallel market rates).

    • If the factors that have caused pressure on the exchange rate persist, then the exchange rate should be expected to carry on weakening. An extreme case is Zimbabwe through 2019, where failure to allow the official rate to move to a market-clearing level, and continued monetary financing in the first half of the year, resulted in a continued depreciation of the market-clearing exchange rate.28

  • (ii) The parallel market rate is likely to be a reasonable indication of the market-clearing rate at a given point in time, particularly if the parallel FX market is well-established and the price well known. But it is important to remember that the parallel market rate is representative of a number of factors: insufficient supply at the official rate; the use of the parallel market to evade capital controls; illegal transactions; uncertainty about the authorities’ future policy actions. Not all of these will feed into a unified market-clearing rate for current account transactions, especially if needed changes to fiscal and monetary policies are credibly undertaken. Moreover, it is not a predictor of where the market-clearing rate for current transactions will move in the future: that depends on the broader macro-context.

  • (iii)The context is crucial: tightening monetary policy at the time of the adjustment is important in helping the market to stabilize; and supportive fiscal policy is essential to stabilization.

    • A new policy for exchange rate intervention (including that there will not be any, if that is the case) will need to be announced, together with a coherent framework for domestic currency monetary policy operations.29 The risk of a persistent exchange-rate overshoot will be mitigated if the central bank announces a monetary policy tightening, which the market will expect to bite once the exchange rate nears a market-clearing level.

    • Monetary policy tightening might not have an immediate impact on reserve money management e.g., if the market starts with a substantial excess of reserve money balances held at the central bank but should nevertheless be important in guiding market expectations. Raising policy rates might not change market responsiveness to monetary operations when the exchange rate is moving, or is expected to move, rapidly. In such situations, the market will be concerned about the opportunity cost of selling FX and holding the domestic currency: the domestic inflation rate at this point is secondary. But it can give a clear signal to the market that the central bank would operate a tight monetary policy stance. It would build expectations that, once the exchange rate had adjusted to (broadly) market-clearing levels, monetary policy would bite; and a policy rate above the expected future rate of inflation should then impact the behavior of economic agents. If tighter policies are announced before or during (rather than after) the adjustment phase, then expectations should adjust faster and become (re-)anchored—allowing interest rates to normalize more quickly at sustainable levels.

    • Continuing fiscal stimulus will tend to weaken balance of payments; monetary financing (and government payment arrears) will lead to higher inflation and so put pressure on the exchange rate. Supportive policies by the government are needed if the central bank is to be able to deliver a measure of exchange rate stability.

  • (iv) The price level in the economy prior to the exchange rate adjustment tends to reflect the parallel market exchange rate, so that the inflation pass-through from an adjustment to the official exchange rate tends to be muted.30 But the monetary and fiscal policy stances are clearly crucial to future inflation developments.

  • (v) If banks and their customers are caught by surprise, they may face losses. But the existence of the parallel market rate in itself indicates that the market is expecting a depreciation. Thus in practice, banks tend to benefit from the depreciation, and economic agents—expecting some measure of exchange rate depreciation—have normally positioned themselves accordingly. State-owned banks may have been pressured, for ‘policy’ reasons, to take a short FX position, and so could be more vulnerable.

  • (vi) Faced with continuing exchange rate pressures, some authorities accuse economic agents of acting as speculators, and attempt to force them to operate with an over-valued exchange rate.31

VI. When and Where to Jump

If moving to a unified, market-clearing rate is “recognizing reality”, then why not simply do it immediately? Indeed, the authorities may be “pushed” before they are ready; and if the (parallel) market has already made the move, policies and instruments need to catch up. The ideal time to move on the exchange rate never comes; a worse time always does.32 Waiting until FX reserves, and policy credibility, are exhausted makes it much harder to manage the transition.

Nevertheless, in discussions with central banks, and as noted above, the potential benefits to future market price formation from communication of a clear and coherent policy package points to taking some time to prepare. Supportive fiscal policiesare an important factor. (The government does need to consider whether its debt servicing costs increase substantially.33 Trade tax revenues are likely to increase with a move to a market clearing rate; this may more than offset the loss of the effective tax on exporters who have to surrender FX at the official rate.34 Consideration should also be given to fiscal subsidies for imported goods including fuel.) If the move to exchange rate unification can be announced as part of a wider, supportive policy package—placing the exchange rate move in the context of a broader macro-stabilization framework—the additional information will support price formation, and so tend to reduce volatility after the move.

