Parallel exchange rates in developing countries : lessons from eight case studies

In parallel (dual) foreign-exchange markets - extremely common in developing countries - a market-determined exchange rate coexists with one or more pegged exchange rates. The authors report the main lessons from a World Bank research project on how these systems work, based mainly on case studies in Argentina, Ghana, Mexico, Sudan, Tanzania, Turkey, Venezuela, and Zambia. On the whole, the experiences were disappointing. Most countriestolerated high premiums for long periods, which harmed the allocation of resources and growth. The studies indicate no clear gains from prolonging a dual system. The case for a dual foreign exchange system is stronger when the system is adopted as a temporary option to deal with a severe balance of payments crisis. Argentina, Mexico, and Venezuela resorted to a dual system at the time of the debt crisis, to smooth out the devaluation in the exchange rate to achieve the needed real depreciation. This helped to maintain limited control over domestic inflation, and avoided a sharp drop in real wages while protecting the balance of payments. In the longer term, not much was gained. In the cases studied, the dual system was misused more often than not: it was used too long and the premium was higher than is should have been. Venezuela, for example, used the system for six years with an average 120 percent premium, Mexico for five years (average 30 percent), and Argentina for eight years (average 44 percent). In Argentina and Venezuela, the dual system was used to avoid macroeconomic adjustment while protecting international reserves. It is doubtful the macroeconomic gains (in terms of keeping equilibrium in the balance of payments and lower inflation) were greater than the costs in terms of misallocation of resources. In Ghana and Tanzania, the dual exchange rate system was prolonged to maintain overvalued real exchange rates and expansionary macroeconomic policies. The large premium in those countries (at times more than 1,000 percent) shows the dramatic inconsistency between exchange rate policy and monetary and fiscal policies. On determinants of the parallel exchange rate, the evidence indicates that macroeconomic fundaments (such as fiscal deficit, credit policies, and so on) matter most. In the short run the premium is driven by expectation about the evolution of these macroeconomic factors. Overall, in the countries examined in the project, the existence of a parallel foreign exchange market generated fiscal losses. These losses resulted because the public sector was a net seller of foreign exchange rate. This means that unification has some pleasant fiscal arithmetic. The experience with unification indicates that it usually takes place at the parallel exchange rate. Most countries unified to a crawling peg system, though some opted for floating exchange rates. Successful unification to a fixed exchange rate was less frequent, and it required strong adjustment in fiscal and monetary policies. Regarding speed, unification was quick in countries where the parallel system was used temporarily, and gradual in those where the system existed for long periods and with a tradition of widespread foreign exchange controls.Financial Economics,Economic Theory&Research,Economic Stabilization,Fiscal&Monetary Policy,Macroeconomic Management

A Sovereign Debt Model with Trade Credit and Reserves

This paper analyzes sovereign debt in an economy in which the availability of short-term trade credit reduces international trade transaction costs. The model highlights the distinction between gross and net international reserve positions. Borrowed reserves provide net wealth and liquidity services during a negotiation, as long as they are not fully attachable by creditors. Moreover, reserves strengthen the bargaining position of a country by shielding it from a cut-off from short-term trade credits thereby diminishing its degree of impatience to conclude a negotiation. We show that competitive banks do lend for the accumulation of borrowed reserves, which provide partial insurance.

A Sovereign Debt Model with Trade Credit and Reserves

This paper analyzes sovereign debt in an economy in which the availability of short-term trade credit reduces international trade transaction costs. The model highlights the distinction between gross and net international reserve positions. Borrowed reserves provide net wealth and liquidity services during a negotiation, as long as they are not fully attachable by creditors. Moreover, reserves strengthen the bargaining position of a country by shielding it from a cut-off from short-term trade credits thereby diminishing its degree of impatience to conclude a negotiation. We show that competitive banks do lend for the accumulation of borrowed reserves, which provide partial insurance

The macroeconomics of delayed exchange-rate unification : theory and evidence from Tanzania

