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52 Emerging Markets Finance & Trade

Purchasing Power Parity and Efficiency of Black Market Exchange Rate in African Countries

Ahmad Zubaidi Baharumshah, Siti Hamizah Mohd, and Siew-Voon Soon

ABSTRACT: This paper investigates the long-run dynamics of black and official exchange rates for ten African countries. Our major findings are, first, that parity holds more favor- ably when the black market rate is used to validate the purchasing power parity hypoth- esis. The evidence supports the notion that the speed of adjustment is much faster in the black market than in the official market. Second, the two rates are connected in the long run, with the official rate adjusting toward the black market rate for the majority of cases. Finally, we find the long-run informationally efficient hypothesis is supported in the majority of African countries.

KEY WORDS: African countries, black market exchange rate, bounds tests, purchasing power parity.

Most of the empirical work on the purchasing power parity (PPP) hypothesis conducted for developing countries is based on official exchange rates, but unfortunately no consen- sus exists regarding the validity of the PPP. The mixed findings on long-run PPP validity depend on numéraire currency, length of data span, and econometric methods used. In many less developed countries (LDCs), a dual (or multiple) exchange system exists, and trade and foreign exchange controls continue to be viewed as a viable policy instrument for stabilization programs. 1 In these countries, including those under current review, the volume of transactions in the black (or parallel) market for foreign currencies is even larger than in the official market, and the official exchange rates are generally controlled by the government. As Baliamoune-Lutz put it, the “black market rate seems to be more forward looking and tends to move freely” (2010, p. 3488). The market size varies from country to country and depends on the type of exchange rate controls and trade restric- tions, as well as the degree to which these restrictions are imposed. Few papers have used black market rates to conduct tests for the PPP hypothesis and the market efficiency hypothesis (MEH), and the focus has been mainly on the experi- ences of Asian and Latin American countries. 2 The limited studies on African countries have been based on traditional unit root and cointegration tests, which are known to exhibit low power for small sample sizes and hence must be interpreted with caution. The exceptions are Caporale and Cerrato (2008) and Cerrato and Sarantis (2007), who

Ahmad Zubaidi Baharumshah (baharumshah@yahoo.com) is a professor in the Department of Economics at Universiti Putra Malaysia. Siti Hamizah Mohd (hamizah@ukm.my) is a lecturer in the School of Economics at Universiti Kebangsaan Malaysia. Siew-Voon Soon (sv_soon2001@ yahoo.com) is a graduate student in the Department of Economics at Universiti Putra Malaysia. This research project was funded by MOSTI (Project no. 06-01-04-SF0414). The authors are grateful to Peter Pedroni for providing the code to conduct the panel cointegration tests. They also thank the anonymous referees and the editor, Ali M. Kutan, for helpful comments and suggestions on earlier draft. Any errors that remain are the authors’.

Emerging Markets Finance & Trade / September–October 2011, Vol. 47, No. 5, pp. 52–70. Copyright © 2011 M.E. Sharpe, Inc. All rights reserved. 1540-496X/2011 $9.50 + 0.00. DOI 10.2753/REE1540-496X470503

September–October 2011

53

employed heterogeneous panel cointegration tests, Bahmani-Oskooee and Tankui (2008), who used autoregressive distributed lag bounds tests, and Hassanain (2005), who used a panel unit root test that accounts for cross-sectional dependence for a large set of de- veloping countries. The purpose of this study is to ascertain whether long-run PPP holds in ten African countries (Algeria, Botswana, Burundi, Ghana, Kenya, Madagascar, Malawi, Mauritius, Nigeria, and South Africa). We investigate this proposition by using monthly data on black market and official exchange rates. Most of these countries are characterized by direct or indirect government intervention in the official foreign exchange rate market and also have adopted some form of capital controls. 3 They have suffered from several episodes of high inflation, large current account deficits, and fiscal deficits, not to mention volatile economic performance. The unique characteristics of the countries have led to the emergence of an active black market for the U.S. dollar. 4 Given the characteristics of these LDCs, an important question in this study is whether the official exchange rate or the black market rate should be used to validate the PPP. Our data (not shown) reveal significant variation over time and across countries with respect to the black market premium, that is, the spread between the black market rate and the official rate. 5 In addition to testing the PPP hypothesis, we extend this line of lit- erature by testing the causal relationship between these two series. To this end, we follow Moore and Phylaktis’s (2000) notion of long-run informational efficiency and short-run predictability to investigate the MEH. In doing so, we implicitly respond to Caporale and Cerrato (2008), who argued that the constant black market premium needs to be tested formally. Specifically, we test for the long-run relation between the two rates and then conduct formal statistical tests to determine whether the relation is one-to-one (i.e., constant black market premium) within the panel cointegration framework. To comple- ment these results, we also provide the half-life deviations to draw some implications on the speed of adjustments.

Review of Relevant Literature

The theory of PPP asserts that changes in the exchange rate between two currencies are determined by the relative prices of those countries. If P t is the domestic price level, P t * is the foreign price level in the foreign currency, and E t is the nominal bilateral exchange rate expressed as the home currency price of a unit of foreign currency, then the PPP requires that E t = P t / P t * , or in logarithmic form (lower case), e t = p t p t * . The hypothesis suggests that the exchange rate depends on the relative price levels. A bivariate relation between the nominal exchange rate and the relative price that imposed the symmetry condition is given by e t = β(p t p t * ) + μ t , where μ t is the usual error term. A popular method used in the empirical literature to verify the PPP proposition is cointegration analysis. A finding of a cointegrating relation is usually interpreted as evidence in favor of the PPP since the nominal exchange rate and the relative prices show a stable long-run relation. 6 This means that the nominal exchange rates and the relative price levels tend to converge in their long-run equilibrium path. If we impose the proportionality condition on the above-mentioned relation, then we have real exchange rate RER t = e t + p t * p t . This yields the strong form of the PPP relation, and it can be verified by a test of a unit root in RERs. If the unit root null hypothesis can be rejected in favor of a level stationary alternative, then there is mean reversion; that is, the PPP holds in the long run. In other words, level stationarity in the RER is compatible

