Black markets in foreign exchange: Origins, nature, and implications
Author: Mr. M. Nowak

Contributor Notes

Their causes, nature, and consequences

This paper anlayzes the role of the International Financial Corporation (IFC) in promoting economic development in developing countries with the private sector. IFC promotes growth of new companies, indigenous companies, and helps to introduce more capital from private sources into developing countries. Many countries need to develop capital market institutions such as stock exchanges, securities companies, leasing companies, and financial intermediaries of one kind or another. IFC has a special department, partly financed by the World Bank, that has provided expertise in these areas to a number of countries.


This paper anlayzes the role of the International Financial Corporation (IFC) in promoting economic development in developing countries with the private sector. IFC promotes growth of new companies, indigenous companies, and helps to introduce more capital from private sources into developing countries. Many countries need to develop capital market institutions such as stock exchanges, securities companies, leasing companies, and financial intermediaries of one kind or another. IFC has a special department, partly financed by the World Bank, that has provided expertise in these areas to a number of countries.

Michael Nowak

Exchange controls have frequently been used by countries attempting to protect their international reserves in periods o balance of payments difficulties. Typically governments have viewed exchange controls as a substitute (or at least as a temporary stop-gap) for unpalatable adjustment measures, even though controls do nothing to address the underlying causes of external imbalance. Indeed, by aggravating existing distortions in relative prices and resource allocation, controls may exacerbate the very problems they were intended to alleviate.

As with any type of restriction, exchange controls encourage evasion. When this happens in an organized manner, “black markets” in foreign exchange arise (“unofficial,” “parallel,” or “curb” have also been used as terms to describe this type of market). Such markets are generally frowned upon by governments because they divert scarce foreign exchange from official channels to uses which the controls are trying to restrict. More important, black markets can affect the economy as a whole and have a number of important policy implications. These matters and other features of black markets in foreign exchange are discussed in this article.

Causes and extent

There are three options open to a country encountering balance of payments difficulties: adjustment measures using the instruments of fiscal, credit, incomes, and exchange rate policy; external borrowing; or imposition of controls on international trade and payments. The first option may have short-term consequences for income distribution, employment, or inflation that governments would like to minimize, while the second—recourse to borrowing—is generally limited in scope, expensive, and capable of providing only temporary relief. Quantitative controls, on the other hand, may appear to provide a solution which has immediate and direct effects but is less troublesome in terms of its social and economic costs. Not surprisingly, therefore, controls have frequently been used in response to external imbalances, particularly among developing economies. (A full description of the exchange control regimes of Fund members may be found in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions.)

A more extended analysis of this topic by the author, Quantitative Controls and Unofficial Markets in Foreign Exchange: a Theoretical Framework, has been published in IMF Staff Papers, June 1984.

When quantitative controls take the form of restrictions on the availability of foreign exchange through official channels, black markets in foreign exchange invariably develop. If a central bank is unable, or otherwise unwilling, to meet all the demand for foreign exchange at its official exchange rate, those whose demand is frustrated will be prepared to offer a price above the official rate, as long as the risks and costs of evading the exchange control regulations are not prohibitive. Faced with such offers, those who earn or borrow foreign exchange will have an incentive to sell on the black market rather than to the central bank.

The size of any black market in foreign exchange and the exchange rate premium it commands over the official market will depend upon the range of transactions subject to controls and the tightness with which they are applied. In countries where the central bank satisfies a large proportion of the prevailing demand for foreign exchange, the black market will tend to be thin and the black market exchange rate volatile. Conversely, in those countries which face chronic balance of payments pressures and have insufficient reserves or borrowing capacity to defend the official rate, black market activities are typically well developed and organized, with the price of foreign exchange as much as ten times higher than the official rate. In a number of countries, black market transactions are officially tolerated, though strictly speaking illegal; under such conditions, the exchange rate in the black market can provide a fairly good indication of the extent to which the currency in the official market is overvalued.

Demand and supply

The sources of demand and supply of foreign exchange in a black market obviously depend very much on the characteristics of the country concerned as well as the exchange control regulations. As a general rule, outward capital transfers, invisible payments, and certain imports (particularly of consumer items) considered inessential will make up the bulk of the demand for foreign exchange in the black market, since these are the types of transactions most frequently subject to control in the official market. While central banks are usually prepared to sell foreign exchange to meet demand for imports such as basic foods, petroleum, and inputs for the export sector, in extreme cases where a country is facing particularly severe balance of payments pressures, these items, too, may be subject to restrictions, and foreign exchange demand to finance them will also tend to spill over into the black market.

