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WP/90/114 INTERNATIONAL MONETARY FUND

Research Department

3
arallel Currency Markets in Developing Countries:
Theory, Evidence, and Policy Implications

si-
Prepared by Pierre-Richard Agenor

Authorized for Distribution by Mohsin S. Khan

December 1990

Abstract

The paper reviews recent theoretical and empirical developments

in the analysis of informal currency markets in developing countries.
The basic characteristics of these markets are highlighted, and
alternative analytical models to explain them are discussed. The
implications for exchange rate policy --including imposition of
foreign exchange restrictions, devaluation, and unification of
exchange markets-- in countries with a sizable parallel market are
also examined.

JEL Classification Numbers:

121, 431

The author would like to thank, without implication, Jagdeep

Bhandari, Dean DeRosaf Joshua Greene, Steven Kamin, Mohsin Khan, Saul
Lizondo, Peter Montiel, and Carlos Vegh for many helpful comments on
a previous draft of this paper.
 - ii -

Contents

Page

I. Introduction 1

II. Scope and Nature of Parallel Currency Markets 1

1. Emergence of parallel markets 2

2. Supply and demand for foreign currency 6

3. Consequences of parallel currency markets 8

III. Analytical Models of Parallel Currency Markets 13

1. Smuggling and real trade models 13

2. Monetary approach 15
3. Portfolio and currency substitution models 16
4. Models of dual exchange markets with leakages 22
IV. Policies Towards Parallel Currency Markets 24

1. Effectiveness of foreign exchange controls 24

2. Devaluations and parallel market premia 25
3. Unification of foreign currency markets 27

V. Concluding Remarks 31

Tables
1. Variability in exchange rates and prices 10
in developing countries, 1975-86

2. Changes in exchange rates, money supply 31

and prices in nine african countries

Figures
1. Parallel market premia in developing countries, 2a
1980-86

2. Variability in consumer prices and parallel 10a

exchange rates in developing countries, 1975-86

3. Parallel market premia in African countries 32a

References 33
 - iii -

Summary

The paper reviews recent theoretical and empirical developments in

the analysis of parallel currency markets in developing countries. The
first part of the paper discusses the scope and nature of these markets
and highlights the common features that are likely to be found in a vari-
ety of institutional settings. UnoffLcial markets in foreign exchange
have emerged primarily out of foreign trade restrictions. The size of
the market depends upon the range of transactions subject to exchange
controls as well as the degree to which these restrictions are enforced.
The supply of illegal foreign exchange may come from under-invoicing or
smuggling of exports, over-invoicing of imports, tourism, remittances
from abroad, or diversion of foreign exchange from the official market.
Demand results from needs for imports, travel, portfolio diversification,
and capital flight.

The second part reviews alternative analytical models of parallel

currency markets and discusses their implications regarding the impact
of macroeconomic policies on parallel market exchange rates. Partial
equilibrium approaches stress the role of the premium in the determi-
nation of illegal trade. The monetary approach emphasizes the impact
of expansionary fiscal and credit policies on the behavior of parallel
exchange rates and prices. Portfolio-balance models stress the role
of asset composition and forward-looking expectations in the determi-
nation of the unofficial exchange rate. Lastly, models of dual exchange
markets with leakages emphasize the flow of arbitrage activity resulting
from a non-zero premium.

The final part of the paper focuses on the policy implications of

the theoretical and empirical literature, and leads to the following con-
clusions . Exchange and trade restrictions are largely ineffective as
long-term policies to maintain the viability of an (overvalued) exchange
rate or to n impose" balance of payments adjustment. Although "socially
beneficial" in some respects, parallel currency markets generate a vari-
ety of costs. In particular, they increase the potential to evade the
inflation tax on domestic cash balances. Permanent unification of for-
eign exchange markets cannot be achieved via devaluation of the official
exchange rate alone. Such a policy has only a temporary effect on the
premium, and furthermore is inherently inflationary. Attempts at uni-
fication by floating the currency are likely to be accompanied by an
inflation burst, which results not from the depreciation of the official
exchange rate per se, but from the loss of the implicit tax on exports.
To be successful, unification must be accompanied by a relaxation of
exchange restrictions and by supportive financial policies.
 I. Introduction

There has been growing recognition over the past few years that
widespread exchange and trade restrictions in developing countries
have been ineffective in preserving foreign reserves or in supporting
an inadequate exchange rate. Evasion has been endemic and illegal
markets for goods and foreign currencies have expanded, defeating the
very purpose of controls. Although the nature of parallel markets
precludes collection of detailed and reliable data, they appear to be
common phenomena in developing countries, with parallel exchange rates
deviating in some cases considerably from official rates. 1/

This paper reviews recent theoretical and empirical analyses of

parallel foreign currency markets in developing countries. Section II
reviews the scope and nature of parallel currency markets in
developing countries, and highlights the basic structural characte-
ristics that are likely to be found in a variety of institutional
settings. Section III provides an overview of alternative analytical
models of the parallel market for foreign exchange that have been
developed over the past few years --real trade models, the monetary
approach, the portfolio balance and currency substitution framework--
and examines as well the implications of the recent literature on dual
exchange systems in which leakages exist between markets. Section IV
considers the conduct of exchange rate policy in countries with a
sizable parallel currency market. The analysis focuses, in
particular, on the impact of foreign exchange restrictions, the role
of nominal devaluations as an instrument to control the spread between
the official and parallel markets, and strategies for unifying
official and parallel foreign exchange markets. Finally, Section V
provides some concluding remarks and highlights some of the directions
in which the recent theoretical and empirical literature could be
extended.

II. Scope and Nature of Parallel Currency Markets

Due to the often illegal --albeit perhaps officially tolerated--

nature of transactions, Information on the functioning of parallel
currency markets is neither readily available, nor very reliable. 2/

1/ According to data presented in the World Currency Yearbook,

1987, parallel currency markets exist in all developing countries,
except the high-income oil exporters. The evidence available suggests
that parallel currency markets have recently increased in size and
sophistication in many countries, in relation with capital movements.
2/ As such, magnitudes mentioned here should be treated with a
certain amount of caution.
 - 2 -

The major qualitative features of these markets are, however, well

documented, suggesting that there are common features to be found in a
variety of institutional settings. This Section discusses how
parallel markets emerge, the nature of transactions in those markets,
as well as their economic consequences.

1. Emergence of parallel markets

Parallel markets generally develop in conditions of excess demand

for a commodity subject to legal restrictions on sale, or to official
price ceilings, or both. 1/ Foreign exchange transactions in a large
majority of developing countries are subject to both kinds of
restrictions. 2/ Typically, the exchange rate is officially pegged by
the central bank, and only a small group of intermediaries are
permitted to engage in transactions in foreign exchange. Sale of
foreign currencies is, in principle, restricted to uses judged by the
authorities to be "essential" for reasons such as economic development
or balance of payments viability. As a consequence, some of the
supply is diverted and sold illegally, at a market price higher than
the official price, to satisfy the excess demand. The proportion by
which the parallel market exchange rate exceeds the official rate, the
"parallel market premium", will depend upon a host of factors --in
particular, the penalty structure and the amount of resources devoted
to apprehension and prosecution of delinquants-- and may vary
substantially over time and across countries.
Figure 1 shows the evolution of the parallel market premium in
twelve developing countries during the early eighties. 3/ The charts
show that the premium typically displays large fluctuations over time
and across countries --a phenomenon often seen as reflecting the

1/ The expressions "parallel11, "fragmented" , "informal" ,

"black" (which has an illicit connotation), and "curb" markets have
been used interchangeably in the literature. Lindauer (1989) provides
an analytical distinction between these alternative descriptions of
market structure. He defines a parallel market (p. 1873) as "...the
structure generated in response to government interventions which
create a situation of excess supply or demand in a particular product
or factor market". Government price fixing (through taxes, regula-
tions, and prohibitions) plays, therefore, a prominent role in the
creation of excess demand at official prices and in the emergence of a
parallel market. See also Feige (1989).
2/ The nature of these restrictions is well documented in the
Annual Report on Exchange Restrictions published by the Fund.

3/ Parallel exchange rates are taken from the World Currency

Yearbook (formerly Pick's Currency Yearbook), and official exchange
rates are from the IMF database. Data are end-of-period exchange
rates relative to the US Dollar.
 - 2a -

FIGURE 1

PARALLEL MARKET PREMIA IN DEVELOPING COUNTRIES, 1980-86

(In percent)
 - 2b -

FIGURE 1 (Concluded)

PARALLEL MARKET PREMIA IN DEVELOPING COUNTRIES, 1980-86

(In percent)
 - 3 -

asset-price characteristics of the parallel exchange rate. 1/ In

periods characterized by uncertainty over macroeconomic policies,
unstable political and social conditions, parallel market rates tend
to react switfly to expected future changes in economic circumstances.
The charts also indicate that the premium has been at times substan-
tially negative in some countries, a somewhat surprising fact since
exchange restrictions in the official market relate typically to the
purchase of foreign currency and not on the sale. Although it is
difficult to systematically rationalize episodes of negative premia, a
number of cases can be accounted for by the following factors. First,
in outward-oriented economies that have experienced high rates of
growth and large external surpluses (notably in Asia), the central
bank has at times restricted the rate of accumulation of foreign
exchange by the banking system, leading to periods of temporary excess
supply of foreign currency in the parallel market. Second, periods
during which a significantly negative premium has emerged may have
been associated in some countries (Morocco, for instance) with
expectations of a revaluation of the official exchange rate. Finally,
a negative premium may have emerged during periods when commercial
banks have not been allowed to buy foreign currency without proper
identification of the seller. In such circumstances, a negative
premium represents essentially a "laundering charge" (Dornbusch et
al., 1983) which is paid by agents who have no legal right to possess
the foreign exchange that they are offering for sale.

