metadata: authors: 0: author: HEE, MICHAEL HOI CHOO
count: World
docna: 0: docna: Conversion factors : a discussion of
            alternate rates and corresponding weights
docty: Policy Research Working Paper
subtopic: International Trade and Trade Rules,Crime and Society,Competition Policy,Competitiveness and Competition Policy,Trade and Services,Natural Disasters
teratopic: Social Development,Private Sector Development,International Economics and Trade,Environment
abstracts: cdata!: The significant operational implications
            underlying the Bank's estimates of per capita GNP,
            represent important considerations in systematizing the use
            of official rates in determining the exchange rate to be
            used in the Atlas methodology. This paper discusses issues
            and procedures to develop a time series of alternative
            conversion factors with corresponding weights for use in
            converting and presenting macro-level country statistics in
            a common unit of account, e.g. the U.S. dollar. The focus of
            the paper is on conversion factors that are representative
            of transaction or "effective" conversion factors.
            It also emphasizes the implications for Bank estimates of
            per capita, the kinds of evidence relevant in assessing the
            underlying conversion factors, and identifies countries
            where review of the official exchange rate merits serious
            consideration. The paper reviews the main concerns about the
            adequacy of the official exchange rate as a conversion factor.
repnme: repnme: Conversion factors : a discussion of
            alternate rates and corresponding weights
display_title: Conversion factors : a discussion of
            alternate rates and corresponding weights
listing_relative_url: /research/1990/08/700198/conversion-factors-discussion-alternate-rates-corresponding-weights
topicv3: Price Controls m1326085 2107,Trade m1326924 698,Trade in Services m1326928 780,Black Market m1439229 BLA-3388,Quantitative Restrictions m1504269 2564
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Social Development,Private Sector Development,International Economics and Trade,Environment
origu: Policy, Research & Ect Affairs
no_of_pages: 68
author_keys: 0: author_key: 98123
model_extractions: <!-- Start of picture text --> Policy, Research, and External Affairs<br><!-- End of picture text -->

# "WORKING PAPERS

<!-- Start of picture text --> Socio-Economic Data<br>WPS 476<br><!-- End of picture text --> This paper - _a_ product of the Socio-Economic D3ta Division, International Economics<sup>Department-</sup> is part of a largereffort in PRE toward a more versatile approach<sup>to estimating conversion factorsfor the</sup><sup>_World_</sup> _Bank Atlas_ and operational purposes. Copies are available free from the World Bank,<sup>**1818**HStreet NW,</sup> Washington **DC** 20433. Please contact Estela Zamora, room **S7-136,** extension<sup>**33706 (59**pages, including</sup> tables).

The significant operational implications underlying the Bank's estimates of per capita **GNP** represent important considerations in systematizing the use of official and other exchange rates in determining the exchange rate to **be** used in the Bank's Atlas methodology. Hee explores the potential for a system of time series for various conversion factors and a corresponding set of time series for weights.

The framework is useful for countries with multiple exchange rates. It gives us a way to develop time series on parallel and black market exchange rates, purchasing-power parities, traderelated taxes and subsidies, and potentially more.

The starting premise is that a single official exchange rate has a weight of **1.0** in all years; all other rates (implicitly) have zero weights. **A** major component of this framework is the redistribution of weights among multiple exchange rates.

Such a matrix of conversion factors and corresponding weights could provide the mechanism **(1)** for a systematic approach to weighting alternative rates; (2) for estimating the effects of alternative weighting schemes; **(3)** for determining the effects of incorporating parallel or black market exchange rates; **(4)** for providing the basis for less erratic and unpredictable fluctuations in the data in the _World Bank Atlas_ and _World Tables; and_ **(5)** for improved and more transparent documentation of methods and "special" cases.

> The PRE Working Paper Series disseminates the findings of work under way in the Bank's Policy. Research, and External Affairs Complex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished. The findings, interpretations, and conclusions in these papers do not necessarily represent official Bank policy.

Produced **by** the PRE Dissemination Center
# TABLE OF **CONTENTS**

|SUMMARY**ANDCONCLUSIONS.......................................**|<br>i|
|---|---|
|I.INTRODUCTION**.................................................**|**1**|
|**A**SystemofConversion<sup>FactorsandWeights</sup><sup>**...............................**</sup><br>ScopeofPaper**.....................................................**<br>MagnitudesofDeviations<sup>asSignals</sup><sup>**.....................................**</sup>|<br>**1**<br>4<br> <br>**6**|
|II.**CONVERSION**FACTORS<sup>a..dRELATIVEPRICE</sup><sup>**MOVEMENTS...........**</sup>|<sup>**..**</sup><br>**8**|
|ConversionFactorasaPrice**...........................................**|**8**<br>|
|<br>ConversionFactorand<sup>PriceLevelsofTraded/NonTradedGoods</sup><sup>**.............**</sup>|<sup>**..**</sup><br>**9**|
|III.CONVERSIONFACTORS<sup>andMULTIPLE</sup><sup>**EXCHANGE**PRACTICES</sup><sup>**......**</sup>|<sup>**...**</sup><br>**13**|
|EffectsofMultipleCurrency<sup>PracticesonConversionFactors</sup><sup>**.................**</sup>|<sup>**..**</sup><br>**13**<br>|
|<br>IncidenceofMultipleCurrency<sup>Practices</sup><sup>**..................................**</sup>|<br>**15**|
|<br>DeviationsofMultipleRates**...........................................**|**15**<br>|
|<br>"Composite"Conversion<sup>Factor</sup>**.........................................**|<br>**18**<br>|
|<br>CountriesforReviewand<sup>AdjustmentforMultipleRates</sup><sup>**.....................**</sup>|<sup>**.**</sup><br>21|

|IV.BLACKorPARALLEL<sup>MARKET</sup><sup>**EXCHANGE**RATES</sup><sup>**................**</sup>|<sup>**....**</sup><br>22|
|---|---|
|FormalandInformalParallel<sup>ExchangeMarkets</sup><sup>**.........................**</sup><br>PurchasingPowerParity<sup>andFactorsAffectingParallelMarketRates</sup><sup>**........**</sup>|<sup>**...**</sup><br>22<br><sup>**.....**</sup><br>**23**<br>|
|<br>ParallelMarketRatesand<sup>MarketInformation</sup><sup>**..........................**</sup>|<sup>**...**</sup><br>**25**<br>|
|DeviationsofBlackMarketRates<br>**....................................**|**..**<br>**27**<br>|
|CountriesforReviewand<sup>AdjustmentforParallelRates</sup><sup>**...................**</sup>|<sup>**....**</sup><br>**28**|
|V.PURCHASING POWERPARITYasCONVERSIONFACTORS**.........**|**......**<br>**32**|
|---|---|
|PurchasingPowerParity(PPP)**......................................**|**...**<br>**32**|
|PPPandDataConversion**...........................................**|**..**<br>34|
|WhatPriceMeasureto Use inPPPComputations**......................**|**.....**<br>34|

|VI.TRADEandEXCHANGETAXESand**CONTROLS.............**|**..........**<br>**37**|
|---|---|
|TradeTaxes onGrossOutputandValue-Added**....................**|**.........**<br>**38**|
|EffectsofTariffsandSubsidiesonConversionFactors**..............**|**..........**<br>**39**|
|IncidenceofTradeTaxesandExchangeControls**...................**|**.........**<br>40|
|"TradeTax-Effective"ConversionFactors**..........................**|**........**<br>45|
|Deviationsof"TradeTax-Effective"ExchangeRates**................**|**..........**<br>48|
|CountriesforReviewandAdjustmentforTradeTaxes**..............**|**..........**<br>49|

|VII. VOLATILITYin**EXCHANGE**RATESandTRADE**VOLUMES........**|**......**<br>**50**|
|---|---|
|Merchandise-WeightedConversionFactors**..............................**|**...**<br>**_50_**|
|DeviationsofMerchandise-WeightedRates**.............................**|**...**<br>**_51_**|
|CountriesforReviewandAdjustmentforVolatility**. ....................**|**....**<br>**52**|

|VIII.**USE**ofPERIODAVERAGE**EXCHANGE**RATESintheBANK**........**|**.....**<br>**55**|
|---|---|
|ShorterPeriodstoLongerPeriodRates**.................................**|**..**<br>**55**|
|Search foraGeneralPurposeConversionFactor**.........................**|**...**<br>**57**|

> BIBLIOGRAPHY **................................................... 58**
# **SUMMARY AND CONCLUSIONS**

The significant operational implications underlying the Bank's estimates of<sup>per capita</sup> **GNP,** represent important considerations in systematizing our<sup>use</sup> of<sup>official(andother)</sup> rates in determining the exchange rate to be used in the Atlas methodology.<sup>Thepaper</sup> explores the potential for a system of time series for various conversion<sup>factors,anda</sup> corresponding set of time series for weights (Table<sup>**1).**</sup> The International Economics Department (IEC) has expanded the availability<sup>of the</sup> repertoire of exchange rates; a major task in this system, however, is the redistribution<sup>of</sup> weights among multiple rates.The starting premise is that a single<sup>officialratehasa weight</sup> of **1.0** in all years; all other rates have (implicitly) zero-weights. We can examine<sup>theissue</sup> of how the "composite" conversion factor would look like<sup>ifsuchrateshavenon-zero</sup> weights. IEC's practice is to take into account such multiple exchange<sup>ratesandtothe</sup> extent data are available, estimates an appropriate conversion factor from<sup>a</sup> multitude<sup>of</sup> exchange rates prevailing in a country (see the examples of<sup>**Egypt**andSyria).</sup> In this connection, the paper reviews the main concerns about<sup>theadequacyof the</sup> official exchange rate as a general conversion factor when in effect countries<sup>maintaindual</sup> or multiple exchange practices, or there are active foreign exchanges<sup>in the parallelor black</sup> markets, or that there is a high incidence of price controls and trade-related<sup>restrictions.</sup>
ii One aspect receiving special attention is the compilation of a general purpose (composite) conversion factor from a set of multiple exchange rates for different types of international transactions. The paper identifies the kinds of evidence that are relevant in assessing the impac. of these practices on exchange rates; provides illustrative examples of **IEC** using the evidence to derive alternative conversion factors (Tables 4 and **_5),_** and concludes **by** identifying countries where review, and adjustment if necessary, of the official exchange rate merit serious consideration. These countries are shown in the Summary Table below. It is of interest to note that the countries emerging from this paper as needing review of their official exchange rates cover some **70** percent of countries listed in the Fund's Annual **Report on Exchange** Arrangements and E%change Restrictions as having "cost-related import restrictions" and/or maintaining -. iultiple exch. we rates for exports and imports.

> It should be emphasized that adoption of approaches suggested in the paper will not

> necessarily lead to an unambiguous conclusion regarding the "right choice" of the conversion factor. **It** must also be recognized at the outset that any adjustments to the official exchange rate require intimate knowledge of the trade and exchange system of the country concerned.

> Nevertheless, these approaches improve the basis for judgments that will always be required in such a decision. More information from and regular discussions with Regional economists

> will, hopefully, lead to the assembly of adequate information to enhance the robustness of such judgments.
_iii_ Summary Table: Countries Recommended for Review/Adjustment of Exchange<sup>Rates</sup>

|_>30%_|**(1)DEVIATIO**<br>>20%**<**_30%_|**NS**ofMULTIPLERATES<br>_>15%_**_<20%_**|**>10%**<20%|
|---|---|---|---|
|**#Egypt**<br>**# El**Salvador|Bahamas||**#**YemenAR|
|**#**Guatemala||||
|**#**Paraguay<br>**#**Romania||||
|**#**Venezuela||||

(2) DEVIATIONS of BLACK MARKET RATE **>30%** >20% **<** _30%_ **>15%** <20% **>10%** _<20%_ **#** Afghanistan **#** Argentina Chile Bahamas Algeria Botswana **#** Jamaica **S.** Africa **#** Bangladesh Haiti Korea Yugoslavia **#** Egypt India **#** Sudan Zaire Ethiopia Thailand **#** Guyana **#** Hungary **#** Kenya Libya Morocco Myanmar **#** Nicaragua **#** Nigeria s- Paraguay **#** Peru # Poland # Romania # Syria Trinidad **&** Tobago **#** Identified in the Fund's Annual Report on Tunisia Exchange Arrangements and Exchange Restrictions # Venezuela as maintaining multiple exchange rate system. # Zambia Zimbabwe <!-- Start of picture text --> (3) TRADE TAXES ("Implicit Tariff Rates")<br>>30% >20% < 30% >15% <20% >10% <20%<br>Burundi Bangladesh * Belize<br>Guinea-Bissau * Pakistan * Burkina Faso<br>* India * Sudan Comoros<br>Uganda * Egypt<br>Gambia<br>Ghana<br>* Iran<br>Myanmar<br>* Peru<br>Sierra Leone<br>* Somalia<br>Sri Lanka<br>Togo<br>Tunisia<br>* Vanuatu<br>Venezuela<br>* Yemen AR<br><!-- End of picture text --> (4) VOLATILITY in **EXCHANGE** RATES and TRADE **VOLUME** Select countries on basis of Volatility in quarterly exchange<sup>rates(e.g.Argentina,Brazil,Yugoslavia.)</sup>
# I. INTRODUCTION

# **A** System of Conversion Factors and Weights

**1.** This paper discusses issues and procedures to develop a time series of alternative conversion factors with corresponding weights for use in converting and presenting macrolevel country statistics in a common unit of account, e.g. the **U.S.** dollar. The potentially significant operational implications underlying the Bank's estimates of per capita **GNP** for the Operational Guidelines represent important considerations in the search for an appropriate conversion factor, notably for use in the Atlas. The discussion is set within the context of IEC's present procedures for choosing exchange rates for use in the Atlas and the Operational Guidelines.' Departures from the use of an exchange rate that is not closely related to the rate at which international transactions actually t **'** place are tolerated over a wide range. However, when the deviation between the official rate and the rates effectively applied to foreign transactions are egregiously large, any conversion of principal macroeconomic indicators based on the official exchange rate are rendered meaningless.

2. The Bank's practice in choosing conversion factors involves IEC staff systematically reviewing and occasionally estimating alternative conversion factors, often involving dialogue with country operational staff. When "conditions are egregiously different from those

**1A** review of the methodological issues, including choosing appropriate conversion factors, relevant to the calculation of per capita **GNP** for operational purposes is found in "Per Capita Income **-** Estimating Internationally Comparable Numbers," (International Economics Department, World Bank, January **13, 1989).** See, in particular, Annex 4 which discusses the search for better conversion factors.
**2**

prevailing under free trade, alternative conversioi. factors are estimated that are deemed to reflect the actual rate at which foreign transactions take place. Such estimates seek to take into account the nature and restrictiveness of trading regime, information on relative prices, and the evolution of real exchange rates." **2** Estimating alternative conversion factors is a difficult process and, in part judgmental.In those **highly** egregious cases, the Bank attempts to estimate alternative conversion factors that permit meaningful calculations for intercountry comparisons.