A rapid exchange rate unification is likely to be much less costly to the economy than a gradual approach (“death by a thousand cuts”). A gradual approach delays normalization of the foreign exchange markets: economic agents that can choose to retain FX, or have some scope to make early purchases, will typically hoard FX to the extent possible, unless the expected pace of depreciatoin is more than offset by high domestic interest rates. It will thus tend to mean the central bank has to sell more of its FX reserves (and at a cheaper price) than would otherwise have been the case; require a higher level of interest rates for longer (or extended financial repression) if inflation is to be kept under control and economic agents motivated to hold the domestic currency; and the distortions imposed on the economy by the overvalued rate would last longer, while benefits of the move may only start to accrue towards the end of the transition. Indeed, the gradual approach may never reach a new equilibrium.

That said, the authorities may prefer a more gradual approach that allows them to develop alternative monetary anchors. A gradual approach will place a greater burder on the central bank’s communications policy, as it will need to give some guidance to the market without provoking a destabilizing response (speculative purchase of FX, hoarding of goods etc.). Communication of the change in exchange rate policy is difficult (especially is the transition is protracted), but crucial in helping to stabilize expectations. Failure to communicate means more uncertainty, and almost certainly more volatility and a larger overshoot. The move cannot be done unobserved: the exchange rate is very visible, and well known.

It will not be possible to predict precisely how the economy will respond to exchange rate unification at a market-clearing rate. Some factors to which attention should be given include: Has the parallel market exchange rate been stable, or was it depreciating continually—and if so, what was driving the depreciation—since the same factors will impact any unified rate. Is the market deep enough to cope with shocks, or is it better characterized as thin and volatile? Did the parallel market rate respond to the central bank’s use of interest-rate based levers?

VII. Communication

Market communication is important. There are a number of important questions that economic agents ask, and where the answers (or lack of them) inform the process of market-price formation, and the willingness of economic agents to sell FX into the market. The more clarity that the authorities can provide, the quicker the exchange rate will settle into a new equilibrium (though this will rarely be nominal stability against another currency), and the smaller the exchange rate overshoot is likely to be.35 Guidance as to the authorities’ intentions—notably, on providing FX to the market (e.g., via daily or weekly FX auctions), and on domestic monetary policy—should cover the medium-term (more than 12 months). If the central bank provides guidance only for the next month, the market will assume that the situation will be less favorable/more uncertain thereafter. Short-term demand for FX will increase as a result—keeping downwards pressure on the exchange rate and perpetuating the imbalance between supply of and demand for FX in the market. Some of the issues where the market will benefit from clarification/confirmation include:

  • What is the exchange rate policy going forward? The approach of economic agents may be characterised as: “We don’t believe a completely free-floating regime is in place, so we just have to guess what the new policy is if you don’t tell us.”

  • What sort of intervention policy should be expected in future? If the central bank plans to switch from being a net provider of FX to being a net purchaser, it should indicate this to the market.36

  • Use of (im)moral suasion to guide the exchange rate post-adjustment will motivate market participants to keep FX out of the market. It is important to avoid any suggestions that the central bank may revert to managing the rate directly e.g., by calling the banks and telling them what rate to post if it doesn’t like the outcome?37 The central bank’s actions in the days and weeks following a regime change will be crucial.

  • • How will the central bank implement interest rate policy, and what is its policy reaction function?

Clear communication on these points, taking into account the different needs and financial sophistication of various economic agents, is important in facilitating efficient price formation and building credibility in the new exchange rate framework.

The market will also be influenced by expectations regarding: (i) whether the government will be able to resist occasional monetary financing if things get difficult, or to run arrears on payments due to domestic suppliers; and (ii) if monetary policy has to push short-term rates higher, in order to stabilize expectations after a nominal depreciation of the official exchange rate, will the government pay the market rate to cover its deficit financing needs, or will it engage in financial repression? The authorities behavior over time will be important in forming market expectations, and supporting (or not) exchange rate stabilization.

VIII. Exchange Rate Policy Post-Unification

As noted earlier, this paper does not discuss in detail the options for the exchange rate going forwards. This will inevitably be country-specific, ranging from a possible re-peg at a new level, to a free float simply because there is no aternative (indeed, in many of the cases included here, the exchange rate is de facto free-floating for much of the population, even if the official rate is stabilized). Where there is some scope for managing the exchange rate, the broad options include re-pegging and a managed float.

