metadata: authors: 0: author: Ghei, Nita
1: author: Kiguel, Miguel A.
docna: 0: docna: Dual and multiple exchange rate systems in
            developing countries : some empirical evidence
docty: Policy Research Working Paper
subtopic: International Trade and Trade Rules,Macroeconomic Management,Crime and Society
teratopic: Macroeconomics and Economic Growth
abstracts: cdata!: The authors examine the determinants of
            the parallel exchange rate for a cross-country sample of
            developing countries. The sample includes countries in which
            the parallel exchange rate is official (dual exchange rate
            systems) as well as those in which it is unofficial (black
            market). They base their empirical analysis on a portfolio
            macroeconomic model in which the parallel exchange rate is
            determined by expectations and equilibrium asset
            considerations in the short run, but depends on the
            evolution of key policy variables (such as stock of money,
            budget deficits, and trade policy) in the long run. The
            results indicate that macroeconomic variables explain more
            than 70 percent of the variation in the spread between the
            official and parallel exchange rates. The authors cannot
            reject the hypothesis that there are no differences in the
            determinants of the spread when the parallel rate is
            official and unofficial. Also, they cannot reject the
            hypothesis that restrictions on the capital account affect
            the spread. These results are consistent with prior findings
            that portfolio considerations dominate the determination of
            the parallel rate in the short run. There is evidence that
            the adoption of dual exchange rate systems only partly
            insulates domestic prices. This insulation may be limited by
            : 1) a leakage of transactions from the official to the
            parallel market; and 2) depreciation of the parallel
            exchange rate.
repnme: repnme: Dual and multiple exchange rate systems in
            developing countries : some empirical evidence
display_title: Dual and multiple exchange rate
            systems in developing countries : some empirical evidence
listing_relative_url: /research/1992/04/699715/dual-multiple-exchange-rate-systems-developing-countries-some-empirical-evidence
topicv3: Capital Account m1326277 1134,Current Account m1326278 1135,Trade m1326924 698,Balance of Payments m1326965 441,Black Market m1439229 BLA-3388
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth
origu: Policy Research Department
no_of_pages: 36
model_extractions: **Policy Research**

**IM;acroeconomic Adjustment l ~~and Growth WPS** 881

- This paper a product of the Macroeconomic Adjustment and Growth Divisiun, Country Economics - Department is part of the department's project, Macroeconomic Implications of Multiple Exchange Markets in Developing CGuntries. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Raquel Luz, room NI 1-059, extension 34303 (April 1992, 31 pages).

Ghei and Kiguel empirically examine the determinants of the parallel exchange rate for a cross-country sample of developiig countries. The sample includes countries in which the parallel exchange rate is official (dual exchange rate systems) as well as those in which it is unofficial (black market).

In the typical exchange rate arrangements considered, the central bank fixes or pegs one rate (the commercial rate), used primarily for current account transactions, and allows the parallel exchange rate, used for capital account transactions, to be market-determined.

They cannot reject the hypothesis that there are no differences in the determinants of the spread when the parallel rate is official and unofficial. This is not entirely surprising, as in most cases where the parallel rate is unofficial, it is largely tolerated by the authorities.

In addition, although they cannot reject the hypothesis that restrictions on the capital account difect the spread, they find that restrictions on the current account have no affect on it. These results are consistent with their prior finding that portfolio considerations dominate the determination of the parallel rate in the short run.

They base their empirical analysis on a portfolio macroeconomic model in which the parallel exchange rate is determined by expectations and equilibrium asset considerations in the short run - but depends on the evolution of key policy variables (such as the stock of money, budget deficits, and trade policy) in the long run.

They find evidence that the adoption of dual exchange rate systems at best only partly insulates domestic priciq. This insulation may be limited by three factors:

* There may be a leakage of transactions from the official to the parallel market.

The results indicate that macroeconomic variables explain more than 70 percent (on average) of the variation in the spread between the official and parallel exchange rates. The results are stronger for countries where the spread is large (above 35 percent), somewhat weaker in countries with moderate spreads (between 10 and 35 percent), and poor when the spread is below 10 percent.

* Depreciation of the parallel exchange rate can enter inflationary expectations.

* The spread might be an important factor when the central bank determines the rate of devaluation of the official exchange rate. Ghei and Kiguel find empirical evidence supporting this factor.

The Policy Research Working Paper Series disseminate the findings of work under way in the Bank. 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 Policy Research Dissemination Center
# Dual and Multiple Exchange Rate Systems in Developing Countries: Some Empirical Evidence*

by Nita Ghei** and Miguel A. Kiguel***

# Table of Contents

|I.|Introduction|1|
|---|---|---|
|II.|A Model for a Dual Exchange Rate System|3|
|III.|The Empirical Estimation|6|
||a. Evidence from Individual Countries<br>b. Additional Cross Country Evidence|7<br>18|
|IV.|Insulation Properties on the Official Exchange Rate and Domestic Prices|20|
||a. The Impact of the Spread in Setting the Rate of Devaluation<br>b. Insulation on Domestic Prices|21<br>24|
|V.|Summary and Conclusions|_5|
|Ref|erences|28|
|App|endix Table 1: Parallel Market Premium|30|
|App|endix Table 2: Sample for Quarterly Estimation|31|

* This paper is part of the CECMG project on "Macroeconomic Implications of Multiple Exchange Markets in Developing Countries."

