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Board of Governorsof the Federal ReserveSystem

InternationalFinanceDiscussionPapers

Number 564

September 1996

THE USE OF THE PARALLELMARKETRATE AS A GUIDE TO


SEn~G THE OFFICIALEXCHANGERATE

Nita Ghei and StevenB. Kamin

NOTE: InternationalFinanceDiscussionPapers are preliminarymaterialscirculatedto stimulate


discussionand critical comment. Referencesin publicationsto InternationalFinanceDiscussion
Papers (other than an acknowledgmentthat the writer has had accessto unpublishedmaterial) should
be clearedwith the author or authors.
ABSTRACT

This paper addressesthe merits of using the parallelexchangerate as a guide to settingthe

official exchangerate. Ideally, policymakerswould set the exchangerate at the level that would

balancetrade and sustainablecapital flows--thatlevel is referred to as the equilibriumexchangerate.

In practice,it is difficultto identi~ the equilibriumexchangerate, particularlyin countriesthat have

experiencedmacroeconomicvolatilityand/or structuralchange. In this context,where parallel markets

for foreign exchangeexist, it is natural to considerthe parallel rate as a proxy for the equilibrium

exchangerate, since it is set directly by the market. The paper developsan analyticmodel to explore

the relationshipbetweenthe parallel exchangerate and the equilibriumrate. It is determinedthat only

under a fairly narrow set of circumstanceswill the parallel rate be set at a level close to the

equilibriumexchangerate. The paper then comparesthe evolutionof official and parallel exchange

rates over time, in a large sampleof different countries,to providea feel for the applicabilityof the

previously-derivedtheoreticalresults.
TheUse of the ParallelMarketRateas a Guideto Settingthe OfflcialExchangeRate

Nita GheiandStevenB. Kamin*

I. Introduction

Determiningthe appropriatelevelat whichto set the exchangerate is a challengingproblemfor any

countrypursuinga managedor fixedexchange-ratepolicy. Ideally,a countrywouldset itsexchangerate at the

realequ.ilibnumra~,thatis, therate consistentwithinternaland externalbalance(tie latterreferringto balance

betwmntradeandsustainableeapital-account
flows). Evenin relativelystableand matureindustrialeconomies,

however,the realequilibriumlevelof theexchangerateis usuallydifficultto identi~. In developingcountries

subject to macroeconomicinstabilityand/orstructuralchange,this identificationis evenmoredifficult. The

determination
of theequilibriumrealexchangerate is especiallyuncertainif theeconomyis in themidstof trade

liberalization
andotherreformsthatpromiseto changepreviouslyexistingrelationsbetweentradeperformance

andtheexchangerate.

In a contextwherea parallelmarketfor foreignexchangeexists,it may appearnaturalto considerthe

pardel exchangerate as a proxyfor theequilibriumrealexchangerate. Theparalielexchangerateusuallyhas

the benefitof beingdeterminedin a free market,andhenceis not obviouslycontaminatedby thedistortionary

effecwof government
policy.Mdtipleexchangerate managements,formaland informal,legalandillegal,were

the norm for developingcountri= until very recently. Even thoughan increasingnumberof countiieshave

tiled theirexchangera@, oftenaspartof a largerliberalizationeffort,parallelforeignexchangemarketshave

l~e au~ors Mecomespnden~ me EconomicTimes~d SeniorEconomist,Divisionof ~~rnation~


Finance,Boardof Governorsof theFederalReserveSystemrespectively.We are gratefulto Lawrence
Hinkle,Peter Montieland SteveO’Comell for helpti mmmentsand suggestions.Thispaperwasprepared
as a chapterin an editedvolume,LawrenceHinkleandPeterMontiel,eds,ficllange RafeManagementin
bw InconleCotlntnes:Metlzoblogiesfor EnzpiricalAnalysis,underpreparationby theWorldBank The
viewsexpressedin thispaper are oursand do notnecessarilyreflectthoseheldby theBoardof Governors,
theWorldBank,TheEconomicTimesor othermembersof theirstaffs.We areresponsiblefor anyandall
emors.
Board of Governorsof the Federal ReserveSystem

InternationalFinanceDiscussionPapers

Number 564

September 1996

THE USE OF THE PARALLELMARKETRATE AS A GUIDE TO


SETTINGTHE OFFICIALEXCHANGERATE

Nita Ghei and StevenB. Kamin

NOTE: InternationalFinanceDiscussionPapers are prelimina~ materialscirculatedto stimulate


discussionand critical comment. Referencesin publicationsto InternationalFinanceDiscussion
Papers (other than an acknowledgmentthat the writer has had accessto unpublishedmaterial) should
be cleared with the author or authors.
ABSTRACT

This paper addressesthe merits of using the parallelexchangerate as a guide to settingthe

official exchangerate. Ideally, policymakerswould set the exchangerate at the level that would

balancetrade and sustainablecapitalflows--thatlevel is referred to as the equilibriumexchangerate.

In practice,it is difficultto identi~ the equilibriumexchangerate, particularlyin countriesthat have

experiencedmacroeconomicvolatilityand/or structuralchange. In this context,where parallel markets

for foreign exchangeexist, it is natural to considerthe parallel rate as a proxy for the equilibrium

exchangerate, since it is set directly by the market. The paper developsan analyticmodel to explore

the relationshipbetweenthe parallel exchangerate and the equilibriumrate. It is determinedthat only

under a fairly narrow set of circumstanceswill the parallelrate be set at a level close to the

equilibriumexchangerate. The paper then comparesthe evolutionof official and parallel exchange

rates over time, in a large sampleof different countries,to provide a feel for the applicabilityof the

previously-derivedtheoreticalresults.
TheUse of the ParallelMarketRateas a Guideto Settingthe OfficialExchangeRate

Nita GheiandStevenB. Kaminl

I. Introduction

Determiningthe appropriatelevelat whichto set the exchangerate is a challengingproblemfor any

countrypursuinga managedor fixedexchange-ratepolicy. Ideally,a countrywodd set its exchangerate at the

realequilibriumrate,thatis, therate consistentwithinternalandexternalbalance(thelatterreferringto balance

betw=ntradeandsustainable~pit.al-account
flows). Evenin relativelystableandmatureindustrialeconomies,

however,therealequilibriumlevelof theexchangerate is usuallydifficultto identi&. In developingcountries

subject to macroeconomicinstabilityand/orstructuralchange,this identificationis evenmoredifficuh. The

determination
of theequilibriumrealexehangerateis especiallyuncertainif theemnomyis in themidstof trade

liberalization
andotherreformsthatpromiseto changepreviouslyexistingrelationsbetweentradeperformance

andtheexchangerate.

In a contextwherea parallelmarketfor foreignexchangeexists,it may appearnaturalto considerthe

paralielexehangerateas a proxyfor theequilibriumrealexchangerate. Thepartilelexchangerateusuallyhas

the benefitof beingdeterminedin a free market,andhenm is not obviouslycontaminatedby thedistortionary

effectsof government
policy.Multipleexchangerate arrangements,formaland informal,legalandillegal,were

the norm for developingcountriesuntil very recently. Even thoughan increasingnumberof countrieshave

tiled theirexehangerab, oftenaspartof a largerliberalizationeffort,parallelforeignexchangemarketshave

l~e auhors ~e cofiespnden~ me EconomicTimesand SeniorEconotist, Divisionof ~~mation~


Finance,Boardof Governorsof theFederalReserveSystemrespectively.We are grateful10Lawrence
Hinkle,PeterMontieland SteveO’Comellfor help~ commentsand suggestions.Thispaperwasprepared
as a chapterin an editedvolume,LawrenceHinkleandPeterMontiel,eds,&clzangeRafeManagenzentin
bw InconleColtntries:A4et)lodologiesfor EnlpiricalAnalysis,underpreparationby theWorldBank.The
viewsexpressedin thispaperare oursand do not necessarilyreflectthoseheldby theBoardof Governors,
theWorldBank,TheEconomicTimesor othermembersof theirstaffs.We areresponsiblefor anyand all
enors.
2

notdisappearedas~ Nigeria,whichhas neverSUCwssfully


unifiedits exchangerate,is a prominentexample

in Africa;in Venezuela,whichunifiedits exchangerate in 1989,a parallelmarketemergedin 1994following

thereimpositionof capitalcontrols.

Notwithstandingthe appealof a market-determinedexchangerate as a guideto settingthe official

exchangerate,however,variousfactorscomplicatethe relationshipbetweentheparallelmarketrateand thereal

equilibrium
exchangeratein aneconomy.First,whilethe parallelmarketfor foreignexchangemaynot itselfbe

controlledbythegovemmen
4 ~nditionsin thatmarketare likelyto be affated by governmentpolicy. Relative

supplies and demandsfor foreigncurrencyin tie parallelmarketwillbe alteredby the levelof the official

exchangerate,theextentto whichexchangeand&adecontrolsare enforced,andthe government’sformulafor

rationingforeignexchangereceiptsto importers. Second,becausethep@lel exchangemarketrepresentsan

assetmarketas well as a trade-relatedmarke4theparallelmarketrate is likelyto reflectexpectations,political

concerns,capitalfigh~andotherfactorsnotdirectlyassociatedwiththerealequilibriumexchangerate. Hence,

only under a relativelynarrow set of circumstanceswill the parallelmarketrate serve as a useti guideto

determiningtie equilibriumvalueof theofficialexchangerate.

Inthispaper,weexplorethedeterminan~of theparallelmarketrate in orderto ass~s ifi usetiness as

a guide to measuringthe equilibriumvalueof the official real exchangerate. The plan of this paper is as

follows. In SectionII, parallelexchangemarketsare definedmorespecificallyand variouscharacteristicof

parallelexchangemarti aredestibed.2 SectionIII addrmsestheissueof theunificationof exchangemarke@

andtheappropriatetargetfor theofficialexchangerate.In SectionIV wereviewa simpletheoreticalmodelof

parallelexchangemarketsto shedlighton howparallelmarketratesaredeterminedin relationto bothofficial

exchangerates andequilibriumexchangerates. SectionV comparestheevolutionofparaUelandofficialreal

exchanger- overtimetoprovidea f~l for the applicabilityof the theoreticalresultspresentedin theprevious


..

ZForgener~ smeys of tie issuesassocia~ withp~~el marketsforforeignexchangessee ‘genor


(1992)and KiguelandO’Comell(1995).
3

section.SectionVI concludes.

II. EssentialCharacteristicsof ParallelExchangeMarkets

11.1Bmic Definitions

A parallel foreignexchangemarketsystemis onein whichtransactionstakeplaceat morethanone

exchangerate and at leastoneof theprevailingrates is a tieelyfloating,market-determined


rate (theparallel

exchangerate). (KiguelandO’Connell,
1995)ParaUelmarketsystemsrepresenta subsetof thebroadercategory

of multipleexchangerateregimes,whichreferto anyregimesin whichtwoor moreexchangeratesare applied

to thesa,mecurrency,
Manydevelopingmuntrieshaveappliedseparate,fixedexchangeratesto differenttypes

of transactions,
butthispracticeis, in essence,equivalentto a singleexchangeratecoupledwithdifferenttaxa

orsubsidi=(depending
on thetransaction).Bycontrast,a parallelmarketfor foreignexchangeis distinguished

bythefactthattheparallelexchangerateis determinedfreelyin themarke~ Usually,theofficialexchangerate

in parallelmarketsystemsis peggedby the authoritiesat a particularfixed (or crawling)rate, althoughin

principletheoficialratecouldbe flotig as well, Additionally,it is frequently-dthoughnot always- thecase

thattheoficialexchangerateapplimtocurrentaccounttransaction,whiletheparallelmarketrate,whetherlegal

or illegal,appliesto capitaIaccounttransactions.