**3.** The repertoire of exchange rates available has expanded. In addition to the official exchange rate' shown in the Fund's International **Financial Statistics (IFS),** secondary and tertiary rates are also available in the **IFS.** In addition, IEC has created an internal file on parallel or black exchange rates from various sources. These are weekly or monthly quotations covering the period **1960-89** from Pick's Currency Yearbook, International Report: Statistical Market Letter, and Africa Analysis. Other rates (e.g., purchasing-powerparities, rates accounting for trade taxes and subsidies) can also be estimated, as explained later in the paper. With the increasing availability of country-specific multiple exchange rate data, the paper suggests that these alternate conversion factors be included in a system so that time series of alternate conversion factors can be made **by** choosing a preference order among different sets of conversion possibilities. Obviously the choice **'f** preference order varies from country to country and also from year to year within each country.

> **2 Ibid; pp. 2-3.**

> **'** In general, the official exchange rate is that reported as line rf in IMF,International Financial Statistics **(IFS)** (Washington **D.C.;** International Monetary Fund).
**3**

4. **A** major task of this system is the assembly of appropriate weights. The starting premise in the envisaged system of alternative conversion factors and corresponding weights is that the official exchange rate has a weight of **1.0** and all other rates implicitly assigned zero-weights. It is expected that further review and analysis of the trade and exchange system **by IEC** staff, and more information from and regular discussions with Regional economists on various exchange rates will, hopefully lead to the assembly of information on some distributional weights to be attachea to the various rates. Table **1** below illustrates the range of conversion factors and weights underlying this objective. It is expected that users and analysts can individually devise a set of simple rules to derive what may be called "the preferred" conversion factor.

Table **1:** EGYPT **-** System of Alternative Conversion Factors and Weights

||**1980**|**1981**|**1982**|**1983**|1984|**1985**|**1986**|**1987**|**1988**|**1989**|
|---|---|---|---|---|---|---|---|---|---|---|
|IternativeConversionFactors|||||||||||
|Principal(official)rate(IFSRF)<br>|**0.7000**<br>|**0.7000**<br>|**0.7000**<br>|**0.7000**<br>|**0.7000**<br>|**0.7000**<br>|**0.7000**<br>|**0.7000**<br>|**0.7000**<br>|**0.8516**<br>|
|Secondaryrate|**NA**|**0.7390**|**0.8317**|**0.8317**|**0.8317**|**1.3010**|**1.3503**|**1.5015**|**2.2128**|**2.5712**|
|**3.**Tertiaryrate|**NA**|**1.0100**|**1.1300**|1.1453|1.2543|**1.5488**|**1.8838**|2.1459|**2.5082**|2.6452|
|4.Parallel/blackmarketrate|**0.7609**|**0.8772**|**1.0236**|**1.1039**|1.2184<br>|**1.4588**<br>|**1.8975**<br>|2.1894<br>|**2.5082**<br>|2.6452|
|**5.**PurchasingPowerParityRate**(1970)/1**|**0.5917**|**0.5503**|**0.5893**|**0.6133**|**0.6553**|0.6914|**0.7849**|**0.9079**|**11850**||
|**6.**PurchasingPower ParityRate**(1980)/1**|**0.7000**|**(1.6510**|**0.6971**|**0.7255**|**0.7752**|**0.8179**|**0.9285**|1.0740|1.4018<br>||
|**7.**PurchasingPower ParityRate**(1987)/1**|0.4562|0.4243|0.4544|0.4729|**0.5052**|**0.5331**|**0.6052**|**0.7000**|**0.9137**||
|**8.**Merchandiseweightedconversionfactor|||||||||||
|Wei2hts|||||||||||
|**1.**Principal(official)rate(IFS_RF)|0.4350|0.4350|_0.43.0_|0.4350|0.4350|0.4350|0.4150|**0.3690**|**0.3200**<br>||
|Secondaryrate|**0.3150**|**0.3150**|**03150**|**03150**|0.1400|0.1400|**0.1830**|**0.2370**|**0.2880**||
|Tertiaryrate|**0.2500**|**0.2500**|**0.2500**|**0.2500**|0.4250|0.4250|0.4020|0.3940|**0.3920**||
|Parallew/blackmarketrate|||||||||||
|PurchasingPowerParityRate**(1970)**<br>PurchasingPowerParityRate**(1980)**<br>PurchasingPowerParityRate**(1988)**<br>Merchandiseweightedconversionfactor|||||||||||
|MemoItems|||||||||||
|Nominalexchangerateindex**(1980=100)**|**100.0**|**100.0**|**100.0**|**100.0**|**100.0**|**100.0**|**100.0**|**100.0**|**100.0**<br>|**82.2**|
|Realexchangerateindex**(1980=100)**/2|**100.0**|**93.1**|**98.6**|102.1<br>|109.4<br>|**115.2**|**129.7**|148.3<br>|**193.0**<br>||
|"WeightedAvg.ConversionFactor"|**0.7152**|**0.7898**|0.8490|**0.8528**|0.9540|1.1449|1.2949|1.4596|1.8445||

**/1** The purchasing power parity relationship is computed as R. **Wd,/,r),** where R. is the exchange rate in the base year **"0". Pd,** and P,,t are the domestic price index and **US** (or any other foreign country) price index, respectively, in time period "t" (see Chapter V below). /2 Nominal exchange rate index divided **by** relative domestic absorption deflator index; this shows the real exchange movement.
4

**_5._** Such a matrix of conversion factors and corresponding weights could provide the mechanism for the following: (a) a systematic approach to the weighting of alternative rates; **(b)** estimating the effects of alternative weighting schemes, (c) determine what would be the effects of incorporating parallel or black market exchange rates; **(d)** provide the basis for less erratic and unpredictable fluctuations in the data shown in the Atlas, Worid Tables etc. and (e) improved and more transparent documentation of methods and "special cases."

# Scope **of Paper**

**6.** The focus is on conversion factors that are as representative as practicable of transaction or "effective" conversion factors. The choice of an appropriate conversion factor is based on the clear principle that the rate chosen must be that at which foreign transactions are effected. The Bank, like the Fund or any other international institution, would prefer to convert national currency data into a common numeraire at prevailing market exchange rate.<sup>4</sup> Determining the prevailing market rate, however, is a matter of judgment, even for international transactions and in the absence of exchange and trade restrictions. It must be stressed at the outset that much is beyond the scope of this paper.In particular, the search here is not for an "equilibrium" exchange rate or that which is sustainable and compatible with reasonable economic growth and a viable balance of payments situation in the medium term. Suffice to _-- v,_ countries are seldom in equilibrium and the labelling of an exchange rate as "being in equilibrium" is usually associated,

> **'** The technical issues of using the period average of the official exchange rate as a convenient and readily available conversion factor, and the primary requirements for moving from shorter period to longer period rates are discussed in Section VIII.
_5_ explicitly or implicitly, with a complex policy<sup>networkandpolicychangesthat bringthe rate</sup> to the "equilibrium" level.

**7.** The paper emphasizes the implications for Bank estimates of per<sup>capita,thekinds</sup> of evidence relevant in assessing the underlying conversion factors, and identifies<sup>countries</sup> where review, and adjustment if deemed necessary, of the official<sup>exchangeratemerits</sup> serious consideration. The paper provides illustrative examples in using the<sup>evidenceto</sup> derive alternative conversion factors.

**8.** This paper takes the view that the exchange rate 1,onversion factor) is a pric used in international transactions. Restrictions introduced into the price system in international transactions impact on the domestic relative price level. The reliance, in general,<sup>onthe</sup> officil exchange rate sometimes produces substantial discrepancies in the data.<sup>Thepaper</sup> reviews the main concerns about the adequacy of the official exchange rate as a conversion factor when in effect countries maintain dual or multiple exchange practices,<sup>orthereare</sup> parallel or black market foreign exchange activities, or there is a high incidence<sup>of price</sup> controls and trade-related restrictions. One aspect receiving special attention is the compilation of a general purpose conversion factor from a set of multiple exchange rates for different types of international transactions.

s **A** useful survey of this topic is given in **G.G.** Johnson, "Formulation of Exchange Rate Policies in Adjustment Programs," IMF Occasional **1.** jer, No. **36** (Washington,D.C.: International Monetary Fund, August **1985).**
**6**

> **9.** The existence of **q** parallel or secondary market, where a portion of current transactions takes place at floating exchange rates that are more depreciated than the rate

> in the official market, is _prima facie_ evidence that the official exchange rate may be inappropriate and therefore, requires further review. Also, _a priori,_ it is reasonable to expect that countries with price controis and trade-related restrictions would exhibit large

> deviations between the transaction and official rates.

# Magnitudes of Deviations as Signals

> **10.** Any large deviations of the respective conversion factors from the official rate should

> be taken as signals that further review of the adequacy of the official exchange rate as an appropriate conversion factor is warranted. When the official exchange rate is judged to diverge **by** an exceptionally large margin from the rate effectively applied to international

> transactions, that serves as to signal that an alternate conversion factor needs to be estimated if conversions are to be meaningful. Any decision on the preference order between alternative conversion factors would have to take into account relevant

> country-specific knowledge, not just the magnitudes of the deviations between the two rates. For example, where we know national compilers used the official exchange rate to assign a national currency value to international transactions, that rate must be used as the

> conversion factor, regardless of whether it was the rate actually applied to international transactions. Assume in this instance that the two rates (the official rate used **by** national

> compilers and the transaction rate) are significantly different. **If** a decision is made to use the known transaction rate as a conversion factor, say for **GNP** per capita computations, it

> is necessary that all the expenditure and value-added components of the national accounts
**7**

in local currency be "modified". This should be avoided. Notwithstanding that the official rate may be egregiously different from the transaction rate, the conversion factor to be used in the above instance should be the official exchange rate as used **by** the national compilers.
**8**

# **II. CONVERSION FACTORS and REIATIVE PRICE MOVEMENTS**

# **Conversion Factor as a Price**

> **11.** This paper focuses on the search for conversion factors that reflect market valuations

> (prices). The market-valuation principle serves to measure the economic value of resource transferred between two economies. External transactions should be viewed as the exchange of goods for money. In this connection, the role of the conversion factor is to define the

> price of money in terms of goods. Whenever governments impose price and non-price measures in international trade, valuation or price (i.e. conversion factor) adjustments

> should be made that will serve to bring the valuation closer in concept to market value. The probl.m, therefore, is to determine how far the price deviates from or approximates the market valuation.

> 12. The exchange rate is the relative price of two national monies and must bear a close relationship to price level developments in the two countries. Thus the exchange rate determines the relative prices of traded goods and, therefore, international competitiveness. Thus the conversion factor should be considered as a "price" and, like any other price, it can

> influence the environment in which domestic and international transactions are conducted.

> As a price, the conversion factor appears as exogenous to any individual transaction in the

> market but endogenous to the aggregated system of market demands and supplies because
**9**

the conversion factor is determined **by** interacting supply and demand for foreign exchange. It is shifts in these supply and demand schedules that give rise to price (i.e., exchange rate) changes. Thus it should be recognized that the exchange rate is a price that balances the desire to exchange one currency for another in order to effect trade in goods and services. The introduction of restrictions into the price system prevents the price from fulfilling a stabilizing function of equalizing supply and demand, thus affecting relative prices, the profitability of individual activities, and thus resulting in distortions in resource allocations.

# Conversion Factor and Price Levels of Traded/NonTraded Goods

> **13.** The imposition of price measures (tariffs, specific taxes, import surcharges, advance deposits on imports, export taxes and subsidies, and multiple exchange rates) and non-price measures (quotas, licencing **)** alter relative price levels between sectors, e.g., traded goods and nontraded goods. Here we are confronted with the issue of the distinction between "traded goods (sector)" and "nontraded goods (sector)" as well as between "tradables" and "nontiadables." In very general terms, traded goods can be regarded as those that can be imported (and exported), while nontraded goods are those without close, foreign-produced

> substitutes and must therefore be supplied **by** domestic producers. More specifically, traded goods can be regarded as "goods that are sufficiently substitutable with goods produced

> abroad that there exists an international market; nontraded goods are those that are not

> **highly** substitutable with foreign-produced goods so that international trade in these goods does not exist".' **A** very narrow dichotomy is that given in the foreign trade statistics in the

> **6** George **A.** MacKenzie and Susan M. Schadler, "Exchange Rate Policies and Diversification in Oil Exporting Countries," (Unpublished; International Monetary Fund, May **9, 1980) pg.3.**
**10**

**GDP** accounts where **GDP** is divided into goods and services actually traded (exports and imports, i.e., "traded goods") and goods and services absorbed in the domestic economy ("nontraded goods").

> 14. Provided a market exists through which trade could potentially be conducted, a good need not actually be traded to be termed a "traded" good: it becomes a "tradable good." If one classifies as tradable any good that either is internationally traded or could be traded at some plausible range of variation in relative prices, then the tradable category becomes

> very broad indeed.

> **_15._** However, given the close integration of the traded and nontraded sectors in most economies, in practice the distinction between industries producing traded (tradable) goods

> and those producing nontraded (nontradable) goods is rather tenuous. Rather, a country's output can be thought of as lying along a spectrum of greater or lesser exposure to foreign

> competition. Goldstein and Officer' suggest the use of both trade flows and market

> behavior, particularly the degree of independence between domestic and foreign prices, in

> identifying tradable and nontradable commodities or industries. They suggest three

> complementary criteria to distinguish between tradables and nontradables: (a) the degree of foreign trade participation should be substantially higher for tradables than nontradables;

> **(b)** cross-country correlations of price changes should be much higher for tradables than

**'** Morris Goldstein and Lawrence H. Officer, "The Measures of Prices and Productivity for Tradable and Nontradable Goods", Review of Income and Wealth, Vol. 4, December **1979, pp.** 413-425.
11 nontradables; and **(c)** tradables should be closer substitutes for traded goods from other countries than are nontradables.

**16.** Policies adopted to protect the domestic traded goods sector, such as import tariffs, export subsidies, quotas, licensing, have the immediate effect of increasing the domestic price of the commodities in question. Consider the following simple examples:

**--** an importer pays the c.i.f. import price of **$1.00** for a unit of product X. Converted at the official exchange rate of **LC200.00 = $1,** the price (i.e., the exchange rate) paid **by** the importer is **LC200.00. A 10** percent tariff (or specific taxes, import surcharges) on X means that the importer effectively pays **LC220.00** in the transaction. The price (i.e., conversion factor) increases from **LC200.00 = $1** to **LC220.00 = $1. A** world market price of **$1.00** now corresponds to a domestic price of **LC220.00;**

**--** in the meat export industry, meat is sold at world market prices. The meat exporter receives the world market price of **$1.00** per unit. Converted at the official exchange rate of **LC200.00** to the dollar, the exporter receives a price of **LC200.00.** An export subsidy of **_25_** percent on that unit of export means that the exporter effectively receives **_LC250.00_** in the transaction.