- * The World Bank and University of Maryland, College Park

- ** * The World Bank
# 1. Introduction

Most developing countries impo&e restrictions on foreign exchange transactions, especially on the capital account. The imposition of this type of restrictions generally leads to the emergence of a parallel foreign exchange market. Dual exchange rate systems are one way of introducing these restrictions. In that system there are two officially accepted exchange rates: a commercial exchange rate for current account transactions, and financial exchange rate for capital account transactions. In the typical arrangement tke commercial exchange rate is either pegged or managed, while the financial exchange rate is market determined. In other cases, an illegal (or blac'x) parallel market develops in response to the imposition of restrictions to operate in the official foreign exchange market for certain trade and capital transactions. Official dual exchange rates are typically adopted in response to a particular macroeconomic shock (this was tho case for both Mexico and Venezuela at the outbreak of the debt crisis). Illegal foreign exchange markets, on the ot.qr hand, emerge as a response to market imbalances caused by legal restrictions on trade and capital flows. These markets vary in size, depending on how extensive restrictions are and the extent to which the official exchange rate is inconsistent with overall macroeconomic couditions.

The principal motivation for resorting to a dual exchange rate system is to protect international reserves in a balance of payments crisis without resorting to maxi-devaluations, which can be inflationary. By adopting this system, the central bank can fix the official exchange rate and yet avoid any loss in reserves from speculation against the domestic currency which is instead channelled to the parallel foreign exchange market. At the same time, **domestic** prices are partly insulated (at least in theory), as the authorities can defend the fixed exchange rate vhich is used for trade, while they maintain greater control of the money supply.
The main purpose of thie paper is to examine empirically the determinants of the spre&d between the two exchange rates. In addition, it vill examine the ability of the syatem to insulate domestic prices from movements in the parallel exchange rate. The paper will look at a large sample of developing countries.1 In selecting the sample of countries we made two important decisionst first, we study together countries vith official and unofficial parallel foreign exchange markets, because our premise was that the behavior of the parallel rate is similar in both casess second, we divided the sample in countries with high premiums on the one hand, and low and moderate premiums on the other, because the relationship between the parallel rate and the fundamental factors affecting it are expected to be clearer in the former group.

In this paper we take the view that, especially in the short run, the parallel exchange rate (and hence the spread between both exchange rates) is primarily determined by the evolution of macroeconomic variables, expectations and portfolio considerations. We will argue that this view is useful for countries in which the parallel exchange rate is official and for those in which is illegal.

The paper will be organized as follows. Section II sets out a basic portfolio model for a dual exchange rate system, which is based in Riguel and Lizondo(1990) and belongs to the same strand of thought as Dornbusch et al. (1983) and Lizondo (1987) among others. Section III presents the econometric results for the determinants of the parallel premium for a panel of twenty high and moderate premium (developing) countries, a4 vell as individual estimations for twenty-one countries. Section IV investig - the insulation properties of the dual exchange rate system of domestic prices. In section V we present the main I In dual exchange rate systems the parallel market is official. 1n most cases, however, the parallel foreign exchange market is illegal (black), though usually tolerated.

2
conclusions of this paper study and relate them to other works.2

# II. A Modgl fo a Dual Exchange Rate System

There has been considerable interest in the functioning of dual exchange rate markets and the effect of their presence on various macroeconomic variables. Two excellent surveys on the existing literature have recently been written by Lizondo (1990) and Agenor (1990a). Analytical models for parallel markets can be classified into the following four categories (Agenor,1990a): smuggl'ng and real tradelmodels, the monetary approach, portfolio and currency substitution models and, most recent, models of dutl markets with leakages.

In this section ye present a portfolio model based on Flood (1978), Lizondo (1987) and Kiguel and Lizoneo (1990), which serves as the basis fo- the cc. nometric estimations presented in the next section. The model assum'e. a small open economy with one traded good and one non-traded good. All commercial transactions take place at the official rate Eo, which crawls at a rate w. All financial transaktions take place at the parallel rate 16, which is determined by the market. Private sector nominal wealth, W, is t

## _PM+ER,F_

where M is nominal money stock and F is the stock of foreign assets held by private agents. Private sector consumption of traded and non-traded Soods respectively is

**_c,-aa_** _(m+fq_

2 In particular we will compare them to the studies for Argentina (Kamin(1991)], Mexico (Raminsky(1991)], Sudan [Elbadawi(1991)) and Tanzania (Kaufman and O'Connell(1990)J. aswell _as_ the comparison of the European HER arrangements with some of the Latin American HERs (Marion(1991)l prepared for the project on the "Macroeconomic Implications of Multiple Exchange Ratc Systems," at the World Bank.

3
where a is the proportion of private sector expenditure devoted to traded goods, m - MHEo and q is E1/EO, the parallel premium.

_c,- (1-&) a(m+qF) e_ (3) where e- EO/P is the real exchange rate.