54 Emerging Markets Finance & Trade

with the PPP hypothesis. Conversely, a unit root that mimics the true data-generating process of the RER would behave like a random walk or, more generally, martingale process without reverting to the constant mean. The PPP relation has been empirically examined in many studies (see the survey by Bahmani-Oskooee and Hegerty 2009). The bulk of the literature has utilized an array of unit root and cointegration tests to validate the hypothesis as a long-run relation. Unfortunately, the results from these empirical studies have not reached a consensus on whether this hypothesis holds. Recent evidence provided by Narayan and Prasad (2005) and others indicates that the long-run PPP holds for developing countries. Holmes (2000) applied panel unit root tests that allow for heterogeneous panel data set to a group of twenty-seven African countries from 1974 to 1997. Overall, Holmes’s results using consumer price index (CPI)-based RERs against the U.S. dollar were in favor of the parity. The estimated half-life of a one-off shock to parity is six quarters, which is less than the existing calculation for developed countries (three to five years) and less than the estimates reported in Baharumshah et al. (2007) for a set of Asian emerging market economies (one to two years). Hassanain (2005) turned to a newly developed panel unit root that accounts for cross- sectional dependence to show stronger evidence of the PPP for developing countries. For the subpanel of African countries that ended 1993, the evidence shows that the PPP is upheld using both the official market and the black market rates. Interestingly, the author reported that the half-life for the black market rate (2.18 years) is much shorter than that for the official rate (3.48 years), cautioning that the speed of adjustment toward equilibrium in the two markets may differ. Other comparative studies include Bahmani- Oskooee and Goswami (2005), Cerrato and Sarantis (2007), and Kargbo (2006), who used different econometric approaches, sampling periods, and country coverage. The findings from these studies seem to indicate that the black market rates better reflect the economic fundamentals, which has motivated us to consider them in validating the parity condition. The literature has also used an array of stationarity techniques in an attempt to validate PPP. Recent contributions to the literature have considered nonlinear stationary methods to model the behavior of exchange rates and validate the hypothesis. Bahmani-Oskooee et al. (2008) applied nonlinear augmented Dickey–Fuller unit root tests to a set of eighty- eight LDCs, finding that the PPP is validated in forty-one countries (47 percent). Closely related to our work, Bahmani-Oskooee and Tankui (2008) examined the link between the official and black market exchange rates for twelve developing countries, including four from Africa (Kenya, Nigeria, Malawi, and South Africa) that we also consider in our research. Interestingly, their results, which are based on Pesaran et al.’s (2001) bounds- testing approach, reveal that PPP is supported relatively more when black market rates are used in testing the relations. Evidently, the results indicate that the speed of adjustment is much faster for black market rates than for the official rates. This finding supports the results from earlier work by Moore and Phylaktis (2000) for seven Pacific Basin countries and by Diamandis (2003), who studied four Latin American countries. Baliamoune-Lutz (2010) also recently examined the long-run relation between the black market and official exchange rates. Based on the vector error correction model, the author confirms that there is a long-run relation between Morocco’s black market and the official exchange rate for the period 1974–92. The author finds that the move- ments in black market rates cause changes in official rates, and not the other way around. Baliamoune-Lutz (2010) went on to argue that the agents in the black market correctly

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55

anticipate the changes in the official exchange rate, and as such, it is consistent with the MEH. Sanchez-Fung (1999), however, argued that efficiency of the black market for exchange can be assessed by testing the PPP hypothesis. Similarly, Caporale and Cerrato (2008) found a long-run relation between these two exchange rates. The authors highlight that the proportionality restriction, which is an essential feature of portfolio-balance models, is easily rejected for the six emerging economies (Iran, India, Indonesia, Korea, Pakistan, and Thailand), although the estimated coefficient in their model in most of the countries is close to unity. This finding suggests that the adjustment toward equilibrium is incomplete, which is in sharp contrast to the findings of Diamandis (2003), who reported that the black market rate in four Latin American countries possesses long-run informational efficiency. Taken as whole, the evidence on the MEH is at best mixed, and there seems to be room for further research due to the important policy implication relating to the exchange rate policy and manag- ing risk in the LDCs.

Methodology and Data

Ng and Perron asserted that we should be cautious with estimations and inferences in a nearly unbalanced cointegrated system, stating that “this occurs when the cointegrated system contains variables with different univariate properties if one of the variables has a weak random walk component or is nearly stationary” (1997, p. 55). Ng and Perron’s critique has prompted us to adopt the bounds-testing procedure advocated by Pesaran et al. (2001) to address the issue. Specifically, the value added of the autoregressive distributed lag (ARDL) procedure is that it allows for testing cointegration when it is not known with certainty whether the regressors are purely I(1) or I(0). Moreover, the small-sample properties of the ARDL approach are far superior to the Johansen cointe- gration technique. Applying this method together with Pedroni’s (2000, 2004) cointegra- tion procedures, we hope to provide a better understanding of the workings of the black market in African countries. To examine the cointegrating properties of the estimated equation under symmetry conditions, we utilized the bounds test procedure proposed by Pesaran et al. (2001) to test the long-run PPP proposition. The ARDL approach to cointegration involves estimating the conditional error correction version of the PPP model for the nominal exchange rate and relative price:

er

t

=

λ

0

q q

+

λ

i = 1

1

er

t i

+

i

== 0

λ

2

p

(

p

* )

t

i

+

δ

1

er

t

1

+

δ

2

(

p

p

*)

t

1

+

u

t

,

(1)

where er is the bilateral exchange rate, p is the domestic price index, and p * is the price index of the country chosen as the numeraire currency, in our case the United States. In Equation (1), λ 0 is the drift component and u t is the white noise error term. All variables are expressed in logarithmic form, and Δ is the first-difference operator. As noted earlier, this approach allows the regressor to be either I(0) or I(1). 7 We begin with “bounds testing” the model for the presence of a long-run relation between the exchange rate and relative price, which involves an F-test on the joint null hypothesis that the coefficients on the level variables as per Equation (1) are jointly equal to zero (H 0 : δ 1 = δ 2 = 0). The test statistic is then compared with two sets of asymptotic critical value bounds tabulated by Pesaran et al. (2001). One set, the lower bound, as- sumes that all the variables are I(0), and the upper bound assumes that all the variables

56 Emerging Markets Finance & Trade

are I(1). If the statistic falls outside the lower-bound critical value, the null hypothesis of no cointegration cannot be rejected. If the test statistic exceeds its upper bound, then we can reject the null hypothesis of no cointegration regardless of the order of integration of the variable. Finally, if the value falls inside the critical band, the test is inconclusive. As such, the calculated F-statistic should be greater than the upper-bound critical value for cointegration irrespective of the order of their integration. The distribution of the test statistic under the null depends on the order of integration, I(0) or I(1) regressor(s). Next, to achieve the second objective of the study, the same procedure is applied to examine the existence of a long-run relation between black market (pr) and official (or) exchange rates:

pr

t

=

γ

0

+

p p

i

=

1

γ

1

pr

t

i

+

i =

0

γ

2

or

t

i

+

θ

1

pr

t

1

+

θ

2

or

t

1

+

υ

t

.