**17.** Specifically, for a country facing a given world price of traded goods, the domestic price of traded goods is simply the world price adjusted for changes in the domestic currency value of foreign exchange, so that price measures introduced into the trade system
12 have the immediate effect of raising the relative price of traded goods to nontraded goods. The new, higher relative prices of traded goods in terms of nontraded goods are likely to induce consumers to substitute nontraded for traded goods. The increase demand for notraded goods puts pressure on the p. :ze of nontraded goods. The increase in the traded goods price raises the general price level. Higher wage demands aimed at restoring real wages drive up the cost of producing traded and nontraded goods. The pervasive effect on the real cost of domestic factors of production will impact on the competitiveness of the country's traded goods sector.
**13**

## **III. CONVERSION FACTORS and MULTIPLE EXCHANGE RATE PRACTICES**

**18.** Multiple exchange rates arise directly when separate groups of foreign<sup>exchange</sup> transactions are conducted at different exchange rates; they<sup>alsoariseindirectlywhena</sup> variety of taxes, subsidies, surcharges, or equivalent devices are applied<sup>to foreignexchange</sup> transactions. Multiple exchange rates are usually adopted to address<sup>externalpayments</sup> difficulties **by** attempting to relieve the pressure on<sup>different elementsof theexternal</sup> account. The most common features of multiple currency regimes are<sup>the maintenanceof</sup> a preferential rate for essential imports, often combined<sup>withdebtservicepayments;</sup> separate rates based on a distinction between capital<sup>andcurrenttransactions;'anda</sup> separate rate for some important<sup>currentinvisiblepayments.</sup>

# Effects of Multiple Currency Practices on Conversion Factors

**19.** The operation of a system of multiple exchange rates leads to effects very similar<sup>to</sup> the intended results of a system of tariffs and subsidies. The percentage<sup>differencebetween</sup> * For a broad historical review of country experiences with multiple exchange systems, the<sup>reasonsfor</sup> resorting to such system, their outcome, and the significance for the Fund<sup>intermsofitsjurisdiction and</sup> maintenance over the international exchange system, see the<sup>followingunpublished documentsof the</sup> International Monetary Fund: "Review of Experience with Multiple Exchange Rate Regimes", (SM/84/64), March **19,** 1984; "Review of Multiple Exchange Rate Regimes **-** Background Information", **_(SM/84/65),_**<sup>March</sup> 20, 1984; and "Multiple Currency Practices Applicable Solely to Capital Transactions", **_(SM/85/19),_** January **19,** **_1985._**

**"** For a discussion of issues arising from dual exchange rate markets for capital and current transactions,<sup>see</sup> Anthony Lanyi, "Separate Exchange Markets for Capital and Current Transactions," **IMF Staff Papers, Vol. 22** (Washington **D.C.:** International Monetary Fund, November **1975) pp.** 714-49.
14 the exchange rate applicable in a particular transaction and the basic (official) rate can be regarded as a tariff on imports, or a subsidy on exports. The impact of these rates is on goods where relevant consumption and production decisions are sensitive to relative price changes brought about **by** the application of differentiated rates for traded goods. In principle, a set of differentially appreciated and depreciated rates should provide similar economic incentives and distortions to those resulting from a system of subsidies and tariffs. In terms of its effect on price and resource allocations, the application of a depreciated rate to "non-essential" imports to foster import substitution **by** domestic producers is similar to the imposition of a tariff on imports that compete with domestic production;'o essentially, the importer and the domestic consumer pay a domestic price that is higher than the world market price (i.e.; more local currency per unit foreign currency).

20. The choice between multiple currency practices and a system of taxes and subsidies may be based on administrative feasibility." On the other hand, multiple rates may be considered less expensive to administer than a system of taxes and subsidies that require complicated administrative machinery.

**10** The very similar effects on prices and resource allocations of multiple exchange rates and a system of tariffs/taxes and subsidies are discussed in details in, John F. Laker, "Fiscal Proxies for Devaluation: **A** General Review," (Unpublished; International Monetary Fund, October 21, **1980);** and George **A.** Mackenzie and Susan M. Schadler, "Exchange Rate Policies and Diversification in Oil Exporting Countries," (Unpublished; international Monetary Fund, May **9, 1980).**

> **"** The basic problems in the use of fiscal proxies for exchange rate changes are discussed in John F. Laker, "Fiscal Proxies to Devaluation," (Unpublished; International Monetary Fund, October 21, **1980).**
**_15_**

# **Incidence of Multiple Currency Practices**

21. The incidence of multiple exchange rates among Fund members is shown in Table 2. The Fund's **Annual Report on Exchange Arrangements and Exchange Restrictions has** reported that developing countries have, in general, moved towards reduced reliance on multiple currency practices, or made progress in either simpl;fying multiple currency practices, or in reducing the distortions associated with them. **A** look at Table 2 reveals that virtually all countries with multiple currency practices employ different rates for different types of imports (e.g.; essential imports against payments on invisibles) as well as for exports. Multiple exchange rates for about 20 member countries are shown in the **IFS.**

# **Deviations of** Multiple Rates

22. The existence of a multiple exchange system provides indications that the use of the official rate as a conversion factor is inappropriate. The larger the deviations in the multiple rates relative to the ficial rate, the stronger the reasons for a careful and systematic review of the various rates. The focus on multiple rates should be determined on the basis of the magnitude of the premium as well as the size of the market, i.e., how much economic activity is performed through this channel.

> **"** For a detailed discussion of developments in multiple currency practices, see International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions, (Washington,D.C.; International Monetary Fund, **1986); pp. 18-20.**
**16**

Table 2: Incidence of Multiple Currency Practices in Developing Countries

|Country<br>|DifferentRates<br>for<br>Exports andImports|Exports<br>MoreThan1Rate|Imports<br>MoreThan1Rate|
|---|---|---|---|
|*Afghanistan<br>|**x**|**x**|**x**|
|*Argentina<br>|**x**|**x**||
|*Bangladesh<br>|**x**|**x**|**x**|
|Bolivia<br>|**x**|**x**||
|Brazil|**x**|**x**|**x**|
|Colombia<br>|**x**|**x**|**x**|
|Dominica<br>|**x**<br>|**x**|**x**|
|*DominicanR|ep<br>**x**|**x**|**x**|
|Ecuador|**x**|**x**|**x**|
|***Egypt**<br>|**x**|**x**|**x**|
|***El**Salvador|**x**|**x**|**x**|
|Gambia|**x**|**x**|**x**|
|Ghana<br>|**x**|**x**|**x**|
|Grenada|||**x**|
|*Guatemala|**x**|**x**|**x**|
|GuyanA<br>|**x**|**x**||
|Honduras<br>|**x**|**x**|**x**|
|*Hungary|**x**|**x**|**x**|
|*Jamaica<br>||**x**|**x**|
|Kenya<br>|**x**|**x**||
|*Lao|**x**||**x**|
|Mexico<br>|**x**|**x**||
|Nicaragua<br>|**x**|**x**|**x**|
|Nigeria|**x**|**x**|**x**|
|*Paraguay|**x**|**x**|**x**|
|*Peru<br>|**x**|**x**|**x**|
|*Poland|**x**|**x**|**x**|
|*Romania|**x**|**x**|**x**|
|*Somalia<br>|**x**|**x**|**x**|
|*Sudan|**x**|**x**|**x**|
|Syria|**x**|**x**|**x**|
|Uruguay|**x**|**x**||
|*Venezuela|**x**|**x**|**x**|
|Vietnam|**x**|**x**|**x**|
|W.Samoa|**x**||**x**|
|*YemenAR|**x**||**x**|
|Zambia|**x**||**x**|
|Total|34|**31**|**32**|

> Source: Extracted from IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (Washington **DC:1989)**

* Principal, secondary, tertiary rates, and their applicability to types of transactions are found in **IFS.**
**17**

> **23.** Table **3** shows the distribution of deviations of multiple rates from the official rate of those countries for which multiple rates are available in the IFS."

Table **3:** Distribution of Deviations of Multiple Rates from IFS_RF

|Range**(%)**|**1980**|**1981**|**1982**|**1983**|1984|**1985**|**1986**|**1987**|**1988**|**1989**|
|---|---|---|---|---|---|---|---|---|---|---|
|**0.0-5.0**<br>|2|**1**|2|2|4|2|4|**3**|**_5_**|**3**|
|**5.1-10.0**|**1**|**3**|**1**|**1**|**0**|**1**|**1**|**3**|**1**|**0**|
|**_10.1-15.0_**|**0**|2|2|**1**|4|**1**|**0**|**1**|**0**|**0**|
|**15.1-20.0**<br>|2|**1**|**1**|**1**|2|2|**1**|**1**|**0**|**0**|
|**20.1-25.0**<br>|**1**|**1**|**1**|2|**0**|**1**|**1**|**0**|**1**|**1**|
|**25.1-30.0**<br>|**1**|2|2|2|**0**|2|**3**|**1**|**1**|**0**|
|**30.1-40.0**<br>|2|**1**|**1**|**1**|**1**|**0**|**0**|**1**|2|**1**|
|40.1-50.0|**1**|2|**3**|**1**|**0**|**0**|**0**|**1**|**0**|**0**|
|**50.1-60.0**<br>|**1**|**0**|**0**|**1**|**1**|**0**|**1**|**1**|**0**|**0**|
|**60.1-70.0**<br>|2|**1**|**0**|**1**|2|**0**|**1**|**0**|**1**|**1**|
|**70.1-80.0**<br>|**0**|**0**|**0**|**1**|**1**|**0**|**0**|**0**|**0**|**0**|
|**80.1-90.0**|**0**|**1**|**0**|**0**|**1**|2|**0**|**1**|**0**|**0**|
|**90.1-100.0**<br>|**0**|**1**|**0**|**0**|**0**|2|**1**|**0**|**0**|**0**|
|**>100**|**0**|**0**|**1**|**3**|**3**|**3**|4|2|**3**|**1**|
|TOTAL<br>Source:Multip|**13**<br>lerates a|**16**<br>refrom|14<br>**IFS.**|**17**|**19**|**16**|**17**|**_15_**|14|**7**|

> 24. Almost half of them maintain multiple rates with the premium exceeding **30** percent. In recent years, the spread between multiple rates has narrowed for most countries.

> However, the spread has remained consistently high in **Egypt** (exceeding **100** percent),

> Paraguay and Venezuela (about **90** percent), Guatemala (averaging **60** percent), and Romania (about 40 percent).

> **'3** As trade and exchange systems have been liberalized, and multiple exchange systems have been unified, the number of countries with multiple rates shown in the **IFS** has decreased.
**18**

# "Composite" Conversion Factor

**_25._** The proper use of multiple rates demands a "matrix" weighting approach, that is, a distribution **-f** weights among the multiple exchange rates. What is envisaged here is a system with time series for multiple rates and a corresponding set of time series for weights. Obviously, adjustments to the official and multiple rates require intimate knowledge of the applications of respective rates to specific transactions. Two illustrative examples of IEC's attempt to develop the envisaged system for composite conversion factors are shown in Table 4 for **Egypt,** and Table **_5_** for Syria.

**26.** Table _4_ below illustrates the **Egypt** situation where the multiple rates are from the **IFS** but the weights are from the Fund and Regional staff. Notice that the premium enjoyed **by** each of the rates in the secondary and tertiary markets is very significant.

Table 4: EGYPT **--** Rates and Weights for Computing Average Exchange Rates from Multiple Rates

|**1980**|**1981**|**1982**|**1983**|1984|**1985**|**1986**|**1987**|**1988**|**1989**||
|---|---|---|---|---|---|---|---|---|---|---|
|AlternativeConversionFactors|||||||||||
|**1.**<br>Principal(CentralBank)Rate|**0.7000**|**0.7000**|**0.7000**|**0.7000**|**0.7000**|**0.7000**|**0.7000**|**0.7000**|**0.7000**|**0.8516**|
|2.<br>Secondary (CommercialBank)Rate|**NA**|**0.7390**|**0.8317**|**0.8317**|**0.8317**|**_13010_**|**1.3503**|**_1.5015_**|**2.2128**|**2.5172**|
|**3.**<br>Tertiary(Parallel)Rate|**NA**|**1.0100**|**1.1300**|1.1453|1.2543|**_1.5488_**|**1.8838**|2.1459|**2.5082**|2.6452|
|Wei2hts|||||||||||
|**1.1**Principal(CentralBank)Rate|0.4350|0.4350|0.4350|0.4350|0.4350|0.4350|0.4150|**03690**|**0.3200**|**NA**|
|1.2Secondary(CommercialBank)Rate|**0.3150**|**03150**|**03150**|**03150**|0.1400|0.1400|**0.1830**|**0.2370**|**0.2880**|**NA**|
|<br>**_13_**Tertiary(Parallel)Rate|**0.2500**|**0.2500**|**0.2500**|**0.2500**|0.4250|0.4250|0.4020|0.3940|**0.3920**|**NA**|
|"COMPOSITE"Rate<br>**[(1*1.1)+ **(2*1.2)**+(3*13)]**|**NA**|**0.7898**|0.8490|**0.8528**|0.9540|1.1449|1.2949|1.4596|1.8445|**NA**|
|MemoItems|||||||||||
|**GNP**percapita**(using**PrincipalRate)|**573**|**553**|**637**|**690**|**771**|**847**|**925**|1034|1274|**NA**|
|<br>**GNP**percapita(using"Composite"Rate)|**NA**|1432|**798**|**582**|**611**|**606**|**576**|**561**|**592**|**NA**|
|Ratio:"Composite"Rate/PrincipalRate<br>|**NA**<br>|**1.13**|1.21|1.22|**1.36**|1.64|**1.85**|**2.09**|2.64|**NA**|
|"Composite"percap/"IFSRF'perc|alNA|**2.59**|**1.25**|0.84|**0.79**|**0.72**|**0.62**|0.54|0.46|**NA**|

Source: Multiple rates are from IFS Weights: **1980-85:** Unpublished data from the Fund's Information Notice System; **1986-88:** Regional Staff.
**19**

**27.** The respective premiums for the commercial (secondary) rate and the parallel (tertiary) rate are extremely high. Given such a high degree of deviation among the different rates, it is to be expected that the average of the multiple rates is significantly different from the official (Central Bank) rate. Perhaps what is more significant from the Bank's operational point of view is that with the shift (and therefore weights) away from the official (Central Bank) rate in recent years, its is likely that Egypt's per capita **GNP** will remain within the threshold for Bank's **IDA** eligibility."

**28.** The Syria example (Table **_5_** below) is intended to illustrate the types of relevant information **IEC** staff can be expected to extract from various Bank and Fund documents to estimate a trade-weighted average of officially recognized exchange rates. The Fund's Annual Report on Exchange Arrangements and **Exchange** Restrictions lists Syria as maintaining multiple rates, but these rates are not available in the **IFS.** On the basis of information in the Fund's Annual Report on Exchange Arrangements and Exchange Restrictions, and unpublished Recent Economic Development on member countries, Table **_5_** below illustrates the procedures **by** which **IEC** staff, in consultation with Regional staff, derives a time series of multiple rates and a corresponding time series of weights.