Government consumption of traded and non-traded goods is given by 8s and gm respretively. Total government expenditure is g-g!*glJ (4) Equilibrium in the non-traded goods market requires _( (1-a) a (m+qF) +gd ewy%_ (5) vhere yp is the value of output in the sector. Change in international reserves is equal to the current account balance _A-yr-aa (m.qF -gr_ (6) where yT is the value of traded goods. It is assumed that domestic credit creation is used to finance the public sector deficit and therefore change in domestic credit,D, is _D-RO(9gt)_ (7) where t is revenue of the goverment. Combining equations 6 and 7, the change in real money stock is given by <!-- Start of picture text --> lhuyT-sa (maqF) M+gr- t-zia (8)<br><!-- End of picture text --> The composition of the private sector portfolio depends on the expected rate of depreciation of the parallel rate. Assuming perfect foresight, 4
_") qF= I_ t _( ) +il] qF,_

**(9)**

M-A ( which describes the evolution of the parallel premium. Setting **zhadrO,** we obtain the following steady state conditions, _aa (m+qF)_ **_-yTgN-_** _t-xrm_ (10) and ( _QF)_ s ~~~~~~~~~~~(11) and the steady state values of the money<sup>stock and parallel</sup> premium are _s=_ I _( ) [y+qjr t]_ (12) &a (I (it) +I1] J ~:(s) and _F aa El (x) +1J_ **_.A(w)_** _-13_ These stationary equilibrium solutions, in particular the one for the parallel premium is the basis for the estimation<sup>of the co-integration</sup> and error correction equations for the parallel premium in Section 3. These solutions suggest the following general relationship: _q'f(F,W,D)_ where 5
f1<O, _4-?. f3>0_ A larger stock of foreign assets will reduce the parallel exchange rate. Higher deficits will result in an increase in the level of the parallel premium. In addition, in the short run, the premium will be affected by expectations of a devaluation on the official exchange rate, or the an appvoa?hing balance of payments crisis.

# III. The Em&irical Estimation

The model presented in the preceding section indicatee that the size of the parallel premium depends on the consistency between monetary policy and exchange rate policy, expectations of devaluation of the official exchange rate, the size of the budget deficit, and the nature and scope of controls in the current and capital accounts of the balance of payments.

For estimation purposes we focused primarily on certain macro variables. In particular, we examine the relationship between the parallel premium, the money stock, the stock of international reserves, and expectations of devaluation of the official exchange rate. From the preceding discussion, the following hypotheses were formed. There should be a positive relationship between the parallel exchange rate and the money stoc-, as postulated by simple monetarist models (e.g. Blejer (1978). The relevant definition of money for this purpose is mainly an empirical question, and we find that **42** is useful in most caess. Large changes ir the money supply which are not accommodated by proportional changes in the official exchange rate signal inconsistent macro policies, thus leading to an increase in the premium. Second, falling stocks of international reserves in countries with limited access to external financing could signal the approach of a balance of payments crisis which would cause the parallel rate to depreciate and the premium to increase. Third, expectations of devaluation of the official exchange rate in the immediate future should lead to a depreciation 6
of the parallel rate and an increase in the prsmiua. T some cases, devaluations can be predicted by looking at the evolution of the real official exchange rateg a strong real appreciation could indicate that a devaluation is in the making. The deviation of the real exchange rate from its equilibrium value would then influence the level of the parallel premium.

# a. Evidence From Individual Countries

In this section we will, run similar regressions explaining the premium for each of the couptries in our sample. Given that the macroeconomic variables that we use are liLely to evolve along similar paths, we first test for cointegration. The parallel premium could be said to be cointegrated with these variables in the sense of Engle and Granger (1987). For the following expression, where q, is the parallel premium and F is the vector of fundamentals, _lnq,-P'F_ (14) if both qt, and F are first difference stationary, then equation (14) is integrated of order zero, and hence the left hand side describes a co-integration relationship, where B is the cointegrating vector. The equilibri-a error is integrated of order zero and hence we can talk. about a stable equilibrium relationship between the premium and the fundamentals. The residual from the cointegrating equation is the estimated 'error'. The error-correction equation, then, provides a specification for the short run dynamics of the behavior of the parallel premium and has the following representation:

**_Aqt.4_** _-B(RESD) t+Ue_ (15)

where RESD is the residual from the cointegration equation and ut is a 7
disturbance term. From the statistics obtained from the Dickey-Fuller cestsl, all the series seem to be first difference 6tationary for the sample of twentyone countries (see appendix ta'ole 2 for the list of countries in the sample). Therefore, the procedure followed for estimating the cointegrating relationship would seem to be reasonable.

The following specification war eatimated for the couutries included in our sample. Tu- fundamentals chosen were the broad money, stock of nor.-gold international reserves, deviation of the real exchange rate form the equilibrium and lagged level of the premium.

where mn is broad money divided by the official exchange rate, R, is the stock of non gold international reserves denominated in US dollars, Ae, is deviation of the real exchange rate form its equilibrium value and _ct_ is an iid error term. The expected signs of the coefficients are: PO>° P2<° , 2">0,=?

The procedure used for estimating disequilibrium of the real exchange rate was the following. The real exchange rate, et was defined as: ,here Et is the nominal official exchange rate, p'% is world price and is proxied by the US producer price index and p, is domestic price, using the domestic consumer price index. The equilibrium real exchange rate depends on a number of fur' mentals, such as fiscal and monetary policy, the terms of trade, availability and size of foreign financing and aid, etc. Unfortunately, these 'Results of the Dickey-Fuller tests are available on request.

8
variables are not available for majority of the countries in our sample with the frequency uaed for the estimation. Instead, the equltibrium raal exchange rate was calculated as a twelve period (quarter) moving average. This assumes that the actual real exchange rate observed during a span of three years roughly correspends to the equilibrium one. The difference between the calculated and the actual real exchange rate was used to proxy for the extent of disequilibrium of the real exchange rate at any point in time.