(2)

As mentioned earlier, the market efficiency requires cointegration between the two rates. In Equation (2), the cointegration can be established if the null hypothesis H 0 : θ 1 = θ 2 = 0 is rejected (i.e., if the test statistic exceeds its upper bound). 8 Once the long-run relation has been verified based on the bounds test, the conditional long-run model can be derived from the reduced-form solution of Equation (1) for the PPP test or from Equation (2) for the market efficiency test, when the first-differenced variables are jointly set to equal zero. The long-run coefficients and the error correction model (ECM) are estimated by the ARDL approach to cointegration, in which the conditional ECM in Equation (1) or Equation (2) is estimated using the least squares procedure. Our empirical analysis is based on monthly data over the period January 1980 to July 1998. The sample period ended in 1998 because the black market exchange rate data were not available beyond that year. 9 (We note here that only a few studies have assessed the PPP hypothesis using data for the late 1990s.) The U.S. dollar is used as the base cur- rency. The black market nominal exchange rate is collected from different issues of the World Currency Yearbook. The official exchange rate and the CPI series are drawn from International Financial Statistics, published by the International Monetary Fund (IMF). Extensive major economic events occurred in the 1970s, so using data earlier than 1980 would have increased the possibility of structural breaks in the model. Over the period under investigation, many African countries adopted a more flexible exchange rate regime to improve their economic growth. Government in some countries may enforce the official rates (e.g., through foreign exchange restrictions or direct inter- vention in the foreign exchange market) to make their own currency artificially stronger relative to the currency’s black market exchange rate. Many of them have been imple- menting monetary and macroeconomic reforms supported by the World Bank and the IMF. In fact, the centerpiece of the reform programs is designed to reduce (or eliminate) the distortion in the foreign exchange market and improve external competitiveness. Despite the implementation of these programs, there is still a wide gap between the of- ficial and black market rates in some of the countries, especially in Algeria, Burundi, Ghana, and Nigeria.

Empirical Results

In the bounds analysis, the first step is to test the presence of long-run relationships be- tween the variables. The null hypothesis of “nonexistence of the long-run relationship” is tested against the alternative using the bounds test approach. Because the outcome of

September–October 2011

57

the test is known to be sensitive to the choice of lag order, we followed Pesaran et al. (2001) and imposed a maximum lag number in the model. Based on a maximum lag of twelve, we selected the optimum lag length using the Schwarz Bayesian criterion (SBC). To ensure the adequacy of the model, we also conducted the Lagrange multiplier (LM) test for serial correlation. We found the estimated model passed the autocorrelation test at the usual signifi- cance levels in all but one case (Ghana) for Panel B at the 10 percent significance level (see Table 1, eleventh column). For Ghana, even considering higher lag order failed to improve the results. The calculated F-statistics for both the official (Panel A) and black market rates (Panel B) are presented in Table 1. As shown in Table 1, when the official exchange rate is used as the dependent variable, the F-statistic is greater than its criti- cal value (4.78) in only two countries—Kenya and Mauritius. In five countries (Ghana, Kenya, Madagascar, Malawi, and Mauritius) the error correction term (ECT) is negative and significant at 10 percent or better, suggesting the adjustment toward equilibrium is in the official rate. Adding a trend variable in the cointegrating relationship adds another two countries to the list (Botswana and Burundi). Therefore, the long-run PPP can be confirmed in seven out of ten countries. Motivated by these findings and the empirical evidence reported in previous studies mentioned earlier, we proceeded by using the black market rate instead of the official rate to provide new perspectives on the behavior of exchange rates for the countries ex- amined. Based on the F-test for the black market rate (Panel B of Table 1), we found the weak form of PPP hypothesis is upheld in all countries except Burundi and Nigeria. For Burundi, the F-statistic (3.3543), as well as the t-statistic for ECT (–0.0578; p = 0.0270), is statistically significant when the trend variable is added in the model. Meanwhile, for Nigeria, we found the PPP failed to uphold with the addition of a time trend to the rela- tion, even at the 10 percent significance level. Hence, the PPP is confirmed in nine out ten countries using the black market rates. All in all, the magnitude of ECT that pertains to the black market rate indicates a much higher speed of convergence, from 0.018 to 0.153 at most. As expected, we are able to confirm the PPP (weak form) in more countries (90 percent) when using the black market exchange rates. Taken together, the empirical find- ings indicate that the adjustment to the long-run equilibrium occurs in the black market for foreign currency, and in all cases it is affected by the relative prices. Our analysis so far has tested for a cointegration relation between the exchange rate and relative price levels. If the outcome of the test fails to reject cointegration, as is true for the majority of the cases, the two series move in direct proportion, but not necessarily with a cointegrating vector of one. We applied Pedroni’s (2004) panel cointegration tests to the same set of data, and, surprisingly, there is sufficient evidence of panel cointegra- tion for the black market rates, but not for the official rates (see Table 2, “Panel statistics” and “Group statistics”). Then we applied Pedroni’s (2000) fully modified ordinary least squares (FMOLS) procedure to estimates of the cointegrating relationship between the exchange rates and the relative price for each of the countries in the panel. Focusing on the black market rates (Panel B), we made the following major findings: First, the null hypothesis of a zero slope coefficient is easily rejected at the 1 percent significance level in all the cases. Second, the slope coefficient of the relative price for the official rate when the black market rate as the dependent variable β i ranges from 1.34 (Algeria) to 0.89 (Botswana). Although the slope coefficient of the relative price is close to unity, the null hypothesis that β i = 1 is rejected in all cases except for Burundi (1.56), Kenya (0.49), and South Africa (1.41). By adding the time trend in the cointegrating relationship, we have

reject null hypotheses of no long-run relationship. Upper-bound critical value at 10 percent significance level = 4.78 (Pesaran et al. 2001, table CI (iii), Case III). t refers to

[0.1100]

[0.1320]

[0.5220]

[0.7790]

[0.0830]

[0.9200]

[0.5200]

[0.2540]

[0.2820]

[p-value]

Notes: Values in parentheses are t-statistics. * and ** significant at 1 percent and 5 percent, respectively. a denotes statistically significant at least at the 10 percent level to

LM test

6.5734

2.4854

8.4709

4.2069

6.2566

1.4429

8.9802

10.0037

4.1897

6.6741

[0.124]

additional cases when trend included in the model. Upper-bound critical value at 10 percent significance level = 6.26 (table CI (v), Case V) for unrestricted trend (t).