Parallelmarketsfmforeignexchangecane~ge onlywhenthegovernmentimposesexchangecontrols,

that is, restrictionson the volumeof certainforeignexchangetransactionsor on the price at whichsuch

transactionsare made, Trade barriers,quantitativerestrictions,or high tariffs aloneare not in themselves

sufficientto giverise to a parallelexchangemarket. Whilesuchcontrolsmayaffectthedemandor supplyof

foreign currencies,theywillnot drivea wedgebetweenexchangerates for differenttransactions,as longas

foreign exchangeis freelyavailablefor all transactionsat an officialor market-determined


exchangerate. A

parallelmarketarisa whenthegovernmentlimitstheamountof foreignexchangethatcanbe boughtor sold for

particulartransactions,causingexcessdemandor supplyto spilloverintoa parallelmarkegor authorizesthat

exchangeratesfor certaintransactionsbe peggedandfor othertransactionsbe floating.


4

11.2kgal andIllegalSystem

Parallelexchangeratesystemsmaybe legalor illegal. Whentheparallelmarketfor foreignexchange

is legal, it is often referredto as a dual exchangerate (DER) system.In these cases, most currentaccount

transactionstakeplaceat a peggedcommercialrate, and capitalaccount&ansact.ions


at a marketdetermined

financialrate.Anumberof countrieshaveexperimentedwithDER systemsof varyingduration.Somecountriw

maintainedofficialdualexchangerates for longtimeperiods,such as Belgium(from 1957to 1990)and the

DominicanRepublic(until 1993).The parallelmarket,in thesewuntria, was used to insulatether=tofthe

-nomy fromshorttermcapitalflows. France(1971-74) and Italy(1973-74)adopteddualratesfor a short

period followingthe mllapse of the BrettonWoodssystemas a transitorymeasure.Argentina Mexiw and

VenezuelaadoptedDER regimes in the 1980sh the wakeof balanceof paymentscrises and huge capital

outflows.

Illegalparallelmarketsystemsemergewhenprivateagenfiattemptto evaderestrictionson thepriceor

quantityof foreignexchangetransactions.Illegalmarketswerethenormin mostof Afri~ andSouthAsia,as

well in severalLatinAmericanmuntrim, ~pecially throughthe 1980s.The parallelmarketsweregenerally

toleratedby the authorities,withsomeexceptions.For example,the threatof enforcementandpenaltieswas

significantinGhanapriorto 1983,but theseeffortsfellby thewaysidelateron, andthe coverageof theparallel

marketgrew,asdidtheparallelpremium(KiguelandO’Connell,1995).In Sudan,tradingon theparallelmarket

was a capitaloffence,and enforcementwas attemptedbetween1970and 1990.But eventhe threatof capital

punishmentdid not totallywipeout the parallelmarket,thoughit may have kn a factor in the veryhigh

p~miLlmobservedin Sudan.

Inprinciple,thereis littledifference,in termsof macroeconomicimplications,betweenlegaland illegal

systems. In eithercase, free-markettransactionsin foreignexchangetake placealongsidecontrolledprice-

transacdons.Thismeanshat in eitherlegalor iliegalsystems,thereare incentivesfor transactionsto spillover

or “leak”horn one marketinto the other. These leakagesmay tend to underminethe parallelexchangerate
5

system,dependinguponhowrigidlyexchangecontrolsareenforced.

11.3:ParallelMarketsin the 1990s

Agreatmanycountri=haveexperimen
M withparallelexchangearrangemen~at varioustimes.These

arrangementshaveincludedformal,legaldualratesas wellas illegal“black”rata. However,theincidenmof

sud wangernentshasbeendecliningin the1990s,as an increasingnumberof developingcountrieshavesought

tounifytheirexchangerati, oftenaspartof a largerstructuralreformeffortwhichincludesliberalizationof the

externalaccounts.Evenpartialconvertibilityof thecurrency,for ment accountpurposes,forexample,leads

to progresstowardsunifyingtheexchangerate.

Observers frequentlyviewthe incidenceof restrictionson internationaltransactionsas evidenceof

prevalenmandimportanceofparallelextige marti. Accordingto IMFrepo~, aboutone-haifof the member

countrimimposer~trictions on paymen~on transactionon thecurrentaccount;overthree-quartersdo so on

capitalaccountpayments(Table1).However,themereexistenceof restrictionsdoesnotnecessarilyimplythe

existenceof si@lcant parallelmarb~, sincetheseare qtitative data,withtwovalues- yes andno, andso do

notcaptureeithertheintensityof restrictionsor theeffectivenessof enforcementTherefore,usingtheexistence

on paymentsrestrictionswodd r~ult in an overestimateof the prevalenceof parallelmarketsfore foreign

exchange.

Parallel marketsare likelyto be unirnportan~and the parallelpremiumlow, when the payments

r~trictionsandcapitalcon@olsareeitherminimalor notenford. For example,SouthMnca imposedcapital

controlsin 1985,followingmassivecapitaloutflows,andre-introdud a dualexchangeratesystemat thattime.

Buttheparallelpremiumhasremainedmodest- themedianpremiumwas4.4per centfor theperiod 1980-89,

and declinedto 2.3 per centduringtheperiod 1990-94(Ghei,Kigueland O’ComeU1996)- whichwouldbe

consideredto a unifiedexchangerate regimeunderthedeftition in Section5 below. Thereare severalother

examplesof countri~ with extremelylowpremia,including~ailand, Malaysiaand Indonesia,withmedian

premiavaryingfmm-1.5 to 3.4 percent (Gheiet al, ibid).


6

Table1
Incidenceof PaymentsRestrictionsamongIMF MemberCountries
1980 1994
CurrentAccount 51.77% 51.69%
CaDitalAccount 78.01% 77.53%
Source:
Exchange and Excbange
Restrictions ArrangcmenU:
AnnualReport
oftheIMF,various
issues.

At thepr~entmomen~parallelexchangeratearrangementareto befoundin developingcountriesonly;

Belgium,which wasthe lastdevelopedcountrywithdualexchangerates,movedto a unifid exchangeratein

1990. Parallelexchangerates werea featureof onehalfofour sampleoftwenty-fourdevelopingcountriesat

theendof 1994(see Table2)3. Parallelexchangeratearrangemen&wereevenmorewidespreadin developing

countries in the 1980s- everycountryin our samplehad morethanoneexchangerate in 1985. Our sample

includes countrieswheresignificantparallelmarkefiexistedfor some time,and includesmost of the more

importantdevelopingcountries,outsideeasternand=ntral EuropeandtheformerSovietUnion.

Parallelmarkefihavehaddifferentdegreesof longevity.ArgentinaMexicoandVenezuelahad legal

dualrates that wereexpectedto be temporary.All threecreateddualrates and thenunified withintheperiod,

1980 to 1994,thougha parallelmarketdid re-emergein Venezuelain 1994,as discussedabove.OtherLatin

Americancountriesmovedto multiplerates or unifiedwithinthe same period.In the fican and Asian

muntri=,bycontras~paraLlel
rnar~ weremorelonglivd A fewof thesecountriesunifiedtheirexchangeratw

in the 1990s,butmajorexceptionsremain- mostlyin MCZ includingNigeri~KenyaandZambia.

Thelevelof theparallelpremiumhasdeueased,on average,in thecountrieswiti parallelexchangerate

wangements.Wefindlowerprerniain 1994reladveto 1985inrnanycases,for our sample. For a selectedgroup

me sampleis drawntim a WorldBankresearchproject,“Macroeu)nomicImplicationsof Multiple


ExchangeRatesin DevelopingCountriW”.A volumebasedon theprojec~“ParalielExchangeRatesin
DevelopingCountries,M.A.Kiguel,J.S.LizondoandS.A.O’Comell,eds,is forthcoming.Thedatawere
updatedto theend of 1994for thispaper.
7

Table2
Statusof ParallelMarket/ Levelof ParallelPremium(%) ?
country 1980 1985 1990 lm
htin Americanand Turkey
Argentina Unified 30.79 29.93 unified
Bolivia 19.85 223.60 unified unified
Brazil 8.90 30.12 14.28 Unifi
Chile 6.03 25.39 16.78 8.67
Colombia unified 11.42 9.24 6.12
DominicanRep. 38.00 7.69 68.01 unified
Ecuador 11.45 76.90 23.53 5.45
Mexico unified 28.46 7.41 Unifld
Peru 36.25 29.53 104.80 unified
Uru~ay unified 9.41 10.93 16.51
Venezuela unified 104.00 unified 4.73
Turkey 9.98 -7.17 unified unified
Aflica andAsia
gena 193.25 375.23 248.81 253.95
Egypt 7.77 122.90 89.47 unified
Ethiopia 35.02 127.66 192.75 113.2
Ghana 485.92 143.48 9.84 Utifi
Kenya 9.38 4.51 3.11 19.78
Malawi 92.27 49.51 17.51 14.62
Nigeria 67.67 306.22 19.40 231.87
Sudan 92.40 27.14 955.45 53.13
Tanzania 174.00 271.89 56.36 Unified
Zambia 70.27 65.39 279.56 -6.15
India 9.58 15.12 9.10 Unifl
Pakistan 26.26 -0.67 8.72 Unifi

. 1
NOM:Premiumisdefinedas(&/e”-l)*
IW. Exchangew k expressedas local currency/US$. Dataareannualaveragescalculatedusing
endingof quartervalum.
Source:IFSandWorldCurrencyYearbook,CurrencyAnalysis,variousissues
8

of high premiumcountri=4,Ghei,Kigueland O’Comell (1996) fmdthatthe medianpremiumfor the period

1990to 1994was49 perm~ comparedwitha figureof 100percentfortheperiod 1980-89.Similartrendshave

beenobsexvedfor moderateandlowpremiummuntri= as well.

Ovmti, thereareindicationsthatdevelopingcountriesue movingin thedirectionof unifiedexchange

rates.Thenumberofcountrimwithsignificantparallelmmke~has declined,and thegap betwun theofficial

andtheparallelrate is steadilydecreasinginmost of thecountriesthatstillhaveparallelratm.

11.4Rationalefor ParallelMarht Systems

Parallel marketsystemsemergefor differentreasonsin differentcountri=. Thereis one legitimate

rationalefor a systemin whichcment accounttransactionsare conductedat a peggedrate andcapitalaccount

transactionsareconductedat a floatingrate:to insulatedo-tic pricesandeconomicactivityfromexchangerate

fluctuationsderivingtim transitoryshocksin thefinancialmarket.

In practice,the implementationof parallelmarketsystemsin developingmuntrim rarelyhas been

consistentwith this rationale. In certainLatin Americancountries,dualexchangerate systemswereindeed

adoptedinrmponseto strong,temporarycapitaloutiowsr=uitingfrombtiance-of-paymentscrisesin the 1980s,

andthisdi&to a @ ex~ protecttheireconomiesfiornexcessive,transitorydepreciationsof theexchange

rate. However,thedualmarketswereretainedlongafterthefmancid criseshad passed. Moreover,evenafter

the criseshad passed,thepdel rates continuedto be moredepreciatedthan theo~cial rates; in a dualrate

syskmtiigned topm~ thewnomy tim exchangeratevariability-asopposedto a systemdesignedto target

theofficialrateat a levelpe~iskntly moreappreciakdthanwhatthemarketwodd set--theparallelratewould

be expectedto fluctuatebothaboveandbelowtheofficialrate.

InMean countri~,p~el marketswereevenlessconsistentwiththebestradonalefor theexistence

4A~@ pre~um coun~ iswherethemedianp~tium eX=dS 50 per ~n~ The te~ “m~era~
premium”is appliedto countrieswithmedianpremiumbetween10and50 percen~ A medianlevelof less
than 10percent putsa muntry intothelowpremiumcategory.The timeperiodexaminedin 1970-1994.
9

of suchs~terns. Frequently,exchangecontrolsweretightenedin th=e countriesas a gradualovervaluationof

the officialexchangerate led to ex~ss demandfor foreignexchangeat tie officialrate. This, in turn,led to

creationof parallelmarketsto evadesuch controls,evenin the absenceof strongcapitalaccountpressures.

Hence, exchangecontrolswereused to prop up persistently misalignedexchangerates, not to insula~ the

domesticeconomyfromtransitoryfluctuations.