A 1n&-1n6,-1ne, We used a sample of twenty-one developing countries for which quarterly data are available. In turn, we divided the sample between countries having high premia (i.e. in e*zess of 35 percent) on sverage, and moderate premia (i.e. below 33 percent on average. There were thirteen countries in the high premium group, and seven experienced premia averaging between 10 and 35 percent. The rationale for this division is that we et,ect the relationship between the premium and macroeconomic variables would be clearer in high premium countries than in the countries with moderate premia. In addition, high premium countries were also subject to larger macroeconomic imbalances. For most countries estimation was for the sample period was 1970 to 1990 using quarterly data. All data are from the IFS tapes except the parallel exchange rate which are obtained from various issues of the World Currency Yearbook, Pick's Currency Yearbook and Currency Alert. Periods when the exchange rate was unified were excluded.' Dumaies were used for Bolivia, DUMMY1 for the period of the hyperinflation, DUMMY2 for the period following. In some cases, lagged values of the variables were used with or instead of the curren; values Lagged money was used in the case of Tanzania, 4 For Argentina, this means excluding the period from the last quarter of 1976 to the end of 1980. The period from the last quarter of 1977 to the second quarter of 1981 Was excluded from the regression for Chile (1970-1990). For Colombia, this meant excluding the period from the third quarter of 1977 to the second quarter of 1981 and for Ecuador it extended from the thirc! quarter of 1973 to the end of 1974. In the case of Venezuela, estimation was only for the period 1983 to 1989. For Mexico, the period was 1976 to 1987. Dual exchange arrangements were in place in these countries for only the stated periods.

9
Zambia, Kenya and Pakistan in the cointegration equation. The lagged value real exchange rate variable was used for Ethiopia, Argentina, Bolia and Brazil. We found lagged change in money to be appropriate for the error-correction equation for Pakistan. For most cases we<sup>included</sup> a lagged dependent variable for the cointegration equation (with Ghana, Tanzania, Zambia, Argentina, Bolivia, the Dominican Republic and Peru being the exceptions). This lagged variable was also included in some of the cases for<sup>the error-correction</sup> equation (including Ethiopia, Venezuela, Turkey and<sup>Colombia, among others). The precise</sup> specification of the estimated equations differs slightly for each country, but the fundamentals are the same. The results of the<sup>estimations for the</sup> cointegration and error-correction equations are reported in tables 1 and 2 respectively.

10
Table 1. DETRMIANTS OF Te LEVEL OF TEE PARALLEL PREMUM Dependent variable LPREE,1

|ocountry|Constant|Ll<br>20|UT20t 1|LUESVDt|LuESvD0t1|lEtt|BEUt1|PEE,|_R_|Dw|DP|ADi4|
|---|---|---|---|---|---|---|---|---|---|---|---|---|
|Higb Premium Co|untriesC||||||||||||
|Egpt|-0.93<br>(-2.43)|0.14<br>(1.67)||-0.08<br>**(-0."6)**||2.12<br>(4.01)||.J8<br>(12.84)|0.86|1.48|-6.27|2.00|
|Ethiopia|-3.02<br>(-2.3S)|0.31<br>(2.38)||0.15<br>(1.45)|||-0.51<br>(-1.19)|0.60<br>(9.26)|0.79|1.88|-8.31|A|
|Gbans|-13.29<br>(-7.74)|1.40<br>(7.92)||0.72<br>(3.21)||0.10<br>(6.92)|||0.77|1.53|-6.41|-3.16|
|**Nigeria**|-1.89<br>(-2.33)|0.32<br>(3.40)||.0.16<br>(-2.66)||0.56<br>(3.56)||0.58<br>(7.21)|0.81|2.14|-8.92|_-3.11_|
|Tanzania|0.47<br>(0.43)||0.14<br>(1.14)|-0.27<br>(-3.40)||0.43<br>(2.18)|||0.39|0.66|-3.60|-2.86|
|Zmble|1.35<br>(0.97)||-0.20<br>(-1.20)|0.003<br>(0.03)||0.24<br>(2.32)||0.91<br>(13.07)|0.77|1.96|-8.07|.3.46|
|Argentina|-6.06<br>(-1.98)|1.26<br>(3.24)||-0.90<br>(-4.97)|||0.19<br>(0.27)||0.31|1.92|-6.91|-3.02|
|Bolivia,|-1.53<br>(-1.34)|1.04<br>(3.17)||-1.44<br>(-5.87)|||2.55<br>(2.00)||0.69|1.28|-4.89|-2.68|
|**Brazil**|-2.67<br>(-0.72)|0.29<br>(0.41)|||-0.004<br>(-0.01)||290.11<br>(0.94)|0.54<br>(4.70)|0.29|1.90|-6.97|-1.90|
|**Chile**|-6.89<br>(-2.45)|2.21<br>(3.09)||-1.63<br>(-3.36)||0.003<br>(0.24)||0.37<br>(2.28)|0.72|1.49|-3.53|-1.27|
|Dominican<br>Republlc|-6.49<br>(.5.13)|1.43<br>(5.73)||-0.98<br>(-5.64)||0.71<br>(2.69)|||0.49|0.70|-3.47|-1.96|
|**Peru**|-14.6t<br>(-3.09)|2.45<br>(3.38)||-0.94<br>(-2.78)||0.11<br>(0.54)|||0.48|0.73|-2.91|-1.81|
|**Venezuela**|.11.23<br>(-3.39)|1.39<br>(2.72)||-0.28<br>(-0.8)||0.08<br>(1.44)||0.32<br>(3.31)|0.73|0.76|-1.69|-1.54|
|**Soderato**<br>**Prerum**|<br>**Countries**||||||||||||
|**Colobia**|-4.31<br>(-1.85)|1.01<br>(2.12)||0.74<br>(-2.51)||0.03<br>(1.21)||0.37<br>(5.16)|0.61|2.32|-9.06|-2.68|
|Ecudor|-3.46<br>(.3.31)|0.74<br>(3.12)||-0.38<br>(-2.42)||0.02<br>(2.11)||0.79<br>(13.23)|0.91|1.64|-6.15|-4.68|
|**India**|-1.71<br>(-0.77)|0.07<br>(0.19)||-0.06<br>(-0.18)||.0.04<br>(-0.15)||0.17<br>(1.44)|-0.02|2.06|-8.65|-3.77|
|**ea**|1.03<br>(0.98)||0.05<br>(0.41)|-0.37<br>(-1.84)||0.10<br>(1.14)||0.60<br>(5.77)|0.54|1.86|-7.46|-2.60|
|**Henlco**|-7.39<br>(-1.64)|0.52<br>(1.48)||0.1i<br>(1.02)||-0.001<br>(-0.32)||0.83<br>(9.46)|0.72|2.55|-8.99|-3.12|
|**Pakistan**|1.64<br>(1.16)||-0.30<br>(-1.53)||0.04<br>(0.20)|0.18<br>(2.70)||0.55<br>(5.69)|0.47|1.99|-8.07|-3.44|
|Turkey|-9.45<br>(-0.60)|3.99<br>(2.51)||-4.34<br>(-2.61)||-0.003<br>(-0.12)|||0.12|2.33|-3.62|-1.52|
|Uruguay|-0.07<br>(-0.08)|0.16<br>(0.74)||-0.37<br>(-2.19)||0.03<br>(2.72)||0.55<br>(5.98)|0.70|1.98|-5.20|-1.99|

