Abstract
Burundi’s foreign exchange market is characterized by strong restrictions that have contributed to external imbalances and led to the burgeoning of a sizable parallel market where the currency currently trades at close to a 60 percent premium. Going forward, unifying the exchange rate, and reducing these distortions is an important near-term objective for authorities.
The Parallel Foreign Exchange Market in Burundi and the Path Towards Reform1
Burundi’s foreign exchange market is characterized by strong restrictions that have contributed to external imbalances and led to the burgeoning of a sizable parallel market where the currency currently trades at close to a 60 percent premium. Going forward, unifying the exchange rate, and reducing these distortions is an important near-term objective for authorities.
A. Overview
1. Over the last six decades, Burundi has had several episodes of transitions into and out of episodes of predominant parallel exchange rate markets. The most recent one began in 2015 with the parallel market premium against the US dollar increasing from 1 percent in end-2014 to about 70 percent in December 2021, placing it among the highest instances of parallel premia observed since the 1960s (Figure 1).2
Historical Occurrences of Large FX Market Premia
(Percent, log difference)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Sources: Gramacy, Malone, and Horst (2014)Historical Occurrences of Large FX Market Premia
(Percent, log difference)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Sources: Gramacy, Malone, and Horst (2014)Historical Occurrences of Large FX Market Premia
(Percent, log difference)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Sources: Gramacy, Malone, and Horst (2014)2. This section draws on lessons from the literature and recent country experiences to understand the causes and consequences of parallel FX markets in Burundi and the key tradeoffs that authorities are likely to face when attempting a unification.
B. Parallel FX Markets: Occurrence, Pros, and Cons
3. A parallel foreign exchange market system is one in which two nominal exchange rates that are substantially different from one another operate simultaneously in an economy. Typically, one of these is the official exchange rate that is fixed by regulation, while the other is a freely floating and market determined “parallel” exchange rate. Parallel markets typically emerge when authorities impose substantial volume or price restrictions at which official FX transactions can take place. In theory, a parallel exchange rate system can be beneficial under certain circumstances. For example, it can help ensure the stability of current account transactions (at the official rate), while shielding the terms of trade and hence the variation in imports and exports from volatile fluctuations in financial markets and the capital account (at the parallel rate).
4. In practice though, parallel exchange rates in developing countries have rarely provided any benefits.3 Instead, economies characterized by parallel FX markets tend to suffer from increased uncertainty and depressed macroeconomic outcomes (IMF, 2018). This is in large part because parallel markets distort prices in the economy and create significant impediments towards efficient resource allocation. They generate sizable implicit taxes and subsidies in the economy depending on access to the official FX market, and in turn create incentives for rent seeking and misreporting (for instance for export revenues). For instance, exchange rate restrictions resulted in an estimated implicit tax on exporters amounting to 3.6 % of GDP.4 In addition, parallel markets also impinge on the efficacy of monetary policy since the exchange rate is an important conduit of monetary policy transmission.
5. Given that the costs of the existence of a parallel FX market invariably tend to outweigh its benefits, exchange rate unification becomes an important objective for policymakers whenever the parallel market premium becomes significant. A reform to tackle parallel exchange rates relies on four key steps. First, a recognition of the channels through which exchange rates affect the economy, and an assessment of the vulnerability of various segments of the economy to large movements in the exchange rate. Second, an assessment of the equilibrium exchange rate for the economy that would be consistent with macroeconomic and external stability over the medium term. Third, agreement on a time horizon over which the transition to this equilibrium should be implemented. Fourth, implementation of a robust macroeconomic framework, including coordinated fiscal objectives and monetary policy frameworks and objectives, which would ensure a smooth transition as well as the sustainability of the new regime. The remainder of this section considers each of these factors in turn.
C. Channels of Transmission of Exchange Rates
6. The literature has identified three main channels through which exchange rates affect macroeconomic outcomes. Chief among them is the textbook trade channel, whereby an exchange rate depreciation leads to an increase in import prices (and hence consumer price inflation) and a decrease in export prices, in turn boosting economic output via an increase in net exports. The strength of this effect depends on the trade elasticities-the sensitivity of import and export volumes to their respective prices.
7. The second channel is the financial channel of exchange rates, which is particularly strong in emerging markets and developing economies. When segments of the economy carry a currency mismatch, typically due to unhedged foreign currency debt, they are vulnerable to a sudden tightening in financial conditions when the exchange rate depreciates. The tightening in financial conditions leads to a decline in credit, investment, and production. If currency mismatches in the economy are large enough, this channel can even offset the positive effect of an exchange rate depreciation on output via the trade channel (Kearns and Patel 2016).