> **29.** As can be seen in Table **_5,_** the impact of the **30** percent premium in the secondary market is dampened **by** the fact that transactions in this market is only about one-third of total transactions. Thus, the "composite" rate does not exhibit the wide margin of deviation

> **"'** The Bank uses the weighted ("composite") exchange rate in the computation of Egypt's **GNP** per capita for the **Atlas** and the Operational Guidelines.
20 seen in the example on **Egypt.** This does not detract from the fact that there is a substantial differential in the **GNP** per capita estimate for the Bank's Operational Guidelines.

Table **5:** SYRIA **-** Derivation of Composite Exchange Rate

|**1983**|1984|**1985**|**1986**|**1987**|**1988**|
|---|---|---|---|---|---|
|MultileRates||||||
|**1.**<br>PrincipalRate**/1**<br>**3.95**<br> <br> <br>|**3.95**<br>|**3.95**|**3.95**|**3.95**|**11.225**|
|**2.**<br>SecondaryRate:**/1**<br>5.45<br> <br> <br>|5.45<br>|5.45<br>|5.45<br>|5.45<br>||
|**3.**<br>TertiaryRate<br>**5.70**|**7.06**|**8.80**|**9.81**|**10.00**||
|DerivationofWeights<br>**1.**Principal(O<br>Merchand<br> <br>|fflcial)Ra<br>iseTrade<br>|teforPu<br><br>|blicSect<br>|or<br>||
|Exports**%**Total**GNFS**<br>**20.9**<br>|**21.8**|20.4|**16.6**|**193**||
|Imports**%**Total**GNFS**<br>48.9|493|44.9|**36.7**|**33.0**||
|**%**ShareinTotal**GNFS**<br>**69.8**|**71.1**|**653**|**53.3**|**52.3**||
|2.Secondary(Parall<br>TradeinGoo<br> <br>|el)Ratef<br>dsand**N**<br>|orPrivat<br>**FS**<br>|eSector<br>|||
|Exports**GNFS% **Total**GNFS**<br>7.4|6.4|**6.8**|**13.1**|14.2||
|Imports**GNFS% **Total**GNFS**<br>14.9|**13.7**|**18.6**|**23.9**|24.8||
|**%**ShareinTotal**GNFS**<br>**22.3**|20.1|**25.3**|**37.0**|**38.9**||
|**3.**TertiaryRatefor<br> <br>|Tourism<br>|||||
|**%**ShareinTotal**GNFS**<br>**7.90**|**8.88**|**9.37**|9.64|**8.82**||
|SummaryWeights<br>||||||
|**1.1**Principal<br>**0.70**|**0.71**|**0.65**|**0.53**|**0.52**|**1.00**|
|2.1Secondary<br>0.22<br>|0.20|**0.25**|**0.37**|**0.39**||
|**3.1**Tertiary<br>**0.08**|**0.09**|**0.09**|**0.10**|**0.09**||
|***0**<br>"COMPOSITE"Rate**0*****<br>4.4225|4.5269|4.7844|**5.0701**|**5.0676**|**11.225**|
|Computedas:**[(1*1.1)+ **(2*2.1)**+(3*3.1)]**||||||
|MemoItems||||||
|**GNP**percapita (Atlas..principalrate)<br>**1919**|1849|1946|**2053**|**2155**|1954|
|**GNP**percapita(Atlas..compositerate)<br>**1703**|**1629**|**1670**|**1688**|**1701**|**1711**|
|Ratio:CompositeratetoOfficialrate<br>**1.13**|**1.15**|1.22|**1.29**|**1.29**|**1.00**|
|"Composite"percap/"Atlas"per<br>**0.89**|**0.88**|**0.86**|**0.82**|**0.79**|**0.88**|

> Source: IMF, "Recent Economic Development" (Unpublished); March **6, 1987;** and March **9,1988.**
21

# **Countries for Review and Adjustment for Multiple Rates**

**30. The time** series multiple rates and corresponding time series weights derived in Tables 4 and **_5_** form the crux of the envisaged matrix of conversion factors and weights.

**31.** The examples of **Egypt** and Syria illustrate the operational significance of the need for careful review of the presence of multiple conversion factors. Table 2 lists countries that should come under the type of review shown for **Egypt** and Syria. Given the<sup>continued</sup> high spread between these rates from the official rate and, therefore, the potential operational impact of per capita **GNP** estimates, particular attention should be directed at **Egypt, El** Salvador, Guatemala, Paraguay, Romania, and Venezuela.

**32.** It should be emphasized that a definitive assessment would require more information from and continued dialogue with Regional staff. Emphasis is placed, wherever data are available, on the applicability of the respecti,e rates on the types of transactions.
22

# **IV. BLACK or PARALLEL MARKET EXCHANGE RATES**

# **Formal and Informal Parallel Exchange Markets**

> **33. Lindauer** suggests that "a parallel market is a structure generated in response to government interventions which create a situation of excess demand or supply in a particular product or factor market which is both dependent upon conditions in the official market and responsive to market forces."<sup>5</sup> For example, the excess demand for foreign exchange in the official market, resulting from exchange controls, is satisfied at a premium price in a secondary, or parallel market. The official, and overvalued, exchange rate creates

> a parallel, usually called "black," market for foreign currency. **A** parallel exchange market

> is one of the by-products of restrictionist trade and exchange policies. Import and export

> duties, and import quotas generate parallel markets **by** creating excess demand for

> commodities at illegal, pre-tax prices. The removal of government interventions can unify an otherwise parallel market.

> 34. Are parallel markets always illegal? **A** formal parallel market typically is introduced

> when a government resorts to a secondary exchange system as a transitional measure to correct for external imbalance and, therefore, avoid a formal depreciation. Usually essential

> **' David L. Lindauer, "Parallel, Fragmented, or Black? Defining Market Structure in Developing Economies," World Development, Vol. 17, No. 12 (Cambridge, MA: Harvard Institute for International Development, December 1989); pp. 1871-1880.**
**23**

imports and exports are conducted at the (relatively overvalued) official rate, while other transactions, including capital flows, are assigned to the secondary exchange<sup>market. On</sup> the other hand, the tightness and effectiveness of exchange controls result<sup>in</sup> transactions that operate outside the normal and regulated channels, that is,<sup>in</sup> an<sup>informalsecondary</sup> exchange market which is characterized **by** risks and penalty structure.

**_35._** In this paper, the terms "black market" and "parallel market" are used interchangeably, as well as "illegal" and "unofficial" to refer to "market<sup>structureswhich</sup> result from suboptimal government interventions which create a<sup>situation ofexcess</sup> demand."<sup>16</sup>

# Purchasing **Power Parity and Factors Affecting Parallel Market Rates**

**36.** In his empirical paper on black markets for currency, Culbertson"<sup>postulatesthat</sup> given the official exchange rate, changes in the parallel market rate will occur due<sup>toshifts</sup> in either the supply or demand schedule for foreign exchange.<sup>Oneofthemostlikely</sup> sources of change stems from variations in the equilibrium rate. Since the equilibrium<sup>or</sup> market-clearing rate is unobservable, it is proxied through the ratio of domestic-to-foreign price level **--** i.e., the purchasing power parity relationship<sup>is</sup> instrumentai<sup>indetermining</sup> the (unobservable) equilibrium rate. **A** secondary consideration concerns<sup>therole ofthe</sup> government's holdings of international reserves, especially foreign exchange<sup>holdings.</sup>

**" Lindauer, Op.cit., pp. 1878.**

> **17 W. Patton Culbertson, "Empirical Regularities in Black Markets for Currency," World Development, Vol. 17, No. 12 (Cambridge, MA: Harvard Institute for International Development, December 1989);**<sup>**pp.1907-1919.**</sup>
24 Consider the following exchange-control scenario in Culbertson's study: an overvalued currency produces a supply of foreign exchange; a black market price of foreign exchange emerges as the government allocates this quantity to the market (e.g. to importers, investors, travel abroad, etc.); consider further that the government may choose to add to its reserve holdings, in which case the supply of foreign exchange is reduced; or the government may choose to draw down its reserves, thus increasing the supply of foreign exchange. Consequently, changes in the level of foreign exchange holdings represent a potential influence on the parallel market rate.

**37.** Culbertson's study for **10** countries with long-existing exchange controls and black market activity lends support for the hypothesis that the black market rate depends on the level of the official rate, the foreign-to-domestic price level (which proxies the unobservable equilibrium rate), and government reserve-level policy. The strongest coefficients are those relating the black market rate to changes in the foreign-to-domestic price level. While the R' are relatively robust for most of the countries (see the following chapter for a discussion of purchasing power parities as conversion factors), the large degree of serial correlation is disturbing. This indicates the danger of inferring that only those variables with significant coefficients are important.

**38.** The supply of foreign exchange in this market may come from various sources. Overand underinvoicing of exports and imports could potentially attract significant amounts of foreign exchange to the black markets over time. Also, if the premium on foreign currency is significantly higher than the official rate, a significant proportion of remittances would
**_25_**

eventually pass through the illegal market. Another potential source of generating a higher volume of foreign exchange in this market is smuggled exports, though conclusions on the level of smuggling is largely impressionistic. An important factor determining the level of the black market rate is the nature and extent of the risk and penalty structure faced **by** sellers who circumvent foreign exchange controls. Suppliers of foreign exchange in the black market. In general, the black market rate is likely to be more depreciated than the official (and restriction-free) rate. This is more so in a situation where there is strict imposition of foreign exchange controls and the emergence of expectations of depreciation. Proper caution should be exercised, however, in using the black market rate as an ineication of the appropriate exchange rate.

**39.** While the estimated coefficients in Culbertson's study should be treated with caution, the empirical results suggest that:

"black market exchange rates are largely determined **by** and reflect fundamental economic developments... **......** the exchange rate is the relative price of two national monies and, while influenced **by** myriad factors, must bear a close relationship to price level developments, and hence monetary conditions in the two countries.

# Parallel Market Rates and Market Information

40. **If** the exchange rate is itself a price upon which economic agents must rely in making decisions about resource allocation, then a question in an exchange-control economy posed **by** Culbertson is whether the parallel market rate better reflects available information on price developments, including current expectations about the future price level, than the

**18** Culbertson, Op.cit., **p. 1917**
**26**

official rate. Indeed, the very fact that a parallel or secondary market, where a portion of current transactions takes place at floating exchange rates that are usually more depreciated than the rate in the official market, exists is evidence of the inappropriate level of the official rate.<sup>19</sup> Without the black market, there v. uld be little if any guide to indicate just how overvalued the official rate had become. The official exchange rate changes only at intervals and can hardly react to or reflect constantly changing economic conditions. Consequently, Culbertson's empirical study hypothesizes that it would seem that a _prima facie_ case can be made that the black market rate is likely to be a better guide to efficient resource allocation than the official rate.

41. **If** black market rates fully reflect all historical price information, including current expectations about the future rate, then the current price will provide good prediction of next period's price. To assess how well black market rates seem to meet this criterion of "market efficiency", Culbertson regresses current period black market rates on previous period rates. The principal conclusion from the regression suggests that the behavior of black market rates is consistent with the broad principles of the efficient markets hypothesis.

42. The focus on the parallel exchange market should be determined on the basis of its size, that is, how much economic activity is performed through this channel. In addition, the

> **"** Culbertson, op.cit., **pp. 1915-1916;** see also Ahsan H. Mansur, "Determining the Appropriate Levels of Exchange Rates for Developing Economies," **IMF Staff** Papers, Vol. (December **1983), pp. 784-818;** and **G.G.** Johnson, "Formulation of Exchange Rate Policies in Adjustment Programs," International Monetary Fund, IMF Occasional Paper, No. **36** (Washington, D.C.:International Monetary Fund, August **1985).**
**27**

extent to which the legal parallel market rate is allowed to float and react to market forces, and the demand and supply elasticities of foreign exchange in the official market<sup>relative</sup> to the secondary market will help draw some tentative inferences about the appropriateness of the official rate as a conversion factor.

43. Although for many developing countries the illegal or black market can be quite sizeable and potentially influential in the trade and exchange system, it<sup>is</sup> rarely<sup>possible</sup> to assign (or agree on) a weight to the parallel market. The very nature of parallel<sup>markets</sup> makes it difficult to assess total quantities marketed, since many small traders are likely to be involved. Black or parallel market rates are seldom documented. Therefore, it is too large a leap to reach the conclusion that the exchange rate prevailing in the parallel (especially that in the illegal parallel) market is necessarily a reliable indicator<sup>ofthe</sup> (unobserved) equilibrium rate.

# Deviations **of Black Market Rates**

> 44. Table **6** shows deviations of the black or parallel rates from official rates. Again, caution must be exercised in reading the significance of the deviations from official rates. These do not necessarily provide a direct indication of the appropriate exchange<sup>rate.The</sup> divergence between the official and black market rates also depends very much<sup>onthe</sup> penalty structure, that is, the rigor of its enforcement and the extent to<sup>whichparticipants</sup> in black market exchange transactions are apprehended and prosecuted. Nevertheless,<sup>it is</sup> useful to know parallel market rates (and their deviations) if only to set upper<sup>limitsfor</sup>
**28**

what the Bank's Regional staff sometimes advocate as rates to replace official rates in those cases where **IEC** and the Region agree that official rates differ egregiously from transaction rates.