11
Tabl 2. M0 C03CIO 10 TM FARM= PRM Dependent variable DMtE1

|Country|Res"Ral.|p|W201|SDN+l||O+1 Egt|i|DW|
|---|---|---|---|---|---|---|---|---|
|BflbPremim Cou|ntries||||||||
|4gpt|0.-0<br>(1.54)|0.97<br>(2.02)||-0.07<br>(-0.78)|3.27<br>(5.09)|0.24<br>(1.50)|0.59|2.02|
|Etiopia|1.16<br>(3.21)||-0.84<br>(-P.")|0.05<br>(0.29)|-1.32<br>(-2.50)|0.69<br>(2.62)|0.19|1.92|
|_Ghana_|0.64<br>(6.54)|-0.4"<br>(-1.27)||0.09<br>(0.24)|0.15<br>_(16.33)_||0.66|1.65|
|Niger"|0.87<br>(4.4)|0.75<br>(1.81)||-0.09<br>(-0.57)|O."<br>(2.14)|0.31<br>(1.95)|0.43|1.96|
|Tanznia|0.34<br>(3.81)|0.26<br>(0.56)||0.06<br>(0.64)|0.03<br>(1.45)||0.30|2.09|
|Zambla|1.21<br>(2.93)|0.71<br>(1.43)||.0.07<br>(-0.59)|0.12<br>(0.67)|1.10<br>(2.64)|0.13|1.97|
|Argentina|0.96<br>(4.60)|1.11<br>(2.37)||-0.96<br>(-2.55)|_6.51_<br>(0.91)||0.49|1.99|
|3011,1|0.42<br>(3.31)|1.38<br>(2.19)||-0.32<br>(-1.14)|-0.42<br>(-0.26)||0.33|2.34|
|Urauil|0."9<br>(2.76)|2.42<br>(2.55)||-1.10<br>(-1.67)|||0.19|2.04|
|Chile|0.50<br>(2.38)|1.16<br>(0.69)||-2.78<br>(-5.03)|0.05<br>(2.51)||0.59|2.02|
|Donican<br>lep,btlc|0.25<br>(3.27)|||-0.17<br>(.1.67)|1.09<br>(5.96)||0.36|2.09|
|poru|0.24<br>(2.53)|1.77<br>(2.73)||.0.60<br>(-1.02)|||0.16|1.63|
|Venezuela|0.32<br>(1.41)|1.93<br>(2.56)||-O.48<br>(-0.84)|0.03<br>(0.40)|0.27<br>(2.66)|0.77|1.90|
|Moderate Psdur|CoustriUs||||||||
|Columbia|0.56<br>(4.16)|0.20<br>(0.10)||-0.74<br>(-1.00)|0.07<br>(1.64)||0.26|2.32|
|Ecuador|0.96<br>(4.04)||||0.03<br>(4.66)|1.02<br>(4.65)|0.33|1.69|
|India|0.63<br>(6.76)|3.65<br>(1.24)||-1.64<br>(-1.50)|-0.21<br>(-0.62)||0.43|1.98|
|MenYa|0.89<br>(3.19)|-1.63<br>(-1.54)||-0.35<br>(-1.13)|0.17<br>(1.60)|0.53<br>(2.15)|0.17|2.06|
|mbmio|0.50<br>(3.36)|0.54<br>(0.")||.0.80<br>(-2.02)|-0.001<br>(.0.29)||0.23|1.92|
|Pokaitan|0.32<br>(4.39)||2.11<br>(2.92)||0.26<br>(4.06)||0.34|1.74|
|Turkey|0.09<br>(1.21)|2.24<br>(2.3)||.0.62<br>(-1.A8)|0.006<br>(1.43)|-0.58<br>(.4.26)|0.44|2.26|
|Uuguay|0.78<br>(3.29)|0.005<br>(0.004)||0.80<br>(-2.29)|0.02<br>(1.15)|.0.30<br>(-1.65)|0.34|2.2'|
Notes for Tables 1 and 2: Source: IFS, World Currency Yearbook, and Currency Analysis (various issues) Data are quarterly end of period.