8. The volatility and uncertainty of the exchange rate have also been shown to be important drivers of macroeconomic outcomes, particularly for foreign investment, in addition to the trade and financial channels which are linked to the level of the exchange rate (Servèn, 2003).
9. Burundi’s financial sector comprises of well-capitalized banks with minimal FX mismatches (Figure 2). Consequently, the trade and uncertainty channels are likely to be more dominant than the financial channel.5 Depreciation of the official exchange rate is therefore likely to have a positive impact on both inflation and output, particularly if clear and guided communication through the transition and beyond can mitigate uncertainty in the path of the exchange rate along the way.6 Having output and inflation moving in the same direction is a more pleasant scenario for central banks as opposed to one in which output falls as inflation rises, since monetary tightening can be used effectively in the former case to stabilize both output and inflation.
FX Mismatches in the Financial Sector
(Percent of total assets, RHS; percent of total liabilities, LHS)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Note: Currency mismatch calculated as FX liabilities minus assestsSources: Burundi authorities and IMF staff calcaulationsFX Mismatches in the Financial Sector
(Percent of total assets, RHS; percent of total liabilities, LHS)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Note: Currency mismatch calculated as FX liabilities minus assestsSources: Burundi authorities and IMF staff calcaulationsFX Mismatches in the Financial Sector
(Percent of total assets, RHS; percent of total liabilities, LHS)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Note: Currency mismatch calculated as FX liabilities minus assestsSources: Burundi authorities and IMF staff calcaulationsD. Equilibrium Exchange Rate
10. Recent experiences have shown that the post-unification exchange rate ends up very close to the parallel market rate (Gray, 2021). However, this may not always be the case and having an estimate of the equilibrium exchange rate for the economy- usually a range and even if imprecise- is critical to anchor the unification.
11. Ghei and Kamin (1996) outlined a theoretical framework to pin down the equilibrium exchange rate in a parallel exchange rate system. They showed that it typically falls between the official and the parallel market rates. The fraction of exports and imports conducted at the parallel vs. official rate, as well as the elasticity of exports and imports with respect to the exchange rate are its key determinants.
12. On the empirical side the IMF’s external sector assessment (ESA) modules provide estimates of the equilibrium exchange rate, one that is consistent with macroeconomic stability and a current account profile that is in line with fundamentals.7, 8
13. Both empirical and theoretical approaches typically pin down the equilibrium real exchange rate. A second step towards operationalizing the transition is to determine the nominal exchange rate path that is consistent with this real rate, given the monetary framework that is in place. Box 1 summarizes how such a nominal exchange rate profile can be calibrated to achieve a given real exchange rate adjustment, given the time horizon over which it is sought, and how this varies depending on the monetary policy framework summarized by an average inflation target.
Quantifying Nominal Exchange Rate Adjustments to Address a Given Real Misalignment
Since the real exchange rate is the conceptually relevant measure to study the implications of movements in relative prices, misalignment of the exchange rate is typically measured in terms of the real as opposed to the nominal exchange rate. In practice though, policymakers often must use the nominal exchange rate as an instrument to achieve a real adjustment. This box summarizes how such a nominal exchange rate profile can be calibrated to achieve a given real exchange rate adjustment given the time horizon over which it is sought, and how this varies depending on the monetary policy framework summarized by an average inflation target.
Let m be the (log of) real exchange rate misalignment that is desired to be corrected, s be the current nominal exchange rate (official), and ST the target terminal exchange rate which would eliminate the real exchange rate misalignment. Let e denote the starting real exchange rate, and eT the terminal exchange rate post alignment.
The starting and terminal nominal and real exchange rates are linked to domestic and foreign price levels via the following relations
e = s + p* – p
eT = sT + pT* – pT
Where p and p* denote the domestic and foreign price level respectively.
The targeted real exchange rate adjustment, which is equal to the current misalignment, is given by:
m = ST – S
This misalignment can be expressed in terms of the nominal exchange rate and price levels as follows:
m = eT – pT* + pT – e + p* – p
| Time Horizon | ||
| Inflation | 1 year | 5 years |
| 2% | 4027.5 | 4027.5 |
| 10% | 4362.9 | 6008.3 |
| Time Horizon | ||
| Inflation | 1 year | 5 years |
| 2% | 4027.5 | 4027.5 |
| 10% | 4362.9 | 6008.3 |
A rearrangement of terms in the above equation leads to the following equation for the terminal nominal exchange rate T periods ahead.
eT = m + e + T (p – p*)
Here p* and p are the average annual foreign and domestic inflation rates over the T year horizon.