Table **6:** Frequency Distribution of Deviation of Parallel/Black Market Rates from Official Rates (percent)

|Deviation|**1975**|**1976**|**1977**|**1978**|**1979**|**1980**|**1981**|**1982**|**1983**|1984|**1985**|**1986**|**1987**|**L9**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
|**0-10**|49.4|443|**53.8**|**57.7**|**48.7**|49.4|48.1|40.5|34.2|**29.5**|**33.9**|**37.1**|**28.6**|**28.**|
|11-20|**10.1**|**13.9**|**9.0**|6.4|**12.8**|**12.7**|**10.1**|**10.1**|11.4|14.8|**13.6**|**9.7**|**163**|**17.**|
|**21-30**|**63**|**_5.1_**|**7.7**|**_5.1_**|6.4|**7.6**|**63**|**3.8**|**63**|**9.8**|3.4|14.5<br>|**6.1**|**_7.5_**|
|31-40|2.5|**_5.1_**|**2.6**|**5.1**|**2.6**|**3.8**|**2.5**|**1.3**|**5.1**|**6.6**|**6.8**|**1.6**|4.1|**5.7**|
|41-40|**8.9**|**5.1**|**1.3**|**1.3**|**2.6**|**_13_**|**5.1**|**8.9**|**3.8**|**1.6**|**1.7**|**1.6**|10.2|**5.7**|
|**51-60**|**0.0**|**1.3**|**1.3**|**1.3**|5.1|**0.0**|**3.8**|**8.9**|**5.1**|**1.6**|**1.7**|4.8|**0.0**|**3.8**|
|**61-70**|**2.5**|**1.3**|**3.8**|**1.3**|**3.8**|**5.1**|**3.8**|**3.8**|**_13_**|**1.6**|**6.8**|**0.0**|4.1|**3.8**|
|**71-80**|**2.5**|**2.5**|**2.6**|**3.8**|**2.6**|**2.5**|**2.5**|**5.1**|2.5|4.9|**1.7**|**1.6**|**0.0**|**0.0**|
|**81-90**|**1.3**|2.5|**1.3**|**3.8**|**3.8**|**0.0**|**1.3**|**1.3**|**1.3**|**1.6**|**1.7**|**0.0**|**0.0**|**0.0**|
|**91-100**|**5.1**|**1.3**|**1.3**|**1.3**|**0.0**|**3.8**|**0.0**|**1.3**|**1.3**|**3.3**|3.4|**0.0**|2.0|**1.9**|
|**>100**|11.4|**17.7**|15.4|**12.8**|**11.5**|**13.9**|**16.5**|**15.2**|**27.8**|24.6|25.4|**29.0**|**28.6**|**26.**|
|No.of|||||||||||||||
|Countries|**79**|**79**|**78**|**78**|**78**|**79**|**79**|**79**|**79**|**61**|**59**|**62**|49|**53**|
|Deviations<br>**>30%**|**27**|**29**|**23**|24|**25**|24|**28**|**36**|**38**|**28**|**29**|24|24|25|

Sources: **1975-1983:** Pick's World **Currency Yearbook** (various issues);

**1984-1988:** Financial Times International Reports: Statistical Market Letter (weekly issues)

# Countries for Review and Adjustment for Parallel Rates

_45._ Table **7** below shows countries with egregious (say, **30** percent or greater) deviations between the black market and official rates. They represent that set of countries for which the appropriateness of the official rate as a general conversion factor merit further review and adjustments, if deemed necessary. Also, a closer look at the deviations of the black or
**29**

parallel market rates from the official exchange rates reveals half of the countries with such egregious deviations are characterized **by** the maintenance of dual or multiple exchange systems (see Table **7** below). The significance of these relatively large deviations is Table **7:** Ratio of Parallel/Black Market to Official and Atlas Exchange Rates

|BlacktoOfficialRate<br>(Official**=1.00)**<br>**1987**<br>**1988**|TotalTrade<br>**%GDP**<br>(Avg.1987-88)|
|---|---|
|Algeria<br>7.64<br>na|**28.7**|
|*Romania**/1**<br>**_5.70_**<br>6.42|na|
|*SyrianArabRep.<br>**5.66**<br>**1.98**<br>|**31.5**|
|Burma<br>4.32<br>4.50|na|
|* Afghanistan**/1**<br>**3.95**<br>na|na|
|Iraq<br>**3.76**<br>**3.76**|na|
|*Poland**/1**<br>3.40<br>4.10|41.6|
|***Egypt/1**<br>**3.13**<br>**3.58**|**_50.0_**|
|Zambia<br>**3.06**<br>3.04|64.0|
|* Bangladesh**/1**<br>**2.91**<br>2.84|**23.2**|
|* Nicaragua<br>**2.81**<br>na|na|
|<br>Ethiopia<br>2.54<br>_2.54_|**33.9**|
|Zimbabwe<br>2.42<br>**2.83**|**_51.5_**|
|Libya<br>2.34<br>2.41|na|
|<br>*Peru**/1**<br>**2.27**<br>**2.27**|**23.8**|
|*Guyana<br>**2.05**<br>**3.58**|149.5|
|* Venezuela**/1**<br>**1.93**<br>**2.32**|46.8|
|Tunisia<br>**1.68**<br>**1.62**|**78.2**|
|South Africa**/1**<br>**1.61**<br>1.14|**50.8**|
|*Paraguay**/1**<br>1.46<br>**1.69**|54.6|
|Trinidad andTobago**/1**<br>1.46<br>**1.33**|**72.5**|
|<br>*Hungary**/1**<br>1.46<br>1.43|74.4|
|<br>*Nigeria<br>1.44<br>**1.58**|**53.0**|
|Morocco<br>1.42<br>1.46|49.6|
|*Kenya<br>**1.32**<br>**1.32**|44.8|
|Zaire<br>**1.31**<br>**0.86**|**73.9**|

***** Countries identified in IMF, Annual Report on Exchange Arrangements and Exchange Restrictions as maintaining multiple exchange systems.

/1 Principal, secondary or tertiary rates for these countries are available in **IFS.**
**30**

further heightened **by** the importance of total external trade in **GDP.** It is clear that the combination of large deviations and large trade shares in **GDP** provides prima facie evidence that adjustment of official exchange rate as a general purpose conversion factor should be accorded serious consideration.

46. IEC has expanded its collection of various exchange rates to include parallel or black market rates. For Operational Guideline purposes, black market rates have zero weights. They are used only to shed light on conversion issues and set outer limits on any possible adjustment of conversion factors.

47. Should "unofficial" exchange rates, in addition to officially recognized multiple exchange rates, be used to obtain reasonably meaningful estimates for per capita **GNP?** In principle, the conversion factor used **by** the Bank to transform major macroeconomic aggregates in local currencies into a common numeraire should reflect the effective transaction rates used in international transactions. In addition, for the resulting overall conversion factor to be analytically relevant and meaningful, the major macroeconomic variables, such as **GNP,** should reflect consistently the relative prices implicit in the effective transaction rates believed to apply. Therefore, the effective transaction rates should refer to all the various rates at which foreign transactions take place, including "unofficial" exchange rates. Failure to attach any importance to the unofficial rates which are known to prevail (because they are "unofficial" or "illegal") gives rise to both price and conversion distortions which will tend to show up in erratic trends in derived per capita **GNP** estimates.
**31**

It should be stressed, however, that consistency must prevail, that is, the effective transaction rate encompassing all (official and "unofficial") rates becomes a relevant and meaningful conversion factor only if the macroeconomic aggregates in local currencies reflect consistently the relative prices implicit in the effective transaction rates believed to apply (cf.para.10).

48. The Harvard Institute for International Development-sponsored workshop on parallel markets in developing countries provided clear indications that "increasing attention to parallel markets in general has arisen in response to price controls," **....... that** "although economists increasingly recognize the importance of parallel markets, many policy analysts treat them as an inconvenience to be avoided," **.......** and, in the face of pervasive price controls and market interventions **by** governments in developing countries, "parallel markets can compromise the policy prescriptions that are part of most reform packages and can lead to different interpretations of the benefits of reform." **20** 49. While recognizing the importance of parallel or black markets in many developing countries the Bank, however, should be mindful of the risks of using statistics pertaining to what are in many countries illegal activities.

> * **_A_** summary of the major contributions to the workshop on parallel markets in developing countries sponsored **by** the Harvard Institute for International Development (November 11-12, **1988)** is found in Christine Jones and Michael Roemer, "Editors' Introduction:Modeling and Measuring Parallel Markets in Developing Markets," **World Development, Vol. 17,** No. 12 (Cambridge, MA: Harvard Institute for International Development, December, **1989); pp. 1861-1870.**
**32**

# **V. PURCHASING POWER PARITY as CONVERSION FACTORS**

# **Purchasing Power Parity (PPP)**

> **_50._** The purchasing power parity (PPP) theory of exchange rates argues that the foreign

> exchange value of a national currency is largely determined **by** the purchasing power of that

> currency relative to the purchasing power of foreign currencies.<sup>21</sup> Two aspects of the PPP doctrine deserve attention. The more fundamental element focuses upon the manner in

> which the relation between national price levels leads to market-clearing exchange rates for national currencies. This argument hypothesizes that changes in relative price levels dominate exchange rates changes rather than vice versa. Thus PPP involves a relationship between a country's foreign exchange rate, on the one hand, and its price level or price

> movemcnt compared to the foreign price level or movement, on the other, that is, the

> exchange rate is determined **by** the level of prices in the domestic currency compared to that abroad, that changes in the exchange rate are determined **by** changes in these price

> levels, and that the percentage change in the exchange rate per month, quarter, or year is determined **by** inflation at home relative to that abroad over these time intervals. Thus

> in the PPP, relative inflation movements are offset **by** exchange rate changes. PPP may be

> **" A** comprehensive discussion of various aspects of the purchasing power parity doctrine is given in

> Lawrence H. Officer, Purchasing Power Parity and Exchange Rates (Greenwich, Connecticut: Jai Press, **1982);**

> see a.. Alan **C.** Shapiro, "What Does Purchasing Power Parity Mean?" Journal of Money and Finance, Vol.2, No. **3,** December **1983, pp. 295-318.**
**33**

> expressed in terms of price movements rather than levels, with price movements measured **by** price indices:

# where

**E, =** the exchange rate expressed as the number of domestic currency units per unit of local currency at time **t;**

**Pd =** domestic price index at time **t;** and

Pt **=** foreign price index at time **t.** Alternatively, the purchasing power parity of the domestic currency with respect to the foreign currency can be expressed as: (P,t/Pt) ***** R.

where Ro is the actual or "market" or current exchange rate in the base year "o" and not necessarily equal to the "equilibrium" rate defined in any manner. Purchasing power parities for **Egypt** are shown in Table **1** above.

> **_51._** PPPs are distinct from and not necessarily equal to the "equilibrium" exchange rate, defined in any manner. They do not measure the degree of overvaluation or undervaluation of a currency. In the absence of other influences PPPs can, however, serve as a guide to the levels of equilibrium exchange rates between the various currencies provided that the base period chosen is one in which equilibrium values prevailed.' PPPs become all the more

**' William P. Culbertson, "Purchasing Power Parity and Black-Market Exchange Rates," Economic Inquiry, Vol. 13, June 1975, p. 287.**
**34**

applicable if trade restrictions and exchange controls are sufficiently high and comprehensive to distort the official exchange rate.

# **PPP and Data Conversion**

**_52._** Probably the most generally accepted use of PPP is as a conversion factor, given the simplicity of the PPP approach, the ease in calculating relative PPP measures, and the intuitive appeal of PPP as a valid theory. International comparison of real output in different countries requires that the conversion rate reflect relative price levels. The absolute PPP measure **( E, =** Pd/PL founded on the **GDP** price level has been used for the currency conversion of the national accounts data at finely disaggregated levels of expenditure **by** Kravis.'

# What Price Measure to Use in **PPP Computations**

> **_53._** The individual prices used to construct the price level or price index for PPP must be presumed to reflect accurately the prices at vhich transactions occur in a free market.

> In a multicommodity world with relative price changes, differing consumption preferences

> across countries, nontraded goods, transportation costs, and trade barriers, the PPPs are

> likely to be distorted so that they do not reflect true relative purchasing power.

> **' Irving B. Kravis, Alan W. Heston, and Robert Summers, International Comparisons of Real Product and Purchasing Power (Baltimore,MD: Johns Hopkins University, 1978).**
**_35_**

_54._ Suggestions to the appropriate price index to use in computing<sup>and testing PPPs have</sup> "ranged from the price of the least traded commodity **--** labor<sup>**--**</sup> to<sup>anindexofnontraded</sup> goods only, to the broadest domestic index available, to an<sup>index comprisedonly</sup><sup>**of**traded</sup> goods, to individual prices of traded commodities."<sup>**2**Comparison ofunit laborcostsis</sup> beset with measurement problems. Among these are measurements<sup>reflectingdifferences</sup> in types and quality of labor; and adjustment for differences<sup>in productivity(tradedgoods</sup> sector only, nontraded goods sector only, or combination of<sup>both?).Price indicesbasedon</sup> internationally traded goods (export and import price indices)<sup>arelimitedtoasmallclass</sup> of commodities, relative to all goods and services, and are therefore<sup>subject tovariations</sup> that presumably would not be present in a broad-based price measure.<sup>Also,tradedand</sup> nontraded goods are not unvarying collections of commodities. There<sup>isneveradefinite</sup> group of commodities that can be exported. Changes in the structure<sup>oftheeconomyor</sup> changes in profitability may widen or restrict the group of<sup>traded/exportablegoods.Inthe</sup> same vein wholesale price indices (WPI) are also heavily weighted<sup>withtraded goods.The</sup> use of cost-of-living indices **(COL)** requires that the weighting<sup>patternbethesamefor</sup> each country's price level, that is, taking a common basket of goods with<sup>a standardsystem</sup> of weighting. The PPP theory essentially refers to the internal value of the currencies concerned, and variations in this value can be measured best<sup>**by**generalindex figures</sup> representing as far as possible the whole mass of commodities (and<sup>services),tradedand</sup> nontraded, marketed in the country. This is reflected in the **GDP** deflator<sup>whichisthe price</sup>

> **' Alan C. Shapiro, "What Does Purchasing Power Parity Mean?" Journal**<sup>**ofInternational Moneyand**</sup> **Finance, Vol. 2, No. 3 , December 1983; pp. 295-318.**
**36**

concept with a firm analytical foundation in PPP theory.' In essence, a PPP measure based on the **GDP** deflator is advocated since each country's own pattern of production provides the ideal source of weights to construct its price measure for PPP computation.

**"** See Lawrence H. Officer, "The Relationship Between Absolute and Relative Purchasing Power Parity,* Review of Economics and Statistics, Vol. **60,** November **1978, pp. 562-568**
**37**

# **VI. TRADE and EXCHANGE TAXES and CONTROLS**

> **_55._** Countries facing unsustainable external balance and payments difficulties, often react **by** imposing a variety of policy instruments and restrictions on the use of foreign exchange and/or to protect industry-specific industries. These include price measures such as tariffs, import surcharges, advance deposits for imports, export taxes, subsidies and multiple

> exchange rates, as well as non-price measures such as quotas, licensing, voluntary restraint agreements, and exchange controls. Over time and as a result of these ad hoc decisions rather than an overall policy design, the trade regulations become increasing complex."

> Price measures, in general, can be expressed in terms of tariffs. Specific taxes or import

> surcharges are added to tariffs; the tariff equivalent of advance deposits is given **by** the interest foregone on loans designed to make the deposits; export taxes and import subsidies

> are regarded as negative tariffs; and the premium in the secondary exchange market can

> also be regarded as a tariff. In the case of nonprice measures, permissible levels of imports are set directly in quantitative terms. **By** restricting the amount of imported commodities made available on the home market, these measures lead to a rise in the domestic prices

> of the commodities in question. The excess of domestic price over world price can be regarded as an "implicit tariff."

> **2 For a comprehensive description of exchange rate arrangements and exchange controls, and changes in these as they occur, see International Monetary Fund, Annual Report on Exchange Arrangements and Exchange Restrictions (WashingtonD.C.: International Monetary Fund, 1989).**
**38**

> **_56._** The nature and extent of price measures and nonprice measure restrictions can alter relative prices and profitability between sectors, leading to distortions in resource

> allocations. Frequent increases in tariffs and import surcharges, the imposition or tightening of quantitative restrictions and resorting to multiple exchange rates for balance of payments purposes mean that the actual value of traded goods do not reflect the outcome of market

> forces. Tariffs and nontariff barriers and subsidy measures represent attempts **by** governments to offset the negative effects of the overvalued exchange rate **by** influencing domestic relative prices and, therefore, on import demand and export supply.

# Trade Taxes on Gross **Output and Value-Added**

> **_57._** The impact of taxes and subsidies on relative prices and the profitability of industry-

> specific activities (with its attendant resource allocation implications) should take note not

> only of the tariff (and subsidy) structure on the final product but also on material inputs. From the point of view of the producer, not only tariffs and other protective measures on the final output matter but also tariffs levied on material inputs because the latter would reduce the domestic value-added. In export industries the increase in costs due to tariffs on material inputs may be compensated **by** the provision of export subsidies. Balassa concludes that tariffs and subsidies on gross output and intermediate inputs permit domestic industries to operate with a value-added higher than under tariff-free trade."