11.5EconomicFunctionof ParallelMarkets

We haveidentiled twocentraleconomicfunctionsof parallelexchangemarkets.Whenparallelrates

emergedfollowinga balanceof paymentscrisis,as wasthecasein muchof LatinAmerica,theparallelmarket

wasusedprimarilytofinancecapitalflowsin andoutof thecountry.Therewas verylittlerationingin themarket

for trade transactions,as foreignexchangesupplywas usuallyenoughto satisfydemand. On average,the

premiumof theparallelrate relativeto theofficialrate was quitemoderatein thesecases- thoughtherewere

occasionalspilceswhenthepremiumwasveryhigh.But thesespikesreflectedtemporarymacroeconomiccnsm,

nota drasticandpersistentmisalignmentof therealexchangerate.

Preciselytheoppositewas truein thecaseof mostAfricancountrim.In theprototypicalcase,foreign

exchangerationinggrewmorestringentovertimeas theofficialexchangeratebecameincreasinglyovervalued.

Importerswholackeda-s toeverscarcerforeignexchangethroughtheo~cial channels,turnedto theparallel

marketto obtainforeignexchangefor tradetransactions,Theparallelpremiumgrewto very highlevels,and

stayedthere,astheofficialrate* moreandmoreovervalued.Ghanais the kxtbookexamplefor this,when

by the end of the 1980s,tie o~lcial exchangerate was so overvaluedthat it karne irrelevantfor most

transactions;
evendomesticpricesandMation reflectedtheparallel,not theofficialrate (ChibberandShtilk,

1991).

III. Unificationof ExchangeRatesto a SingleEquilibriumRate

Observa haveidentiledvariousnegativeconsequencesof exchangecontrolsandtheparallelmarkets

that they engender. A non-exhaustivelist wodd include,fns~ the fact that exchangecontrolsallow the

—--
10

authoritiato maintaina persistentlymisalignedofficialexchanger~-perhaps coupledwithinappropriatefiscal,

monetary,andcommercialpolicies--withoutlosingall their internationalreserves,therebydistortingrelative

prices in the wonomyand inhibitingthe growthof exports. Second,Wause parallelmarketregimesof~n

involvetherationingof foreignexchangeat subsidizedratesto thosewithpreferentialaccessto theauthoriti~,

exchangecontrolsencouragethedevelopmentof rent-seekingbehavioramongpriva~ entrepreneurs.Finally,

theintroduction
ofexchangecontrols,whichby theirnaturearehard to enforceandprofitableto evade,tendsto

promotea cultureof lawevasionamongprivateentrepreneursthat mayspillover intootherareassuchas tax

complianceor adherenceto otherwonomicandfiancial regulations.

Inrmponseto theseandoth~adverseeff~ of exchangecontrols,an increasingfractionof developing

countrimhavemovedtodismantleexchangecontrolsandunifytheirexchangemarkets. Someparallelmarkets

wmeabandonedeitherbecausetheywereno longerneeded(whenthecrisiswasover)or becausetheywereno

longereffmtive,thatis,rampantevasionofextiangecontrolsunaed thesystem.Otherdevelopingcountries

(includingTanzania,GhanaandIndia)movedto legalizetheirparallelmarketsas a transitionalmeasurewhile

easingrestrictionson cment accounttransactions- as a stepon the pathto Mlcation of theexchangerate. In

thosecases,unificationhas beenpart of a largerstructuralreformeffortaimedat liberalizingmarketsoverall.

Becausetheemergaceof a parallelmarketusuallyrefl~ theexistenceof anexcessdemandfor foreign

exchangeat theprevailingofficialexchangerate (so thatforeignexchangemustbe rationedby the authorities),

successfulunificationof the exchmgemarketsgenerallyrequiresthat the officialexchangerate be devalued

stilcientlyto e”
~ “ excessdemandsfor foreignexchange.Put anotherway,successfulWlcation requirw

thattherealofficialexchangeratebe set at its “realequilibrium”level.

Definitionsof the “realequilibriumexchangerate” aboundin the literature. Herewe focuson two

equilibrium
concepts,the“short-run”
and“long-run”equilibriumexchangerates,whichare morefullyd~cribed

inanotherchapterin thisvolumes The long-runequilibriumexchmgerate is thatrate whichequatesthetrade


.

bpekrMontiel,“me maw of tie ~ng-R~ EquilibriumRealExch~ge ‘a~”*


11

balancewith sustainablenet capiti flOWS,when fisc~, mOne@, mcl commercialpolici= are “normal”and

sustainable,
whenforeignassetholdingsareequalto theirdesiredlevels,andwhenno exchangecontrolsarein

place. The short-runequilibriumexchangerate,by contras~is thelevelof theexchangerate that equatesthe

tradebalanceto net capitalflows--thatis, equatesthe supplyanddemandforforeignexchange--givencwent

settings of economicpolicyand cment demandsfor foreigncapiti, regardlessof whethereitherare at their

normal levels;as in the caseof the long-runequilibriumrate, the short-runequilibriumreal exchangerate is

definedas thatwhichinducesbalance-of-payments
equilibriumwhenno exchangecontrolsarein place.

Theshort-runquilibriumrd exchangeratemaydiffertim its long-runvaluefor innumerablereasons.

Forexample,startingoutin aneconomywhereboththeexchangera~ andothergovernmentpoliciesare at their

sustainable,
long-runsettings,theimpositionof extraordinaryimportbarriers,by reducingtheeffwtivedemand

fmforeignexchangein theforeignexchangemarke~willcausetheshort-runequilibriumreal exchangerateto

appreciaterelativeto its iong-runlevel. Conversely,expectationsofa futuredevaluationor politicaldisruption

will lead to a temporaryheighteneddemandfor foreignassets that will lead the short-runequilibriumreal

exchangerateto depreciatein relationto thelong-runequilibriumra~.

Bydeftition, as longas theoff~cialexchangerate is at its short-runequilibriumlevel,therewillbe no

imbalancebetweendemandsand suppliesfor foreignexchange.Thereforeparallelexchangemarkets,to tie

extentthattheyreflectanexcessdemandforforeignexchangeunderuent economicpolicim,are associated

with real officialexchangerates that are overvalued--thatis, apprwiated--withrespectto the short-runreal

equilibriumexchangerate. However,successfullysustaininga unificationof the exchangemarketprobably

requirmthattherealofficialratebe set to its long-runequilibriumvalue,not its shon-run value. Moreover,it

probablyrequiresthatotherelementsof governmentpolicy,in additionto theexchangerate,be changedas well.

Toseethis,consideranexamplein whichtheauthoritieshaveimposedveryhighquantitativerestrictions

(QRs)onimports,therebyreducingtheeffectivedemandfmforeignexchangeandappreciatingtheshofi-runreal

equilibrium
exchangeraterelativeto its long-runlevel. At thesametime,assumethattheauthoritieshaveaiso
12

w theofficialex-ge rateata levelthatis evenmoreappreciatedthantheshort-runequilibriumrate, so that

in response to an excessdemandfor foreignexchange,the authoritiesration dollars and a parallelmarket

ernerg=. Inthisexample,devaluingtheofficialexchangerate to its short-runequilibriumlevelwouiduni~ the

extiangemarkets,butwouldleavemuchof thedistortionassociatedwiththeQRsuntouched.A ~lly successful

tilcation thereforewouldentaildismantlingthe QRsanddevaluingthereaIofficialexchangerate all theway

to its long-runequilibriumlevel.

k practice,somecountri=mightnotregardit as feasible,withina shortperiodof time,bothto devalue

theirexchangerateto itslong-runequilibrium
levelandto adjustinappropriatefiscal,monetary,andcommercial

policiesas well. They may fear the inflationaryad distribution consequencesof a very large “maxi”

devaluation,andmayfacestrongpoliticalpressuresagainstchangingparticularaspectsof governmentpolicy,

particularlytradebtiers that benefitcertainvated interests. In sucha case,the authoritiesmightatmmptto

implementa gradualprocessof unificadon,movingtheofficialrate towardits long-runequilibriumvalueeven

as theyadjustassociatedeconomicpoliciesin the appropriatedirectionas well.

Whetherthe authoritiesintendto implementeithera gradualor a rapidtilcation, theywillneedto

iden~ thelong-runequilibriumvalueof thereal exchangerate, and,as notedin the introduction,thistaskwill

be fraught with mnsiderableuncertainty. Underthesecircumstances,the prevailingparallelexchangerate

W-M anobvio~PmXYfm the~uilibriumrate,andthe authoritiesmightnaturallyconsidertheparallelrate

to be m appropria~targettowardwhichto movetheofficialrate,eithergraduallyor all at once. As shownin

thefollowingsection,however,thereare manyfactorsthatcodd causetheparallelra~ to divergesignticantly

hornitslong-runequilibrium
value,makingig in manyinstan~, aninappropriatetargetfor theofficialexchange

rate.

IV.A SimpleModelof ParallelExchangeRateDetermination

Thisstion presentsa simplepartialequilibriummodelto illustratehowthe parallelwket exchange

rateisdeterminedinrelationbothtotheoKlcialexchange
rateandto the long-runequilibriumexchangerate,that
13

is, the rate that wouldproduceequilibriumin the balanceof paymen~ under normal, sustainablepolicy

conditions!Thereisnoconsensusregardingthemostappropriatemodelto use in explainingtie parallelmarket

rate, just as thereis no agreementas to whichmodelbest explainsthe movementof floatingexchangerates

amongindustrialcountries.Themodelillustratedbelowhas theadvantageof beingrelativelystraightforward

andintuitive,whilehopefillyhighlightingthe mostimportantfeatur= influencingtheparallelmarketrate.

N.1 BasicSetup

Considera smallopeneconomytradingin twogoods,a nondomesticallyconsumedexportgoodanda

non-domestictiy producedimport;the worldpricesof both goodsare fixed and set to unity. To focuson

developmentsin the externalsector,we assumeit to be smallrelativeto the domesticeconomy,so that the

analysis&cribes theoperationof theparallelexchangemarketin partialequilibrium Therefore,theoutputof

anon-tradedgoodanditi priceareconsideredf~ed as well. We assumefor conveniencethattheUSdollaris

theonlyforeigncurrencytraded.

Turningto theparametersof governmentpolicy,it is assumedthatmonetaryandfiscalpoliciwareat

theirlong-~ sustainablelevels,andmoreovm,fortiytid convenience,


thereareno tariffs,subsidies,or other

commercial
policyintervention.(Theroleof importbarrierswillbe examinedlater.) Therefore,in termsof the

deftitionsintrodud in theprecedingsectiontheshort-runrealequilibriumvalueof theexchangerateis, at least

initially,the sameas its long-runvalue. TheofficialexchangerateE (measuredin termsof domesticcwency

per dollar) is peggedat an overvaluedlevelrelativeto the equilibriumrate. Therefore,at that levelof the

exchangerate, theflowdemandfor dollars(to be elaboratedbelow)exc~ theirflowsupply. Exportersare

requiredto surrendertheirdollarearningsto thecentralbankat theofficialrate E. Importerspurchasedollars

fromthecentralb~ whichrationsdollarsalesOS, basedon the amountof exportrevenuessurrenderedto the

centralbankOX, accordingto thecentralbankrationingfunction:

%e modelanditsexpositionarebasedon the analysispresentedin Kamin(1993,1995).


14

0s = os(o~,osf() >0 (1)

Inraponse to theprevailingexms demandfordollarsat the officialrate E, a parallelmarketfor dollars

pricedat theparallelmartirate Epemerges. We followthe conventionalstock/flowapproachto exchangerate

determinationin positingthat in the longrun, theparallelrate movesso as @equateflowdemandsfor dollars

by importerswithflowsuppliesfor dollarsby exporters. Thatis, ti the longrun Epis set so as to balancetie

privatesector’scurrentaccount In the shortrun, on theotherhand,theparallelmarketrate is assumedto move

exclusively
tosettheportfoliodemandfor dollarsequalto the stockof dollarsoufitanding,so thatat anygiven

momen~theprivatecwnt accountmaybe out of balance.