Parallel exchange-rate markets have often been dismissed by authorities as a nuisance or as the domain of a small group of economic saboteurs. Using Tanzania as a case study, the authors argue instead that these markets played a central macroeconomicrole in the 1970s and 1980s. They provide a rigorous macroeconomic analysis of the parallel foreign-exchange market and its fiscal implications. First, they investigate the evolution of that market in Tanzania from the mid-1960s to 1990. That period stretched from the adoption of exchange controls to macroeconomic collapse and then to subsequent reforms in the mid- to late 1980s. A reduced -form econometric equation (of a Dornbusch stock-flow model type) indicates that both trade and financial portfolio factors were important in determining the parallel premium, with trade determinants the parallel premium, with trade determinants dominating in the long run, as theory suggests. Then they investigate the fiscal impact of the parallel exchange-rate premium, an issue emphasized in the literature on exchange-rate unification. They construct a counterfactual simulation of fiscal and balance-of-payments flows under alternative assumptions about the indexing of those flows to the parallel and official exchange rate. They find that a more aggressive move toward exchange-rate unification would have already delivered a fiscal bonus by the mid-1980s. Accordingly, unification of the exchange rate would have reduced monetary growth and inflationary pressures. So, contrary to conventional advice often given in Africa and elsewhere, the case of Tanzania suggests that from a fiscal viewpoint there was no economic rationale for gradualism in exchange-rate unification and delay of a move toward convertibility.Economic Theory&Research,Banks&Banking Reform,Fiscal&Monetary Policy,Payment Systems&Infrastructure,Environmental Economics&Policies,Economic Theory&Research,Macroeconomic Management,Fiscal&Monetary Policy,Environmental Economics&Policies,Economic Stabilization

Aid versus trade revisited

This paper examines the (non) equivalance between aid flows and trade preferences as alternative forms of donor assistance in the presence of learning-by-doing externalities in recipient country export production. Using a two-period model based on vanWijnbergen (1985), in which the productivity externality consistitues the only (inter-temporal) distortion, we show that switching donor support on the margin from aid to trade preferences can increase recipient country welfare. To evaluate the size of this potential welfare gain to small African economies we simulate donor policy reforms using a dynamic CGE model where the productivity externality may also interact with private capital accumulation. We show that for reasonable values of key behavioural parameters, the potential growth and welfare gains from a (donor) revenue neutral re-orientation of assistance to developing countries could be substantial. The paper concludes by considering why these potential dynamic gains appear to be unexpoited by both donors and recipients.Foreign Aid, Trade Preferences, Africa.

On the Pricing of Intermediated Risks: Theory and Application to Catastrophe Reinsurance

We model the equilibrium price and quantity of risk transfer between firms and financial intermediaries. Value-maximizing firms have downward sloping demands to cede risk, while intermediaries, who assume risk, provide less-than-fully-elastic supply. We show that equilibrium required returns will be "high" in the presence of financing imperfections that make intermediary capital costly. Moreover, financing imperfections can give rise to intermediary market power, so that small changes in financial imperfections can give rise to large changes in price. We develop tests of this alternative against the null that the supply of intermediary capital is perfectly elastic. We take the US catastrophe reinsurance market as an example, using detailed data from Guy Carpenter & Co., covering a large fraction of the catastrophe risks exchanged during 1970-94. Our results suggest that the price of reinsurance generally exceeds "fair" values, particularly in the aftermath of large events, that market power of reinsurers is not a complete explanation for such pricing, and that reinsurers' high costs of capital appear to play an important role.

Single-equation estimation of the equilibrium real exchange rate

Estimating the degree of exchange-rate misalignment remains one of the most challenging empirical problems in an open economy. The basic problem is that the value of the real exchange rate is not observable. Standard theory tells us, however, that the equilibrium real exchange rate is a function of observable macroeconomic variables and that the actual real exchange rate approaches the equilibrium rate over time. A recent strand of the empirical literature exploits these observations to develop a single-equation approach to estimating the equilibrium real exchange rate. Drawing on that earlier work, the authors outline an econometric methodology for estimating both the equilibrium real exchange rate and the degree of exchange-rate misalignment. They illustrate the methodology using annual data from Cote d'Ivoire and Burkina Faso.Fiscal&Monetary Policy,Economic Theory&Research,Environmental Economics&Policies,ICT Policy and Strategies,Scientific Research&Science Parks,Economic Stabilization,Macroeconomic Management,Economic Theory&Research,Environmental Economics&Policies,Achieving Shared Growth