Parallel currency markets in developing countries have emerged

primarily out of foreign trade restrictions. 2/ Typically, the
process starts with the government trying to impose regulations
(licensing procedures, administrative allocations of foreign exchange,
prohibitions, etc.) on trade flows. The imposition of tariffs and
quotas creates incentives to smuggle and fake invoices (so as to lower
the tariff duties), by creating excess demand for goods at illegal,
pre-tax prices. 3/ Illegal trade creates a demand for illegal currency

2/ Figure 1 also suggests the existence of a clear seasonal

pattern for some countries (Malaysia and Morocco, for instance). At a
more formal level, Akgiray, Booth and Seibert (1988) provide a
statistical analysis of the distribution properties of parallel market
exchange rates for 12 Latin American currencies. See also Akgiray,
Aydogan, and Booth (1990).
2/ In some countries, however, capital controls (often moti-
vated by recurrent balance-of-payments difficulties) were the primary
factor leading to the emergence of an informal market in foreign
exchange. See, for instance, Kamin's (1990) account of Argentina's
experience in the 1930's.
.3/ For a general description of illegal transactions, see
Bhagwati (1978, pp. 64-81). An interesting case study of Indonesia is
described by Cooper (1974).
 - 4 -

which, in turn, stimulates its supply, and leads to the creation and
establishment of a parallel currency market if the central bank is
unable, or unwilling, to meet all the demand for foreign exchange at
the official exchange rate. 1/ At a later stage, the parallel
marketexpands to become a major element in financing capital flight
and portfolio transactions, foreign currency being a hedge against
adverse political change and --in high-inflation economies-- a hedge
against the inflation tax. 2/ There are, evidently, many other
factors that may help explain the development of a parallel currency
market in a particular country; in Pakistan for instance, the rapid
expansion of the illegal market for foreign exchange in the late
seventies is primarily the result of the sudden influx of worker
remittances from the Middle East (Banuri, 1989). In Colombia and
Guyana, the develop- ment of the illegal market for dollars has been
closely associated with drug-related activities (Thomas, 1989).

whatever the initial factors leading to the emergence of a

parallel market in foreign currencies, in any given country, the size
of this market will depend upon the range of transactions subject to
exchange controls, as well as the degree to which these restrictions
are enforced by the authorities. In countries where the degree of
demand rationing in the official market for foreign exchange is low,
the parallel market will play only a marginal role. Conversely, in
countries where balance of payments deficits are chronic and where the
central bank does not have sufficient reserves (or the borrowing
capacity) to satisfy the demand for foreign currency at the official
parity, parallel currency markets will typically be well developed and
organized, with an exchange rate substantially more depreciated than
the official rate.

The coexistence of an official and a parallel market in foreign

exchange results from the possibility of potential penalties --or, in
other words, expected costs-- on private agents who fail to conform

1/ The imposition of a tariff, by itself, creates incentives

for smuggling but does not create incentives for the emergence of
a parallel currency market. Such a market will usually emerge only if
foreign exchange controls are in place. In the particular case where
legal trade requires the sale or purchase of legal foreign exchange,
the existence of a positive tariff will also be sufficient to induce
illegal trade activities and foreign currency transactions (Pitt,
1984).
2/ Restrictions on capital flows may take the form of taxes or
discriminatory reserve requirements on non-resident bank deposits,
etc. Phylaktis and Wood (1984) provide an analytical framework for
classifying, and appraising the impact of, various forms of exchange
controls. Swidrowski (1975) provides an extensive discussion of
various aspects of foreign exchange and trade restrictions.
 - 5 -

with pricing or other regulatory directives (surrender requirements on

exports, etc.). 1/ Pitt (1984), and Jones and Roemer (1987), for
instance, suggest that the existence of legal and illegal markets is
based on how penalties are levied, that is, on the determinants of
getting caught. Both the legal and the parallel markets will exist if
the risk of penalties is reduced by engaging in legal sales which mask
profitable but illegal transactions. However, even if the probability
of detection depends upon illegal sales, the official market may still
exist. This will occur if the expected penalties for illegal transac-
tions drive the net marginal revenue of parallel market sales below
the official selling price at quantities where official sales remain
profitable. Without these requirements and given the pressure of
competitive forces, the parallel market would likely collapse and a
unified official market would emerge.

Parallel currency markets, although illegal, are often tolerated

by the authorities in developing countries. 2J Although exchange
dealers do not always advertise their services, "local" markets are
substantially unified and the prevailing price is common knowledge
among all those with an interest in it. 3/ In some countries, users
of the market appear to go through personal intermediaries, which may
be a reason why the market seems so uniform. In other countries, the
market is dominated by a small number of "big" operators --who fix the
exchange rate, sometimes on a daily basis, based on their judgement of
supply and demand-- followed by a large number of intermediaries, who
are physically present in the market on a day-to-day basis. The
spread between what the intermediaries pay and what the major opera-
tors pays them is the source of the intermediaries' income, thereby
leading to the emergence of a spread between asking and trading rates.
One consequence of this type of intermediation is that the actual size
of the market is difficult to evaluate, and estimates become subject
to wide margins of error.

1/ Greenwood and Kimbrough (1986) motivate the existence of a

parallel currency market with a cash-in-advance requirement that
forces individuals to accumulate foreign currency (either officially
or illegally) before they can consume.
2/ A strictly illegal market often develops into a tolerated
one --or becomes officially recognized and legitimized, as in
Bangladesh in 1972, in the Dominican Republic in 1982 or in Guyana in
1987-- as its scope of operations expands and the authorities
recognize its inevitable character and relative benefits.
3/ This does not preclude substantial variations within
countries. For instance, in Guyana, the exchange rates offered in
border towns are significantly more depreciated relative to those
quoted in the "Wall Street" area of Georgetown (Thomas, 1989).
 - 6 -

2. Supply and demand for foreign currency

Transactions in parallel currency markets take usually the form

of operations in cash, but checks are also commonly used in some
countries. In markets where the risk of default is low and the
surveillance of international transfers is ineffective, transactions
in foreign currency notes are sometimes completed abroad. In Latin
America and Asia, the principal traded item is US currency notes,
although bilateral trade with the United States accounts for only a
small share of external transactions for some countries. 1/ Sources
of supply and demand vary from country to country, and depend heavily
on the nature and effectiveness of exchange restrictions imposed by
the authorities.

The supply of illegal foreign currency comes in general from five

possible sources: under-invoicing or smuggling of exports, over-
invoicing of imports, foreign tourists, and diversion of remittances
through non-official channels. 2/ In most circumstances, although all
five sources are likely to be utilized to some degree, there is in
general a "dominant" source which may vary over time and across
countries. For instance, the smuggling of exports was considered to
be a major source of supply in Pakistan, India and Turkey in the early
seventies (Gupta, 1981, 1984). More recently, Gulati (1985) has
estimated that during the period 1977-83, under-invoicing of exports
as a percentage of official exports was 20 percent for Argentina, 13
percent for Brazil, and 34 percent for Mexico. Foreign tourism is
regarded as a dominant source of supply of foreign currency in the
case of Caribbean countries, while worker remittances represent the
key component in the case of Egypt (Bruton, 1983), Morocco, Pakistan
in the late seventies, Turkey, and Sudan. For Pakistan, Banuri (1989)
estimates the volume of illegal remittances to be anywhere between 15
percent and 35 percent of the officially recorded amount. This source
alone of illegal dollars amounted to between 20 and 47 percent of
international reserves (excluding gold) in 1983, and between 8 and 20
percent of the official money stock --a quite significant increase in
liquidity. In the case of Bangladesh, studies in the early eighties
found that 35 percent of the migrants remit their savings through
private, informal channels. Similar observations have been made for
several other remittance countries (Keely and Tran, 1989).

1/ This may be the result of the "convenience" of the US dollar

in international transactions or a "safe haven" effect. The use of US
currency notes may also result from the importance of non-trade -
related sources of supply and demand for foreign exchange in the
parallel market.
2/ Government officials may also allow diversion foreign
exchange from the official to the parallel market in return for bribes
and favors.
 - 7-

Remittances and tourism differ from illegal trade sources of

foreign currency in that they do not necessitate an additional illegal
transaction (Banuri, 1989). Smuggling of exports, for example,
requires that the export good be illegally transported across the
country's borders. This raises the real costs (in terms of
clandestine transportation, payoffs to officials, risk of confiscation
and of other legal penalties) of supply. This implies that the
parallel market premium should be high enough to compensate the
supplier for the higher risk, as well as for higher real costs.
Unless there are significant economies of scale and learning by doing
in smuggling activity, this argument suggests that, everything else
equal, the parallel market premium will be lower in remittance
countries.