Figures in parentheses are t-statistice Variables: LPRE: ln(premium) LM20: ln(Money/Officlal Exchange Rate) LRESVD: ln(non-gold international reserves) RER: Deviation of real exchange rates from equilibrium DPREt change in ln(premium) DM20: change in ln(Money/Official Exchange Rate) DRESVD: change in ln(non-gold international reserves) DRER: change in RER Statistics: DF: Dickey-Fuller ADF: Augmented Dickey-Fuller DW: Durbin-Watson l: The cointegration equation for Bolivia included the following dumnies: DUMMYl: 3.41(10.30) for the period of the hyperinflation. DMIMY2: -1.97(-3.87) for the periof following the hyperinflation.
As may be expected, the results are clearer and stronger<sup>for the high premium</sup> countries. Money stock has the expected sign for<sup>all high premium countries and</sup> is significant for most. The coefficients obtained for the level of international reserves are negative for nine of the thirteen of the<sup>high premium</sup> countries and is statistically significant at the 5 percent level for most. The level of international reserves is not statistically significant<sup>for the cases</sup> where the coefficient has a positive value, with Ghana being the sole exception. The coefficient obtained for the term representing<sup>deviations from equilibrium</sup> of the real exchange rates has the expected<sup>sign for all the high premium</sup> countries andis statistically significant for the majority.<sup>The R' and the</sup> Durbin-Watson statistic are quite good, though the presence<sup>of the lagged</sup> dependent variable term does bias the Durbin-Watson towards<sup>a value of 2. The</sup> Dickey-Fuller as well as the Augmented Dickey-Fuller tests<sup>strongly support the</sup> hypothesis of cointegration, with the exception of Venezuela.<sup>However, the</sup> period under consideration for Venezuela is extremely short<sup>(six years) and the</sup> weakness of the Dickey-Fuller test statistic is to be<sup>expected.</sup> The results are not quite so strong for the moderate<sup>premium countries.</sup> Excluding Pakistan, the coefficient for the money stock has the<sup>expected sign for</sup> all the moderate premium countries in the _sarple._ The money<sup>stock is positive</sup> though not significant for India, Kenya, Mexico and Uruguay;<sup>it is negative but</sup> not statistically significant for Pakistan. The coefficient<sup>for international</sup> reserves has the expected sign for six of the moderate<sup>premium countries,</sup> Pakistan and Mexico being the exceptions. However,<sup>the coefficient for</sup> international reserves is not significant for either country; neither<sup>is it</sup> statistically significant for India or Kenya, even though<sup>it has the expected</sup> sign. The results for the real exchange rate term<sup>are more mixed, but the</sup> coefficient has the expected sign for every case it is statistically significant. Cointegration is supported for most of the countries, but<sup>the result of the</sup> augmented Dickey-Fuller test is ambiguous for Kenya, Turkey<sup>and Uruguay.</sup> The error-correction equation is a flexible specification<sup>of the short run</sup> dynamics. The residual from the cointegration equation measures<sup>the 'error',</sup>
that is, the extent of disequilibrium in the market. Regressing the change in the parallel premium on last period'o residual yields an estimate of the correction in the 'error'. In this case, the residual term captures the shortrun impact of the portfolio factors that were used as the fundamentals in the cointegration equation. In most cases we expanded the error-correction specification to include the first difference of the fundamentals, the money stock, level of international reserves and the real exchange rate variable as well as a lagged value of the dependent variable.

The results of the error correction equations are, in general, quite good, even for the moderate premium countries. They indicate that the short run behavior of the premium is primarily influenced by portfolio considerations and changes in variables such as the money stock and the level of international reserves are important. The residual 'error-correction' term is positive for all countries and statistically significant, with the exception of Egypt and Venezuela in the sample of high premium countries and Turkey in the sample of moderate premium countries . While the weakness of the results for the case of Venezuela are to be expected, given the brevity ef the period with dual exchange rates, the results for Egypt and Turkey are puzzling. It is possible that the results would improve with the inclusion of other, country specific variables. In most cases the coefficient of the error-correction term is less than 1, providing support for the hypothesis of stable dynamics. The exceptions are Ethiopia and Zambia, both countries subject to extensive controls. Zambia was subject to various terms of trade shocks thr ugh the period under consideration and underwent several regime changes. Elbadawi and Aron(1991) include a terms of trade variable as well as regime change dummies in their estimation and do not find any evidence of unstable dynamics. Since this paper is concerned more with providing results across a broad spectrum of countries, rather than detailed results for an individual country, we prefer not to expand our specification for countryspecific features.

In several cases the evolution in the money stock is relevant and statistically significant in the determination of the short run behavior of the parallel premium. This includes high permium countries, such as Egypt, Argentina,
Bolivia, Brazil, Peru and Venezuela, as well as moderate premiL- countries, such as Pakistan and Turkey. The change in international reserves is statistically significant in the cases of Argentina, Chile, Mexico and Uruguay. The change in the disequilibrium of the rea1 exchange rate has a postive and significent coefficient for Egypt, Ghana, Nigeria, Chile, Dominican Republic, Ecuador and Pakistan. The results obtained tend to support the view that the parallel premium exhibits very similar behavior acrcas the sample, regardless of countryspecific features in the dual exchange rate arrangements. Further, portfolio factors dominate the behavior of the parallel premium in the short run in both high and moderate premium countries.