A new peg at a different level

It may be possible to undertake a one-off devaluation, re-pegging at a rate that is sustainably market-clearing—moving from a possibly fictitious peg (where the parallel market was the “real” rate for much of the economy) to a real one. Judging the appropriate new level for the exchange rate is hard if (i) the needed adjustment is large as the margin for error is greater;38 (ii) the causes of the official-parallel spread are not effectively tackled (the “appropriate” exchange rate may be a rapidly-moving target); or (iii) the inflation pass-through from the adjustment is not well estimated or controlled.

A step devaluation to a new exchange rate level (whether pursuing nominal or real stability) will require that the fiscal position and balance of payments be sustainable at that level, and the recognition that the adjustment involves a degree of overshoot (since an undershoot would not deliver sustainability, and it is impossible to know precisely what the right level is). Importantly, the authorities would also need to communicate credibly that future policies would maintain sustainability of the exchange rate, in order to avoid pressures from capital flight.

A managed float

Some countries appear to have allowed a few months of managed exchange rate flexibility, following a large depreciation, in order to “fine-tune” the rate setting before re-fixing e.g., Azerbaijan in 2016. Some that try re-pegging find themselves forced to make a further adjustment within a relatively short period, whether because the underlying pressures on the exchange rate have not been addressed, or because the economy is hit by another shock (e.g., the oil price shock in 2014 that hit a number of commodity exporters was followed in 2020 by a second, COVID-19 related, oil price shock).

A number opt for a managed float rather than a hard peg, following the adjustment. If a more flexible exchange rate is to be adopted, then longer-term stability suggests the need for: developing a deeper and more liquid foreign exchange market; intervention strategies for a flexible exchange rate regime; establishing an alternative credible monetary anchor; instruments available for management of exchange rate risk; and appropriate regulation and supervision. In practice, it may be impossible to develop all these before making the move; and it is impossible to develop any of them fully.39 Recognizing this, some e.g., Agenor (“Orderly exits from adjustable pegs and exchange rate bands”, 2004) argue for an ability to adopt an alternative anchor in a timely manner; capacity to implement monetary policy independently; and maintenance of transparency during the transition. Others have noted that pressure on fixed exchange rate regimes is nearly always a consequence of unsustainable fiscal policies (e.g., Rebelo and Vegh, “When is it optimal to abandon a fixed exchange rate?”, 2008), and thus that it is not just monetary policy that needs to be implemented well, but that broader macroeconomic policies are crucial (e.g., Stan Fischer, Mundell-Flemming lecture 2008).

IX. Conclusions

A decision to “recognize reality” by abandoning an official exchange rate at which demand cannot be satisfied is not determined by, nor does it determine, the future exchange rate regime. Rather, it reflects a recognition that a unified, market-clearing rate will reduce distortions and better serve the real economy. In some cases, it appears that the policy decision was to move to a more depreciated, but still managed, exchange rate at which supply and demand were expected to be in balance (thus avoiding a sustained drain on reserves and/or a significant parallel market spread), but without necessarily changing the general approach to exchange rate policy. In a few cases, there appears to be a policy change, after a one-off depreciation, from stabilized nominal exchange rate to a stabilized real effective exchange rate.

The factors that led in the past to the emergence of the parallel rate will rarely disappear overnight, and to the extent that they continue, a unified market-clearing exchange rate may continue to depreciate in future. But the rate of depreciation should be expected to slow as the authorities tackle the root causes; and if the initial overshoot is large, the nominal rate may even appreciate for a period as the market recognizes the overshoot.

Discussions with country authorities and country teams, and the evidence of the case studies presented in this paper, suggest that abandoning an official exchange rate which is significantly out of line with the FX transactions occuring in the real economy need not, in itself, lead to a jump in inflation or in expectations of future depreciation of the exchange rate. This is particularly the case where the spread between the official and parallel market exchange rates is wide (e.g., more than 50 percent). Indeed, if communicated clearly and credibly and—importantly—as part of a policy package, exchange rate unification at a market-clearing level may strengthen confidence in the future manangement of the exchange rate and so reduce depreciation expectations. It can also reduce uncertainties and facilitate legitimate transactions in the real economy, supporting economic growth.

The “bottom line” is that where an official exchange rate has become irrelevant to most economic actors—because they only have (reliable) access to FX at the parallel market rate—then abandoning the official rate should not be expected to cause macroeconomic disruption. There will of course be losses to those who had privileged access to FX at the official rate; but, importantly, significant net benefits to the broader economy (including the most vulnerable in society) from a unified and market-clearing rate that can be traded easily.