3.3543[5] t

4.8090[9] a

6.1759[6] a

5.0567[5] a

5.1259[4] a

7.8323[6] a

7.8272[8] a

5.6566[5] a

4.8490[2] a

1.2005[5]

F-test

[lag]

Panel B: Black market rate

–0.02973

[0.0270]

[0.0500]

[0.3880]

[0.1720]

[0.0540]

[0.0020]

[0.0000]

[0.0020]

[0.3130]

[0.0000]

[p-value]

–0.0578

–0.1008

–0.0184

–0.1534

–0.0685

–0.1225

–0.0216

–0.0782

–0.0962

ECT t1

1.0651 (2.5662)**

1.0715 (5.3121)*

1.0863 (6.1136)*

1.2605 (4.1761)*

1.0756 (13.8799)*

0.96574 (22.1719)*

0.9813 (16.7934)*

0.9314 (8.3392)*

Log(P /P*)

0.5514 (0.8292)

0.1542 (0.5170)

8.8470 (103.5884)*

5.3999 (13.3168)*

4.4559 (9.8875)*

3.2390 (40.7846)*

1.5312 (14.5411)*

5.6643 (5.9207)*

8.0856 (77.7350)*

1.6659 (18.1115)*

3.9117 (23.4055)*

4.7455 (0.9090)

Constant

[0.3680]

[0.5730]

[0.2670]

[0.4470]

[0.9370]

[0.7920]

[0.7570]

[0.6480]

[0.5920]

[0.8200]

[p-value]

LM test

3.8364

6.5164

3.3354

6.4300

4.7506

2.3933

2.2043

2.6287

1.2771

3.7121

Table 1. Purchasing power parity (ARDL cointegration tests)

5.2223[6] a

4.9169[8] a

4.5897[6] t

2.8868[2] t

0.0933[5]

1.3805[9]

2.7368[6]

1.1392[2]

1.7833[7]

0.8125[5]

F-test

[lag]

Panel A: Official rate

[0.7950]

[0.0160]

[0.0570]

[0.0090]

0.0019 [0.8390]

0.0016 [0.9290]

[0.0180]

[0.0820]

[0.0420]

[0.0020]

[p-value]

–0.0448

–0.0414

–0.0354

–0.0630

–0.0035

–0.0506

–0.0489

–0.0802

ECT t1

1.5958 (7.6687)*

1.1696 (6.8946)*

1.0915 (5.9948)*

1.1215 (13.0280)*

0.9786 (12.1454)*

Log(P /P*)

2.1681 (0.9103)

0.5751 (1.4676)

5.0583 (0.2581)

5.9507 (0.1088)

0.3657 (0.1619)

(2.0516)**

(15.0413)*

(36.4471)*

(43.6127)*

(46.3115)*

(17.0394)*

Constant

(0.6338)

(–0.7673)

(0.2767)

(0.4237)

8.9968

4.8314

0.8610

9.2805

4.3596

3.1756

3.2089

4.0263

6.9657

–9.3177

South Africa

Madagascar

Botswana

Mauritius

Country

Burundi

Nigeria

Malawi

Algeria

Ghana

Kenya

58 Emerging Markets Finance & Trade

(continues)

H 0 : ß i = 1

–2.10**

3.75*

–2.76*

4.19*

–6.99*

–3.21*

4.08*

–0.34

1.25

0.76

–0.06

Panel B: Black market rate

H 0 : ß i = 0

27.49*

5.17*

17.26*

20.99*

3.10*

6.56*

9.61*

4.57*

11.06*

7.30*

1.32

1.28

1.24

0.88

0.58

0.39

2.76

0.59

0.99

1.32

1.33

2.27

ß i

With trend

H 0 : ß i = 1

–2.10**

2.05**

8.71*

7.04*

2.81*

2.78*

7.92*

2.72*

4.71*

0.92

–1.31

Panel A: Official rate

H 0 : ß i = 0

37.64*

6.85*

5.07*

27.17*

5.24*

7.50*

6.85*

17.57*

22.37*

15.51*

4.88*

1.34

1.68

1.14

0.80

1.44

1.60

1.16

1.35

1.82

1.72

0.71

ß i

H 0 : ß i = 1

1.74***

–2.11**

–2.10**

3.52*

5.13*

–3.16*

3.15*

5.02*

Table 2. Individual and group FMOLS estimates of long-run coefficient

Panel B: Black market rate

0.49

1.56

1.41

H 0 : ß i = 0

75.62*

20.37*

22.85*

23.40*

35.29*

26.27*

19.09*

46.44*

9.38*

16.36*

19.70*

1.08

1.14

1.14

1.34

1.20

1.29

0.89

0.92

0.92

1.07

1.03

ß i

Without trend

1.70***

H 0 : ß i = 1

2.53**

2.48**

2.51**

14.99*

2.96*

8.92*

8.71*

3.54*

13.00*

1.06

Panel A: Official rate

H 0 : ß i = 0

75.53*

21.88*

12.17*

12.78*

41.20*

30.15*

31.21*

23.05*

14.69*

17.26*

34.36*

1.08

1.24

1.10

1.06

1.13

1.27

1.42

1.32

1.17

1.61

1.61

ß i

Individual estimation

South Africa

Madagascar

Botswana

Mauritius

Panel group

Burundi

estimation

Nigeria

Malawi

Algeria

Ghana

Kenya

September–October 2011

59

Notes: The bivariate test for PPP estimation is based on fully modified ordinary least squares (FMOLS). The estimating equation is er i,t = β i (p p * ) t + ω i,t , where (p p * ) denotes relative price ratio and er refers to either the official or black market rates for individual country at time t. The row “panel group estimation” refers to the panel coefficient for relative price. *, **, and *** significant at the 1 percent, 5 percent, and 10 percent levels, respectively. There is overwhelming evidence to reject the null hypothesis of no cointegration if k < –1.64 for the test statistics with the exception of the v-statistic (i.e., k > 1.64 implies a rejection of the null hypothesis).