The condition shows that the nominal exchange rate adjustment has two components: (a) Correcting the real exchange rate misalignment (m) , and (b) average inflation differential over the adjustment period (T(p-p*)) . Typically, this inflation differential is positive for developing countries, implying an equilibrium nominal exchange rate that increases with the length of the adjustment window.
For the case of an instantaneous adjustment discussed in the text for instance, T = 0, and the last term on the right-hand side disappears. In this case, the nominal exchange rate merely needs to adjust by the current misalignment of the real exchange rate. On the other hand, as the adjustment period T increases, the nominal adjustment needs to account for not only the current misalignment, but the change in the equilibrium real exchange rate over the transition period, as summarized by the inflation differential.
The graph and table show the nominal exchange rate required to correct a real exchange rate misalignment of 70 percent, depending on the number of years of adjustment and inflation rate, assuming a starting exchange rate of 2000BIF/$ and an average foreign inflation rate of 2 percent.
The equation can also be used to highlight the role of a credible monetary policy framework. The variance of the equilibrium nominal exchange rate is given by
var (eT) = T2 * var (p – p*)
If the monetary framework is weak and unable to generate stable inflation expectations, the volatility of the nominal exchange rate would increase. This uncertainty can hamper the credibility of the unification program, especially if communication is weak or speculative forces in the FX market are ripe.
E. Speed of Adjustment and Managing the Transition
14. ER unification may be achieved through two approaches: An instant “Big Bang” approach which unifies the exchange rate instantly, or a gradual unification lasting for several weeks to months.
15. Since the root cause of the existence of parallel markets is some form of government restrictions on foreign exchange transactions, it is in many cases feasible to drop the restrictions and attempt to achieve an instantaneous adjustment to the new equilibrium. If implemented smoothly, this approach has the advantage of transitioning the economy swiftly to a new equilibrium and eliminating the distortions and inefficiencies linked with the parallel market. It is also easier to communicate, and hence offers more policy credibility. However, a fast transition also risks being disruptive and hence counter-productive if sizable segments of the economy have currency mismatches or are exposed to sharp exchange rate fluctuations in other ways, including via large implicit subsidies generated by a misaligned official rate. Notably, the financial sector could prove vulnerable to instant exchange rate unification. Moreover, a sharp exchange rate depreciation could trigger a sudden spike in inflation, which could become entrenched into inflation expectations if second round effects are strong (Text table 6).
16. The alternative of a slow and drawn-out adjustment offers agents time to adjust smoothly. However, the communication challenges associated with implementing a longer process are more challenging compared to the “one-and-done” approach of instantaneous transition. For instance, shocks occurring during the transition may change the equilibrium level of the exchange rate, generating uncertainty and questions regarding the commitment of authorities to continue with the reform. Such concerns may be particularly pronounced since FX market and availability may deteriorate during the transition while benefits mostly accrue once full unification is achieved.
17. In either case, but particularly in the instant unification scenario, the inflationary impact of an exchange rate unification is one of the major concerns. Figure 3 shows the inflationary impact of recent exchange rate unifications. While unification does tend to increase inflation, the passthrough of exchange rate movements to prices during unification episodes is 12 percent on average, which is much lower than estimates during normal times. As discussed in Gray (2021), this is in part because in the presence of sizable parallel markets, the price level in the economy already reflects the level of the parallel exchange rate which is typically close to the post- unification exchange rate. Moreover, in instances where the post-unification passthrough was high, authorities were able to use monetary policy tightening more aggressively to tame inflationary pressures (Figure 4).
Exchange Rate Premiums and Passthrough in Peer Countries
(Percent)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Sources: Gray (2021)Exchange Rate Premiums and Passthrough in Peer Countries
(Percent)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Sources: Gray (2021)Exchange Rate Premiums and Passthrough in Peer Countries
(Percent)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Sources: Gray (2021)18. A related concern is the possibility of a “free fall” of the exchange rate post-unification. Recent country experiences with exchange rate unification have however shown that this is rarely the case (Gray (2021)). While the exchange rate does and can be expected to overshoot its equilibrium level moderately, it quickly stabilizes, and in some cases even appreciates (e.g., Angola and South Sudan) on the back of a credible unification initiative inspiring market confidence.