IV.2me ParallelMarketRate in hng Run CurrentAccountEquilibrium

Wenowanaiyzethedete* “onof theparallelmartirate inprivatecurrentaccountequilibrium.The

private sector currentaccountis defied as the differencebetweenprivatedollarinflowsor suppliesS and

outflowsor demandsD. We assumethat foreignersholdno domesticassets,so that changesin the stockof

dollarsheldbytheprivatesector,B,- exclusivelythroughimbalancesin theprivatesector’scurrentaccount:

dB = S - D (2)

The cment account(or flow)demandfor dollarsis a deriveddemandfor importedgoods. Arbitrage

ensures that thepriceof the importwillbe the same,whetherpurchasedhorn a legalimporterwithaccmsto

officialforeignexchangeor horn a smugglerusingdollarspurchasedin theparallelmarket.’ In eithercase,the

priceof importswillbesetqual toi~ marginalms~ theparallelmarketrateEP(sin@by assumption,tie foreign

currencyprice is set to unity). Therefore,the privatedemandfor imports,as indica~ in equation3 below,

TWe~sme hat theremen. t~ffs andthatrestrictionson smugglhg ~ cosfl~slYevad~” ‘e ‘at&r


assumptionis relaxedbelow.
15
depends
(negatively)
uponthedom=ticcmency prim of importsEPrelativeto thepriceof non-tradeablmPm.8

D = D(Ep/Pn) = D(ep), D/( ) <0 (3)

where&is therealparallelexchangerate.

Thement account(or flow)supplyof dollarsderiva bothfromunder-invoiceddollarearnings--that

is,exportreceiptsnotturnedoverto thecentralbank--andfromofficialdollarsalesto importersOS. Notethat

whileholdersofimportii~~ haveanincentiveto over-invoice,thisdoesnot addto thetotalsupplyof dollars

to theprivatesector,whichis fixedby thecentralbank’srationingtiction (equation1). Let X representthe

quantityof totalexportsandtotaldo~arrevenues
aswell(sincetheworldpriceis set to unity),while$ represents

theshareof totalexportproceedsdivertedto theparallelmarke~ Then

s = ox + Os(oxi = $x + 0s((1 -(#)x) (4)

Exporters~ domesticcurTency
profi~subjectto risingmarginalcostsof production--which
we

assumetoberelatedto thepriceofnon-tradedgoods--aswellasrisingcostsassociatedwiththeunder-invoicing

share~. Wecanderivethesupplycurvefor totalexportsas a functionof theweightedaverageof thereal (non-

tradeablespricedeflated)official(e) andparallelmarketexchangerates(eP):g

X = X(@eP + (1 -@)e), X’( ) >0 (5)

Theunderinvoicingshare$ canbe shownto positivelydependupontherealparallelmarketpremium:

(6)

8~ p~ciple, imwfi demmd is a ~ction of in~me as well. Sin~, in tis p~~ ~~ibrium ‘Odel$
“ incomeis consideredto be fixed,we do not includeit explicitlyin thedemandtiction.
9SW K- (1993)for ‘ews’
16

For a given vaiueof the real oficid rate e, a uniquereal pdlel marketrate & will equatedollar

demandsandsupplimin equilibrium:

D(e~ = @X + OS(O~ (7)

Thisequationw be Mer simplifiedif wepositth~ on averageandovera longenoughtimeperiod,thecentral

bankwillhaveroughlystable
internationalreserves. Therefore,we can assumethatovera longtimeperiod,the

centralbank willresellall surrenderedexportreceiptsOX= (1+)Xtolicensedimporters,afterit extrac~any

foreignexchangeneedsof thegovernment(assumedto be invariantto theexchangerate)D~10

OS(O~ = OX - Dg = (1 -$)X - Dg (8)

Therefore,equadon7 can be rewrittenas

D(ep) = +X + (1-+)X - Dg = X - D$ = x((#)ep+(l -@)e) - D8 (9)

Figure1belowdepictsvariousdifferentequilibriain theparallelexchangemarke~dependinguponthe

valueof e set by the authoriti~. TheDD curvedepictsequation3, theprivatedemandfor foreignexchangeas

a tiction of thereal parallelrate &. The SS curvedepictsthe supplyof foreignexchangeto the marketas a

titionof ~; itslocationalsois atitionof e, sinmboth & ande affectthe totalquantityof exportssupplied.

e* is thelong-m equilibriumrealexchangerate, thatis, thelevelof therealexchangerate thatwodd cl~ the

market- set toti de~ds for foreignexchangeequalto totalsupplies-in a unifiedforeignexchangemarket.

Notethatwhatheofficial exchangerateis setequalto e*, theparallelrate alsomustequale*.11In otherwords,

llwe bow thiS ‘w u


D(e*)= X(e*). Dg
in a unifiedexchangernarke~andif in a parallelmarketsystem,
D(ep)= X(W + (1-@~*)- Dg,
16a

ep
D

epl . . . . . . . . . . .
+
......... .....................
e*

D,S
Figure 1
17

when the officialexchangerate is set at its equilibriumvalue, there is no current-accountmotivefor the

emergenceof a parallelforeignexchangemarket,sincethereis no excessdemandfor foreignexchangeat tie

officialrate.

Wenowcomidertheeffecfion therealparallelrateof a real appreciationof theofficialrate. Assume

thattheauthoritiesallowtheofficialratee to appreciateto an overvaluedlevelel< e*. Becausethislowersthe

profiti-ilityof exports,thesupplycurveSS shiftsinwards,creatingan exmssdemandfor foreignexchangeat

thatrate. Thisputsupwardpressureon theforeignexchangevalueof thedollarin the (nowemergent)par~el

marke~causingthep@el exchangerate to depreciatefrome* to &l .12

Hence,in cases wherethe emergenceof the parallelmarketreflectsthe overvaiuationof the offlcia.1

commercial
exchangerate,theparallel-ket rate,on average,is likelynotonlyto be moredepreciatedthanthe

commercialrate, but it probablyis more depreciatedthan the long-runequilibriumexchangerate ~ well.

Various factors are likely to determinethe extent to which the parallelrate is more depreciatedthat the

equilibriumexchangerate. As Figure1makesobvious,the moreovervaluedtheofficialexchangerate,andso

thegreatertheextentto whichthe SS curveshiftsinwards,thegreaterwillbe the gapbetweentheparallelrate

and the equilibriumrate. It also is straightforwardto showthat the gap willbe greater,the moreelasticare

exportsand thelesselasticareimportswithrespectto theexchangerate.

Theex~t to whichexportsurxender
requiremts areenforcedplaysa keyrolein determini.n
g thevalue

of theparallelexchangerate, as well. Recallthattotalexportsarea functionof a weightedaverageof thereal

officialandparallelexchangerates. If foreignexchangeregulationsaretightlyenforced,exportunderinvoicing

willbe limited,reducingthe underinvoicingratio $ and therebyincreasingthe weightplacedon the official

exchangerate. Inthiscase, theovervaluationof theofficialexchangeratedepressestotalexportssigtilcantly,

reducingthesupplyof foreignexchangeto theparallelrnar~ anddepreciatingtherealparallelmarketexchange

thenit is obviousby inspectionthatthe secondequationis satisfiedfor ep=e*.


l~s resdt is ~mis~nt with tilatfoundby NOW*(1984)”
18

rate substantiallyrelativeto the equilibriumrate.

Conversely,
i.fforeignexchangere@ations arepoorlyenforcedandwidelyevaded,theunderinvoicing

ratiowillbe higher,theweightedaverageexchangerate willbe morefavorablefor exporters,andtoti exports

will not be as severelydepressed. ~s willlead to less pressureon theparallelmarketexchangerate and a

smallergaprelativeto theequilibrium
rate. At anextreme,as to someextentoccurredin someWean countries,

theo~cialexchangeratebecomessowidelyevadedas to becomeirrelevantto mosteconomicdecisions.In this

context,mosttradeis routedthroughtheundergroundeconomy,and tie parallelexchangeratemaybecomea

reasonablyaccurateguideto thelong-runequilibriumra~.

Finally,thevalueof theparallelexchangeratein long-runequilibriumis likelyto be influencedby the

ex~ntto whichbarriersto imports(aboveandbeyondmerelyrationingofficialsalesof foreignexchangethrough

exchangecontrols)are enforced.The aboveanalysisassumesthat onceimportersacquireforeignexchange,

Whethmofflcially
orfiomtheblackmarke~theymayusethatfinancingto freelyimportgoods. However,if the

authoritiesimposehighimportbarriersand theyare well-enforced,so thatsmugglingis costly,thiswillact to

redumthedemandforforeignexchangeintheblackmarket--thatis, theDDcurveshownin Figure1wodd shift

inwardsandto thelek Thisreduceddemand,in turn,wouldcausetheshort-runrealequilibriumexchangerate

to appreciaterelativeto its long-runvalue,sincethe long-runequilibriumvalueof the real exchangerate is

predation theabsenceof extraordinarycommercialpolicimof thissofi Theimpositionof thebarriersalso

wouldleadtherealparallelexchangerateto appreciaterelativeto thecasewhereimportbarriersarenot enforced.

Forstilcientlytightcontrolson imports,therealparallelratecouldalsobe moreappreciatedthanthelong-run

equilibriumrealrate.

IV.3TheParallelMarketRate in Short-RunPortfolwEquilibrium

The resultsdescribedaboveare likely,at bes~to holdon averageoverrelativelylongperiodsof time.

Intheveryshort~ thestockof dollarsheldby tie privatesectoris consideredto be fixed,sinceit ti time

to
accumulate
ordecumulate
dollarsthroughaent accountimbalan~; duringthisshortrun,thepardel market
19

is modeledas behgde~tied bytie portfolio-bued


rate conventionally demandfor dollars. This portfolio

demanddependsuponthe relativeexpectedrates of return to holdingdollarsand domesticassets,whichare

Muend by anticipatedinflation,otheraspectsof maaoeconornicperformance,andpoliticalevens as well.

Thevolatilityof suchexzons largelyexplainsthehigh volatilityexhibitedby mostfreelyfloatingexchange

rates,includingparallelmarketexchangerat=.

Fora simpletheoreticalexposition,assumethatprivatesectoragentshold two asse~ in theirportfolio,

dollarsand domesticcurrency.FollowingDombuschet. al. (1983),thedesiredratioof thedomesticcurrency

valueofprivatesectordollarholdingsto thenominaldomesticmoneysupply(M) is modeledas a tiction of the

expectedrateof depreciationof theblackmarketrate (the Adeno~ percentagechange):

or, dividingtiough by non-tradedgoodsprices,

(11)

Thenotationfor therate of depreciation,;P, ornitsan expectationaltermto reflectthe assumptionof perfect

foresight. The portfoliodemandfor dollars(whenthe parallelmarketrate is stable)tracesout a downward

slopingcurvein ( 4, B) spaw as shownin Figure2. GiventhatB is consideredfixedat anyone momen~the

levelof B determinesthelevelof & at thatmomen~

In thelongrun, theparallelmarketrate and the privatestockof dollarholdingsare determinedby the

require~ts ofbothportfolioandcurrentaccountequilibrium.In additionto theportfolioequilibriumcondition

hdbed above,Figure2 depictsthelocusof poinfifor whichthe privatecurrentaccountis in equilibrium,so

thatthestockofdollarsB heldby theprivatesectoris unchanging.This curve, denoteddBsO,is vertical,since


19a

dB=o

o ep
Figure 2
20

for any givenofflcid exchangerate, a singlevalueof the parallelmarketrate ep clears the privatecment

account.13
Thepointwherethe twocurv= cross--thesteady-stateequilibrium--istheonlypointwhereboththe

currentaccountis in equilibriumandthestockof dollarsheldby theprivatesectorequalsits portfoliodemand.

Finally,theverticalandhorizontalmows repraentthedirtion of movementof B andepoukideof equilibrium,

while the diagonalline-the “stablesaddle path’’--indicatestie path by which B and # convergetoward

equilibrium,shodd theystartout ou~ideof equilibrium.

Wenowconsidertheeffectsontheparallelmmketrateof a rise in inflation--say,fromOto 20 percent--

leadingtohigherratesofnorninaldepreciationof theofficialandparallelexchangerates. Thisis an impo~t

example,sincemanycountri~ that imposedexchangecontrolsexperiencedincreasesin inflationand other

measuresof macroeconomicvolatilityat aboutthesametime,particularlyin LatinAmerica(andTurkey).