Quantitative restrictions may constitute part of the formal exchange control machinery. Those who wish to purchase foreign exchange at the official rate can then obtain advance information of their entitlement from the general rules that apply; these may be in the form of quantitative limits on invisible payments, such as overseas travel, or they may comprise allocations for the purchase of specified imports. Frequently, however, restrictions arise in an ad hoc manner as a result of foreign exchange being withheld after authorization has been granted and payment has fallen due. These types of restrictions, known as payments arrears, have grown markedly in recent years with respect to both trade and debt obligations; they have had particularly damaging effects on the international credit standing of the countries concerned.

While commodity exports provide the bulk of foreign exchange earnings in most countries, proceeds from the smuggling abroad of export products will not necessarily account for a large part of the foreign exchange sold on the black market. Apart from commodities produced close to the frontier and involving relatively low transport costs, the black market is more likely to be fed from other sources of foreign exchange where evasion of the law is easier. Notable among these are sales of foreign exchange by tourists, diplomats, and foreign workers; remittances sent back by nationals resident abroad; and, perhaps most important of all, the overinvoicing or underinvoicing of trade documents.

Overinvoicing of imports (that is, overstating the value of an approved import) will allow an importer to obtain additional foreign exchange at the official rate, which he can resell at a profit in the black market. Similarly, an exporter who underinvoices (that is, understates the value of goods exported) can sell the unreported part of the value of his exports on the black market. In both these transactions, which frequently take place with the collusion of the external seller or buyer, the true price is misstated and foreign exchange is diverted away from the official market by the premium offered in the black market. (But it is not always the case that improper invoicing is a source of supply to the black market. For example, where import duties are high compared to the black market premium, it will be profitable to underinvoice imports and purchase the necessary balance of foreign currency in the black market. Likewise, there will be an incentive to overinvoice exports in instances where a relatively high export subsidy is provided.)

Black markets in foreign currency do not necessarily operate within the frontiers of the country concerned. There are many cases of unofficial transactions being handled in offshore locations, usually in a country which is a major source of foreign exchange. The obvious advantage offered by offshore transactions is the comparative ease with which exchange control regulations can be evaded.


Were controls to be effectively implemented, they could provide protection against reserve loss, even though they would still fail to address the fundamental economic policy weaknesses that lie at the root of chronic balance of payments difficulties. Invariably, however, controls are evaded through improper invoicing of trade documents and other leakages arising from the spread between the official and black market exchange rates. As a consequence, a central bank may find itself faced with continuing pressures on its international reserves and a loss of firm control over the uses of foreign exchange it allocates. Exchange controls also have unintended consequences which may involve substantial social and economic costs. The most prevalent of these are inflationary effects, distortions caused in the pattern of resource allocation, and bureaucratic corruption. Each may be considered in turn.

In an economy where the central bank defends a fixed exchange rate without resort to exchange controls, reserve losses through the balance of payments will act as a brake on excessive monetary expansion. When controls are applied, this automatic mechanism limiting the build-up of inflationary pressures is no longer operative. While the prices of nontraded goods tend to rise as fast, if not faster, than the prevailing rate of inflation, the prices of traded goods will be held down by conditions in international markets and the official exchange rate. The resulting decline in the price of traded, relative to nontraded, goods will encourage, on the one hand, a reallocation of resources away from production of exports and import substitutes and, on the other, a shift in consumer preferences in favor of imports. The consequence will be an oversupply of those goods which do not generate or save foreign exchange and an insufficient supply of those that do. This suboptimal pattern of production and consumption will involve a real cost to the economy and a loss of national income and welfare. Furthermore, without corrective policy action, the distortions in relative prices resulting from the controls will tend to grow increasingly acute over time.

To the degree, therefore, that black market activities circumvent foreign exchange controls, they may fulfill a useful function in the sense that they mitigate the adverse repercussions of quantitative restrictions on the allocation of resources. They provide exporters who do not sell foreign currency to the official market with increased prices and allow importers to purchase goods which they could not otherwise obtain at prices they are willing to pay. In this way, the black market provides a mechanism by which the domestic currency effectively undergoes a depreciation in its external value, while the official rate is fixed.

The application of exchange controls entails the rationing of scarce resources through means other than the price mechanism. As a general rule, this rationing will take place in accordance with established economic and social priorities, as embodied in the regulations governing exchange control procedures. But, in spite of this, officials of central banks or government departments invariably find themselves with discretionary powers to allocate foreign exchange. This may be because the exchange control regulations are not being strictly adhered to or, more usually, because the regulations themselves allow foreign exchange approval to be granted in a discretionary manner. This is particularly true for those foreign exchange approvals typically made on a case-by-case basis, such as those for nonessential imports, payments of arrears, and various invisible payments, including education and medical expenses.