" Bela Balassa, "Industrial Protection in Developing Countries," Report No.EC-175, (Unpublished; The World Bank, June **1980).**
**39**

Effects of Tariffs and Subsidies on Conversion Factors

**_58._** The imposition of tariffs, surcharges and subsidies represents the use of "fiscal proxies" for exchange rate changes. Simply stated, such a policy may be designed to force imports competing with domestically traded goods to enter the country at a depreciated exchange rate (i.e.; at a higher domestic currency price) and/or to allow producers to export at a depreciated rate while preserving a higher exchange rate for other transactions. In essence, the imposition of import tariffs and export subsidies means that, effectively, importers pay more and exporters receive more local currency units per dollar than they would under free trade. It appears, then, that the price (i.e.; conversion factor) paid for or received under tariffs and export subsidies tends to overvalue the domestic currency as compared to the tariff-free trade situation and, in the process, raises the relative price of traded to nontraded goods.' On the other hand export taxes (and import subsidies) are regarded as negative tariffs.

> **_59._** The extent of the implications on international data comparability and on comparative analysis resulting from the reliance on the official exchange rate as a

> conversion factor depends on the incidence and magnitude of price measures and nonprice measures in international trade." How prevalent are import and export taxes and subsidies

> in developing countries? Are tariff structures and schedules prohibitive? This is examined below.

> 2 See para. **15** above for simple numerical examples illustrating this.

> 2 An overview of current developments in trade and exchange controls is presented in International Monetary Fund, Exchange Arrangements and Exchange Controls, (Washington,D.C.; International Monetary Fund, **1989);** and International Monetary Fund, "Developments in International Exchange and Trade Systems," World Economic and Fir .ncial Surveys (Washington,D.C,: International Monetary Fund, September **1989).**
40

# **Incidence of Trade Taxes and Exchange Controls**

**60. The Fund's Annual Report on Exchange Arrangements and Exchange Restrictions** reports that, in general, most developing countries had adopted, or were edging towards more liberal trade policies at the end of the **1980,** than they had before the external balance difficulties of the late 1970s, albeit from a considerably restrictive base. On the other hand the industrial economies, especially the **EEC** and the **US,** have intensified their recourse to quantitative controls. Given their varying forms and purposes and lack of transparency, it has been difficult to assess the incidence and quantitative impact of nontariff barriers on trade. They take many forms: import licensing, quotas, quantitative restrictions in the form of outright prohibition, voluntary export restraint arrangements, government procurement and state trading practices that may have some hidden discrimination against specific foreign suppliers, etc. But the end result of tariffs and quantitative controls is the same: they raise the price of imported goods in a particular market relative to prices without restrictions and relative to world prices.

**61.** Table **8** below shows the frequency distribution of developing countries **by** the size of the tariff rates, measured here as total, import, and export taxes as a percent of total, imports, and exports of goods and nonfactor services, respectively? It is clear that many developing countries still resort to tariffs and import surcharges to deal with acute balance of payments difficulties. Dudes on overall trade of **10** percent or greater are registered in about one-third of developing countries for which data are available. Other notable features

> **30** Since trade flows and taxes used here are at the aggregated level, the implicit assumption is made that the tariff barrier, which in fact applies only to certain product groups, affects all trade.
41 in Table 2 are: (a) most of the taxes on international trade<sup>andtransactioasareimposed</sup> to curtail imports; **(b)** two-thirds of the<sup>developingcountriesforwhichdataareavailable</sup> impose implicit import tariff rates of **10** percent or more;<sup>and(c)thedutyrateonexports</sup> are relatively low though its incidence is still high.

Table **8:** Distribution of "Implicit Tariff Rates" "Implicit Tariff Rate" (Total Duties **%** Total Goods<sup>**&**NonfactorServices)</sup>

|Range(%)|**1980(%)**|**1981(%)**|1982(%)|**1983(%)**|1984(%)|**1985(%)**|**1986(%)**|**1987(%)**|
|---|---|---|---|---|---|---|---|---|
|**0.0-5.0**|**21(263)**|23(28.4)<br>|24(31.6)<br>|**22 (28.6)**<br>|**23(28.4)**<br>|**20(26.3)**<br>|**19(29.7)**<br>|**8(27.6)**<br>|
|**5.1-10.0**|33(41.3)|42(51.9)<br>|32(42.1)<br>|**37(48.1)**<br>|**35**(43.2)<br>|**38(50.0)**<br>|30(46.9)<br>|**11(37.9)**<br>|
|**_10.1-15.0_**<br>**15.1-20.0**|**17(21.3)**<br>**7(8.8)**|**11(13.6)**<br>**5(6.2)**|14**_(18.4)_**<br>**5(6.6)**|**12(15.6)**<br>4(5.2)|**16(19.8)**<br>4(4.9)|**10 (13.2)**<br>**5(6.6)**|9(14.1)<br>3(4.7)|**8(27.6)**<br>**0(0.0)**|
|20.1-25.0|1(1.2)|**0(0.0)**|**1(1.3)**|**1(1.3)**|**3(3.7)**<br>|**3(3.9)**<br>|**1(1.6)**<br>|**1**(3.4)<br>|
|**>25.0**|**1**(1.2)|**0(0.0)**|**0(0.0)**|**1(1.3)**|**0(0.0)**|**0(0.0)**|**2(3.1)**|**_1(3.4)_**|
|Total|80|**81**|**76**|**77**|**81**|**76**|64|**29**|
||"ImpilcitImBo|rtTariffRat|e"(Import|Duties**%**Imp|orts<sup>Goods</sup>|<sup>**&**Nonfactor</sup>|<sup>Services)</sup>||
|Range**(%)**|**1980(%)**|**1981(%)**|**1982(%)**|**1983(%)**|1984(%)|**1985(%)**|**1986(%)**|**1987(%)**|
|**0.0-5.0**|**5(7.6)**|7(10.4)|**5(7.8)**<br>|**6(9.5)**<br>|**7(10.3)**<br>|**7 (11.1)**<br>|4(7.5)<br>|1(4.3)<br>|
|**5.1-10.0**|9(13.4)|**9(13.4)**|**11(17.2)**<br>|**7 (11.1)**<br>|**7(10.3)**<br>|**7(11.1)**<br>|**6(11.3)**<br>|**0(0.0)**<br>|
|**_10.1-15.0_**|11(16.4)|15(22.4)|**16(25.0)**|16(25.4)|15(22.1)|**12(19.0)**<br>|**10(18.9)**<br>|**7**(30.4)<br>|
|**15.1-20.0**|**16(23.9)**|**21(31.3)**|14(21.9)|**19(30.2)**|**17(25.0)**|**17(27.0)**|**17(32.1)**<br>|**5(21.7)**<br>|
|20.1-25.0|**12(17.9)**|**8(11.9)**|**11(17.2)**|9(14.3)|**11(16.2)**|12(19.0)|**6(11.3)**|**5(21.7)**|
|**>25.0**|14(20.9)|**7****_(10.4)_**|**7(10.9)**|**6(9.5)**|**11(16.2)**|**8 (12.7)**|**10(18.9)**|**5(21.7)**|
|Total|**67**|**67**|64|**63**|**68**|**63**|**53**|**23**|

"Implicit Export Tariff Rate" (Exnort Duties **%** Exports Goods **&**<sup>NonfactorServices)</sup>

|Range**(%)**|**1980(%)**|1981(%)|**1982(%)**|**1983(%)**|1984(%)|1985**(%)**|**1986(%)**|**1987(%)**|
|---|---|---|---|---|---|---|---|---|
|**_0.0-5.0_**<br>**_5.1-10.0_**|**40(63.5)**<br>**16(25.4)**|48**_(77.4)_**<br>**11(17.7)**|**48(78.9)**<br>**11(18.0)**|46(76.7)<br>**9(15.0)**|53**(80.3)**<br>**8(12.2)**|**50(82.0)**<br>**6(9.8)**|40(81.6)<br>4(8.2)|**18(78.3)**<br>**2(8.7)**|
|**_10.1-15.0_**|<br>**0(0.0)**|<br>1**(1.6)**|<br>**0(0.0)**|**3(5.0)**|**1(1.5)**|**2(3.3)**|2(4.1)|1(4.3)|
|15.1-20.0|3(4.8)|**1(1.6)**|**0(0.0)**|**0(0.0)**|**1(1.5)**|**0(0.0)**|**1**(2.0)|**1**(4.3)|
|**20.1-25.0**|<br>**0(0.0)**|**0(0.0)**|**1(1.6)**|1**(1.6)**|**2(3.0)**|**0(0.0)**|**0(0.0)**|**0(0.0)**|
|**>25.0**|<br>4(6.3)|**1(1.6)**|**1(1.6)**|**1(1.6)**|**_1(1.5)_**|3(4.9)|2(4.1)|**1**(4.3)|
|Total|**63**|**62**|**61**|**60**|**66**|**61**|49|**23**|

Source: Taxes on international trade are from the IMF Govt. Finance<sup>statisticsfile;</sup> Exports and Imports of goods and nonfactor services are from **IEC** data file.
42

> **62.** Table **9** lists the countries in the Fund's **Annual Report on Exchange Arrangements and Exchange** Restrictions with "cost-related import restrictions" (import surcharges and

> advance import deposits) as features of the trade and exchange system, as well as other

> countries not included in the Fund's list but with import and export duties of at least **10** percent of imports and exports of goods and nonfactor services, respectively. The "implicit

> average import tariff rate" varies substantially among the countries, ranging from **1** percent

> in Greece to _45_ percent in India. It should also be noted that these average taxation rates on imports often mask some fairly high tariffs protecting individual import-sensitive industries, although in practice the bulk of transactions may take place within a relatively narrow tariff schedule.

> **63.** The data in Table **9** reinforce the features evident in Table **8:** that most trade taxes

> are imposed on imports; their incidence is dispersed in both low- and mid-income countries; and the implicit tariff rate in low-income countries (e.g.,Bangladesh, Gambia, India,

> Myanmar, Pakistan, Sudan, Sierra Leone) averages **_25_** percent, which is twice that imposed

> **by** the middle-income economies.
43 Table **9:** Incidence of Import and Export Taxes in Selected Developing Countries

||Country|ImportDuties<br>**%**Imports**GNFS**|ExportDuties<br>**%**Export**GNFS**|TotalDuties<br>**%**TaiGNPs|
|---|---|---|---|---|
|**X**|Argentina|36.2/1984|**8.9/1984**|9.2/1984|
|**GFS**|Bangladesh|**26.9/1985**|**6.1/1985**|**17.9 /1985**|
|**X**|Belize|**21.7****_/1985_**|**1.0/1985**|**11.2****_/1985_**|
|**GFS**|Botswana|**17.0/1986**|**1.0****_/1985_**|**7.4/1986**|
|**X**|BurkinaFaso|**15.2/1987**|**1.6/1987**|**10.5/1987**|
|**GFS**|Burundi|**15.6/1986**|**32.9/1986**|**21.9/1986**|
|**GFS**<br>|Cameroon<br>|**19.0 /1987**|**2.5/1987**|**9.3/1987**|
|**X**|China|na|na|na|
|**X**|Colombia|**20.1/1987**|**1.0/1987**|**8.3/1987**|
|**GFS**|Comoros|21.1**/1987**|**13.2/1986**|**13.8/1987**|
|**X**|Congo|**7.7 /1980**|**1.0/1980**|**3.8/1980**|
|**X**|CostaRica|**20.8/1986**|**_5.5_/1986**|**7.4/1986**|
|**X**|CoteD'Ivoire|**31.3/1985**|**_5.6_/1985**|**9.7/1985**|
|**X**|Cyprus|na|na|na|
|**X**|Djibouti|**2.6 /1986**|**1.0/1986**|**1.6/1986**|
|**X**|DominicanRep.|**20.5/1986**|**3.2/1986**|**9.9/1986**|
|**X**|Ecuador|**15.6/1985**|**1.0/1985**|**6.2/1985**|
|**X**|**Egypt**|**18.2/1987**|**1.0/1987**|**11.5/1987**|
|**GFS**|<br>**El**Salvador|**19.1/1987**|**10.6/1987**|**6.9/1987**|
|**GFS**|**Fiji**|**15.8/1986**||**7.7/1986**|
|**GFS**<br>|Gabon|**19.3/1985**|**1.1/1985**|**6.7/1985**|
|**GFS**|Gambia|**25.5/1987**|**1.0/1987**|**13.6/1987**|
|**GFS**|Ghana|**10.1/1987**|**17.4/1987**|**13.5/1987**|
|**X**|Greece|**10/1985**|na|na|
|**X**|Grenac:a||na|na|
|**X**<br>|Guatemala<br>|**11.1/1982**|**3.8/1982**|**_4.5_/1982**|
|**X**<br>|Guinea|na|na|na|
|**GFS**|Guinea-Bissau|na|na|**24.1/1987**|
|**X**|Haiti|**11.9/1987**|**1.3/1987**|**6.8/1987**|
|**GFS**|Honduras|**20.2/1981**|**6.4/1981**|**8.1/1981**|
|**X**|India|**45.7/1987**|**26.1/1987**||
|**X**|Indonesia|**3.7 /1987**|**3.5/1987**|**3.6/1987**|
|**X**<br>|IranIraq<br>|na|na|**11.9/1985**|
|**X**|Iraq|na|na|na|
|**X**|Israel|na|**3.0/1985**||
|**X**|Jamaica|na|na|**1.6 /1981**|
|**X**|Jordan|na|na|**7.2/1986**|
|**X**|Kenya|**17.5/1986**|**2.6/1986**|**7.4/1986**|
|**X**|Lebanon|na|na|na|
|**X**|Liberia|**14.0/1986**|**1.1/1986**|**6.2/1986**|
|**X**|Libya|na|na|na|
|**X**|Madagascar|**15.0/1982**|**3.8 /1982**|**8.1 /1982**|
|**X**|Malawi|**15.3/1986**|**1.0/1986**|**7.6 /1986**|
|**GFS**|Mali|**14.6/1987**|**3.6 /1987**|**8.5/1986**|
|**X**|Mauritius|**19.5/1988**|**3.2 /1988**|**8.2/1988**|
|**GFS**<br>|Myanmar<br>|na|na|**14.6/1985**|
|**X**|Nepal|12.0/1984|1.0/1984|7.2/1984|
|**X**|NetherlandAnt.|na|na|na|
44 Table **9** (Cont): Incidence of Import and Export Taxes in Selected Developing Countries