Available estimates, although generally subject to error, stress

the importance of smuggling, 1/ under-invoicing of exports and
over-invoicing of imports as the major sources of supply of foreign
currency in most developing countries. 2/ It should be noted, however,
that the incentive for over-invoicing of imports exists only when the
tariff rate on imported goods is sufficiently lower than the parallel
market premium. In a country with high tariff barriers, the price
incentive is for under-invoicing (smuggling in) of imports rather than
for over-invoicing --the one exception being, of course, the case of
capital goods imports, where tariffs are generally lower than average,
or even zero. Consequently, it appears likely that the single major
source of unofficial currency supply from illegal trade is the

1/ Smuggling may take place with regards to legal or prohibi-

ted goods. Cocaine exports, for instance, is considered to account
for a large share of the unofficial inflow of US dollars in certain
Latin American countries. In Brazil, illegal trade (gold and coffee
exports, in particular) is believed to account currently for nearly 30
percent of foreign currency supply in the parallel market (Novaes,
1990).
7J The extent to which traders engage in fake invoicing is
typically measured by partner country trade-data comparisons. To
investigate the scale of under-invoicing or over-invoicing of exports,
for instance, one would need to look at the ratio of exports to major
partner countries, as shown by domestic data, to the corresponding
imports as recorded in partner country data. When this ratio is less
than unity, the evidence points to under-invoicing of exports. To be
able to make these partner-country comparisons, however, it is
important to adjust the trade data for transport costs, timing of
transactions, and classification of transactions. See McDonald
(1985), Gulati (1988), and Arslan and van Wijnbergen (1989) for recent
attempts to use these procedures to estimate the degree of under- and
over-invoicing in foreign trade transactions.
 - 8 -

under-invoicing of exports. When there is a tariff on exports,

under-invoicing permits the exporter to avoid the tariff and to sell
the illegally acquired foreign exchange at a premium; when there is a
subsidy on exports which is less than the parallel market premium, the
sale of foreign exchange in the parallel market more than compensates
for the loss of the subsidy. Thus, for given taxes, the higher the
parallel market premium, the higher the propensity to under-invoice
exports, 1/
The demand for foreign currency in the parallel market results
generally from four main components: imports (legal and illegal),
residents traveling abroad, portfolio diversification, and for
purposes of capital flight. The demand for foreign currency to
finance legal imports stems from the existence of rationing in the
official market for foreign exchange. Demand is also to finance
illegal imports of goods which are either prohibited or highly taxed
and which are smuggled into the country. The inherent "confidentia-
lity" of transactions in the parallel market --and the absence of
legal accountability to anyone operating in it-- provides an incentive
to agents to use it for concealing illicit activities.
The portfolio motive is particularly acute in high-inflation
economies, and in countries where considerable uncertainty over
economic policies prevails, because foreign currency holdings repre-
sent an efficient hedge against domestic inflation bursts. Econo-
metric evidence suggests that in middle-income developing countries,
this component accounts for a substantial part of the demand for
foreign exchange in the parallel market (Agenor, 1990d). This
phenomenon is conducive to a high degree of substitution between
domestic and foreign currencies, with consequent problems of monetary
control, as discussed below. Finally, the capital flight motive
derives from the existence of restrictions on private capital outflows
in many countries. Attempts at circumventing the regulations are
funded through the parallel market.

3. Consequences of parallel currency markets

What are the consequences of a large parallel currency market?

The following arguments have often been advanced in favor of these
markets. First, parallel markets make available commodities (food,
intermediate inputs, durable goods, etc.) which would not have
otherwise been forthcoming, due to the existence of rationing in the
official market for foreign exchange. Second, the increased supply of
goods through these markets has often reduced social and political
tensions. Third, the existence of informal markets for goods and
foreign exchange provides employment and income opportunities to small
traders.

1/ See Arslan and van Wijnbergen (1989) for econometric eviden-

ce supporting this proposition in the case of Turkey.
 - 9 -

There are, however, a variety of distorsions created by the

existence of parallel currency markets. First, and most generally,
the expansion of a parallel market for foreign exchange weakens the
effectiveness of capital controls imposed by the central bank.
Formally, it has effects similar to an increase in capital mobility
--which may help accelerate capital flight-- and may lead to an
increase in the degree of substitution between domestic and foreign
currencies. The potential for currency substitution --defined as the
ability of domestic residents to switch between domestic and foreign
money-- becomes an effective way of avoiding the inflation tax on the
holdings of domestic cash balances. The shift from domestic to fo-
reign money results therefore in a loss of seignorage for the govern-
ment which, for a given real fiscal deficit, may call for a higher
inflation rate, an expansive monetary policy, or recurrent
devaluations of the official exchange rate (see Agenor, 19905).

Second, although informal markets increase the supply of goods,

parallel exchange rates have an impact on domestic prices. Since
trade takes place at both the official exchange rate (through official
channels) and the parallel market rate (through smuggling), the
domestic price of tradable goods will reflect both exchange rates.
However, in most countries where foreign exchange rationing by the
banking system prevails, the officially fixed exchange rate is not
relevant for the determination of market prices of tradable goods. It
only measures the rents captured by those (usually the government and
a small group of "privileged" importers) to whom foreign exchange is
made available at the official rate. If domestic prices of tradables
are based on the marginal cost of foreign exchange --or its implicit
resale value, that is, the parallel market rate-- the aggregate price
level will reflect to a large extent the behavior of the unofficial
exchange rate. It has been noted that in Ghana and Uganda for
instance, prices of tradable goods have tended to reflect more the
prevailing exchange rate in the parallel market than that in the
official market (Chhibber and Shafik, 1990; Roberts, 1989). To the
extent that parallel exchange rates --being very sensitive to actual
and anticipated changes in economic conditions-- are more volatile
than official exchange rates, domestic prices are likely to display a
significant degree of instability, which may adversely affect economic
decision making.

Table 1, which presents data over the period 1975-86 on exchange

rate variability and consumer price volatility for the group of twelve
developing countries referred to in Figure 1, provides some empirical
evidence on this issue. The results shown clearly suggest that
parallel exchange rates have been subs tan- tially more variable than
official rates (except in Pakistan and, to a lesser extent, Korea),
and that countries with the highest degree of parallel exchange rate
variability have also exhibited a significantly greater degree of
price volatility ^Figure 2 ) .
 - 10 -

Table 1. Variability in Exchange Rates and Prices

in Developing Countries, 1975-86 1/

Country Exchange Rates Consumer

Prices
Official Parallel

Colombia 0.693 0.732 0.672

India 0.173 0.178 0.280
Korea 0.243 0.231 0.373
Malawi 0.324 0.413 0.304
Malaysia 0.058 0.061 0.165
Mexico 1.604 1.637 1.446
Morocco 0.371 0.356 0.321
Nigeria 0.214 0.458 0.539
Pakistan 0.216 0.147 0.260
Singapore 0.061 0.064 0.137
Tunisia 0.306 0.320 0.291
Zambia 0.437 0.481 0.675

Sources: International Financial Statistics (IMF),

and World Currency Yearbook, various issues.

1/ Standard deviation of the quarter-to-quarter rate of change

of the relevant variable, divided by the sample mean.
 - 10a -

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 - 11 -

Third, since there are two prices at which foreign exchange can
be bought and sold, exports whose proceeds are repatriated at the
official exchange rate are taxed relatively to other exports. Conse-
quently, the parallel market premium may be seen as an implicit tax on
exports (Pinto, 1989), implying that, in order to depreciate the real
exchange rate and stimulate exports, the premium must be reduced, 1/

Fourth, the parallel market for foreign currency plays an

important role in the transmission mechanism of short-term macro-
economic policies. How do shocks in the real economy influence
conditions in a parallel market for foreign exchange? How is
adjustment to these shocks helped or hindered by the existence and
size of this market? How does a parallel currency market constrain
policy responses to shocks? Detailed, quantitative analysis of these
issues has only recently begun. 2/ The available analytical and
econometric evidence, which will be reviewed below, supports the view
that the parallel exchange rate plays an important role in the
transmission process of short-run macroeconomic policies.

Finally, it should be noted that the welfare implications of the

existence of a parallel market in foreign currencies are unclear. 3/
The gains and losses depend on a number of factors, in particular the
penalty structure. If expected costs of engaging in parallel market
activities are low, for private transactors welfare is likely to be
higher than if they carried out their transactions only through
official channels. For instance, workers abroad remitting funds or
foreign tourists selling dollars would get more units of domestic
currency at the parallel exchange rate than at the official price. If
penalties (fines, prison terms, etc.) are enforced to some degree,

1/ This view suggests the existence of a trade-off between the

premium and the rate of inflation in financing a given real fiscal
deficit. The implications of this trade-off for unification strate-
gies is examined below.
2/ Montiel (1990) provides an analytical discussion of the
role of parallel foreign currency markets (as well as informal credit
markets) in the transmission mechanism of monetary policy.
3./ The welfare effects of foreign exchange restrictions have
been analyzed by Greenwood and Kimbrough (1986). Using a choice-
theoretic cash-in-advance general equilibrium model, they examine how
the imposition of foreign exchange controls affects decision making by
private agents, notably the decision to evade the restrictions by
purchasing foreign currency illegaly in the parallel market. They
show that while foreign exchange controls may improve the trade balan-
ce and the balance of payments of an economy with parallel markets,
they unambiguously lower economic welfare. This is because foreign
exchange controls essentially place a quota on imports, thus raising
their domestic relative price in the same manner as a tariff would.
 - 12 -

however, expected costs for private transactors may be quite high.