As shownin Figure3, the increasedexpectedlevelof ~ation-and henceof nominaldepreciationof

theparallelmarketrate-leadsagentsto desireto holda higherratioof dollarsto dom~tic currency,causingthe

Portfoliobalanmcurvetoshifiupwards. Equilibriumdollarholdingssh.ifttim BOto Bl, whiletheequilibrium

real parallelmarketrate remainsunchanged.However,in orderto accumulateadditionaldollars,the private

currentaccountmustshiftintosurplustemporarily,whichin turnrequiresa temporarydepreciationof thereal

parallelexchangerate. Hence,at themomentof increasedinflationexpectations,theparallelmarketratejumps

tiominitialquilibriumat(l) tothenewstablesaddlepathat (2). Afterthis,theaccumulationofdollm through

thecurrentaccountsurplusreversesthedepreciationof therealparallelmarketrateuntilthesystemreturnsto

equilibriumat (3).

h theexampledepictedabove,thed parallelexchangeratebecomes,for a time,moredepreciatedthan

i~ ownequilibrium
level(conditional
onthevalueof therealofficialrate). (As a resultof thesetemporarycapiti

ltForsimplicity,~s ~~ysis abs~ac~horn the interestpaymentsassociatedwi~ net as~t holdings?U


wellas horn thewealtheffectsof assetholdingson importdemand. In thepresenceof interat paymentsor
wealtheffec~,thedB=Ocurvewouldnotbe vertical,sincethevalueof theparallelmarketexchangerate that
clearedtheprivawcurrentaccountwouIddependuponthestockof dollarholdingsB.
20a

dB=o

BI ........................

~p=zo

BO ........................

Ep=o
ep
Figure3
21

outflows,theshort-runequilibrium
exchangeratein a unifiedmarketalsowodd depreciaterelativeto its long-run

equilibriumlevel.) Sincetie equilibriumlevelof theparallelexchangerateis likely,as shownin Section111.2,

to be more depreciatedthan the long-runequilibriumrate in a unifiedexchangemarket,this meansthat the

parallelrate duringperiodsof macroeconomicvolatilityand capitaloutflowswill be more depreciatedsti~.

Hence,duringperiodsof macroeconomicvolatilityandheavycapitaloutflows,theparallelrate is likelyto be a

particularlybiasedguideto settingthe appropriatelevelof theofficialexchangerate.

Infa~ becauseof theassetmarketfunctionof theparallelexchangemarket,theparallelmarketratecan

trade at a large premiumoverthe officialrate, evenwhenthe officialrate is closeto its long-runequilibrium

value,thatis,thevaluethatequilibra~ thebalanceof paymentsin “normal”macroeconomiccircumstances.As

notedabove,his is becauseduringperiodsof heavycapitaloutflows,theshort-runequilibriumrealexchange

rate in a unifiedexchangemarketmay depreciaterelativeto i~ long-runlevel;if the officialexchangerate

remainsat that( i.e. equilibrium)long-runlevel,an excessdemandfor foreiWexchangewilldevelopthatwill

causea parallelmarketpremiumto emerge. TheLatinAmericancountries’experienceswithexchangecontrols

mayfitthisscenario.Aswillbe discussedfurtherbelow,in variousof th=e countries,a combinationof factors

led to a balance-of-payment
crisisin the 1980s. The governmentsrespondedto thiscrisisby depreciatingthe

officialexchangerate,butbecauseof thesizeof the capi~ outflowstriggeredby thecrism,the parallelmarket

ratesin thesecountriesdepreciatedstillfurther.

Finally,weshouldunderscorethef= thatevenif therealparallelmarketexchangerate,on averageover

longperiodsof time,werea goodindicatorof thelong-runequilibriumred exchangerate,thevalueof thereal

parallelmarketrateat anysinglepointin h wodd likelybe anextremelyunreliableproxyfor thatequilibrium

rate. Thisis becausetheparallelmarketexchangerate, likeanyotherassetprice,dependsuponhighlyvolatile

@otio&-&, adham&i&eMti@y volatile.This volatilitymaybe seenquiteeasilyin thechartsof the

officialandparallelexchanger~ presentedat theend of thispaper. Hen&, asidehorn the factthattheparallel

rateis likelyto be a biasedindicatorof thelong-runequilibriumexchangerate,it is also,unlessaveragedover


22

very long periods,likelyto be a highlyuncertainor inaccurateindicatorof the equilibriumrate as we11.14

V. Trendsin Oficial and ParallelRealExchangeRates

Thetheoreticalmodeldescribedabovesuggeststhat the parallelexchangerate is likelyto be more

depreciated
thanthelong-runequilibriumrealexchangerate,unless(1) macroeconomicfactorsinducingcapital

flightarenot presen~(2) exchangecontrolsare poorlyenformd,and/or(3) therearehighimportbarriersthat

are wellenforced.To evaluatethesehypotheses,we would,ideally,comparethepathof theparallelexchange

rate in variouscountri~ to thatof thelong-runequilibriumreal exchangerate in orderto gaugetheextentto

wtichtheparaIlelratemayserveas a use~ guideto determining


g theequilibriumexchangerateand, therefore,

in settingtheofficialrate.

Unfortunately,
theequilibrium
realexchangerateis a thwreticalconstructwhichmustbe estimati, not

a measuredquantityfor whichdataexis~ Mor@ver,evenin a ~ed markegtheempiricalestimationof the

equilibriumreal exchangerate is no easy task Estimatingthe equilibriumrate is a highlyinvolvedprocess

requiringstrongassumptionsabouttheoperationof thecurrentandcapitalaecounti,as wellas theestimation

of stabletradeandpaymentsrelationshipsovertime15.

Estimationofthelong-runequilibrium
rd exchangeratefor a widesetof countries,in orderto compare

those exchangerates to actualparallelrates,wodd go beyondthe limitedscopeof thispaper. As a f~st step

toward identifyingwhereparallelmarketra~s stand in relationto long-runequilibriumreal exchangerates,

lqBmedon ~ opti~z~g mo~l of tie parallelmarketexchangerate,MontielandOStrY(1994)~me to


muchthesameconclusion.Theyfmdthatin thetransitionbetweensteady-stateequilibriain responseto a
productivityshock,theparallelmarketpremiummaymovebothaboveandbelowzero,andhenceis “an
unreliableindicatorof thesignandmagnitudeof realexchangeratemisalignment.”
lbA nm~r of ~proached haveb~n triedin thelitera~e. Devarajaran(1995)~es a gener~
equilibriummodelthatfactorsin changesin termsof tradeto estimatetheequilibriumrealexchangerate and
theextentof overvaluationin theCFACountrieS; Baffeset al (1995)constructan econometricmodelusinga
varietyof macroeconomictidament,als for severalof thesecountries;AhlersandHi.nkle(1995)followa
tradeelasticitiesapproachin theirestimation.
23

however,it makessenseto comparelevelsof the parallelrate to levelsof theofficialrate, averagedoverlong

periods of time.This comparisonmay be informative,since over stilciently long periods,the balanceof

paymentsmuston averagebe at a sustainablelevel. Additionally,it may be usefulto comparethelevelof the

rd officialexchangerateduringperiodswhenexchangeConwolsare h effec4andhenceparallelmarketsexist,

to periodswhenexchangemarketsareunified.Suchcomparisonsmayshedlighton thefactorsthatmotivated

theimpositionofexchangecontrols,whichin tummayhaveimplicationsfor therelationshipbetweentheparallel

andequilibriumrealexchangeratm.

A complicatingfactorin usingaveragesof actualexchangerates as proxiesfor equilibriumexchange

rates is that for most countrim,the process of developmentand structuralchangewill cause the long-run

equilibrium
exchangeratetochangeovertime. In thatsense,along periodaverageof actualrealexchangerates

mayyiel~at bes~an averageof long-runrealequilibriumexchangeratesoverthatperiod. Withthiscaveatin

mindhowever,westillbelievethatempiricalcomparisonsof actualofficialandparallelexchangeratescan yield

usefi insights.

First, our analysiswillfocuson averagesof exchangerates acrossa largeset of differentcountria.

Therefore,evenif long-runrealequilibriumexchangeratesfollowparticulartrendsin each individualcountry,

theaveragelong-runrealequilibriumexchangeratefor the sampleas a wholemaybe morestation~. Second,

ouranalysisfm~ uponcomparisonof~mnt typesof exchangerates--officialandparallel-duringdifferent

regimes–withand withoutexchangecontrols. Therefore,our results willbe ~erable to misinterpretation

mainlyif thetimingof exchangecontrolperiodsin thesamplecoincidewithparticdar movementsin long-run

equilibriumreal
exchangeratm. Whilewe betieve,asd.iscussedabove,thatexchangecontrolperiodsare likely

to coincidewithsystematicmovementsin shorf-runequilibriumrealexchangerates, as a resultof tempor~

shocksto capitalflowsor thetermsof trade,wehavemuchlesscauseto believethatexchangecontrolshavebeen

. associatedwithparticulartrendsin Zong-runequilibriumreal exchangerates.

Y1 Dataand Methodology
24

To makethesecomparisons,we gathereddataon theofficialandparallelexchangeratesfor a sample

of24 developing
countri=(SeeAppendix1for thecompletelist). Of these,twelveare fromLatinAmerica,ten

are African and twoare SouthAsian.The sampleis basedon onechosenfor an earlierWorldBankresearch

projecton the macroeconomicimplicationsof multipleexchangerates (see footnote3 above).The sampleis

consideredto be fairlyrepresentative- geographically


anclwithrespectto thealternativepathsof evolutionof

theparallelrnarke~Thesampledoesincludemostof themoreprominentdevelopingcountrieswithsignificant

parallelmarkets,outsideeasternandcentralEuropeandtheformerSovietUnion.Thebasicdataset is theone

usedinGheiandKiguel(1992).We addedthreeAfricancountries - Algeri~MalawiandSudan; andextended

thedataset to the lastquartero f 1994.

To meanin~y comparelevelsof exchangeratesovertime,we fmt correctedthedataforchangesin

prim bydculating realexchangerates. Thereare a numberof empiricaldeftitions of the realexchangerate

(seeHinkleandNsengiyumva
(1995)for a detaileddiscussion).We use thebilateralrealexchangeratebetween

thecountrywe areexaminingandtheUnitedStates(localcurrencyper USdollar-an increasein theexchange

rateindicatesdepreciation).Theconsumerprim indexis usedas a proxyfor domesticprices;theUS producer

priceindexfor worldprices.

. E. Pus
e— (12)
P

wheree is therealexchangera~, E, thenominalexchangerate,is the Iocd currencyvalueof U.S.dollar,Pus

is the US producerpriceindexandP is thedom~tic CPIlb.

lbIt is conceivablethattheuse of a bilateralexchangerate,usingtheUSproducerpriceindexas a proxy


for worldpricesmaybiasourresults,in viewof thesi~lcant movementsof tie US dollarvis-a-visother
industrialcountriesduringthe 1980s.Resultsof tesk for sensitivitywithrespectto choiceof foreignprice
indexarepresentedin Appendix3, for a sub-sampleof countriesfor theperiod 1979-94.
25

The datausedare end of quarter,for theperiodfrom 1970through199417.


Therealofficialexchange

rateis indexedsothat1985Q1 isequalto 100. Therealparallelmarti exchangerate is indexedso thatits value

in 1985Q1 is equti to 100plus thepremium(in percent)of the parallelrateoverthe officialratein thatbase

quarter. For eachcountry,meanand themedianaveragevaluesarecalculatedfor thefollowing:e, theofficial

real exchangerate for theentireperiod;ep,theparallelrealexchangeratefor theentireperiodof i~ existence,

that is, whenexchangewntrols werein eff~t; en.,the officialnon-tiled real exchangerate, for theperiods

whmexchangecontrolswerein effectandexchangemarketswerenot Mled; ande’, theofficialrealexchange

rateduringperiods,if anyexisted,whenexchangemarketiwereunified. A unificationof exchangemarketsis

definedtohave* placeif theabsolutevalueof theparallelrate deviateslessthan3 per wnt fromtheofficial

rateforat least4 q~. Thenon-zeronumberis to takeintoaccountmeasurementerrors,sincetheoficial and

parallelrates are horn differentsour= (seetablm).