|/1|Country||ImportDuties<br>**%**Imports**GNFS**|ExportDuties<br>**%**Export**GNFS**|TotalDuties<br>**%**Total**GNFS**|
|---|---|---|---|---|---|
|**X**|Nicaragua||na|na|na|
|**X**|Pakistan||**_29.5_/1986**|**1.6/1986**|**17.7/1986**|
|**X**|Panama||**11.8/1986**|**1.0/1986**|**_5.3_/1986**|
|**X**|Paraguay||**3.4/1986**|**1.0/1986**|2.1**/1986**|
|**X**|Peru||**21.7/1986**|**2.7 /1986**|**10.5/1986**|
|**X**|Philippines||**12.0/1986**|**1.0/1986**|**4.9/1986**|
|**GFS**|Poland||**14.8/1987**|**1.1/1987**|**6.4/1987**|
|**GFS**|St.Lucia||**14.9/1986**|**1.0/1986**|**7.6/1986**|
|**GFS**|St.Vincent||**16.6/1986**|**1.0/1986**|**8.6/1986**|
|**GFS**|Senegal||**15.8/1984**|1.0/1984|**8.8/1984**|
|**X**|SierraLeone||**28.9/1987**|**1.0/1987**|**13.2/1987**|
|**_X_**|Somalia||**17.8/1978**|**1.1/1978**|**12.5/1978**|
|**X**|SouthAfrica||**3.6/1985**|**1.0/1985**|**1.4/1985**|
|**GFS**|SriLanka||**21.1/1988**|**3.9 /1988**|**10.7/1988**|
|**X**|Sudan||**25.1/1981**|**_5.8_/1981**|**17.5/1982**|
|**X**|Suriname||**16.8/1986**|**1.0/1986**|**8.5/1986**|
|**GFS**|Swaziland||**14.8/1986**|**1.0/1986**|**7.9/1986**|
|**X**|Syria||**8.9/1987**|**1.0/1986**|**5.8/1986**|
|**X**|Thailand||**11.3/1987**|**1.0/1987**|**_5.3_/1987**|
|**GFS**|Togo||**19.5/1986**|**1.0/1986**|**11.0/1986**|
|**X**|Trinidad||**7.8/1981**|na|**_3.5_/1981**|
|**GFS**|Tunisia||**23.3/1984**|1.0/1984|**13.1/1984**|
|**X**|Turkey||**5.9/1987**|**1.0/1987**|**3.1/1987**|
|**GFS**|Uganda||**3.1/1986**|**32.6/1986**|**16.0/1986**|
|**X**|Uruguay||**18.1/1987**|**1.0/1987**|**7.5/1987**|
|**X**|Vanuatu||**18.2/1986**|**1.6/1986**|**12.5/1986**|
|**GFS**|Venezuela||**25.0/1986**|na|**12.5/1986**|
|**X**|Yemen AR||**14.8/1987**|na|**13.2/1987**|
|**X**|YemenPDR||na|na|na|
|**X**|Yugoslavia||**13.2/1987**|na|**6.5/1987**|
|**GFS**|<br>Zaire||**19.7/1986**|**_5.1_/1986**||
|**X**|Zambia||**24.0/1988**|**7.4/1988**|**8.5/1987**|
|**X**|Zimbabwe||**16.4/1985**|na|**8.0/1985**|
|||Total|**81**|||
||||X**=56**|||
||||**GFS= 25**|||

Sources: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions, **1989;** Import and exports duties are from the IMF file on Government Finance Statistics.

**1/ "** X "denotes countries identified in the Fund's Annual **Report on Exchange Arrangements and Exchange** Restrictions with "cost-related import restrictions" (import surcharges and advance import deposits) as features of the trade and exchange system.

**" GFS "** denotes other countries not included in the X list with import and export duties of at least **10** of imports and exports of **GNFS,** respectively
45 "Trade Tax-Effective" Conversion Factors 64. Given the high incidence and relatively high implicit tariff rates on imports (and heavy export taxes in a few countries) shown in Tables **8** and **9,** there are strong reasons to examine conversion factors that reflect the impact of substantial tariffs and subsidies. **_A_** _priori,_ it is reasonable to expect that countries with cost-related restrictions on international transactions would exhibit large deviations between the transaction rate and the official exchange rate. In situations where tariffs and subsidies are widely dispersed and substantial, the price (i.e.; conversion factor) paid for or received **by** transactors differs from the price denoted **by** the official exchange rate. In essence, we need to compute so-called "tax-effective" import and export prices (i.e.; conversion factors) as well as a conversion factor that represents an overall "trade-tax effective" con"ersion factor. Significant deviations of the overall "trade-tax effective" conversion factor from the official exchange rate shouid be taken as a signal that further review of the adequacy of official exchange rate as a conversion factor merits consideration.

> **65.** The majority of developing countries **(90** percent) for which data are available

> impose export duties considerably lefs than **10** percent (see Table **8);** that is to say that the

> impact of export taxes on the transaction rate is small. Therefore the last column in Table **9** (total duties **%** total goods and nonfactor services) is a close proxy for the magnitude of the deviations of the "trade-tax-effective" conversion factors from the official rates.

> **66.** Table **10** illustrates an approach towards computing "trade-tax-effective" conversion

> factors. Because data on subsidies are not available, the computational approach shown
46

> below does not take into account the impact of subsidies. To illustrate the _a priori_ reasoning that countries with high cost-related restrictions on international transactions would exhibit larger deviations between the transaction rate and the official rate, Table **10** illustrates the

> impact in two differing situations. India's trade system is characterized **by** high price-

> measure restrictions, particularly on imports; the implicit import tariff rate is over 40 percent since the mid-1980s. On the other hand, the Malaysian trade system is relatively restriction free. As seen in Table **10** (indicator K), there is a marked difference in the

> magnitude of the deviation of the "trade-tax effective" conversion factor (TIXR) from the official exchange rate between the two countries. In Malaysia, the conversion factor effectively used in trade is virtually no different from the official exchange rate; on the other hand, in India the conversion factor in international transactions is some **_25_** percent

> more depreciated than that represented **by** the official exchange rate.

> **67.** It is apparently clear that where we know that a country's trade and payments system

> is very restrictive, the use of the official exchange rate as a general conversion factor needs farther examination. In such a situation, attempts should be made to estimate a conversion factor that takes into account the impact of the trade restrictions (e.g., the "trade taxeffective" conversion factor). It is suggested that this be done for countries shown in the

> Fund's **Annual Report on Exchange Arrangements and Exchange Restrictions as** having

> "cost-related import restrictions", supplemented with a country list (other than those listed in the above-mentioned Fund document) with high import and export duties.
47 Table **10:** "Tax-Effective" Conversion<sup>Factorsfor Importsand Exports</sup>

|**INDIA:HIGHTARIFFS/SURCHARGES**<br>|**1980**<br>**1981**|<br>**198**|**2**<br>**198**|**3**<br>198|4<br>**198**|**5**<br>**198**|**6**<br>**198**|**7**|
|---|---|---|---|---|---|---|---|---|
|BasicData<br>**A.**Total Duties**%**Total<sup>**GNFS/1**</sup>|**15.52**|**17.17**|**20.17**|**19.06**|19.1524.|24<br>**_27.5_**|**_6_**<br>**26.0**<br>|**9**<br>|
|<br>B.ImportDuties**%**Import<sup>**GNFS/1**</sup>|24.66|**28.12**|**33.63**|32.43|32.94|**39.74**<br>|46.06<br>|45.10<br>|
|<br>**C.**ExportDuties**%**ExportS<sup>**GNFS/1**</sup>|**1.33**|**0.60**|**0.63**|0.64|**0.52**|**0.53**|**0.56**<br>|0.43<br>|
|<br>**D.**Imports**GNFS% **Total<sup>**GNFS**</sup>|**60.83**|**60.22**|**59.22**|**57.96**|**57.46**|60.47<br>|**59.33**<br>|**57.46**<br>|
|<br>**E.**Exports**GNFS% **Total<sup>**GNFS**</sup>|**39.17**|**39.70**|**40.78**|42.04|42.54|**39.53**|40.67|42.54|
|<br>F.**IFS**RF|**7.8629**|**8.6585**|9.4551|**10.0990**<br>|**113630**<br> <br>|**123690**<br> <br>|**12.6110**<br> <br>|**129D**<br>|
|**G.E)R_ATLAS**|**7.8930**<br>**8.9**|**290**<br>**9.6**|**280**<br>**103**|**120**<br>**11.**|**8870**<br>**12.**|**2370**<br>**12.**|**7870**<br>**13.**|**000**|
|**DERIVED INDICATORS**|||||||||
|<br>H.ExRate."Import-Tax"<sup>Effective</sup><sup>**(ITXR)**/1</sup>|<sup>**9.8017**</sup><br>**11.**|**0928**<br>**12.**|**6346**<br>**13.**|**3738**<br>**15.**|**1057**<br>17.<br>|2844<br>**18.**<br> <br>|**4198**<br>**18.**<br> <br>|**8075**<br>|
|<br>**I.**ExRate."Export-Tax"Effective<sup>(ETXR)</sup><sup>**/1**</sup>|**7.7580**<br>**8.6**|**066**<br>**9.3**|**955**<br>10.|0345<br>11.|3034<br>**12.**|**3029**<br>12.|5403<br>**12.**<br>|**068**<br>|
|<br>**1.**ExRate-Trade-Tax"Effective<sup>(TTXR)</sup><sup>**/1**</sup>|**9.0011**|**10.1038**|**11.3135**|**11.9699**|**13.4883**|**15.3150**|**16.0286**|**1629**|
|. <br>K.Ratio:TTXR/IFSRF|1.1448|**1.1669**|**1.1966**|**1.1853**|**1.1870**|**1.2382**|**1.2710**<br>|**12573**<br>|
|<br>L.Ratio:TTXR/EXR**ATLAS**|1.1404|**1.1316**|**1.1751**|**1.1608**|1.1347|**1.2515**|**1.2535**|**1236**<br>|
|<br>M.IndexRealEffectiveExRate|**100.00**|**111.96**|12435|**128.09**|**137.27**|**150.20**|**151.20**|14790|
|**MAlAYSIA:**LOWTARIFFS/SURCHARGES|<sup>**1980**</sup><br>**198**|**1**<br>**198**|**2**<br>**19**|**83**<br>198|4<br>**19**|**85**<br>**198**|**6**<br>**198**|**7**|
|**BasicData**||||||<br>|<br>||
|**A**Duties**%**Total**GNFS**<sup>**/1**</sup>|**7.71**|**7.00**|**5.835.**|**93**<br>5.|64<br>**5**|**37**<br>4.|17<br>3.|4|
|**.** <br>BImportDuties**%**Import<sup>**GNFS/1**</sup>|**7.06**|**6.66**|**6.21**|**6.51**|6.48|**6.53**|**5.70**|**4.87**<br>|
|. <br>**C.**ExportDuties**%**Export<sup>**GNFS/1**</sup>|8.34|**7.38**|5.40|**5.28**|4.84|4.32|**2.80**<br>|**2.50**<br>|
|<br>**D.**Imports**GNFS% **Total<sup>**GNFS**</sup>|**48.89**|**52.79**|53.94|52.64|49.11|**47.55**|47.10|43.91|
|<br>**E.**Exports**GNFS% **Total<sup>**GNFS**</sup>|**51.11**|47.21|46.06|**47.36**|**50.89**|52.45|**52.90**|**56.09**<br>|
|<br>F.**IFS**RF|**2.1769**|2.3041|2.3354|**2.3213**|2.3436|2.4831<br>|2.5814<br>|**25L**<br>|
|<br>**G.EXR_ATLAS**|**2.1769**|23041|2.3354|**23213**|2.3436|2.4831|2.5814|**2515**|
|**DERIVEDINDICATORS**|||||||||
|<br>HExRate"Import-Tax"Effective<sup>(ITXR)</sup><sup>**/1**</sup>|**23305**|**2.4576**|2.4803|2.4724|2.4954|2.6419|**2.7270**|_26_|
|.. <br>**I.**ExRate."Export-Tax" Effective<sup>(ETXR)</sup><sup>**/1**</sup>|1.9954|2.1341|**2.2093**|**2.1988**|**2.2301**|**23728**|**2.5077**|245<br>|
|<br>**J.**ExRate."Trade-Tax"Effective<sup>(TTXR)</sup><sup>**/1**</sup>|**2.1593**|23049|<br>**23555**|2.3429|23604|**2.5008**|**2.6110**|253%<br>|
|<br>K.Ratio:TTXR/IFSRF|**0.9919**|**1.0003**|**1.0086**|**1.0093**|**1.0072**|1.0084<br>|1.0120<br>|1074<br>|
|L.Ratio:TTXR/EXR**ATLAS**|**0.9919**|**1.0003**|**1.0086**|**1.0093**|**1.0072**|**1.0072**|**1.0115**<br>|**1015**<br>|
|<br>M.IndexRealEffectiveExRate|**100.00**<br>**10**|**9.77**<br>**11**|**5.12**<br>11|4.05<br>**11**|**6.63**<br>12|4.79<br>12|9.24<br>**12**|**8.88**|

# **COMPUTATION** PROCEDURES:<sup>**/1**</sup>

H. ExRate."Import-Tax" Effective = [Fx (1+B)I

**1.** ExRate."Export-Tax" Effective<sup>=</sup> [Fx<sup>**(1-C)]**</sup>

**J.** ExRate."Trade-Tax" Effective = [(H x **D) + (I** x **E)]**

/1 Because data on subsidies are not<sup>available,theirimpact onthe respective conversion factorsisnotreflectedin the</sup> computations shown above.
48 Table **10** above illustrates the typ of data **IEC** staff is expected to culP from various Bank and Fund documents to support the estimation of an alternative conversion factor that gives some recognition to price-measure restrictions.

# Deviations of "Trade Tax-Effective" Exchange Rates

**68.** Table **11** below shows the distribution of the deviations of the "trade tax-effective" rate from the official rate. The distribution sh(,wn here is very similar to that of total duties imposed on trade in goods and nonfactor services shown earlier in Table **8.** In Table **11,** some **30** percent of developing countries for which data are available show deviations greater than **10** percent in the "trade tax-effective" conversion factor; similarly, Table **8** shows that the "implicit tariff rate" of **10** percent or greater is imposed in some **30** percent of developing countries.

Table **11:** Distribution of Deviations of "Trade Tax-Effective" Rate from Official Rate

|Range**(%**|**)1975**|**1976**|**1977**|**1978**|**1979**|**1980**|**1981**|**1982**|**1983**|1984|**1985**|**1986**|**M87**|
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
|**0.0-1.0**|**1**|**1**|**1**|**1**|**1**|**1**|**1**|**3**|2|2|2|**3**|**6**|
|**_1.1-5.0_**|**17**|21|**17**|**18**|**18**|**19**|20|22|**19**|**19**|**17**|14|**6**|
|**5.1-10.0**|**32**|**_35_**|**33**|**30**|**30**|**31**|**39**|29|**33**|**32**|**35**|**27**|**10**|
|**_10.1-15.0_**|**_15_**|16|**16**|**18**|**15**|**17**|**10**|12|**11**|**_15_**|**8**|**8**|**7**|
|**15.1-20.0**|**9**|**6**|**_5_**|**_6_**|**7**|**7**|**_5_**|**_5_**|**3**|**3**|4|**1**|**0**|
|**20.1-25.0**|2|**1**|**_5_**|2|2|**1**|**0**|**1**|**1**|**3**|**3**|**1**|**0**|
|_2r.1-30.0_|**0**<br>|**0**<br>|**1**|**3**|**1**|**0**|**0**|**0**|**0**|**0**|**0**|2|1|
|>|**1**|**1**|**1**|**1**|2|**1**|**1**|**1**|**1**|**1**|**1**|**1**|**0**|
|Total:|**77**|**81**|**79**|**79**|**76**|**77**|**76**|**73**|**70**|**75**|**70**|**57**|**30**|
**49**

**Countries for Review and Adjustment for Trade Taxes**

**69.** Table 12 below lists countries" with "implicit tariff rates" of at least **10** percent. In the context of the search for an appropriate general purpose conversion factor, the list represents the suggested countries for review, and adjustment if necessary, in the official exchange rate to take into account the cost-related restrictions in the and trade system. It should be emphasized that in the review process, Operations staff should be encouraged to provide data on subsidies if they form a significant part of the trade system.