(0.0034)

(0.0002)

(0.0137)

(0.3566)

(0.0041)

(0.0000)

(0.3685)

Panel B: Black market rate

–3.9372*

–3.0240*

4.3014*

0.3984

3.0895

2.5965

–0.4727

With trend

(0.3987)

(0.3436)

(0.2738)

(0.3983)

(0.3868)

(0.3800)

(0.3850)

Panel A: Official rate

0.0568

–0.0374

0.8678

0.2490

0.5466

0.3116

0.2665

(0.2172)

(0.0017)

(0.1899)

(0.2450)

(0.0006)

(0.0000)

(0.2320)

Group statistics

Panel statistics

Panel B: Black market rate

–3.3041*

–3.5954*

5.0725*

–1.0414

1.1029

1.2185

–0.9877

Alternative hypothesis: individual AR coefficients (between-dimension)

Alternative hypothesis: common AR coefficients (within-dimension)

Without trend

(0.3224)

(0.2123)

(0.3491)

(0.3680)

(0.3374)

(0.3988)

(0.1525)

Panel A: Official rate

0.0238

–0.6529

–0.5165

–1.1233

–0.4017

1.3867

–0.5791

Table 2. Continued

ADF-statistic

ADF-statistic

rho-statistic

rho-statistic

PP-statistic

PP-statistic

v-statistic

60 Emerging Markets Finance & Trade

September–October 2011

61

two additional countries—Botswana and Madagascar—for which the null hypothesis

β i = 1 cannot be rejected by the data (see last column of Table 2, “With trend”). 10 Hence, the general inference to be drawn from the cointegration analysis in Table 2 is that the strong form of PPP is upheld in five out of ten countries and the weak version of the hypothesis is found in the remaining countries. Turning to the panel results, we found the slope coefficient of the relative price variable for the case of without trend is close to unity (1.08) but the null hypothesis β = 1 is rejected. In contrast, the model with trend (last column in Table 2) confirmed that strong-form PPP holds for the whole panel members. For completeness, we also report the results when the official rate is used as the dependent variable (Panel A of Table 2). To address the issue of market efficiency, which is the main thesis of this paper, we follow Moore and Phylaktis (2000). They defined the existence of a stationary black market premium as the long-run informational efficiency. Specifically, they pointed out that long-run informational market efficiency in a black market requires that (1) the of- ficial and black market rates be cointegrated and (2) the black market premium remain constant, that is, the proportionality between the two exchange rates is upheld. These conditions are also consistent with the view that market participants correctly anticipate changes in official rates. We proceed with the bounds test to establish a long-run relation between these two rates. In Table 3, two sets of results are presented—one for black mar- ket rates and another for official rates. Concentrating on the black market rate equation, we found that the calculated F-statistic is greater than its critical value of 4.78 in seven out of ten cases. Hence, the F-test confirms that there exists a long-run relation between the two rates in seven countries. Relying on the sign and significance of the estimated coefficient of the ECT, we find that a long-run relation between the two rates is supported in all the studied countries. At this point, the outcomes of the PPP hypothesis are in line with those of the MEH. 11 The ECT measures how the response (single period) of the dependent variable departs from the equilibrium. In all cases, we noticed that the ECT is statistically significant and carries the expected negative sign when the black market rate is used as a dependent vari- able. In general, our results reveal that the direction of causation runs from the official rate to black market rates in all cases, except for Ghana, Kenya, and Mauritius. In these three countries, however, the direction of causality runs in both directions. Agenor and Taylor (1993), for example, using a data set from nineteen developing countries, discovered that no clear causality pattern emerged. They claimed that the lack of consensus on the issue is primarily due to the different nature of the exchange rate regime adopted by the country under investigation. The official exchange rate is weakly exogenous in the majority of cases, implying that the black market rate can be predicted by past and current values of the official rate. It also means that the free black market rate adjusts to any deviation from the long-run equilibrium value and that the authorities may respond to activities of the black market. This supports the view that the black market is more forward-looking compared to the policy-determined official rate. A change in the official exchange rate due to a change in monetary policy, for example, will induce the black market rate to move (Apergis 2000). It also indicates the capacity of the monetary authorities to set the official rate independently. As shown in Table 3, the ECTs in Panel A are generally in the range of 0.038 (Nigeria) to 0.528 (South Africa), which is much higher than when black market rates are treated as exogenous variables, except for two cases (Kenya and Ghana). In sum, we found a unidirectional causal relation that runs from the official rate

Notes: Values in parentheses and square brackets are t-statistics and p-values, respectively. * significant at the 1 percent level. a significant at least at the 10 percent level

to reject the null hypothesis of no long-run relationship. Critical upper bound at 10 percent significance level = 4.78 (Pesaran et al. 2001, table CI (iii), Case III,). The

lag order of the ARDL model was selected based on SBC and LM tests to serial correlation. Each series is estimated when official rates are assumed as exogenous in Panel A and black market rates as exogenous in Panel B.

Lag

8

4

4

4

4

4

6

6

6

3

Panel B: Official rate equation

1.8085
1.9000 7.3007 a

2.0648
0.6034

0.4488

0.5544
3.5355

2.6776
3.0854

F-test

[0.3370]

[0.1060]

[0.0000]

[0.1600]

[0.1850]

[0.1130]

[0.1880]

[0.3520]

[0.0049]

[0.0000]

[p-value]

–0.0128

–0.0828

–0.2028

–0.0450

–0.0255

–0.0965

–0.0946

–0.0916

–0.0073

–0.0311

ECT t1

Lag

4

5

5

5

2

3

3

1

1

1

4.8861 a

3.8942 12.7496 a

1.6863 25.5964 a

5.7053 a

5.0466 a

5.1450 a

4.7092 5.0654 a

F-test

Panel A: Black market rate equation

Table 3. Long-run relationship between black market and official rate

[0.0000]

[0.0000]

[0.0030]

[0.0312]

[0.0020]

[0.0160]

[0.0000]

[0.0030]

[0.0076]

[0.0020]

[p-value]

–0.0688

–0.0384

–0.1114

–0.0714

–0.1220

–0.1040

–0.0770

–0.1300

–0.2547

–0.5281

ECT t1

0.9463 (64.0938)*

1.0035 (10.9929)*

0.9288 (33.7088)*

1.0183 (7.3850)*

0.8763 (14.9411)*

1.1023 (10.8073)*

0.8860 (7.0251)*

0.7717 (8.6379)*

0.4863 (3.7324)*

0.8007 (9.0722)*

or

(3.2266)*

(7.6947)*

(3.9606)*

(3.3207)*

(3.5749)*

(5.4473)*

(10.5259)*

(0.2320)

(–0.4133)

(1.3025)