A~S-COUntI’y
Summaryof our calculationsof thefourrealexchangeratecategoriwdescribedabove,

basedonmeanaveragesof theexchangeratedatafor eachseparatecountry,is prmentedin columns1 through

4 of Table3. Resultsarepresentedin Table3 for thewholesample,as wellas twosubsets. For the countri~

in each subset, we presentthe mean,median,andstandarddeviationof therealexchage rate. In columns5

though9 ofTable3, wecalculmvariousratiosof thedatashownin columns1through4, andperfoxmbinomial

signhts to ~e whethertheseratiosdiffersignificantlyfromone. The Pr (Ho is true) rowindicatesthe

probabilitythattheob~ed configuration
ofratioswouldbeobsemed,if thenu~hypothesis- thattheratiowere

equalto 1-weretrue.

Theregionalgroupingswerechosenin orderto testourhypoth~s concerningthedifferentmotivation

and functionof parallelmarketsin differentregions. In Latin Americaand Turkey,exchangemntrols were

imposed,particularlyin the 1980s,in situationsof ~nornic and balance-of-payments


crisisleadingto

ITTheoffici~exchangera~s andprim are fromII’vIF,


InternationalFinanciaZStatistic. The p~allel
exchangerat= are from WorldCurrencyYearbookandInternationalCurrencyAnalysis,Inc.
Z6

strongcapitaloutflows.Inthesecountriw,pressurmtim capitalflightarelikelyto havecausedtheparallelrate

todepreciatewellabovethelong-runequilibriumrealrate,evenif theofficialexchangera~ wm notespecially

overvaluedrelativeto its long-runequilibriumvalue. tican and SouthAsiancountri~, on the otherhand,

experienced
muchlessmacroeconomicdistress. In thosecountries,exchangecontrolsweremorelikelyto have

arisen as a meansof rationingforeignexchangereceiptsin the contextof a progressiveovervaluationof the

officialexchangerate. As describedin SectionIV.2,theparallelrateis likelyto be moredepreciatedthanthe

long-runequilibriumrate in this mntext as well,unlessexchangecontrolsare poorlyenforcedand/orwell-

enforcedimportbarrierseffectivelycurtailthedemandfor foreignexchange.

K2 Comparisonsof PeriodAverages

Wenowcomparetherealparallelrate epto variousproxiesof theequilibriumrealexchangerate. The

fmt possibleproxyfortheequilibrium
RERwe wnsideris e, theaverageRERfor a periodof twentyfiveyem.

Asmaybeseenincolurnn5,&/e,onavaage,is greaterthan1,witha meanof 1.64for theentifesample.In fact,

thereisnocountryinoursamplefor whichtheaveragerealparallelmarketexchangerate wasmoreappreciated

thantheaveragerealofficialrate (calculatedfor periodswhentheexchangemarketwasunifiedas wellas non-

unified). To theextentthat the averageofficialrate, whenaveragedovera stilciently longperiod,is a good

proxyfortheequilibrium
realrate,thissugg~~ thattheparallelrate is a biasedindicatorof the equilibriumrate.

However,usingtheaverageRERfor theentireperiodmaybe misleading,sinceit includ~ periodswith

exchangecontrolsas wellas whenthe exchangemarketis unified.Whenexchangemntrols are in place,the

nominalprice of foreignexchangeis set by the authorities,and accessto foreignexchangeis determinedby

quantitativerationing.Hence,theofficialreal exchangerate duringperiodsof exchangecontrolis likelyto be

more appreciatedthan the equilibriumreal rate, It may be moreappropriateto use the RER averagedover

periodsof un~ledexchangemarke~- thatis, em- as a proxyfor thelong-runequilibriumRER.

For the wholesample,theparallelrateis, on average,moredepreciatedthantheunifiedofficialRER;

asindicatedincolumn8,themeanof theratio,&/e”, is 1.43for all wuntries.However,thisresultmash strong


27

@erenm Nw= LatinAmericaandTurkey,witha meanof 1.58,andMca and Asia,witha meanvalueof

1.05(whichis not si@lcantly differentfrom 1).Hence,to tie extentthate“is a goodproxyfor thelong-run

equilibrium
realexchangera~, epappears,on average,to havebeencloseto thelong-runequilibriumexchange

rate in Africaand Asia but muchmoredepreciatedthan the long-runequilibriumlevelin LatinAmericaand

Turkey.Thismayseemsurprising,giventhefarhigheraverageparallelpretia thathavebeenobservedin much

of Africa; as shown in column7, the ratio of the parallelmarketrate to the officialrate duringperiodsof

exchangecontrolaveraged1.85for AfricaandAsiabut only 1.42for LatinAmericaandTurkey.

The strong~erenc~ in &/e”,theratio of the parallelrate to the unifiedofficialrate, betwwnLatin

Americaandficaappear to berelatedto equallymarkeddifferencesin the evolutionof theofficialexchange

ratebetweenthetworegions.As indicati in column9, in LatinAmericaandTurkey,thereal officialexchmge

ratetendedto be moredepreciatedduringperiodsof exchangewntrols thanduringperiodswhentheexchange

marketsweretiled; themeanratioof e“-/e”was 1.12,with 9 of the 12countrieshavingratiosgreaterthan 1.

This is consistentwith our view that in Latin America and Turkey, unsustainablepoliciesresulted in

macroeconomicdisequilibrium,which,in turn, triggeredcapiti outflowswhich depreciatedthe short-run

equilibrium
realexchangerate(a relationshipthatwouldholdin a unifiedexchangemarket)relativeto i~ 1ong-

run level. The governmentdid depreciatethe officialexchangerate, but not by as much as the short-run

equilibrium
ratedepreciated.Therefore,anex~s demandfor foreignexchangedeveloped,causingtheparallel

ratetodepreciateaswell.Asmacrop=urm _ capitaloutflowsmoderatedandreversedthemselves,leading

to anappreciation
of theshort-runequilibrium
exchangerateandfacilitatingtheunificationof exchangemarkets.

IncontrasttoLatin~ca andTurkey,in theMean andSouthAsiancountriesin our sample,thereal

officialexchangeratetendedto be moreappreciatedwhenexchangecontrolswerein placethanwhenexchange

marketsw=unified. As shownin column9, for ~ca andSouthAsia,theratioof eB9/em


wasonly.65,with

al15countriesin thisgroupingshowingratioslessthan 1. This evidence,whilequ~ledby thelownumberof

observationsin thesub-sample,supportsour speculationthatthe emergenceof a parallelmarketin Mca and


Lo

Asia was typicallythe result of an appreciationof the real officialexchangerate relativem the long-run

equilibriumrate. Authoritieschose,for a varietyof reasons,to rationforeignexchangewhilemaintainingan

overvaluedreal exchangerate. As the extentof overvaluationinaeased, often foreignexchangerationing

tightened,andtheparallelmarketgrew,as did thepremium.

Consideringhowovervaluedtherealofficialexchangerate wasin manyAfricanandtheSouthAsian

countries,relativeto itslong-runequilibriumvaiue,it is surprisingthatrealparallelratesin thosecountrieswere

not more deprwiatedcomparedwith averagereal officialexchangerates duringthe periodswhenexchange

marketswereunified. SectionIV.2showedthat,allelseequal,themoreovervaluedwastheofficialexchange

rate, the moreundervaluedwouldbe the parallelrate relativeto the long-runequilibriumrate. Therefore,

unificationpresumablywouldhaverequiredtican and Asiangovernmentto devaluetheirofficialexchange

ratesto a leveltiat was not asdepreciatedas thepriorlevelof theparallelrate.

Inaddressingthisissue,it is importantto pointout thatwe havea verysmallsampleto examine- only

5 ~untriminoursamplein thesubse~AfricaandSouthAsia,unifiedtheirexchangera~. In twoof thesefive

cases(EgyptandT~ania), theratiois greaterthan 1. Additionally,as wepointedout in SectionIV.2,thereare

factorsthatmaylowertheparallelraterelativeto the levelpredictedby thebasicmodel. Firs~considerthecase

whenunderinvoicing,+, ishighbecauseexchangecontrolsarenoteffective- whenenforcementis lackadaisical

andevasionwikprd Th~ for allpracticalpurposes,therelevantratefor theemnomybecomestheparallel

rate, whichmay,in thiscase,be closeto theequilibriumrate. Then,whenexchangemarketsareunified,the

officialratewouldneedtobedepreciatedto thelevelof theformerparallelrate,and&/eUwouldbe closeto one.

Ghanais anexullent illustrationfor this (ChibberandShaffii (1991)).

A s~nd factorthatmightappreciatetheparallelmarketraterelativeto thelevelpredictedby thebasic

modelmightbethestrongenforcemt of importcontrols.Thiswouldcausethepremiumto be low,evenif the

. officialexchangerateis maintainedat a substantiallyovervaluedlevelcomparedwiththelong-runequilibrium

exchangerate,sinceeffectiveimport~ntrols reducethedemandfor foreignexchangeandtherebyappreciatethe


29

short-run equilibriumexchangerate. Then, if tilcation is associatedwith import liberalization,thereby

depreciating short-runreal equilibriumexchangerate, theofficialexchangerate willhaveto depreciateby

a largeamountifexms demandsforforeignexchangeareto be eliminated.Thisscenariowouldleadto a ratio,

&/e”,tiat wouldbelowcomparedwiththepredictionsof thebasicmodeloutlinedin SectionIV.2. Indiais the

ht examplefmthis-tilcation oftheexchangerate tookplacein 1993as pm of a largerliberalizationeffort,

requiring greaterdevaluationof the officialexchangerate than wouldhavekn the case in the absenceof

importliberalization.

Table3: FullPeriodStatistics,Ratiosand BinomialSi~ Tests


1 2 3 4 5 6 7 8 9
Offlciai Parallel Official Official Ratio, Ratio, Ratio Ratio, Ratio,
RealER RealER ERwith ER when #/e e’”le #/e”” @/e” e-lea
Country 1970-94 Par. mkt Unifjed 2fl 3/1 2f3 W4 3/4
~tin Americaand Turkey
Mean 82.52 121.02 85.13 76.91 1.46 1.03 1.42 1.58 1.12
Median 69.10 115.01 69.43 64.66 1.24 1.06 1.36 1.32 1.10
Std Dev 26.17 24.29 47.71 27.28 0.36 0.26 0.34 0.39 0.16
Numbers 1 0 3 0 0 3
Number>1 12 9 12 12 9
Pr (HOis true) 0.0002 0.019 0.0002 0.0002 0.019
A~“ca &Asia
Mem 120.04 222.82 117.94 195.24 1.82 0.98 1.85 1.05 0.65
Median 103.56 186.64 101.56 267.03 1.78 1.00 1.81 0.97 0.57
StdDev 45.99 111.76 45.03 85.81 0.58 0.02 0.58 0018 0.12
Numbers 1 0 12 0 3 5
Number>1 12 0 12 2 0
Pr (HOis true) 0.0002 0.0002 0.0002 0.500 0.031
All countries
Mean 101.28 171.92 101.53 111.71 1.64 1.01 1.64 1.43 0.99
Median 91.38 131.33 91.10 86.24 1.52 1.00 1.54 1.36 1.07
Std Dev 41.60 99.81 40.40 74.67 0.50 0.04 0.51 0,38 0.25
Numbers 1 15 0 3 8
Number>1 24 9 24 14 9
Pr (~ is true) O.000 0.153 0.000 0.006 0.50C,
Source:
ES,WorldCurrency
Yearbook,
Currency
AnalysisInc,various
issues,
authors
~culations.
30

K3 The Oficial ExchangeRate afierExchangeMarht Unification

The issuesrelatedto unificationcan be tier examinedby consideringwhathappensto the official

exchangerate at that time. We havetwentyobservationsof unifications.In somecases,a countryhas two

episti of dualexchangerat~, witha periodof unifiedexchangeratesin theinterim;theseare treatedas two

separateobservations.
Somecountrimhavenevertiled, andthereforearenotrepresented(seeAppendix2 for

thecompletelist).Thecomposition
of thetilcation dataset is quitedifferentfromthatusedin Table 1.Firstly,

threequartersoftheobservationsarehorn theexperienceof unificationin LatinAmerica;onlythreeoutof the

twentyobservationsare for Africa,withthe twoSouthAsiancountriu completingthe coun~The verysmall

samplemeansthatthesubsetsresultsare to be interpretedwithcautionfor the AfricaandSouthAsiasubset.