Though it is not possible, in general, to quantify the exact magnitude
of gains and losses, it can be shown (see Bhagwati and Hansen, 1973)
that in the case of smuggling losses can outweigh gains. This is when
smuggling operations are subject to rising costs (on account of
penalties) so that smuggling activity only replaces the official
imports without lowering the cost of imports to domestic consumers.
This result may not, however, carry over to other forms of cheating
like fake invoicing and diversion of remittances. For instance, if
manipulation of invoices is associated with negligible costs, welfare
gains will probably outweigh potential losses (Gupta, 1984).

From the point of view of the authorities, parallel markets have

some obvious adverse effects. First, there is a cost of enforcement,
to counteract somewhat parallel market activities and punish
offenders. Second, there is a loss of tariff revenue (due to smuggling
and under-invoicing), a loss in income taxes and domestic indirect
taxes, and a reduced flow of foreign exchange to the central bank,
which lowers the capacity to import of the government. Third,
parallel markets encourage rent-seeking activities (corruption of
government officials, for instance), which lead to a sub-optimal
allocation of scarce resources. Despite these costs, however,
parallel currency markets are widely tolerated in developing
countries. The usual argument to justify this is that governments
realize that as long as there is demand rationing in the official
market for foreign exchange, there is bound to be a "secondary"
market, whose cost of elimination is likely to be prohibitive. Viewed
in this way, a parallel market in foreign currency can be taken to be
"socially desirable" --even though ultimately the authorities' goal is
to remove discriminatory practices and stress legality in economic
activities-- as it meets the demands of operators rationed in the
official market. Another interesting argument which may help explain
why authorities tend to accomodate rather than confront unofficial
markets has recently been put forward by McDermott (1989) . The
existence of a parallel currency market may yield, according to
McDermott, two types of benefits. First, it increases employment by
raising the domestic availability of imported inputs. Second, it may
actually raise the flow of foreign currency to the central bank. This
latter --somewhat paradoxical-- effect may arise when the increased
availability of inputs allows total exports to be increased, and so
much so that foreign currency flows in in increased amounts, both
clandestinely and legally.

The foregoing analysis suggests that, to a large extent,

exchange restrictions are inoperative. Instead of increasing the
foreign exchange reserves at their disposal, the controls imposed by
the authorities only succeed in diverting a substantial part of the
foreign exchange underground, implying that they not only fail to
solve the problem, but they actually worsen it. The logical and
obvious implication is that if parallel markets emerge in response to
the imposition of controls, the most effective way to reduce their
 - 13 -

size is to eliminate these restrictions and let prices reflect the

full scarcity of foreign exchange. 1/ Indeed, in the past decade,
several developing-country governments have shifted towards relatively
less restrictive trade and exchange regimes. 2/ There are, however, a
variety of costs associated with such a liberalization process which
are not yet fully understood. These issues will be examined in light
of the predictions derived from analytical models, and the evidence
pertaining to the behavior of parallel exchange rates.

III. Analytical Models of Parallel Currency Markets

Over the past few years, parallel markets for foreign exchange
have been analyzed and modeled from a number of different perspecti-
ves. This section briefly reviews these alternative approaches and
highlights their major implications. 3J

1. Smuggling and real trade models

Following the early partial equilibrium analyses of Boulding

(1947), Bronfenbrenner (1947) and Michaely (1954) of a consumption
commodity market subject to price control and rationing, "real trade"
models of the determination of the premium focus on the parallel
market for foreign exchange and neglect its interactions with the rest
of the economy. Specifically, the parallel market for foreign
exchange is modeled as reflecting the demand for foreign currency to
purchase illegal imports and the supply of foreign currency derived
from illegal sources. Martin and Panagariya (1984), McDermott (1989),
Sheikh (1976), and Pitt (1984) for instance emphasise the role of
smuggling and under-invoicing of exports as the main sources of
foreign exchange supply, whereas Culbertson (1975) stresses the resale
of the officially allocated foreign exchange.

1/ Policies of active repression of parallel markets have been

attempted by some countries (Guyana in 1980, Tanzania in 1983, or
Algeria in May 1990). It has proved difficult to maintain an agre-
ssive or punitive stance against well-entrenched informal activities.
2/ See Quirk et al. (1987, 1989).
3/ In addition to the approaches discussed here, there have
been some recent attempts to integrate informal markets in goods and
foreign currencies in Computable General Equilibrium models; see
Franco (1985), Azam and Besley (1989), and Nguyen and Whalley (1989).
See also Charemza and Ghatak (1990) for a disequilibrium approach.
 - 14 -

This class of models emphasizes the impact of rising trade taxes

on smuggling activities and illegal currency transactions. 1/ As
shown by Macedo (1987) and Branson and Macedo (1989) for instance, an
importer will tend to smuggle if the tariff is so high that it pays to
purchase foreign exchange in the parallel market at a premium, given
the possibility of getting caught by the customs enforcement agency.
If r denotes the tariff, TT the probability of success in smuggling,
and p the premium, a necessary condition for import smuggling to occur
is nr > p. Similarly, under the same detection technology, the
incentive to smuggle exports out will exist when # < 7rp, that is, when
the subsidy (or tax rate) on exports 6 is smaller than the parallel
market premium weighted by the probability of success in smuggling.

In this framework, planned smuggled imports are interpreted as

the flow demand for foreign currency in the parallel market, while
successfully smuggled exports are interpreted as the flow supply of
foreign currency. The long-run parallel market premium is then
determined by the equilibrium conditions for legal and illegal trade.
In the long-run equilibrium, where legal exports equal legal imports
and successfully smuggled exports pay for planned smuggled imports,
the premium can be expressed as a weighted average of r and £, and is
therefore determined (as is the smuggling ratio) by the structure of
tariff barriers.

Real trade models provide an adequate framework for an analysis

of the impact of trade restrictions (as opposed to exchange controls)
on the parallel market exchange rate. The basic limitation of the
approach is that, since the only reason to deal in foreign currency is
to buy imported goods, the sole purpose of black market activity is to
enable smuggling to take place. This, however, assumes away the
portfolio motive which has been identified as a critical component of
the demand for foreign currency. Moreover, although the approach
provides a useful analysis of the long-run determinants of the
exchange rate differential, there is no mechanism providing a
satisfactory explanation of the short-run behavior of the premium
(which is taken as given by exporters and importers in most models).
The approach can, however, be extended in this respect. Macedo (1987)
for instance develops a model where the long-run premium is determined
by the structure of trade taxes, while the short-run premium results
from the requirement of portfolio balance.

1/ The treatment of risk in real trade models of smuggling is

critically examined by Sheikh (1989).
 - 15 -

2. Monetary approach

The monetary approach, developed initially by Blejer (1978a),

emphasises the role of monetary factors in the behavior of parallel
market exchange rates. Blejer outlines a model of the premium by
grafting a flow parallel market for foreign currency into a monetary
model of the balance of payments in which the rate of devaluation of
the official exchange rate depends on the inflation differential with
the rest of the world. In Blejer's model, an increase in the domestic
money stock --initiated, say, by a rise in net domestic credit--
results in an ex ante disequilibrium between supply and demand in the
money market. 1/ As excess cash balances are worked off by agents,
domestic prices rise. This reduces the demand for domestic goods,
raises the demand for foreign goods and foreign currency, and entails
a depreciation of the parallel exchange rate. This, in turn,
increases the differential between the official and the parallel rate,
thereby raising the incentive to under-invoice exports, to smuggle
exports, or to divert remittances through unofficial markets.
Although the increase in the illegal supply of foreign exchange tends
to reduce the initial upward pressure on the parallel rate, a higher
stock of money will in general be associated with a depreciation of
the free exchange rate. Therefore, a restraint on the rate of growth
of domestic credit is a key policy instrument for preventing official
reserve losses when there exists a parallel market for foreign
currency.

The monetary model provides important insights into the

relationships between monetary policy and the behavior of parallel
market exchange rates. In addition to the empirical results reported
by Blejer for Brazil, Chile, and Colombia, the model has been tested
for India (Biswas and Nandi, 1986) and Turkey (Olgun, 1984), with
generally good results. Blejer's formulation suffers, however, from
an important limitation. The model assumes that the demand for
foreign exchange on the unofficial market arises only because the
public desires to alter the composition of its portfolio of financial
assets and not for the purpose of carrying out international purchases
of goods. By doing away with the existence of restrictions on trade
(like tariffs and quotas), it is further assumed that no foreign
exchange is demanded in the parallel market to pay for goods that are
imported into the home country without declaration at the border.
Thus, all the current account needs are assumed to be satisfied by the
official foreign exchange market. This assumption may be particularly
inadequate in view of the exchange controls on both the current and

1/ In Blejer's model, flow monetary disequilibrium is measured

as the difference between the expansion of the domestic-credit
component of the base (and variations in the money multiplier) and the
changes in the demand for real cash balances.
 - 16 -

capital account operations and the quantitative restrictions on

foreign trade imposed by most developing countries, which divert a
substantial part of the transactions demand for foreign exchange --as
emphasized in real trade models-- from the official market to the
parallel market.

Agenor (1990d) has recently developed a model which extends

Blejer's (1978a) monetary model so as to deal with some of the
restrictive features described above. The model provides a synthesis
between the monetary approach and the currency substitution framework
described below, and is based on a careful formulation of stock-flow
interactions. Econometric estimates of the model using quarterly data
for a group of twelve developing countries confirm the role of
monetary disequilibra, as well as changes in the official exchange
rate and expected rates of return, as major determinants of the
behavior of the parallel market exchange rate.