The danger then arises that decisions made by officials in such “gray areas” not clearly defined by exchange control regulations will be influenced by the potential profits to be made by exploiting the exchange rate differential between the official and black markets. This differential places a premium on gaining access to the official market and thus exposes the officials responsible for making foreign exchange allocations to an environment conducive to corruption. Indeed, the political leverage of those groups with vested financial interests in the maintenance of controls may account for the reluctance of some governments to dismantle them.

Some policy considerations

If indeed black market activities do temper some of the harmful consequences of quantitative restrictions, then measures aimed at repressing these activities (such as stricter enforcement of exchange control laws and harsher penalties) would serve only to make matters worse. On the other hand, liberalizing exchange and trade restrictions in the face of continuing balance of payments pressures is likely to lead to the exhaustion of reserves and the emergence of new arrears. If external balance is to be restored without renewed resort to controls, the adjustment process will usually require policies to curb the growth of domestic expenditures and encourage a transfer of resources to the traded goods sector.

It is in the area of exchange rate policy that governments have, in general, shown most reluctance to undertake corrective action in addressing balance of payments problems, even when there are clear indications that the currency in the official market is grossly overvalued. To some extent, this is attributable to pressures from interest groups anxious to maintain the existing distribution of income. In addition, though, the reluctance of governments to undertake a devaluation reflects concern over the effects on prices and real wages. Such concern is not necessarily warranted.

Devaluation and inflation. For economies with exchange controls in place, the adverse short-term impact on prices and real wages normally associated with a devaluation will already have been partially felt as a result of the depreciation of the currency in the black market. Once the official rate is devalued, the extent to which the domestic price and cost structure adjusts may be limited, if not negligible. The actual magnitude of the direct impact on prices will depend on the response of the exchange rate in the black market and on the size of this market relative to the official market. Devaluation will also affect domestic prices through indirect effects on the money supply and output.

A devaluation of the official exchange rate raises the domestic currency price of officially traded goods relative to that of nontraded goods, and thereby provides an incentive to increase domestic production of exports and import substitutes. The resulting increase in the country’s overall foreign exchange earnings will cause, other things given, an appreciation of domestic currency in the black market, even though sales to the black market may contract. In theory, therefore, one would expect the prices of imports purchased on the black market to decline when the official rate is devalued. When a relatively large proportion of the economy’s foreign exchange transactions are conducted on the black market, a devaluation of the official rate could have a significant deflationary impact on consumer prices.

In practice, however, one might not observe, in the short run at least, an appreciation of the domestic currency in the black market following a devaluation. For a number of export commodities, particularly agricultural products, it may take some time for production, and thus the supply of foreign exchange, to respond to favorable shifts in relative prices. Moreover, in cases where export activities are dominated by foreign-owned enterprises, the amount of foreign exchange brought into the country by them in order to cover local production costs (which are fixed in terms of domestic currency) will fall as a result of a devaluation and this could cause the black market rate to depreciate. Another factor affecting the relationship between the black and official market exchange rates concerns the role of expectations. If a devaluation was widely anticipated, the black market rate will have adjusted in advance as a result of speculative activity. The direction of the movement in the black market rate at the time of the devaluation will then depend on the size of the devaluation, compared with initial expectations; if it turns out to be less than expected, there will be a tendency for the black market rate to decline. If the underlying rate of currency depreciation is substantial, because for example, the domestic inflation rate is substantially greater than that prevailing externally, this could mask any appreciation of the black market rate that may take place as a result of a change in the official rate.

In any event, even though the black market rate may depreciate following a devaluation, it is most improbable that the exchange rate premium on the black market will rise. Hence, solely in terms of the direct price effects, one could safely argue that a devaluation will be less inflationary when there is a black market than when there is not. The inflationary impact associated with the imposition of controls will, of course, already have taken place.

A devaluation may also set in motion deflationary forces through its impact on the money supply and output. For example, a devaluation which is undertaken in the context of an economic adjustment program will generally involve external financing additional to that which the country in question might normally obtain. While such financing will allow some replenishment of reserves, it will also permit a liberalization of the exchange control regime and an increased flow of imports of goods and services. This will help contain any inflationary pressures resulting from the direct price impact of a devaluation. In addition, excessive monetary expansion may be curbed by a widening of the tax base following a devaluation, although the overall effect on the central government’s borrowing requirement will, of course, depend also on the response of expenditures.