InTable4, we lookat themean,medianandstandarddeviationof threevariables:theaverageofficial

RERfortheyearbeforethetication (10),theaverageofficialRERin theyearfollowingMlcation (11) and

the averageparallelrate for the year precedingthe unification(12). We calculatetwo ratios, of the post-

tilcation officialRERto thepre-unificationRER,egt+l/emmt.l;


andtheratioof thepostunificationofficial(and

sole) RER to thepre-unificationparallelrate, eot+l/&t.l.


As before,we reportthe mean,medianand standard

deviationfor allvariablmas wellas ther~ults of binomialsigntestfor tie ratios.

Theresultsareconsiskntwiththefindingsreportedin table3. Theratioof thepost-to pre-untication

officialexchangerate, ew,+l/em9i.1,
is approximatelyequal to one for the wholesample.Again,aggregation

obscurathedifferenmin resul~betweenthe twosubsefi.Theratio, eut+l/e’gt.l


is (very)slightlylessthan 1for

LatinAmericaandTurkey,suggwtinga smallappreciationin theRERfollowingunification.Thisis consistent

with the ideathancapitalWows resumedas the macrocrisiswas alleviated,appreciatingthe short-runreal

equilibriumexchangerate and allowingthe authoritiesto appreciatethe real offlcid exchangerate while

simultaneously
unifyingtheexchangemti. Theratiois slightlygreaterthan 1on averagefor AfricaandAsia,

as theexchangerate wasdevaluedfollowingunification.Again,this is consistentwiththeobservationthat in


.
threecountria,officialexchanger- duringtheexchangewntrol periodwereovervaluedrelativeto theirlong-
n

31

runequilibriumraks, so thatunificationrequiredthedevaluationof theofficialrate.

Therelationship
betweenthetild officialrateandthepriorparallelrate alsodifferssomewhat

the sub-samples.The ratio eO,+l/ept.l


clearlyis lessthan 1 for the entiresample,indicatingthatin general,the

offlcirdrateis not depreciatedall the way@the levelof the formerparallelrate. Withthe exceptionof Ghana

and Bolivia,the averageratio is less tian 1 for all countrim. ~S rault also is unambiguousfor the Latin

AmericaandTurkeysubs& On the otherhand,berat.io egt+l/&,.ldoesnot appearto be significantlydifferent

fromone for the~can and Asiansample,whichis consistentwithresultsd=cribed above-averagetiled

officialexchangeratesappearto be closeto the averagelevelof theparallelrate in Asiaand Mea. -

Table 4: UnificationEpisodes- Statistics,Ratiosand BinomialSign Tests


10 11 12 13 14
OfficialRER, OfficialRER, ParallelRER, e8~+1/eaut.1 e“*+l/#~.l
Country Year,unif-1 Year,unif+l Year,unif-1 11/10 11/12
- America& Turby
Mean 85.15 85.62 109.31 1.00 0.83
Median 81.99 75.74 101.98 0.98 0.87
StdDev 29.89 33.19 54.88 0.09 0.15
Numbers 1 9 15
Number>1 7 1
Pr (~ is true) 0.576 0.001
Aftia & Ash
Mean 183.67 201.5~ 203.81 1.08 0.98
Median 172.71 155.21 180.99 1.11 0.94
StciDev 71.92 87.56 85.81 0.12 0.13
Numbers 1 1 4
Number>1 4 1
Pr (HOis true) 0.188 0.188
All countries
Mean 108.61 113.21 131.81 1.02 0.86
Median 99.42 83.77 118.08 1.00 0.90
StdDev 60.60 71.42 75.28 0.11 0.16
Numbers 1 10 19
Number>1 11 2
Pr (~ is true) 0.500 0.0001
Source:
IFS,WorldCmencyYearbook,
Currency
~ysis Lnc,various
issues,
authorscalcu~ons.
32

VI.Conclusion

Wenows~ themostimportantfindingspresentedin ourpaper. To beginwith,ourtheoretical

analysisindicatedthatwhentheemergenceof a parallelexchangemarketis motivatedby theovervaluationof

theofficialexchangeraterelativeto thelong-runequilibriumred exchangerate,theparallelmarketrateis likely,

on average,tobemore@reciatedthanthelong-runequilibrium
realextiangerate. Thegap betweentheparallel

rate and the long-runequilibriumrate is likelyto be smaller,to the extent that export receipt surrender

requiremen~arenutwelldor~ andto theextentthatbarriersto importsandothercommercialpoliciesthat

tendto appreciatetheshort-runequilibriumrealexchangerate are well-enforced.

Moreover,our theoreticalanalysisindicatedthatevenif tie officialexchangerate is set at i~ long-run

equilibrium
level,a parallelmar~ mayarisein orderto meetthedemandsof residentsseekingto augmenttheir

holdingsof foreignassets. Duringtheperiodwhenforeignassetsare beingaccumulated--that


is, whencapital

mghtis ~g-the parallelexchangeratewillbe moredepreciatedthanitsownequilibriumvalue,andhence

probablymoredepreciated
thanthelong-runequilibriumextige~ fm theeconomyas a whole. Additionally,

becausetheparallelmarketrateis anasw price,andexhibitsthevolatilitythatis characteristicof all assetprices,

the valueof theparallelrate at anygivenmomentis likelyto be a particularlypoor indicatorof the long-run

equilibriumexchangerate.

Th~e considerations
suggestthaton balance,theparallelrate is likelyto be moredepreciatedthanthe

long-runequilibriumrealexchangerate,andhencetheofficialexchangeratein a unifiedexchangemarketwill

in generalht besetat a levelthatismoreappreciatedthanthepriorparallelrate (averagedovera suitablylong

period).Inthisp~, wedidnotcomparea parallelexchangeratesto estimatesof thelong-runequilibrium

rateindifferentcountries,owingto thed~lculty of estimatingequilibriumratesfor a largesample. However,

wecomparedmulti-yearaveragaofrealparallel~ to realofficialratesin a sampleof 24 developingcountries,

andmadea numberof useti findings.

First, we found that for the sampleas a whole,the real partiel marketrate was uniformlymore
33

depreciatedthantheofficialexchangerate,evenwhentheofficialratewas measuredonlyduringperiodswhen

the exchangemarketswere unified. Duringperiodswhen the exchangemarketis unified,and thereare no

exchangecontrolsto bridgethegapbetweensuppliesanddemandsfor foreignexchange,theofficialexchange

rateis morelikelytobecloseto tie long-runequilibriumrate on average. Hence,thisrepresen~partialevidence

thattheparallelrateten~ to be undervaluedrelativeto the long-runequilibriumexchangerate.

Secondwefoundimportantdifferencesin therelationshipbetweenparallelandofficialexchangerates

among differentsubsefi of our countrysample. In Latin Americaand in Turkey,the emergenceof parallel

exchangemarketsappears~ havereflecteda sharp depreciationof the short-runequilibriumexchangerate

relativeto its long-runvalue,not the appreciationof the offlciaiexchangerate horn its long-runequilibrium

value.Inthose~untri~, theparallelratewasclmly depreciatedcomparedwith theofficialexchangerateduring

periodswhentheexchangemarketswereunified. However,theundervaluednatureof theparallelratedoesnot

ap~ tOhavereflect~ fie overvaluat.ion


of theofficialexchangeraterelativeto the long-runequilibriumreal

exchangerateduringperiodsofexchangecontrols,sincetheofficialexchangerate in thissubsetwason average

moredepreciated
duringtheperiodswhenexchangecontrolsw=e in effectthanin theperiodswhenmarketswere

unified.

We surmisethat a combinationof internaland externalshocksled to macrmnomic turbulenceand

capitalflightin LatinAmericaandTurkey,mainlyin the 1980s. Thesedevelopments,in turn,depreciatedthe

short-run equilibriumrealexchangerate relativeto its long-runlevel. Whilethe authoritiesdepreciate their

officialexchange~-possibly evento levelsmoredepreciatedthanthelong-runequilibriumrate--theydidnot

dosobyenought.or~olveex~s demandsfor foreignexchange.Thatis, evenifofflcialexchangeratesduring

the exchangewntrol periodwereundervaluedrelativeto the long-runequilibriumrate, theywereovemalued

relative to the short-runequilibriumrate, therebygivingrise to parallelexchangemarkets. As a resulg the

parallelra~ probablywereeva moreundervalued


relativetothelong-runequilibriumrate thanweretheofficial

rates.
34

Third,we foundthattheAfricanand SouthAsia countriesin our samplebetterfit our preconception

thattheemergenceof parallelexchangemarketsreflectstheovervaluationof theofficialexchangeraterelative

to its long-runequilibriumvalue. Amongthe fewcou.ntrimin this subsetthatexperiencedperiodsof tiled

exchangerates, the real officialexchangerate clearlywas moreappreciatedduringperiodswhenexchange

controlswereineffwtthaninperiodswhenexchangemarketswereunified. Thissuggeststhatin contrastto the

LatinAmericaandTurkeycase,therealappreciation
ofofficialexchangeratesin Afticaand SouthAsia,relative

to long-runequilibriumvalues,was themainfactorunderlyingtheemergenceof parallelmarkets.

On the other hand, in Africaand SouthAsia the parallelexchangerate was not si~lcantly more

depreciatedthanthe officialexchangerate duringperiodswhenmarketswereunified--putanotherway,when

exchangemarketswereunified,the authoritieshad to depreciatethe officialrate all theway to thelevelof the

formerparallelrate. The relativesimilarityof parallelandunifiedofficialexchangeratesunderscor~thefact

thatinthecaseof someMean countries,exchangecontrolsmayhavebeenso poorlyenforcedthattheparallel

rateeff~vely mimickedtheroleof theofficialratein a unifiedexchangemarke~ Additionally,in someAsian

countries,well-enforcedimportbarriersconstrainedthedemandfor foreignexchangewhenexchangecontrols

wereineffec~therebyappreciatingboththe short-runequilibriumexchangerate andtheparallelrate;exchange

marketsweretiled at aboutthesametimeas importbarrierswerelowered,makingit necessaryto depreciate

theofficialexchangeratesubstantiallyin orderto maintainthebalan~ of paymentsin a unifiedmarke~

Our findingsfor someWean and Asiancountriessuggestthatin somecases,theparallelratemight

notbean inappropriti proxyfor thelong-run~uilibriumexchangerate,andhencecouldbe a guideto setting

the officialrate. Somewhatspecialfactorswereoperativein thesecountrieshowever--verypoorlyenforced

exchangecontrolsinsomeAfricancountri~,verywell-enforcedimportcontrolsin someAsiancountries.More

gen~y, theparallelmarketratewouldseemto representan upperbound,in termsof localcurrencyperdollar,

on the appropriatelevelof theofficialexchangerate.