A full macroeoconomic model based on the monetary approach has

also been discussed by Agenor (1990a). The model, which is estimated
using cross-section annual data for eight countries, incorporates
illegal trade transactions, foreign exchange rationing, currency
substitution features, and forward-looking rational expectations. The
simulation results indicate that anticipated expansionary credit and
fiscal policies have a positive impact on real output and prices, a
negative effect on foreign assets, and are associated with a depre-
ciation of the parallel exchange rate. The analysis also shows that
the adjustment process following a temporary shock is inversely
related to the degree of rationing in the official market for foreign
exchange. The higher the degree of rationing is, the lower will be
the offsetting effect on the money supply coming through the balance
of payments, and the higher the rate of depreciation of the parallel
exchange rate generated by an expansionary policy. The simulation
results for a once-and-for-all devaluation are also of considerable
interest, and will be discussed after reviewing the analytical
predictions of portfolio models regarding the relationship between the
official and the parallel exchange rate.

3. Portfolio and currency substitution models

The portfolio-balance approach, developed by Macedo (1982, 1985)

and Dornbusch et al. (1983), stresses the role of asset composition in
the determination of the parallel market exchange rate, in contrast to
the "flow" approach typical of smuggling models. The general observa-
tion underlying this class of models is that foreign exchange is a
financial asset --even in countries with a low level of capital market
development. Loss of confidence in the domestic currency, fears about
inflation and increasing taxation, and low real interest rates give
rise to a demand for foreign currency, both as a hedge and a refuge
for funds, and as a means of acquiring and hoarding imports.
Expectations are taken to play a key role in determining short-term
 - 17 -

supply and demand shifts and in accounting for the volatility of

parallel exchange rates.

Although the partial equilibrium formulation of Dornbusch et al.

(1983) assumes the existence of domestic and foreign interest-bearing
assets, the essential features of the approach are best captured by
models where domestic agents hold in their portfolios only
non-interest bearing domestic and foreign money. 1/ This class of
models, based on the "currency substitution" hypothesis, provides
considerable insight into the short- and long-run behavior of parallel
market exchange rates. 2/

In all these models, output is exogenous and the desired

proportion between domestic and foreign currencies is given by a
"liquidity preference function" (Calvo and Rodriguez, 1977) which
depends on the expected --and, under perfect foresight, actual-- rate
of depreciation of the parallel market exchange rate. Private capital
transactions are usually ignored, so that the reported current account
is equal to the change in central bank reserves, which determines in
turn --together with an exogenously determined rate of growth of
domestic credit-- changes in the domestic money stock. The unreported
current account determines the change in the stock of foreign currency
held in private agents' portfolios. The flow supply of foreign
exchange in the parallel market usually derives from under-invoicing
exports. The propensity to under-invoice, when endogenous, is assumed
to depend positively on the level of the premium. The probability of
detection is also assumed to rise as fraudulent transactions increase,
and this translates into a rising --but at a decreasing rate--
marginal under-invoicing share.

Portfolio balance implies that at each instant the domestic

currency value of the stock of foreign assets is equal to a desired
proportion of private wealth. In the short run, the parallel market
rate moves so as to set portfolio demand equal to the existing stock
of foreign currency, implying that flow demand and supply may diverge
at any given moment. The determination of the parallel exchange rate
at any instant of time is made therefore through the portfolio balance

1/ The Dornbusch et al. formulation (and also that of Frenkel,

1990) is not particularly adequate for the majority of developing
countries with underdeveloped financial systems. Moreover, the
process of currency substitution --whereby foreign-currency
denominated money balances increasingly substitute for domestic money
as a store of value, unit of account, and medium of exchange-- has
gained importance in many countries over the past few years.
2/ See Dornbusch (1986), Edwards (1989), Edwards and Montiel
(1989), Kamin (19885), Kharas and Pinto (1989), Kiguel and Lizondo
(1990), Lizondo (1987, 1990), Pinto (1986, 1988), and Samiei (1987).
 - 18 -

equation, with the stock of foreign currency assumed fixed. In the

long run, the parallel rate and the private sector holdings of foreign
currency are determined by the requirements of both portfolio and
current account equilibrium.

Although there remain important differences between the indivi-

dual formulations, 1/ some general conclusions can be derived from
this class of models. In a fixed-exchange rate regime, an expansionary
fiscal and credit policy generates a depreciation of the parallel
exchange rate, a rise in prices, an appreciation of the official real
exchange rate, and a decline of the relative price of exports
surrendered via the official market relative to those that use the
parallel market. As a consequence, the proportion of export proceeds
repatriated at the official exchange rate falls, and foreign reserves
decline. 2J Eventually, the central bank will "run out" of reserves,
and a balance of payments crisis will ensue. At this point, the
inconsistency between expansive macroeconomic policies and a pegged
official exchange rate will become unsustainable, and corrective
measures will need to be implemented --for instance, in the form of a
parity change. This process leading to a "devaluation crisis" has
been well documented by Edwards (1989), and Edwards and Montiel
(1989).

In a crawling-peg regime, the official and parallel exchange

rates depreciate at the same rate in the steady state, thereby leaving
the spread unaffected. An increase in the rate of devaluation of the
official exchange rate leads to an equivalent rise in the rate of
depreciation of the parallel rate, and this generates a portfolio
shift away from domestic money holdings. If the official and parallel
foreign exchange markets are effectively segmented, the supply of
foreign currency is fixed in the steady state, so that only an
increase in the premium can restore portfolio equilibrium. The
increase in the steady-state level of the premium caused by a higher
rate of official exchange rate depreciation has been emphasized by

1/ Edwards and Montiel (1989) for instance consider a three -

good economy and develop a fairly general analytical framework, but
they assume that foreign currency holdings remain constant --excluding
therefore an important source of dynamics.
2/ In addition to its impact on the propensity to under-invoice
exports, an increase in the premium --without an equivalent increase
in domestic prices-- may generate a positive wealth effect on aggre-
gate demand, which may further deteriorate the current account of the
balance of payments.
 - 19 -

Dornbusch (1986) and Pinto (1986). 1/ It is important to note that

the steady state premium does not depend on the level of the official
exchange rate, but only on its rate of change. This implies that
discrete, one-shot devaluations, will reduce the premium only
temporarily, in the absence of fundamental changes in fiscal and
monetary policies. This result has important implications regarding
attempts at unifying the official and parallel foreign exchange
markets. %J
In more elaborate models where cross transactions exist and where
the under-invoicing share is treated as endogenous, however, the
long-run impact of a once-and-for-all official devaluation on the
parallel rate becomes ambiguous. The effect will in general depend on
the degree to which fraudulent transactions react to changes in the
premium, the rationing scheme imposed by the central bank, and the
elasticity of export volumes to changes in relative prices. The
greater the response of the under-invoicing share to the change in the
premium, the smaller the central bank's marginal propensity to resell
officially remitted foreign exchange, and the smaller the response
of export volumes, the more likely it will be that the parallel market
rate will depreciate --less than proportionally, so that the premium
falls-- in response to a parity change. 3/

Another source of ambiguity in the long-run effects on the

premium of an increase in the rate of crawl relates to the role of the
exchange rate differential as an implicit tax on exports (Pinto, 1989,
and Kharas and Pinto, 1989). On the one hand, a higher rate of
devaluation raises the rate of depreciation of the parallel market
rate, making foreign currency holdings more attractive. This, by
itself, would raise the premium. At the same time, however, for a
given real fiscal deficit, a smaller domestic currency base is
required to generate a given amount of revenues from the inflation
tax, creating therefore the ambiguity. Whether the premium rises or
falls depends upon the inflation elasticity of the share of domestic
currency holdings in total financial wealth. If this is less than

1/ In some models of dual exchange markets with leakages

discussed below --in particular those of Gros (1988) and Bhandari and
Vegh (1990)-- arbitrage flows between markets eliminate the exchange
rate differential through time, so that the steady-state value of the
premium is zero. This result, however, derives from the implicit
assumption that arbitrage activity is subject to negligible transac-
tion costs.
2/ The unification issue is discussed below.
3/ Nowak's (1984) result, according to which an official
devaluation will be associated with an appreciation of the parallel
exchange rate, depends critically on the assumption that the central
bank does not accumulate foreign exchange (Kamin, 1988b, pp. 8-9).
 - 20 -

unity, raising the rate of devaluation of the official exchange rate

raises the unit yield of the inflation tax, and lowers the premium.
Otherwise, the premium will actually rise. Thus, an acceleration of
the official rate of devaluation does not necessarily lower the
premium; the outcome depends crucially on the inflation elasticity of
the demand for foreign currency. In turn, this elasticity rises with
the rate of inflation --that is, the propensity to shift into foreign
currency to avoid the inflation tax becomes stronger as the rate of
growth of domestic prices rises. This results in a "seignorage Laffer
curve", with the (unit) yield of the inflation tax rising for
inflation rates below the seignorage-maximizing level of inflation and
falling above it. A similar reasoning yields a U-shaped curve linking
the steady*state premium and the inflation rate, representing the
trade-off between the tax on exports and the inflation tax.

The short-run behavior of the parallel exchange rate and the

premium in response to a devaluation reflects the typical behavior of
asset prices. Consider first the case where the devaluation is
unexpected. The parity change causes a decline in the flow supply of
foreign currency to the private sector (since the premium falls) at
the initial parallel rate. 1/ For current account balance to be
maintained, a depreciation of the parallel rate is required. At the
moment of the devaluation, the parallel rate depreciates sharply.
Subsequently, current account losses of foreign currency drive the
unofficial exchange rate up still further until it reaches a new long-
run equilibrium at the same moment foreign currency holdings reach
their new steady-state level.