Table 12: Selected Countries for Review and Adjustment of Official Rate for Trade Taxes

|Country|"ImplicitTariff<br>Rate"**(%)**|Country|"ImplicitTariff<br>Rate"**(%)**|
|---|---|---|---|
|Bangladesh|**17.9/1985**|*****Pakistan|**17.1/1986**|
|*Belize|**11.2****_/1985_**|*****Peru|**10.5/1986**|
|*Burkina Faso|**_10.5_/1987**|SierraLeone|**13.2/1987**|
|Eurundi|**21.6 /1986**|*****Somalia|**12.5/1978**|
|Comoros|**13.8/1987**|SriLanka|**10.7/1988**|
|***Egypt**|**11.5/1987**|*****Sudan|**17.5/1982**|
|Gambia|**13.6 /1987**|Togo|**11.0/1986**|
|Ghana|**13.5/1987**|Tunisia|**13.1/1984**|
|Guinea-Bissau|**24.1 /1987**|Uganda|**16.0/1986**|
|*India|**26.1/1987**|*****Vanuatu|**12.5/1986**|
|*Iran|**11.9 /1985**|Venezuela|**12.5/1986**|
|Myanmar|**14.6 /1985**|*****YemenAR|**13.2/1987**|

Source: Table **9**

> * Countries identified in the Fund's **Annual** Report on **Exchange Arrangements** and Exchange Restrictions with "cost-related import restrictions."

> **31** Based on the Fund's **1989** Annual Report on Exchange Arrangements and Exchange Restrictions, and

> supplementary information from the Fund's Government Finance Statistics file.
**_50_**

# **VII. VOLATILITY in EXCHANGE RATES and TRADE VOLUMES**

**70. In** addition to taxes and subsidies and the use of multiple exchange systems in international trade directly applicable to the conversion of local currency into foreign exchange, the conversion factor should also encompass volatility in exchange rate and volume of trade during the period in question. The following paragraphs of the paper examines the merchandise-trade weighted conversion factor (MWXR) that captures volatility in the exchange rates and traditional cycles or fluctuations in the volumes of trade transactions. Because of large variations in the official rate, the MWXR encompasses the recommendation stated in Section **II,** para. **13** above: that shorter period data (e.g., quarterly exchange rates and trade volumes) should be used and then summed to derive longer period data, e.g., annual exchange rates and trade volumes.

# **Merchandise-Weighted Conversion Factors**

> **71.** Each average quarterly exchange rate from the **IFS** is weighted **by** the respective shares of the corresponding quarterly total merchandise trade (exports plus imports) in the

> annual total trade according to this relationship:
**_51_**

**Q4** MWXR =L. RF, i= **Q**

# where

MWXR **=** merchandise-weighted conversion factor;

**wj=** merchandise trade weight in Quarter i

**(xi + mi)** 2:(xi **+ in')** x, = merchandise exports in Quarter i; mi = merchandise imports in Quarter i; RFj = official exchange rate in Quarter i; i = Quarter **1,2,3** 4

# Deviations of Merchandise-Weighted Exchange Rates

**72.** The magnitude of the deviations of merchandise-weighted rates (MWXR) from<sup>the</sup> average annual official rates for the period **1980-88** are presented in<sup>Table</sup><sup>**13.A**closer</sup> examination of the percent deviations of MWXR from the official rate reveals that<sup>for most</sup> countries the deviations are relatively minor. Consistently about **_95_** percent of the<sup>countries</sup> exhibit deviations of less than **_5%_** over the period **1980-88,** as shown in Table<sup>**13.**Thus,it</sup> is evident from the results presented in Table **13** that the MWXRs,<sup>ingeneral, donot</sup> reveal anything significant about the preference order between the MWXR and<sup>theofficial</sup> rate for most countries.
**_52_**

Table **13:** Distribution of Deviations of MWXR from IFS RF

|Deviation**(%)**|**1980**|**1981**|**1982**|**1983**|1984|**1985**|**1986**|**1987**|**1988**|
|---|---|---|---|---|---|---|---|---|---|
|**0**|**_15_**|14|14|12|**9**|**8**|**7**|**10**|**7**|
|**0.1-1.0**|**62**|_54_|**52**|**53**|49|52|**59**|**_50_**|40|
|1.1-2.0|2|**7**|**7**|**6**|12|**9**|**_5_**|**3**|**7**|
|**2.1-3.0**|2|2|2|2|**3**|4|4|4|**0**|
|3.14.0|**1**|2|2|**1**|**0**|**0**|**0**|**3**|**6**|
|4.1-5.0|**0**|**1**|2|**0**|**1**|2|**0**|**0**|**1**|
|**_5.1-6.0_**|**1**|**U**|**0**|**1**|2|**0**|**0**|2|**0**|
|**6.1-7.0**|**0**|**0**|**0**|**1**|2|**1**|**1**|**0**|**1**|
|**7.1-8.0**|**0**|**0**|2|**1**|**0**|**1**|**0**|**1**|**0**|
|**8.1-9.0**|**0**|**1**|**0**|**0**|**1**|**0**|**0**|**0**|**0**|
|**9.1-10.0**|**0**|**0**|**0**|**0**|**0**|**0**|**1**|2|**0**|
|**_10.1-15.0_**|**0**|2|**0**|**1**|**1**|2|**0**|2|**0**|
|**15.1-20.0**|**0**|**0**|**1**|2|**0**|**1**|2|**0**|2|
|**20.1-25.0**|**0**|**0**|**0**|**0**|**0**|**0**|**0**|**0**|**0**|
|**25.1-30.0**|**0**|**0**|**0**|**0**|**1**|**0**|**0**|**0**|**1**|
|**>30.0**|**0**|**0**|**0**|2|**1**|**0**|**1**|**0**|2|
|Total|**83**|**83**|**82**|**82**|**82**|**80**|**80**|**77**|**67**|

Source: **IFS**

# **Countries for Review and Adjustment for Volatility**

> **73.** Nevertheless, any large deviations should be taken as signals that the MWXR could be the preferred choice among the two rates. The results do suggest, however, that for three countries in particular the use of MWXR, instead of the official exchange rate, merits

> consideration. The three countries showing strong deviations are Argentina, Brazil, and Yugoslavia. Any decision on the preference order between MWXR and official rate would

> have to take into account relevant country-specific knowledge, not just the magnitudes of the deviations between the two rates.
**_53_**

74. Argentina offers some interesting observations which account for the relatively large percent deviations of its MWXR from the _official_ rate. **A** closer look at the quarterly official exchange rate (Table 14 below) reveals significant volatility in the quarterly rates in the 1980s.

TabLe 14: **ARGENTINA** --Fluctuating Quarterly Exchange Rates and Trade Weights

|||**IFS**Quar|terlyRate|s|**%**|Change||
|---|---|---|---|---|---|---|---|
||**01**|<br>02|<br>**03**|04|02|**03**|04|
|**1980**|**0.00017**|**0.00018**|**0.00019**|0.00020|**7.0**|**5.2**|**3.5**|
|**1981**|0.00022|**0.00038**|**0.00051**|**0.00065**|**71.3**|**36.5**|**27.0**|
|**1982**|**0.00103**|**0.00137**|**0.00377**|0.00420|**33.2**|**176.0**|11.4|
|**1983**|**0.00575**|**0.00782**|**0.01073**|**0.01781**|**35.9**|**37.3**|**66.0**|
|1984|**0.02784**|0.04118|0.06934|0.13224|47.9|68.4|**90.7**|
|**1985**|0.24952|**0.55672**|**0.80050**|**0.80050**|**123.1**|43.8|**0.0**|
|**1986**|**0.80050**|**0.84896**|**0.97216**|**1.15051**|**6.1**|14.5|**18.3**|
|**1987**|1.40493|**1.61000**|2.14627|**3.41599**|14.6|**33.3**|**59.2**|
|**1988**|**4.37877**|**6.79771**|**11.18150**|12.65240|**55.2**|64.5|**13.2**|
|||Trade|Weights||Z|Change||
||**01**|<br>**02**|<br>**03**|**04**|02|**03**|04|
|**1980**|**0.2172**|<br>0.2240|<br>**0.2662**|<br>**0.2926**|**3.1**|**18.8**|**10.0**|
|**1981**|**0.1263**|0.2403|<br>**0.3309**|<br>0.3024|**90.2**|**37.7**|**-8.6**|
|**1982**|0.1439|<br>**0.1970**|<br>0.2455|<br>0.4136|**36.9**|24.6|**68.5**|
|**1983**|**0.1308**|<br>0.2002|<br>0.2643|<br>0.4048|**53.1**|**32.0**|**53.2**|
|1984|**0.1071**|**0.1836**|<br>**0.2831**|<br>0.4262|**71.5**|54.2|**50.5**|
|**1985**|**0.0953**|<br>0.2654|<br>**0.3336**|<br>**0.3057**|**178.3**|**25.7**|-8.4|
|**1986**|**0.1781**|0.2427|<br>**0.2876**|<br>**0.2916**|**36.3**|**18.5**|1.4|
|**1987**|0.1408|<br>**0.1903**|<br>**0.2613**|<br>0.4076|**35.2**|**37.3**|**56.0**|
|**1988**|**0.0897**|<br>**0.1838**|<br>**0.3500**|<br>**0.3765**|104.9|**90.5**|**7.6**|

**%** Deviations **of** taR from IFS RF **1980 0.7 198513.5 1981** 10.2 **1986** 2.2 **1982 18.9 198714.6 1983** 17.4 **198817.9** 1984 **27.9**

Source: **IFS**
_54_ This is compounded **by** the fluctuations in Argentina's quarterly trade shares where, traditionally, a high proportion of total trade occurs in the third and fourth quarters. Together, they account for the large deviations of the merchandise-weighted conversion factor form the unweighted official exchange rate. **A** closer look at Table 14 reveals that the small deviation in MWXR in **1980** is the result of relative stability in exchange rates and the dispersion of total trade, **by** quarters, in **1980;** similar observations are seen in **1986.** The outcome of the high volatility in exchange rates and trade shares in the other years is obvious: large deviations between MTXR and official rate. It is obvious that while the official rate encompasses the unweighted exchange rate changes over the entire year, its suffers from the drawback of not encompassing the volumes of transactions at each of these fluctuating rates; hence the need for a weighted conversion factor based on shorter period (quarterly) data.
**_55_**

## **VIII. USE of PERIOD AVERAGE**<sup>**EXCHANGE**</sup> **RATES in the BANK**

**_75._ In** principle, the Bank adopts the unweighted<sup>annualaverageof the official exchange</sup> rate (line **rf** in **IFS) for conversions between**<sup>**nationalcurrency**and</sup><sup>**U.S.**dollarvalues,</sup> except in those instances where<sup>it was seriously consideredthat this rate was "inappropriate"</sup> and that consideration of an<sup>alternativeconversionfactoriswarrantedonlywhenthe</sup> difference between the official exchange<sup>rateandthatapplyingtotheaverageofforeign</sup> transactions is egregiously<sup>large.</sup>

# Shorter Periods to Longer<sup>PeriodRates</sup>

**76.** Market rates, however, vary from day<sup>today, but the various types of dataseries that</sup> need to be converted to a common currency<sup>(e.g.,</sup><sup>**GNP,**foreigntrade, balanceof payments,</sup> etc.) are compiled over a period **--**<sup>usuallyquartersoryears.Thuslongerperioddataare</sup> the sums of the compilation period. It<sup>followsthattheuseofprevailingmarketrate</sup> conversion requires the use<sup>of averages.</sup>

**77.** The primary requirement for converting<sup>longerperioddataisthattheconversion</sup> should be made from shorter period data and that<sup>longerperioddatabe calculatedas the</sup> sums of the converted short period data. For example,<sup>themonthly(quarterly)foreign</sup> trade statistics, if available, in national currencies should be converted with the respective
**_56_**

> average monthly (quarterly) exchange rates and then summed to obtain the annual data instead of summing the monthly (quarterly) data and then converting with the average annual exchange rates. The major drawback of the latter instance is that the annual average exchange rates may not be in accord or conform with the known contributions of

> the annual data within the monthly (quarterly) time periods. Given country X's traditional,

> say, fourth quarter's trade or current account surplus together with fluctuating fourth quarter's exchange rate, any difference in the conversion procedure will result in noticeable

> effects on the longer period data expressed in the common numeraire.

> **78.** The recommendation is obviously clear **...** that whenever shorter period data are available these should be converted at the average of monthly (or even daily) rates and then summed to derive longer period data, e.g.,annual data. One should, however, draw

> the distinction between what is desirable and what is statistically feasible. Consideration of statistical feasibility would pr3clude deriving an overall conversion factor based on

> **highly** disaggregated levels involving various commodities at respective rates. More often than not many macroeconomic data (e.g., **GDP, GNP)** from developing countries are not available for the shorter periods but are usually available as annual observations. In the extreme circumstance where volatility in the exchange rates is accompanied **by** fluctuating

> volumes of international transactions, the adequacy of the official exchange rate as a

> conversion factor becomes questionable. An alternative conversion factor in such a situation

> may be in the form of weighted exchange rates at a **highly** aggregated level e.g.,

> merchandise trade weighted exchange rate (discussed in Section VII above) which will

> capture traditional cycles not only in the data but also in exchange rates.
**_57_**

# **Search for a General Purpose Conversion Factor**

**79. Much of the Bank's** analytical work on development in member countries and on the efficacy of policies require inter-country (region) comparisons which require, at some stage, the conversion of indicators expressed in national currencies into a common numeraire. While it is clear that the preferential method of conversion is to use the prevailing or market valuations, their determination is not without ambiguity, even for international transactions that are relatively free of exchange and trade restrictions. Furthermore, the national currency value of a country's **GNP** does not change at the moment its exchange rate changes; it is the measurement of its value in foreign currency that changes. Many value aggregates in **GNP** are not aggregates of international transactions and there is, therefore, no uniquely "true" conversion factor. They are converted to a common currency only for the purpose of international comparison. Thus the search for an appropriate conversion factor should be viewed as a search for a general purpose conversion factor that applies to major economic aggregates.