Constant

0.6798

0.1138

0.4558

0.2764

0.0585

1.2989

3.9322

–0.2202

1.9277

0.5571

South Africa

Madagascar

Botswana

Mauritius

Country

Burundi

Nigeria

Malawi

Algeria

Ghana

Kenya

62 Emerging Markets Finance & Trade

September–October 2011

63

to the black market rate in seven out of the ten countries. This finding indicates the in- ability of black market dealers to lead exchange rate movements. To check the robustness of our findings, we conducted further analysis using Pedroni’s (2000, 2004) methodology. The results using the black market rate as the dependent vari- able from FMOLS are reported in Table 4. Overall, the results are encouraging, and the output generated from the panel approach is qualitatively and quantitatively comparable to those discussed in the section Review of Relevant Literature. As shown in Table 4 (“Without trend”), the cointegrating coefficient (α i ) is close to unity (values ranging from 0.59 to 1.05), suggesting that the gap between the black market and official rates will be close in the long run. We found that the slope coefficient for the official rate of the panel estimates is statistically significant at 1 percent with the coefficient of 0.90. The slope coefficient of the individual estimates in most cases is also close to unity (the sole exception is Ghana). We formally tested for the proportionality relationship implied by the portfolio-balanced models for each of the countries. As shown in Table 4 (“Without trend,” H 0 : α i = 1), the outcome of the test reveals that in four out of ten (Burundi, Kenya, Mauritius, and Nigeria) cases, the coefficient is insignificantly different from unity. For the remaining countries (Algeria, Botswana, Ghana, Madagascar, Malawi, and South Africa), we extended the analysis by including a trend variable in the cointegrating relationship (“With trend,” columns 5–7). The results reveal that the constant risk premium hypoth- esis receives support in three additional countries (Algeria, Malawi, and South Africa). All in all, the statistical evidence based on individual FMOLS supports the constant risk premium in seven out of ten cases. Alternatively, the black market premium can be defined as the black market exchange rate divided by the official exchange rate. A long-run relation between the black market and official rates exists if the percentage excess of the black market rate over the official rate is stationary. For Botswana and Madagascar, we applied Ng–Perron (2001) unit root tests and found that the risk premium is trend reverting. To provide a robust analysis for our results, we applied unit root tests that account for a single break popularized by Lee and Strazicich (2004). The one-break minimum LM unit root test revealed that the risk premium series is stationary only after allowing for a break (break date, August 1984) for Ghana. All in all, our results appear to support the proportionality relation in all the studied countries as implied by the portfolio-balance models. Our results also reveal the danger of relying on a single method to examine the parity condition and the efficient market hypothesis. Ignoring the possibility of structural break may erroneously reject the proportionality (unitary) restriction implied by the portfolio-balance models. For these countries, we also conducted the Granger causality tests, and the results (not reported) suggest that the official exchange rate Granger causes the black market rate, not vice versa, for Algeria, Burundi, Madagascar, Malawi, and Nigeria. However, there is no clear evidence of short-run predictability, because there is feedback causality for the remaining countries. Our results seem counter to those of Caporale and Cerrato (2008), who found that the proportionality restriction, which is an important feature of the portfolio-balance models, is rejected in the majority of the countries. An important implication of this finding is that the black market premium in some countries is unlikely to disappear even in the long run, perhaps due to exchange or capital controls. Having provided evidence concerning cointegration, it is vital to show that the esti- mated parameters are structurally stable over time. To ensure that our model meets this criterion, we relied on a series of tests proposed by Hansen (1992): the SupF, MeanF, and L c tests. All the tests have the same null hypothesis but differ in their choice of alternative

64 Emerging Markets Finance & Trade

Table 4. Individual and group FMOLS estimates of long-run coefficient (black market premium)

 

Without trend

 

With trend

α i

H 0 : α i = 0

H 0 : α i = 1

α i

H 0 : α i = 0

H 0 : α i = 1

Algeria

0.84

21.25*

–4.04*

0.83

7.44*

–1.59

Botswana

0.83

24.51*

–4.96*

1.22

28.23*

5.14*

Burundi

1.05

23.47*

1.20

0.73

7.34*

–2.75*

Ghana

0.59

22.18*

–15.21*

0.24

6.75*

–20.82*

Kenya

1.01

31.96*

0.19

1.37

9.06*

2.44**

Madagascar

0.94

52.24*

–3.32*

1.22

9.85*

1.79***

Malawi

0.83

39.86*

–4.88*

1.02

4.83*

0.07

Mauritius

0.94

23.79*

–1.49

0.70

17.00*

–7.13*

Nigeria

1.03

19.66*

0.65

0.85

7.71*

–1.40

South Africa

0.95

79.14*

–4.00*

1.09

10.39*

0.87

Panel group

0.90

106.90*

–12.29*

0.93

34.34*

–7.39*

estimation

 

Panel statistics

 

Alternative hypothesis: common AR coefficients (within-dimension)

 

v-statistic

4.0696*

(0.0001)

5.8613*

(0.0000)

rho-statistic

–0.4556

(0.3596)

–1.0717

(0.2247)

PP-statistic

–2.9039*

(0.0059)

–5.1268*

(0.0000)

ADF-statistic

1.8188

(0.0763)

2.5681

(0.0147)

Group statistics

 

Alternative hypothesis: individual AR coefficients (between-dimension)

 

rho-statistic

–4.4913*

(0.0000)

–3.6172*

(0.0006)

PP-statistic

–6.8100*

(0.0000)

–7.5719*

(0.0000)

ADF-statistic

–1.2838

(0.1750)

0.0227

(0.3988)

Notes: The estimating equation is pr i,t = α i or t + ξ i,t , where pr and or are the log of the black market and official exchange rates for individual country at time t, respectively. The row “panel group estima- tion” refers to the coefficient for the official rate in the panel group. *, **, and *** significant at the 1 percent, 5 percent, and 10 percent levels, respectively. There is overwhelming evidence to reject the null hypothesis of no cointegration if k < –1.64 for the test statistics with the exception of the v-statistic (i.e., k > 1.64 implies a rejection of the null hypothesis).

hypothesis. The application of Hansen’s parameter stability–testing framework is instruc- tive in the sense that it permits testing for parameter stability as well as for cointegration. 12 Overall, the test results presented in Table 5 indicate that parameters are stable over the full sample period, because the probability values for each of the tests are greater than 0.20 (or below 5 percent critical value lines) in all the countries except Nigeria 13 and Kenya (as indicated by MeanF and SupF, respectively). Hence, we are able to identify a stable long-run relation between the two rates vis-à-vis the dollar exchange rates for most of the countries considered. The evidence presented above has offered little information about the speed at which deviation from the equilibrium dies out. To provide additional information, a computation of the half-life is required. The half-life is a measure of how long it takes for the exchange

umns are the Hansen’s (1992) instability test statistics and the probability values, which were generated by using a GAUSS program provided by Bruce

Phillips and Hansen (1990), which builds on consistency of the static OLS estimator. Figures in parentheses denote standard errors. The remaining col-