Suppose now that the devaluation is anticipated, that is, it is

announced before being implemented. The announcement of the future
devaluation raises immediately the anticipated --and actual, since
expectations are rational-- rate of depreciation of the parallel
exchange rate, so that the free rate depreciates and foreign currency
holdings rise. After the initial jump, the parallel rate continues to
depreciate while private agents accumulate foreign currency in their
portfolios until the economy hits a new stable saddle path at the
instant the devaluation actually occurs. From this point on, the
parallel rate continues to depreciate while foreign currency holdings
now decline, since the unofficial current account deteriorates
following the devaluation. At the date of the announcement of the

1/ An increase in the parallel market rate, given the official

exchange rate, increases the share of exports channeled through the
unofficial market for foreign currency via under-invoicing or
smuggling, and thus increases the flow supply of foreign exchange.
Conversely, import demand will fall, as well as the share of imports
channeled through the parallel market (as a result of over-invoicing
or smuggling), which will in turn decrease the flow demand for foreign
currency.
 - 21 -

future devaluation, the under-invoicing share jumps upwards, and grows

as the parallel market rate depreciates. When the devaluation is
effectively enacted, the premium and the under-invoicing share fall
sharply, but then recover partially, since the parallel market rate
continues to depreciate, until reaching its new steady-state level.

This description of the transmission mechanism of a parity change

provides an interesting explanation for the seemingly puzzling empi-
rical results on sixty devaluation episodes in developing countries
described by Kamin (1988a). The study shows that prior to the typical
devaluation, the growth rates of exports and imports fall sharply,
while the current account balance and reserve levels deteriorate
markedly. Immediately following the devaluation, exports recover
strongly and the current account improves (contrary to what a
"J-curve" model would predict), while imports continue to fall
--albeit at a slower pace-- and rebound sharply in the second year
after the devaluation. A rationale for this sequence is as follows
(Kamin, 1988b). Continuous inflation and hence appreciation of the
real (official) exchange rate lead to increases in the parallel market
premium, increases in export under-invoicing, and reductions in
officially measured exports. In turn, this drop in export proceeds
leads to reserve losses and declines in imports as the authorities
tighten foreign exchange allocations. The expectation that the
deteriorating external balance will prompt an official devaluation
induces a speculative rise in the parallel market rate which further
reinforces the need for official exchange rate adjustment. Following
the devaluation, the parallel market premium falls, reducing under-
invoicing and increasing officially recorded exports. Improved
reserve flows allow the authorities to expand progressively sales of
foreign exchange, so imports increase as well.

Overall, the predictions of the currency substitution models have

been found to be well supported by empirical tests. 1/ Although the
impact of a devaluation on the parallel market premium is theore-
tically ambiguous, empirical evidence supports in general the

1/ Dornbusch et al. (1983) present empirical tests of their

model for Brazil, while Phylaktis (1989) considers the case of Chile.
The results show a significant impact of the interest rate differen-
tial --as well as, for Chile, the degree of capital restrictions-- on
the parallel market premium. Fishelson (1988), using the actual rate
of depreciation of the parallel market rate as a proxy for the
expected rate of official devaluation, tests the Dornbusch et al.'s
model for a group of for 19 countries over the period 1970-79. More
recently, Kaufman and O'Connell (1990) have provided estimates of the
model for Tanzania, over the period 1967-88. Portfolio factors are
shown to affect the behavior of the parallel market premium mainly in
the short run, while flow factors play a predominant role in the long
run.
 - 22 -

presumption that parallel market rates depreciate, but less than

proportionally, in response to a devaluation of the official exchange
rate, and that the premium falls initially. Studies by Edwards
(1989), Edwards and Montiel (1989), and Kamin (1988b) on a large
sample of devaluation episodes in developing countries have well
documented this fact. Similarly, in the empirical model presented in
Agenor (1990a), a once-and-for-all devaluation of the official
exchange rate is associated in the short run with an output
contraction, a rise in the inflation rate, an increase in net foreign
assets, and a less-than-proportional depreciation of the parallel
rate. In the long run, the official devaluation results in a
permanently higher price level and a more depreciated parallel
exchange rate, but has no effect on the premium. The econometric
results presented in Agenor (199Od) also support the view that the
parallel rate depreciates less than proportionally following an
official parity change.

4. Models of dual exchange rate markets with leakages

There have been some major developments, over the past few years,
in the literature dealing with the properties of formal two-tier
exchange rate regimes which may prove useful for understanding the
behavior of parallel currency markets. 1/ The recent analytical
literature has focused on the possibility of illegal cross-operations
between the commercial and financial exchange markets; see for
instance Bhandari (1988), Bhandari and Decaluwe (1986, 1987), Bhandari
and Vegh (1990), Gros (1987, 1988), and Guidotti (1988). Gros (1988)
has shown that a divergence between the two exchange rates induces in
the short run a flow of arbitrage activity, the magnitude of which
depends on both the costs of evading exchange controls and the size of
the exchange rate differential. Bhandari and Vegh (1990) have
developed an optimizing model in which the coefficient of leakage is
endogenously determined by utility-maximizing agents.
Several aspects of dual exchange rate models with leakages are
relevant for the analysis of illegal or quasi-legal markets for
foreign exchange in developing countries. %J In models of economies
with dual legal markets with a floating "financial" exchange rate, the
floating rate plays a role similar to the parallel market exchange

1/ The early strand of literature was based on the assumption

that the dual exchange markets were effectively segmented, implying
that the freely floating exchange rate would ensure a zero capital
account. As a result, a major channel of transmission of external dis-
turbances --via movements in foreign assets-- was completely
eliminated.
7J Note that in a dual rate system (with a fixed commercial
rate and a freely floating financial rate) an illegal parallel market
may persist, owing to the retention of (some) capital controls.
 - 23 -

rate. Moreover, formal economic modeling of legal and illegal

parallel markets for foreign exchange may look very similar, since
risk and transaction cost functions may be indistinguishable. By
incorporating smuggling and a generalized cash-in-advance constraint
in the Bhandari-Vegh model, Agenor (1990c) for instance derives a set
of asset demand equations which displays the same properties as the
"liquidity preference function" used in the portfolio models described
above,

Consider, for example, the model of a legal, dual exchange rate

system with leakages provided by Bhandari (1988). The model, which
explicitly recognizes both private (fraudulent) and officially-
sanctioned cross transactions between the two exchange markets, is
based on a stochastic, rational expectations approach. Both the real
and financial sectors of the economy are explicitly considered. Asset
accumulation equations in the model are specified in beginning-of-
period, ex-ante equilibrium, rather than in end-of-period, ex-post
terms for analytical tractability. Although there is no currency
substitution, agents may hold foreign-currency denominated bonds in
their portfolios. The interest parity condition, properly modified to
reflect leakages between markets from repatriated interest receipts,
is assumed to hold continuously.

The conclusions of the model can be readily re-interpreted for an

economy in which the dual exchange rate system is composed of a legal
and an illegal market. A positive supply shock raises output and
causes excess demand in the money market, necessitating an increase in
the yield on domestic assets to restore equilibrium. As a conse-
quence , the parallel exchange rate must appreciate in order to
maintain uncovered asset yields in line. A permanent increase in the
foreign price level is associated with an appreciation of the parallel
exchange rate and --as a result of the partial offset provided by the
movement in the free rate-- leads to a less than equi-proportionate
rise in domestic prices. In the long run, a devaluation of the
official exchange rate --anticipated or unanticipated-- leads to an
equi-proportionate depreciation of the parallel exchange rate, thereby
leaving the spread unaffected. In the short run, a once-and-for-all
unanticipated devaluation leads initially to an increase in prices and
real output. At the same time, the reported current account improves,
since the premium falls, leading to reserve accumulation and an
expansion of money supply, while the unreported current account
deteriorates, leading to a fall in the stock of foreign assets held by
the private sector. The increase in domestic prices reduces the real
money stock, thus necessitating an increase in the domestic asset
yield to re-equilibrate the market. This, in turn, requires a rise in
the expected rate of depreciation of the parallel exchange rate, which
brings an immediate depreciation of the free rate. The higher the
degree of compulsory cross-transactions, or the higher the penalty
costs associated with fraudulent cross-transactions, the greater will
be the rate of depreciation of the parallel exchange rate. Overall,
the devaluation leads to a less -than-proportionate depreciation of the
 - 24 -

parallel exchange rate, implying therefore a fall in the premium. The

conclusions regarding the short- and long-term effects of an official
devaluation are qualitatively very similar to those derived from
currency substitution models.

A disturbing feature of the model, however, is its treatment of

the dynamics of asset accumulation. Private savings are arbitrarily
allocated between money and foreign assets, and it is not clear how
alternative allocation processes would affect the results. This is an
important question, since as shown above, stock-flow relationships
play a crucial role in the short- and long-term dynamics of the
premium.

IV. Policies Towards Parallel Currency Markets

In light of the foregoing theoretical and empirical evidence,

several key issues will now be examined from a policy perspective: the
effectiveness of foreign exchange restrictions, the role of nominal
devaluations as a tool to control the parallel market premium, and
strategies for unifying official and parallel foreign exchange
markets.