35

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i

*
m

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I
I
37

Appendix 2
Table2.A: UnificationEpisodes
country 10 11 12 13 14
e(nu,t-l)OfficialRERe(q t+l)O~ial RER e(p,t-l)Parallel RER e(u,t+l)/e(nu,t-1) e(u,t+l)/e(p,t-1)
Year,Unification-1 Year,Unifi-tion+l Year,Unification-1 11/10 11/12
Mean IMedian Mean Median Mean Median Mean Median Mean Median
LQtinAmerica and Turkey
Argentina 76.45 69.89 74.17 75.55 147.95 141.42 0.97 1.08 0.50 0.53
Argentina 26.52 26.41 26.03 25.93 29.40 29.04 0.98 0.98 0.89 0.89
Bolivia 126.58 126.10 136.51 136.50 135.79 134.01 1.08 1.08 1.01 1.02
Bolivia 125.96 126.17 128.00 127.70 134.21 134.36 1.02 1.01 0.95 0.95
B- 60.01 59.92 59.30 59.08 64.74 65.17 0.99 0.99 0.92 0.91
Chile 58.23 57.82 64.18 64.31 65.00 65.32 1.10 1.11 0.99 0.98
Colombia 99.42 99.68 83.77 84.26 104.46 104.28 0.84 0.85 0.80 0.81
Dom Rep 57.21 56.98 56.12 56.36 61.18 60.92 0.98 0.99 0.92 0.93
Ecuador 126.11 126.18 126.39 127.84 141.07 140.06 1.00 1.01 0.90 0.91
Mexico 103.69 110.30 106.98 106.10 114.40 115.15 1.03 0.96 0.94 0.92
Mexico 87.53 88.01 76.20 75.50 92.51 93.29 0.87 0.86 0.82 0.81
Pem 64.50 63.99 75.28 75.01 132.37 146.55 1.17 1.17 0.57 0.51
Urumay 68.78 68.40 67.09 67.18 80.93 81.16 0.98 0.98 0.83 0.83
Venezuela 128.77 108.14 149.58 149.64 277.38 272.90 1.16 1.38 0.54 0.55
Turkey 64.49 65.59 57.84 58.19 68.11 68.22 0.90 0.89 0.85 0.85
Turkey 88.19 87.38 82.40 83.32 99.50 97.95 0.93 0.95 0.83 0.85
Afi”caand Asia
Egypt 172.71 171.70 155.21 156.55 180.99 176.55 0.90 0.91 0.86 0.89
Ghana 212.66 212.93 266.21 271.59 217.60 223.52 1.25 1.28 1.22 1.22
Tanzania 305.99 306.85 340.09 334.37 361.34 355.90 1.11 1.09 0.94 0.94
India 120.01 119.88 138.24 138.99 141.04 140.95 1.15 1.16 0.98 0.99
Pakistan 106.97 106.40 107.73 108.31 118.08 116.50 1.01 1.02 0.91 0.93
LatinAmerica& Turkey
Mean 85.15 83.81 85.62 85.78 109.31 109.36 1.00 1.02 0.83 0.83
Median 81.99 78.63 75.74 75.52 101.98 101.12 0.98 0.99 0.87 0.87
Std Dev 29.89 28.91 33.19 33.22 54.88 54.17 0.09 0.13 0.15 0.15
AMca & Asia
Mean 183.67 183.55 201.50 201.96 203.81 202.68 1.08 1.09 0.98 0.99
Median 172.71 171.70 155.21 156.55 180.99 176.55 1.11 1.09 0.94 0.94
,Std Dev 71.92 72.41 87.56 86.23 85.81 84.65 0.12 0.12 0.13 0.12
All countries
Mean 108.61 107.56 113.21 113.44 131.81 131.58 1.02 1.04 0.86 0.87
Median 99.42 99.68 83.77 84.26 118.08 116.50 1.00 1.01 0.90 0.91
Std Dev 60.60 60.74 71.42 71.13 75.28 74.31 (-)-11 0.13 0.16 0.16
38
Appendix3: Sensitivityof Resultsto choiceof RealExchangeRate

Thetrendsin sectionV are estimatedusingtheUS producerpriceindexas a proxyfor worldprices.

Thismaybiastheresul~,particularlyfor timeperiodswhenmovementsin theUS realexchangeratediverge

significantlyfromthoseof otherindustrialcountries,as theydid overmuchof the 1980s.We estimatethe

sameratiosas in Table3, usingtrade-weightedmultilateralreal exchangerat= (seeTables3.A and3.B

below).

Thedatawereavailablein theIn&mationalFinancialStatisticsdatabase,of theIMF, foron.lyten of

thetwenty-fourmuntriesin our sample,for thetimeperiod 1979to 1994. Whileit wouldbe possibleto

calculatemuldlateralrealexchangeratesfor all thecountriesin thesample,for theperiodunder

consideration,thiswodd be a laboriouspr~s. Further,thisdatasetcovers a shortertimeperiodthanthe

oneusedin thestudy(1970to 1994).However,therealUS $ bilateralrate wouldhavedivergedsi~lcantly

horn thetradeweightedmultilateralrateprimarilyin the 1980s;thisdataset includestheperiodof interest.

Therefore,we use thesmallerdatasetreadilyavailableto comparethevaluesobtainedfor tie ratioswe

calculateusingthebilateralrealexchangeratewiththosefor availabletradeweighted,multilateralreal

exchangeratm..

Theuseof multilateralexchangeratesyieldestimatesof theratiosunderconsiderationthatare

remarkablysimilarto thoseobtainedusingbilateralresults.Theoneresdt thatis differentis thebinomial

signt~t for theratio,eDa/e’.TheprobabilitythatHo is trueis muchhigherwhenthemultilateralrateis used.

Thisimprobablydueto the verysmallsample:just fiveobsemations.Theordersof magnitudedo notdiffer

markedlyfor themeasuresof centi tendency.

Thechoiceof a bilateralrealexchangeratewouldnotseemto impacton theresultsin anysignificant

way.At thesametime,usingthebilateralrealexchangeratehasotheradvantages.In particular,-usingthe

bila~ralratepermitsanalysisfor a largersampleof countries,for a longertimeperiod. However,thereare


39
someinstanceswherethedifferencesin thevaluesusingthedifferentrealexchangeraw are moretian triviaI

(seeTable3.B,particularlyUruguay(columns8 and9, and Nigeria).If the analysisis to be donefor a single

country,theuseof the trade-weightedmultilateralrealexchangerate wouldbe preferable.For a sampleas

largeas theonein thisstudy,theadvantagesof usingthebilateralrealexchangera~ are greater.

A uuab 4u=* uvaanpua ann~ -mmutwa us Uamu AT AUS*SSUC - - -- —.--- .--.= - .—.—

21 3 4 5 6 7 8 9
mlciai Parallel mlcial omtid Ratio Ratio, Ratio, Ratio, Ratio,
RealER RealER ER W/ ERwhen #le e“’le &/e”” eple” e“’/e-
1979-94 Parmkt -led
Variable e 4 e08 e“ 2/1 3/1 2/3 2/4 3/4
SummaryStatistim
Wean
Bilateral 118.09 191.01 118.69 8’7.68 1.55 1.01 1.55 1.62 1.19
Multilateral 175.73 279.88 172.69 149.36 1.53 1.00 1.56 1.50 1.lC
Median
Bila~ral 106.28 168.57 104.21 72.18 1.36 1.00 1.36 1.60 1.19
Multilawral 132.80 186.09 124.66 103.88 1.38 1.00 1.40 1.54 1.12
StandardDeviation
Bilateral 54.66 116.71 54.10 35.74 0.37 0.06 0.42 0.25 0.31
Multilateral 120.95 230.58 117.96 104.42 0.37 0.07 0.43 0.30 0.33
BinomialSign Tests
Number<=1
Bilateral o 6 0 0 2
Multilateral o 8 0 1 3
Number>1
Bilateral 10 4 10 6 4
Multilateral 10 2 10 5 3
Pr(HOis true)
Bilateral 0.0001
0.377 0.0001 0.0156 0.3438
Multilateral — 0.0001
0.055 0.0001 0.1094 0.6563
—— .- — . .
Source:M-S,WorldCurrencyY*Q CurrencyAnalysis,Inc,variousissues,authorscalcula&ions.
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47

International Finance Discussion Papers

IFDP
Number Titles Author(s)

1996

564 The Use of the Parallel Market Rate as a Guide Nita Ghei
to Setting the Official ExchangeRate Steven B. Kamin

563 Country Fund Discountsand the MexicanCrisis of Jefiey A. Frankel


December 1994: Did Local ResidentsTurn Sergio L. Schmukler
PessimisticBefore InternationalInvestors?

562 Eastern European Export Performanceduring Nathan Sheets


the Transition Simona Boata

561 Inflation-AdjustedPotentialOutput Jane T. Haltmaier

560 The Managementof FinancialRisks at German Allen B. Frankel


NonfinancialFirms: The Case of Metallgesellschafi David E. Palmer

559 Broad Money Demand and FinancialLiberalization Neil R. Ericsson


in Greece Sunil Sharma

558 StockholdingBehaviorof U.S. Households: Evidence Carol C. Bertaut


from the 1983-89Survey of ConsumerFinances

557 Firm Size and the Impact of Profit-MarginUncertainty Vivek Ghosal


on Investment: Do FinancingConstraintsPlay a Role? Prakash Loungani

556 Regulationand the Cost of Capital in Japan: A Case John Ammer


Study MichaelS. Gibson

555 The SovereigntyOption: The Quebec Referendumand MichaelP. Leahy


Market Views on the CanadianDollar Charles P. Thomas

554 Real ExchangeRates and Inflation in Exchange-Rate Steven B. Kamin


Based Stabilizations: An Empirical Examination

553 MacroeconomicState Variablesas Determinants John Ammer


of Asset Price Covariances

552 The Tequila Effect: Theory and Evidencefrom Martin Uribe


Argentina

551 The Accumulationof Human Cat)ital: Alternative Murat F. Iyigun


Methodsand Why They Matter ‘ Ann L. Owen

Please addressrequestsfor copiesto InternationalFinance DiscussionPapers, Division of


InternationalFinance, Stop 24, Board of Governors of the Federal Reserve System,
Washington,D.C. 20551.

\
48

International Finance Discussion Papers

IFDP
Number Titles Author(s)

1996

550 Alternativesin Human CapitalAccumulation: Murat F. Iyigun


Implicationsfor EconomicGrowth Ann L. Owen

549 More Evidenceon the Link betweenBank MichaelS. Gibson


Health and Investmentin Japan

548 The Syndromeof Exchange-Rate-Based Enrique G. Mendoza


Stabilizationand the UncertainDurationof Martin Uribe
CurrencyPegs

547 German Unification: What Have We Learned JosephE. Gagnon


from Multi-CountryModels? Paul R. Masson
WarwickJ. McKibbin

546 Returnsto Scale in U.S. Production: Estimates SusantoBasu


and Implications John G. Femald

545 Mexico’sBalance-of-PaymentsCrisis: A Chronicle GuillermoA. Calvo


of Death Foretold

544 The Twin Crises: The Causesof Bankingand GracielaL. Kaminsky


Balance-of-PaymentsProblems Carmen M. Reinhart

543 High Real Interest Rates in the Afierrnathof GracielaL. Kaminsky


Disinflation: Is it a Lack of Credibility? LeonardoLeiderrnan

542 PrecautionaryPortfolio Behaviorfrom a Life-Cycle Carol C. Bertaut


Perspective MichaelHaliassos

541 Using OptionsPrices to Infer PDF’s for Asset Prices: WilliamR. Melick
An Applicationto Oil Prices During the Gulf Crisis CharlesP. Thomas
540 MonetaryPolicy in the End-Gameto Exchange-Rate StevenB. Kamin
Based Stabilizations: The Case of Mexico John H. Rogers
539 Comparingthe Welfare Costsand the Initial Dynamics Martin Uribe
of AlternativeTemporaryStabilizationPolicies

538 Long Memory in Inflation Expectations: Evidence Joseph E. Gagnon


from InternationalFinancialMarkets
49

International Finance Discussion Papers

IFDP
Number Titles Author(s)

1996

537 Using Measuresof Expectationsto Identi@the Allan D. Brunner


Effects of a MonetaryPolicy Shock

536 RegimeSwitchingin the DynamicRelationship Chan Huh


betweenthe Federal Funds Rate and Innovationsin
NonborrowedReserves

535 The Risks and Implicationsof External Financial Edwin M. Truman


Shocks: Lessonsfrom Mexico

534 CurrencyCrashes in EmergingMarkets: An Jeffrey A. Frankel


EmpiricalTreatment Andrew K. Rose

533 RegionalPatterns in the Law of One Price: The Charles Engel


Roles of GeographyVs. Currencies John H. Rogers