Our results are broadly in agreement with tnose obtained in more detailed individual country studies on the determinants of the parallel exchange rate. Most of these studies include a variable measuring the deviation from parity of the domestic interest rate from the world interest rate. Theory suggests that interest rate differentials are an important factor in determining exchange rates and should be relevant in determining the parallel premium. However, the countries in our sample differ substantially in availability of data on domestic interest rates and the reliability of such data. Many of them h-ave repressed financial systems and it would be extremely difficult to obtain any reasonable estimate of interest rates that would be consistent across the sample and over the time period under consideration. In some of the country studies, the specification is expanded to include variables such as terms of trade and tax rates on exports and imports as well as dummies for regime shifts. These refinements improve the results obtained in these studies. However, the essential results obtained do not contradict the results obtained here.

Kamin(1991) finds evidence of cointegration between the parallel premium and the macroeconomic fundamentals for Argentina (the fundamentals used are the commercial exchange rate, domestic prices, real GDP, dollar export price, dollar import price as well as tariff rates). Money and the domestic interest rate are included in the estimation for the short run portfolio relationships. Portfolio factors are important in the determination of the parallel premium in the short run in Argentina according to Kamin, which is the result we obtain. He also
finds no evidence to support insulation due to the dual exchange rate system in the case of Argentina, which is in line with what we find (see Section 4, tables 4 and 5). Kaufman and O'Connell estimate a single equation incorporating both long run trade variables as well as short run portfolio factors for Tanzania. They find that the empirical evidence supports the relevance of both<sup>trade and</sup> portfolio factors in determining the behavior of the parallel premium. Portfolio factors, in particular, seem to important in the short run. Hausmann adapts the basic Kiguel-Lizondo framework to incorporate the instability inherent in Venezuela during the period from 1983 to 1988 when a multiple exchange rate system was adopted. Ansu includes in the cocoa smuggling that is important for the parallel market in Ghana. Phylaktis(1992) uses a variant of the Dornbusch model and a cointegration-error correction approach to examine the parallel market in Chile, allowing specifically for foreign exchange restrictions on international trade and capital transactions. The results obtained in most of these studies tend to support the relevance of portfolio factors in determining the short run behavior of the parallel premium. Trade factors, such as tariffs and quotas as well as macroeconomic variables, including the real exchange rate and the money stock help determine the long run behavior of the premium.

our work can also shed some light on the puzzling results presented in Marion(1991). She finds that for Belgium, France and Italy, the premium does not respond to changes in domestic fiscal policy, while it is negatively correlated to the money stock. According to her paper, the premium is best explained by the dollar/domestic currency interest rate differential. Her explanation is that the parallel exchange rate in the European economies responds to different factors than in Latin America.

In our view, the main reason for the dissimilar results is the size of the premium. The Earopean countries in fact had very low premia (it rarely exceeded 10 percent), certainly much smaller than most countries in Latin America, or Africa (with premiums exceeding 100 percent). As we discussed in the previous section, the relationship between the premium and the fundamentals is much weaker (in the sense that it is more difficult to capture it ecorometrically) in the former group. Thus, the inability to explain the premium in the European
countries is probably more related<sup>to econometric difficulties than to the</sup> inappropriateness of the analytical framework.

# b. Additional Cross Country Evidence

We also estimated a single equation<sup>for the level of the parallel premium using</sup> annual data from a panel of twenty<sup>high premium countries. The objective of this</sup> exercise was to evaluate the robustness<sup>of the results obtained for the</sup> individual countries, and to investigate<sup>whether there are any behavioral</sup> difference in countries (or periods)<sup>where parallel markets are official and</sup> those where they are not. In addition, we looked in a crude way at the relative importance of restrictions in the<sup>capital and current account cn the pre,...,</sup> We use a random effects procedure<sup>as set out in Hausman and Taylor(1981) to</sup> account for unobservable, country-specific<sup>effects. Since this requires a</sup> balanced panel, a dummy was introduced<sup>for the period when exchange rates were</sup> unified in the countries in the sample.<sup>The fundamentals used were the real</sup> money stock and the fiscal surplus<sup>to GDP ratio. We included four dummy</sup> variables to account for countries or<sup>periods in which: (i) the foreign exchange</sup> market was unified, (ii) the parallel<sup>market was official, (iii, there were</sup> restrictions in the current account, (iv) there<sup>were restrictions in the capital</sup>
Table 3s Panel Estimation for the Level of the Parallel Premium

# Dependent Variables LPRE,

|Regressor|Version 1|Version 2|Version 3|
|---|---|---|---|
|Constant|0.62<br>(5.87)|0.66<br>(6.07)|-0.50<br>(-1.78)|
|LRMOt-0|0.24<br>(2.61)|0.22<br>(2.47)|0.22<br>(2.61)|
|FSURt|-0.36<br>(-2.28)|-0.35<br>(-2.19)|-0.47<br>(-3.07)|
|DUMHYU|-3.24|-3.17|-3.19|
||(-7.77)|(-7.72)|(-6.86)|
|DUMMYO<br>||--|-0.50<br>(-1.53)|0.17<br>(0.48)|
|RESCUR|--|--|-0.06<br>(-0.15)|
|RESCAP||--|1.26<br>(2.89)|
||0.26|0.27|0.37|
|DW|1.40|1.43|1.52|

Notes: LRMO: _M2/E(1+6GNP)(1+6P*),_ PSUR: Fiscal Surplus/GNP DUMMYU: Dummy for periods of unified exchange rates, DUMMYO: Duymm<sup>for official</sup> dual exchange rate system.