1. Effectiveness of foreign exchange controls

As discussed above, there is considerable evidence that foreign

exchange controls have not been effective. Rationing creates
shortages of imported goods --which encourages smuggling activities--
and makes it highly lucrative for "rent-seeking" traders to acquire
foreign exchange at the official rate (through personal connections or
other illegal means) and to resell it in the parallel market.
Moreover, foreign exchange rationing may have a negative output and
employment effect (Austin, 1989). By reducing the supply of
intermediate goods to import-dependent industries (including the
export-oriented sector), exchange controls may not only reduce the
official supply of foreign exchange, but may also reduce activity to
low levels of capacity utilization. They can, therefore, aggravate
the very problems that they were intended to solve.

Several countries have recently moved in the direction of

liberalization of foreign exchange restrictions. In November 1989 for
instance, Guatemala announced the lifting of exchange controls and the
establishment of a free exchange market, in an effort to end the
parallel market and liberalize foreign currency trading. Similar
reforms have also been introduced in African and Asian countries (see
Quirk et al., 1989).
 - 25 -

2. Devaluations and parallel market premia

Typically, the existence of a parallel currency market, where

transactions take place at an exchange rate that is more depreciated
than the official exchange rate is considered prima facie evidence
that the official parity is inappropriate. In these circumstances,
the question of whether or not to adjust the official exchange rate
--and in what proportion-- becomes a major issue of exchange rate
policy.

The view that a once-and-for-all devaluation of the official

exchange rate may reduce permanently the level of the premium seems to
be a recurrent theme in discussions relative to exchange rate policy
in developing countries. Indeed, an argument often made is that a
devaluation, if a sizable parallel market exists, reduces the
incentive to fake foreign trade invoices, thereby attracting foreign
exchange back to the official market. This argument has been used
recently to motivate several attempts to reduce the parallel market
premium by exchange rate changes. In October 1989, the USSR announced
a new dollar exchange rate for foreign travel of 6.26 rubles per US
dollar versus 0.63 rubles previously, as a measure to stop the leak of
hard currency through the parallel market. In November 1989, the
Argentine government announced its intention to try to reduce the 54
percent premium In the parallel market through fiscal reforms, rather
that devaluation, which would fuel inflation. In early December 1989,
however, the austral was devalued by 54 percent (to 1,000 australes to
the US dollar from 650) with the premium being cited as one of the
reasons underlying the decision to adjust the exchange rate. On April
28, 1990, the Nicaraguan Government devalued the Cordoba by 30 percent
against the US dollar --from 53,800 to 70,000-- and presented the
measure as a key instrument in their attempt to control black market
activities. Finally, in June 1990, the authorities in Guyana devalued
the domestic currency by 36 percent (relative to the US Dollar) and
announced that a series of devaluations will take place during 1991
until the official and parallel market rates for the currency are
equal.

The flaw in the above argument comes, of course, from its partial
equilibrium nature and its neglect of macroeconomic interactions. A
major implication --largely supported by the available empirical
evidence-- of the general equilibrium, currency substitution models of
the parallel currency market reviewed earlier is that following a
nominal devaluation the premium will typically fall. However, this
reduction will only be temporary (since the initial fall in the spread
reduces supply and increases the unofficial demand for foreign
exchange) if fiscal and credit policies are maintained on an
expansionary course. A devaluation, by itself, cannot permanently
lower the premium. Permanent unification of the official and parallel
 - 26 -

exchange markets cannot be achieved by attempting to eliminate the

spread via devaluation of the official rate alone. 1/

Moreover, there is evidence that devaluations aimed at main-

taining the premium below a given level may lead to increasing rates
of depreciation and therefore to accelerating inflation. An often-
cited example is Bolivia in the early eighties (Kharas and Pinto,
1989). 2/ In the three years preceding 1983, the rates of inflation
in Bolivia reached 47, 32 and 124 percent, respectively. In 1983, the
inflation rate reached 276 percent. In the last quarter of 1984, with
the premium reaching 174 percent compared to 22 percent in december
1980, there was considerable pressure to unify exchange rates. The
authorities decided to use nominal exchange rate policy to minimize
the spread. The belief that the equilibrium nominal exchange rate was
a weighted average of the official and parallel rates, 3J and that
the official rate should be devalued towards it, resulted in a rule
that directly linked official depreciation to the parallel market
premium. Official devaluation reached 350 percent in the last quarter
of 1984, and 455 percent in the first quarter of 1985. The premium
fell at first, but with the parallel market rate responding, it rose
again, resulting eventually in an inflation rate of 496 percent in the
first quarter of 1985, an annualized rate of 126,000 percent. This
episode illustrates that targeting the premium through exchange rate
policy alone can be costly. Such a policy carries an inherent risk of
inflation, which can be limited only if restrictive financial policies
are implemented at the same time. The episode also suggests that
there is a sequencing issue in the introduction of fiscal and exchange
rate reforms. As a rule, fiscal reform, which takes longer and is

1/ The recent experience of Argentina provides a good illus-

tration of this proposition. Following the devaluation of December
1989, the premium dropped immediately. But, because of the lack of
financial discipline, the free market rate rose quickly to 1,230
(continued from page 25) australes, bringing the premium back to 23
percent. See Kamin (1990) for a further analysis.
2/ Bolivia has since moved to a fairly flexible exchange
system, based on daily auctions of predetermined amounts of foreign
exchange without restrictions on access to participants. Other
countries that have recently pursued an exchange rate policy involving
the adjustment of the official exchange rate to the parallel market
premium include Bangladesh and Ghana.
3/ Policy discussions have often been centered on the idea that
the restriction-free equilibrium exchange rate lies "somewhere"
between the official exchange rate and the parallel rate --although it
has long been recognized that the latter is often subject to erratic
movements due to fluctuations in the demand and supply of foreign
currency. In fact, as shown by Lizondo (1987), the equilibrium offi-
cial rate can be either above or below the parallel rate.
 - 27 -

more difficult to implement, and therefore takes time to be credible,

should be implemented first. Once the fiscal reform process is under
way, devaluations may be valuable in speeding up adjustment.

3. Unification of foreign currency markets

The unification of foreign exchange markets (that is, the process

whereby the premium is lowered and the official and parallel market
rates are gradually brought close to each other so as to ultimately
give rise to a unique exchange rate), and the transition to a fixed or
a floating exchange rate regime remain key policy issues for a large
number of developing countries. The purpose of unification, when a
parallel currency market is significant as a source of import
financing, is to absorb and legalize it, rendering official the "de
facto" (partial) import liberalization, and eliminating the
inefficiencies and market fragmentation associated with (quasi-)
illegality. Unification attempts may aim at adopting a uniform
floating exchange rate, or a uniform fixed or crawling official rate.
In the first case, the official exchange rate clears the foreign
exchange market, while in the second, changes in the banking system's
foreign reserves serve to adjust supply and demand for foreign
currency.

Consider first the policy of adopting a floating exchange rate.

Theoretically, the impact of such a policy shift on the short- and
long-run behavior of the exchange rate and the rate of inflation is
ambiguous. In the long-run, the effect depends crucially on the
fiscal impact of the exchange rate reform. If the dual arrangement
provides profits (in the form of tax revenues from currency
operations, etc.) to the authorities, the rate of depreciation of the
exchange rate and the rate of inflation would generally rise, as the
authorities may compensate for a fall in revenue by an increase in
monetary financing; conversely, if the system caused losses, the rate
of depreciation and the inflation rate would typically fall. 1/

In the short run, the behavior of the floating exchange rate upon
unification will depend on a number of factors, in particular the
behavior of expectations regarding the reform process. If the
unification attempt is anticipated, in order to avoid capital losses
(or to realize capital gains) agents will adjust their portfolios

\J The effect will also depend on whether the balance of

payments before the unification attempt is in deficit or in surplus.
An initial deficit for instance —which implies that the excess demand
for foreign exchange was partly accomodated through changes in inter-
national reserves-- will translate, upon unification, into a higher
rate of depreciation of the official exchange rate and a higher
inflation rate.
 - 28 -

towards foreign-currency denominated assets if the uniform floating

exchange rate is expected to be more depreciated than the existing
parallel rate, and towards domestic-currency denominated assets if it
is expected to be more appreciated. As a result of this portfolio
adjustment, the parallel market rate will depreciate immediately --at
the moment where expectations are formed-- towards the level asset
holders expect the post-unification floating rate to be. In the
limiting case where private agents anticipate perfectly the evolution
of the post-unification exchange rate, the parallel market rate would
initially jump and then depreciate steadily towards that level at the
time of unification (Lizondo, 1987; Lizondo and Kiguel, 1990).

Consider now the case where the authorities attempt to unify the
official and parallel markets by adopting a crawling peg regime,
possibly following a one-shot devaluation of the official exchange
rate. In the long-run, the rate of crawl must be consistent with
balance of payments equilibrium, and such a rate is equal to the rate
of depreciation that would prevail in the long run under a uniform
floating regime (Lizondo, 1987). In the short-run, the behavior of
the parallel exchange rate upon unification will also depend crucially
on the behavior of expectations. If agents anticipate the unification
attempt, the same type of portfolio adjustments described above will
be initiated. As a result, the parallel market rate will move towards
the expected level of the post-unification official rate. 1/

What is the evidence available concerning the behavior of

exchange rates following a unification attempt? Few developing
countries have attempted to unify their foreign exchange markets by
adopting a crawling peg regime. Since, as shown above, a once-and-
for-all devaluation cannot lead by itself to permanent re-unification
of exchange markets, a sensible approach is therefore to examine
unification attempts that have taken the form of floating the domestic
currency.