Notes: The estimated single cointegrating parameters in the second column are from the fully modified ordinary least squares (FMOLS) estimator of

p-value

0.2000

0.2000

0.2000

0.2000

0.2000

0.0380

0.2000

0.2000

0.2000

0.2000

SupF

7.4458

6.8564

4.7829

6.6806

3.3359

6.4362

7.1662

13.0737

8.5627

7.3481

statistic

Test

p-value

0.2000

0.2000

0.2000

0.2000

0.2000

0.2000

0.2000

0.2000

0.2000

0.1732

MeanF

Table 5. FMOLS and instability tests, black market on official exchange rates

statistic

1.1358

2.3254

2.8554

3.0300

1.7410

3.5936

1.5059

3.7386

1.5962

2.3461

Test

E. Hansen. The p = 0.2000 means p 0.2, which indicates a stable relationship.

p-value

0.2000

0.2000

0.2000

0.2000

0.2000

0.2000

0.2000

0.2000

0.2000

0.2000

L c

statistic

0.1387
0.2080

0.2671
0.2535

0.2309
0.1926

0.1317
0.1039

0.2099

0.0706

Test

estimates

(0.0124)

(0.1214)

(0.0525)

(0.0343)

(0.0280)

(0.0438)

(0.0422)

(0.0887)

(0.0756)

(0.0929)

FMOLS

0.6094

1.0310

0.8136

0.8469

0.7599

0.9492

1.0603

0.8602

0.9531

0.9861

South Africa

Madagascar

Botswana

Mauritius

Country

Burundi

Nigeria

Malawi

Algeria

Ghana

Kenya

September–October 2011

65

66 Emerging Markets Finance & Trade

rate, after a unit of shock, to dissipate by half. Using the same data set for the two market rates, we computed the half-lives of deviations from equilibrium for the PPP (Panel A) and the market efficiency (Panel B) in Table 6. There is considerable intercountry variation in the speed of adjustment in both markets. Strikingly, we found that the point estimates for the PPP half-lives from the black market rates range from 4.16 (Ghana) to 37.32 (Kenya) months. These estimates fall outside the range suggested by Rogoff (1996) and support mean reversion. The point estimates for the market efficiency half-lives from the black market range from 0.92 (South Africa) to 17.70 (Nigeria), with the majority well under one year. Comparing the half-lives from the black market exchange rates with those from the official exchange rates, we found that the former generally show a noticeably lesser persistence (shorter half-lives) in the majority of cases. The half-life deviations from PPP using the official rate range from 1.12 to 28.69 months, and they contrast with those from the black market rates with a range of 1.37 to 16.71 months. The half-life estimate from market efficiency using black market rates range between 1.79 and 9.33 months. As expected, the confidence intervals (CIs) for the estimated half- lives for the black market rates tend to be narrower than those of the official rates. The upper bound of the CIs is less than two years for the black market rates. It appears that the so-called PPP puzzle is not applicable in all the exchange rates under investigation. The estimates of the half-lives for the black market exchange rates are fully consistent with the half-life region of zero to three years, which can be explained by nominal rigidities (sticky price models), and they are also much shorter than those reported in the central and eastern European transition, emerging, and industrial countries (see Baharumshah et al. 2007; Hassanain 2005; Kasman et al. 2010).

Conclusion

This study investigates whether long-run PPP holds in a set of African countries. The focus has been on the black market exchange rates and the long-run relation between black market and official exchange rates. Our major conclusions are summarized as fol- lows: first, we reconfirm that the PPP (both in the weak and strong forms) has received relatively more support when the black market rates are used to test the relation. We also found that the inclusion of a trend variable is deemed necessary in order to validate the PPP hypothesis in some but not all of the countries. Second, we showed that the official exchange rates show more persistence than the black market counterparts, as the PPP’s and market efficiency’s half-lives for the black market rates are shorter than those of the official ones. The CIs for the estimated half-lives for the black market rates are narrower than those of the official rates; the upper bound of the CIs is less than two years, which can be explained by nominal rigidities. Our results confirm Bahmani-Oskooee and Tankui’s (2008) and Hassanain’s (2005) conjecture that the deviation between the exchange rates and relative prices is corrected much faster to its equilibrium in the black market exchange rates. Third, as did Caporale and Cerrato (2008), we found a stable long-run relation between these two exchange rates; that is, black market and official exchange rates are closely connected. The implication of this finding is that the existence of parallel markets for the U.S. dollar in Africa weakens the effectiveness of capital control. However, we depart from the above-mentioned papers by showing formally that a constant black market premium cannot be rejected by the data for the majority of the countries under investigation. This means that the black market rate depreciates in the same proportion as the official rate.

Note: The half-life (HL) is calculated as ln(0.5) / ln(f i ) and is accompanied by the 95 percent confidence interval (CI) h { 0.50 ± 1.96s [ f i ([–ln 0.5 /f i ][ln (f i )] 2 ), where s [ f i is an estimate of the standard deviation of f i , and f i from the ECT t1 .

[0.00,142.65]

[0.00,300.89]

[1.57,13.42]

[2.57,11.86]

[0.00,45.40]

[2.62,13.42]

[1.35,62.82]

[2.53,11.13]

[1.57,28.53]

[2.55,11.40]

[0.00,58.43]

[1.64,4.47]

95% CI

Official rate

equation

Panel B: Market efficiency

(0.57)

(0.58)

(7.88)

(2.24)

(0.25)

(1.25)

(0.67)

(4.48)

(0.60)

(1.83)

(2.03)

(0.60)

HL (Yr)

21.94

94.60

15.05

3.06

26.83

6.83

8.02

7.22

7.22

24.43

6.97

53.81

[2.61,16.10]

[2.63,14.68]

[0.60,34.80]

[1.76,12.48]

[2.12,10.51]

[2.59,16.86]

[0.57,1.27]

[1.79,8.86]

[1.15,8.81]

[1.18,3.54]

[2.40,9.33]

[1.79,9.33]

95% CI

Black market rate equation

HL (Yr)

(0.78)

(0.72)

(0.08)

(1.48)

(0.49)

(0.49)

(0.60)

(0.53)

(0.20)

(0.42)

(0.49)

(0.81)

4.98

5.84

17.70

8.65

9.36

2.36

9.72

0.92

7.17

5.87

5.87

6.31

Table 6. Half-lives and confidence interval estimate in months (in years)

[1.23,127.81]

[0.00,241.58]

[0.00,819.05]

[1.55,28.69]

[1.92,25.73]

[2.62,13.96]

[0.00,38.55]

[2.04,24.66]

[1.12,31.67]

[0.50,35.38]

[1.12,28.69]

[2.51,18.79]

95% CI

Official rate

equation

(1.60)

(1.15)

(16.47)

(0.69)

(1.37)

(3.27)

(0.89)

(1.50)

(1.26)

(6.69)

(1.26)

(1.11)

39.28

17.94

197.70

10.65

13.35

80.25

16.39

8.29

15.12

15.12

19.23

13.83

HL (Yr)