A measure of overvaluation? Under certain conditions, the black market rate can provide useful information on the extent to which the domestic currency has become overvalued in the official market and on the size of the devaluation required to restore an equilibrium rate. If the argument that a devaluation of the official rate will lead to an appreciation of the black market rate is correct, one can infer that the official rate would not have to be adjusted fully to the level of the black rate in order to bring about a reunification of the two rates.

Caution should, however, be exercised in making such judgments since, in some instances, restoration of external equilibrium may require that the official rate be depreciated by more than the prevailing exchange rate premium in the black market. For example, the black rate may be more appreciated than the equilibrium rate if the central bank is selling foreign reserves (running a balance of payments deficit), or if the costs of undertaking illegal transactions on the black market are large and if they affect the buyers of foreign exchange more than the suppliers. Use of the black market rate as an indicator of the overvaluation of the official rate must, therefore, be supplemented by other indicators of disequilibrium, such as real effective exchange rate indices and medium-term balance of payments estimates. (See “Determining the appropriate exchange rate in LDCs,” by A.H. Mansur, Finance & Development, December 1984.)

Transitional arrangements. In the process of liberalizing exchange and trade controls, a number of countries have adopted transitional arrangements involving multiple exchange markets designed to spread the costs of adjustment over time. The transitional arrangements often legalize the existing black market and erect formal controls for delineating transactions between the two markets. Not infrequently, however, legalization of the black market is accompanied by new restrictions on demand that result in the emergence of an illegal third market. Sometimes these restrictions are not applied formally through exchange control regulations but arise in an ad hoc manner because the exchange rate in the secondary market is fixed and the central bank is unable to meet all the prevailing demand for foreign exchange from its reserves.

While transitional arrangements apply, the community as a whole would benefit if the government were to appropriate the profits that accrue to those individuals who are able to obtain access to the relatively cheap foreign exchange in the official market. While eliminating controls and levying a tax on imports and invisible payments is one possible way of achieving this, it is not usually particularly appealing to central banks because they lose direct control over the amount of foreign exchange sold. One method of appropriating the rent, but still allowing the central bank to retain quantitative control over its reserves, is to auction the available pool of foreign exchange. This is equivalent to a tax with a variable rate assessed on the difference between the official exchange rate and the auction price. Schemes to auction import licenses yield the same benefits.

The actual reunification of the two foreign exchange markets can be achieved through progressive devaluations of the official rate and the phased transfer of transactions from the official to the secondary market. It is important that this transitional process be undertaken fairly rapidly, so that any initial improvement in relative prices in favor of the traded goods sector is not eroded.

In conclusion …

When confronted with balance of payments difficulties, policymakers frequently resort to imposing exchange and trade controls as a means of providing protection against reserve loss. Other forms of remedial action, in particular devaluation, are often avoided for fear of kindling inflationary pressures and lowering real incomes. This article has argued that controls are a poor substitute for devaluation and complementary demand management policies. When controls are imposed, the resulting depreciation of the currency in the black market will have inflationary consequences similar to those of an official devaluation. For this reason, once a devaluation actually takes place when controls are present, the inflationary impact may be very limited. In addition, however, controls may be self-defeating. While they restrict the uses for which official foreign exchange may be purchased, by causing distortions to relative prices, controls may also divert resources away from those sectors that either earn or save foreign exchange. Society as a whole is generally made worse off as a result of controls, but substantial benefits may still accrue to those groups with privileged access to subsidized foreign exchange in the official market. In many instances, the political leverage applied by such groups intent on safeguarding their vested interests provides further resistance to devaluation, even in the face of chronic foreign exchange shortages.

Published quarterly in March, June, September, and December, Staff Papers contains studies prepared by members of the Fund’s staff on monetary and financial problems affecting the world economy.

Articles appearing in the December 1984 issue are:

Domestic Credit and Exchange Rates in Developing Countries: Some Policy Experiments with Korean Data

by Leslie Lipschitz

On Growth and Inflation in Developing Countries

by Omotunde Johnson

Credit and Fiscal Policies in a “Global Monetarist” Model of the Balance of Payments

by Peter Montiel

Effects of Increased Market Access on Exports of Developing Countries

by Naheed Kirmani, Pierluigi Molajoni, and Thomas Mayer

The Fund Agreement in the Courts—XX

by Joseph Gold

Subscriptions for Staff Papers (US$15.00 for a volume, US$4.00 for a single issue, special rates—US$7.50 a volume—to university libraries, faculty, and students) should be sent to:

Publications Unit, Box A-851

International Monetary Fund

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Telephone (202) 473-7430

Finance & Development, March 1985
Author: International Monetary Fund. External Relations Dept.