Indeed, recent evidence points to greater flexibility in the

exchange arrangements of some developing economies, with several
countries adopting market-oriented exchange systems. Roberts (1989)
has studied the experience of African countries in the mid-eighties
with market-based exchange-rate determination arrangements, and

1/ This helps illustrate the difficulty involved in using the

parallel market rate as an indicator for the initial level of the
official exchange rate in the crawling peg regime. If private agents
anticipate the unification attempt, the parallel rate will move
immediately --before the reform is implemented-- towards the level the
authorities are expected to set the official crawling rate. Conse-
quently, setting the initial, post-reform rate at the level the
parallel rate is at the time of unification will be consistent with
balance-of-payments equilibrium only if expectations are correct.
 - 29 -

specifically with foreign-exchange auctions and floating. 1/ These

reforms often had as an explicit goal the absorption of the parallel
market in foreign currency and a reduction in --or elimination of--
the premium. Table 2 summarizes the results. The rates of nominal
devaluations which followed the introduction of floating/auctioning
were massive in Nigeria, Sierra Leone, Somalia, Uganda, Zambia, and
Zaire. The Table shows clearly that the failures of floats and
auctions are associated with a loss of control over monetary policy
(Zambia and Ghana, for instance), and the successes with at least a
stabilization, if not a reduction, of liquidity growth (for example
Gambia). Table 2 and Figure 3 (which presents monthly data on the
spread for Guinea, Nigeria, Uganda, and Zaire) shows that the
parallel market premium rose substantially before the reform of the
exchange system. This can be interpreted as being partly the result
of expectations about the reform process. 1/ Figure 3 also shows that
the premium fell sharply following the exchange rate reform in all
countries, while a significant premium reemerged subsequently in those
countries where money growth could not be kept under control (Ghana,
Sierra Leone, Somalia, Zambia). Interestingly enough, the post-
unification exchange rate is typically close to the pre-reform
parallel rate, casting doubt on the argument that the "equilibrium"
exchange rate is some average of the official and parallel rates.
This is not surprising if the resale of foreign exchange is at a large
scale (Nigeria, for instance) and if prices are determined at the
margin. A second misconception, as pointed out by Pinto (1989), is
that the large initial one-shot depreciation of the official exchange
rate, which is typically associated with unification attempts, will be
inflationary. This has apparently not been the case in countries

1/ Other developing countries that have recently adopted a

floating regime include Uruguay (in late 1982), Jamaica and the
Phillipines (in 1984), Bolivia and the Dominican Republic (1985). The
move occured in most cases at a time of increasing external payments
difficulties and increasing arrears (with reserves no longer available
to support the fixed exchange rate), extensive parallel currency
markets (syphoning off foreign exchange from the official channels)
and capital flight. See Quirk et al. (1987, 1989), and Pinto (1989).
See also Branson and Macedo (1989) for an analysis of the (failed)
attempt by Sudan to unify its exchange system in November 1981-March
1982, and Hausmann (1990) for a review of the Venezuelan experience
with multiple exchange rates during 1983-89.
1/ Faced with the possibility of a future depreciation of the
parallel rate, asset holders reallocate their portfolio away from
domestic money, thereby causing the free exchange rate to depreciate
immediately, and thus the premium to increase prior to the depre-
ciation of the official rate. The pattern depicted in Figure 3 is
consistent with the results reported by Kamin (19882?), Edwards (1989),
and Edwards and Montiel (1989).
 - 30 -

where money growth was initially kept under control (Nigeria, Zaire),
since the more depreciated parallel rate is already reflected in
domestic prices. Post-unification inflation seems to depend rather on
the fiscal implications of unification and subsequent or concomitant
changes in macroeconomic policies.

Fiscal factors can indeed account for a substantial rise in the

rate of growth of domestic prices following a unification attempt.
Table 2, for instance, shows that in Sierra Leone inflation rose
substantially in the first year following the attempted unification of
official and parallel exchange markets through floating. An expla-
nation of the often-observed inflationary burst related to unification
has been provided by Pinto (1989). The government in developing
countries is, typically, a net buyer of foreign exchange from the
private sector. Since the parallel market premium is an important
implicit tax, there is a trade-off between the premium (tax on
exports) and inflation (a tax on domestic currency holdings) in
financing the deficit. Therefore, unifying official and parallel
exchange rates could raise inflation substantially (and permanently),
even if the level of government spending remains constant in real
terms, as the loss in revenues from exports is replaced by an increase
in monetary financing of the budget deficit and a higher tax on
domestic cash balances.

There are two major lessons from the above discussion of the
recent experience of African countries with exchange rate reform.
First, unification of exchange markets by exchange rate policy alone
cannot succeed without measures of (at least partial) import
liberalization, specifically the relaxation of import licensing
schemes. The combined effect of relaxing licensing schemes and
administrative allocations of foreign exchange makes importing goods
once again market-determined--subject only to the distortion of
tariffs. In Ghana for example, concurrently with the process of
exchange rate reform, the exchange and trade system was gradually
liberalized, during the 1986-89 period. The import licensing scheme
was first streamlined, then liberalized and finally abolished in early
1989, while other current transactions were progressively made
eligible for funding through the auction. As a result of these
measures, only a few restrictions on current transactions, relating
essentially to invisible transactions, remained in effect by mid-1989.

Second, complete elimination of the premium requires the removal

of all restrictions on capital and commercial transactions. In most
of the countries considered (notably in Nigeria and Zaire), the
currency was floated only for commercial transactions with capital
controls being retained for outwards flows. The "best" route to
unification, therefore, might be to gradually relax foreign exchange
rationing in the official market (starting with commercial
transactions), accompanying this with discrete devaluations, with the
pace of reform being set by the speed of fiscal adjustment. In the
process, monetary policy and liquidity controls are important for
 - 31 -

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 - 32 -

stabilizing expectations and parallel exchange rates. Expectations of

inflation and further depreciation at times of expansionary credit
policies --typically caused by the monetization of fiscal deficits-
may provide a destabilizing influence. In this sense, unification is
a complex process, involving perhaps changes in policy institutions
and requiring gradual adjustment on the part of market participants.

V. Concluding Remarks

The purpose of this paper has been to discuss in a consistent

and coherent framework recent theoretical and empirical developments
in the analysis of parallel currency markets in developing countries.
The policy implications of the results have also been assessed, and
the issue of exchange market unification has been discussed in light
of the recent experience of a group of developing countries with
flexible exchange rate arrangements.

In the process of reviewing the recent literature on parallel

currency markets, it is clear that a number of substantive issues have
not yet been adequately addressed. The transition costs associated
with exchange market unification, for instance, are not well
understood. Issues related to the distributional effects, 1/ as well
as the pace, of the unification process have received only scant
attention, and criteria for choosing between a "gradual" or an
"overnight" attempt --as well as the implications of the alternative
options for fiscal and monetary policies, inflation, and the balance
of payments-- have not been fully addressed. Existing discussions of
this issue, based on models of legal dual exchange rate systems with
no leakages between markets, assume for instance that the central bank
can determine which transactions can be conducted through the
different foreign exchange markets --a possibly inappropriate
hypothesis for developing countries with sizable, informal foreign
currency transactions.

Similarly, the role of the premium as a "signalling" device in

the context of stabilization programs has not been fully explored.
Recent analytical models of devaluation crises have emphasized the
role of the premium in the determination of the degree of credibility
forward-looking agents attach to the official exchange rate, and its
consequent effect on devaluation expectations (Agenor, 1990b). An
interesting extension of this framework might be to analyze the role
of the premium, in an economy subject to a variety of stochastic
shocks, as conveying (noisy) information about the policy stance of

1/ Distributional implications of parallel currency markets

are examined by Gonzalez-Vega and Zinser (1987), in the context of the
Dominican Republic.
 - 32a -

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 - 33 -

Che authorities, and to examine how, when agents face a "signal,

extraction" problem, expectatlons of die collapse of a stabilisation
program can become self-fulfilling. Finally, the Implicat1ons of
alternative exchange rate rules (like a constant: real exchange rar.f:
policy, for instance) for the behavior of the parallel market premium
have not been fully worked out. A systematic analysis of the impact
of external shocks (such as changes In the terms of trade, as In
Edwards and Montlel, 1989) on the behavior of the premium remains to
be done.

Nevertheless, there are some general policy implications that

emerge from the present Literature.. Exchange and trade restrict! ons
are largely Ineffective as long-term policies to maintain the
viability of an (overvalued) exchange rate or to "impose" balance of
payments adjustment. In these circumstances, the emergence of
parallel exchange marke ts Is a normal outcome. Although "socially
beneficial" In seme respects, parallel currency markets generate a
variety of costs. In particular, they increase the potential to evade
the Inflation tax on domestic cash balances. Furthermore, unofficial
exchange rates have a substantial impact on domestic prices, and play
an Important role In the transmission mechanism of macroeconomic
policies. Permanent unification of official and parallel foreign
exchange markets cannot be achieved by attempting to eliminate the
spread via devaluation of the official exchange rate alone. Such a
policy Is also inherently inflationary. Attempts at exchange market
unification by floating the currency are likely to be accompanied by
an inflation burst, which results not so much from the depreciation of
the official exchange rate (since prices will have already reflected
the more depreciated parallel rate), but rather from the loss of the
implicit tax on exports upon unification. To be successful, uni-
fication must be accompanied by a relaxation of exchange restrictions
and by supportive financial policies.
 - 34 -

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