Central Bank Tightening to Curb Inflation
(Percent)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Sources: Gray (2021)Central Bank Tightening to Curb Inflation
(Percent)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Sources: Gray (2021)Central Bank Tightening to Curb Inflation
(Percent)
Citation: IMF Staff Country Reports 2022, 258; 10.5089/9798400219238.002.A003
Sources: Gray (2021)19. These experiences suggest that for Burundi where the parallel market is sizable, the overall inflationary impact and risk of a free fall of the currency should be low, as the parallel rate will partly act as an implicit anchor for both the exchange rate and the price level post- unification. That said, sharp changes in relative prices could well materialize, even as overall inflation remains curtailed. In particular, the price of imports which were prioritized and hence transacted at the official rate before the unification may spike in the aftermath of the unification. For these imports, a phase-in period characterized by subsidies and transfers could be used to ease the burden, particularly on the economically vulnerable segments of the population.
F. Importance of a Robust and Sustainable Macroeconomic Framework
20. Irrespective of the time frame over which the unification is planned, the most critical determinant of its success is a set of macroeconomic policy frameworks that can not only help the economy navigate the transition, but also sustain the new equilibrium. Such a framework should first and foremost identify the root cause of the existence of the parallel market and credibly commit to eliminating it in the new regime. This typically entails a fiscal sector that utilizes market sources to borrow and shuns monetary financing and other forms of financial repression and broad-based restrictions on the FX market. With the burden of fiscal financing relaxed, the monetary regime can focus exclusively on price stability, which, as in many EMDEs, entails a moderate degree of exchange rate management and intervention to reduce excess volatility as well as for financial stability considerations (IMF, 2020). At the same time though, FX reserves should not be used systemically to target a given level of the exchange rate or influence its trend. Maintaining a sufficient, albeit not too large stock of FX reserves and using it judiciously, either in a rule based or discretionary manner is therefore likely to be an important component of the policy framework.
21. Such an integrated policy approach, in line with IMF (2020), would be particularly appropriate for Burundi given the objective of moving to an inflation targeting regime under the EAC framework. With the decline in monetary financing over the last few years, the country has already achieved significant progress towards facilitating this transition. At the same time, it is critical to ensure continued development of a deep market for government securities, one that can attract a diverse range of investors and enable the government to borrow at longer maturities. Apart from ensuring smooth market functioning, financing of the deficit, and providing room for monetary policy to pursue price stabilization, the development of a yield curve for the government bond market would also help anchor policy expectations as well as private borrowing costs.
References
Ghei, N., & Kamin, S. B. 1996. The use of the parallel market rate as a guide to setting the official exchange rate.
Gray, M.S.T. 2021. Recognizing Reality—Unification of Official and Parallel Market Exchange Rates. International Monetary Fund.
International Monetary Fund. 2018. “Review of the Fund’s policy on multiple currency practices: initial considerations—economic context and experiences—background paper II”, August 2018.
International Monetary Fund. 2019. IMF Policy Paper “Review of the Fund’s Policy on Multiple Currency Practices: initial considerations”, June 2019.
Kearns, J., & Patel, N. 2016. Does the financial channel of exchange rates offset the trade channel? BIS Quarterly Review December.
Lee, M.J., Ostry, M.J.D., Prati, M.A., Ricci, M.L.A. and Milesi-Ferretti, M.G. 2008. Exchange rate assessments: CGER methodologies. International Monetary Fund.
Servén, L. 2003. Real-exchange-rate uncertainty and private investment in LDCs. Review of Economics and Statistics, 85(1), 212–218.
Prepared by N. Patel, in collaboration with M. M. Ly.
The parallel market is informal under article 86 of a 2019 regulation, and any individual or legal entity that engages in the activities of foreign exchange in Burundi without prior authorization from the BRB is subject to criminal sanctions.
This is evidenced for instance by the fact that the parallel rate has tended to diverge persistently from the official rate, instead of fluctuating around it in both directions, as would be the case if it was serving the function of limiting exchange rate volatility for current account transactions.
Since exports in 2019 amounted to $181 million, GDP was $3 billion, and the parallel market premium was around 60% on average for the year, the implicit tax on exporters amounted to 181•0.6 = $108.6million=3.6% of GDP.
That said, currency mismatches and associated vulnerabilities may be present in the corporate sector, whose FX exposures are not as well documented as in the case of the financial sector.
The current account may nevertheless experience a temporary deterioration before improving, in line with the “J curve effect”.
Staff report for the 2022 Article IV Consultation, External Sector Assessment (Annex II).
See Lee et al (2008) for a conceptual and methodological overview of different frameworks used to estimate the equilibrium exchange rate at the IMF.