Panel A: PPP

[0.00, 72.27]

[1.37,16.71]

[2.50,10.55]

[1.21,30.27]

[2.54,11.17]

[1.37,18.17]

[0.32,16.71]

[0.00,88.87]

[1.53,21.76]

[0.00,48.07]

[1.79,8.82]

[2.02,6.31]

95% CI

Black market rate equation

HL (Yr)

(0.54)

(0.57)

(0.81)

(1.21)

(0.71)

(0.97)

(2.65)

(0.71)

(0.44)

(1.91)

(3.11)

(0.35)

14.48

31.74

11.64

5.30

6.85

4.16

6.52

37.32

22.97

9.77

8.51

8.51

South Africa

Madagascar

Descriptive

Median

Botswana

Mauritius

statistics

Mean

Burundi

Nigeria

Malawi

Algeria

Ghana

Kenya

September–October 2011

67

68 Emerging Markets Finance & Trade

We found long-run efficiency in the black market to hold for all the countries, and we found evidence of short-run predictability for Algeria, Burundi, Madagascar, Malawi, and Nigeria. It is instructive to note that these results were based on different models. From a policy perspective, the findings suggest that if central banks in these countries were to stabilize the value of their currencies in the black market, it could also stabilize prices. Monetary authority should use black market rates to estimate the RER misalign- ments, and hence in formulating monetary and exchange rate policy as well. Central banks in these countries may have to intervene in the official markets to eliminate the spread between the two rates. This means that the development in the black market ex- change rate may induce the monetary authority to adjust the official rate to align it with other macroeconomic fundamentals. The authorities can use the official rates as policy instrument and target exchange rates to maintain international competitiveness. This follows from our finding that in most of the studied countries, the official rate is weakly exogenous, but the black market rate is not. The official market operates independently of the black market in all but three countries (Ghana, Kenya, and Mauritius), and the black market responds to movements in the official rates. Trades and fund managers may manage exchange rate risks by using information from the official rates, as fluctuations in the black market rates signal adjustment in the official rates. The proportionality relation implied by the portfolio-balanced models is not rejected by the data. This means exchange rate risk can be fully eliminated at least in the long run. As pointed out by Caporale and Cerrato (2008), policymakers may pursue their objectives by imposing foreign exchange controls rather than adjusting the official rate to the market-determined black market rate in order to close the gap between the two rates. Finally, several scholars have pointed out that the persistent deviation from the PPP can cause macroeconomic disequilibrium, as well as resource misallocation and income redistribution. Our results show that there is a difference in the speed of adjustment to shock across the official and black market rates. The level of persistence in the official exchange rates is much higher than that of the black market exchange rates due to exchange rate and capital controls. In fact, our point estimates of the half-life in the majority of the countries under review are less than one year. This finding provides a rationale for a government’s continuing support for the existence of a black market for the U.S. dollar rate and for reliance on the black market exchange rate for policy advice.

Notes

1. The policies adopted by China and Malaysia in the wake of the financial crisis in the late

1990s are cases in point.

2. The workings of the black market are a major concern of policymakers, especially in the

context of the emerging and transition economies.

3. According to a recent IMF classification of exchange rate arrangements, seven out of the

ten countries under investigation are under managed floating with no predetermined path for the exchange rate, the exceptions being Botswana (crawling peg), Malawi (other conventional fixed peg arrangement), and South Africa (independent floating).

4. Algeria (19 percent), Botswana (11 percent), Burundi (11 percent), Ghana (28 percent), Mada-

gascar (17 percent), Malawi (31 percent), and Nigeria (33 percent) all recorded double digit inflation in the 1990s. Except for Algeria and Botswana, all the other African countries under investigation experienced current account deficits for most of the 2000s. Economic agents usually increase their holdings of foreign currency with greater uncertainty in order to hedge against domestic inflation.

5. The average black market premium during the sample period ranged from 4.4 percent (South

Africa) to as high as 231 percent (Algeria). For more details on the black market premium in the African countries, see Kargbo (2006).

September–October 2011

69

6. The two specifications typically used to test cointegration in the PPP literature are (1) a

trivariate relation between the nominal exchange rate, domestic price, and foreign price, and (2) a bivariate relation between the nominal exchange rate and the domestic to foreign price ratio. In this research, our focus is mainly on the second specification.

7. As suggested by a referee, we conducted the unit root tests for nominal exchange rates,

domestic price level, and foreign price level. Based on univariate unit root tests (ADF [augmented

Dickey–Fuller] and Ng–Perron), we found the series under review to be mixed with either I(0) or I(1), which prompted us to proceed with Pesaran et al.’s (2001) procedure. The results are available from the authors upon request.

8. Booth and Mustafa (1991) claimed that the existence of cointegration is not in line with

the MEH, which implies that past information cannot be exploited to forecast future values. More

recently, authors such as Lence and Falk (2005) and Caporale and Cerrato (2008) have shown that cointegration is not inconsistent with market efficiency.

9. The sampling period in this study is through the late 1990s, which is similar to studies by

Bahmani-Oskooee and Tankui (2008) and Cerrato and Sarantis (2007). The limitation of the black

market exchange rates data is primarily attributed to the World Currency Yearbook, which has not been published since 1998.

10. Pesaran and Smith (1999) argued that the restricted-trend model is preferable when one or

more of the underlying variables are trended, which in our case seems likely. Based on this argu-

ment, we have added a trend variable in the cointegrating space. We thank an anonymous referee for this suggestion.

11. It is well known that when two (or more) variables are cointegrated, there necessarily exists

causality in the Granger sense in at least one direction. A negative and significant coefficient for ECT not only reports cointegration between the two variables but also long-run causality that runs from the official rate to the black market rate (Bahmani-Oskooee and Tankui 2008).

12. The L c test statistic is designed to test the null hypothesis of cointegration against the alterna-

tive of no cointegration. But the MeanF statistic is more suitable for testing the null hypothesis of

cointegration with constant parameters against the alternative of a gradual shift in the parameters.

This test may be used to examine the overall stability of the model. The SupF test is based on ideas inherent in the classical Chow F-tests (see Hansen 1992).

13. The analysis is based on a method without breaks in the series. Ashworth et al. (1999)

found that the official rate is trend stationary with break. A single break point (September 1986) was detected by using the exogenously determined break tests for Nigeria. For some Central and East European countries, Kasman et al. (2010) found that the deviation from parity is caused by sudden changes in exchange rates. In further analysis, we applied the univariate test developed by Lee and Strazicich (2004), which allows for endogenous structural break (Model C) and found a single break (December 1992) in the RER series in the early 1990s for Nigeria.

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