RESCUR: Restrictions on payments on the current account,1RESCAPt Restrictions on payments on the capital account.

Annual data 1976-1988. List of countries in the panel is in Appendix Table 1. Source: IFS, World Currency Yearbook, Exchange Arrangements and Exchange Restrictions (various issues), RAL-2.
account.

The coefficients all have the expected sign. Higher money stock has a positive effect on the level of the parallel premium. A smaller budget surplus (or a higher budget deficit) will result in a higher parallel premium. A unifiedexchange rate is expected to drive the parallel premium down (to zero) and hence the coefficient for DUMMYU is negative. When the dual exchange rate system is official, the element of risk involved in trading on the parallel market no longer exists and the premium should be smaller. We find that the coefficient for DUMHYO is negative but statistically insignificant. We also estimated the same equation with dummies for restrictions on payments on the current account and the capital account t RESCUR and RESCAP respectively5 ). The dummy for restrictions on payments on the capital account is statistically significant, while the dummy for restrictions on payments on the current account is not. The coefficient obtained for RESCAP is somewhat large, but this could be due to the nature of the (0,1) dummy being used. The sign of the coefficient for DUMMYO changes but is still statistically insignificant.

We can conclude from these results that it makes little difference to the level of the parallel premium whether the dual exchange rate system is official or not. The evolution of monetary aggregates and the fiscal surplus are found to be important in determining the parallel exchange rate. This corroborates the findings of the previous section. In addition, the results broadly support the view that restrictions on the capital account have a significant effect in increasing the premium while restrictions on the current account do not appear to matter. While this is consistent with more casual empirical evidence (i.e. in countries with no capital controls there is no premium), the results should be taken with some caution because the variable that we constructed does not measure the intensity of cortrols.

# IV. Insulation Properties on the Official Exchange Rate and Domestic Prices

5 The dummies were constructed using information from "Exchange Arrangements and Exchange Restrictions (IMF, various issues)
One of the reasons that lead countries to adopt dual and multiple exchange rate systems is to insulate domestic prices from short term changes in the parallel exchange rate. This is achieved by fixing the official exchange rate and keeping it as a nominal anchor for prices. The ability to insu_.ate domestic prices depends on the following two considerationss first, that the authorities in effect set the official exchange rate independently of the level of the parallel exchange rate, and second, that there are no leakages of transactions between the official and the parallel market. The more actively the authorities intervene to close the spread between the two rates, the closer these two rates will move together and hence the smaller will be the insulation provided by the system. Likewise, to the extent that the parallel exchange rate becomes the marginal cost for imports, and/or the marginal revenue for exports (e.g. because of smuggling), domestic prices will be more closely affected by the parallel exchange rate and insulation will be smaller.

In this section we will examine empirically the insulation properties of dual and multiple exchanger rate systems in the two ways described above. We will first examine the extent to which the authorities take into account the level of the premium in setting the rate of depreciation of the official rate and we will then turn to look at the direct effect of the parallel rate on domestic prices.

# a. The Impact of the Spread in Setting the Rate of Devaluation

One way to examine whether the authorities take into account the effect of the spread in setting the rate of devaluation of the official exchange rate is to estimate an equation of the following form,

## _AE,e=&j_ AERO0<sup>o+s</sup> 2<sup>AFO'</sup><sup>_+&3qt_</sup> _qt:-28)_

where E. is the nominal official exchange rate and q is the parallel premium. The more the rate of devaluation in the current period depends on the size of the premium in the previous periods, the smaller the insulation the system provides. We estimated this equation for a sample of twelve developing countries. In many
cases the second lag was excluded.' The period of estimation was 1970 to 1990 7 for most countries.

The results of the estimation are presented in table 4. In every case the coofficient for the last quarter premium term was statistically significant. The value of the coefficient obtained varied across the sample. It exceeded 1 only in the case of Argentina, and hence it is possible that there was some overshooting in the devaluation in the official rate. In **_six_** cases the size of the coefficient obtained is very small, less than 0.10. For the remaining five cases the coefficient varied between 0.10 and 0.50. It would seem that the level of the parallel premium is a significant factor in determining the timing of the devaluation. The size of the devaluation, however, would depend on the premium as well as other factors.

These results indicate that the authorities did ta&e into account the spread between the two exchange rates in setting the devaluation of the official rate. In this respect the system did not provide the insulation that it was supposed ' Second quarter lagged devaluation of the official rate was included for Argentina, Bolivia, Brazil and Chile. The fourth quarter lag was included as well for Brazil. Second quarter lagged premium was included in the estimation for Egypt, Tanzania and Mexico. Since Mexico had a crawling peg for the period under consideration, a constant term was included in the estimation.

' The period for Argentina and Mexico was first quarter,1982 to fourth quartor,1989. Estimation for Venezuela was fourth quarter, 1982 to fourth quarter, 1989. The period of unified exchange rates was excluded for Chile (fourth quarter, 1977 to second quarter, 1981)
# Table **4t** Devaluation of the Official Exchange Rate

Dependent Variables D0UR

|Country<br>DODZRt|Wtl2<br>w|Nt4|PROk.1<br>2|R|2|IDV|
|---|---|---|---|---|---|---|
|Nigh ?resdim comitias<br>|||||||
|Argentina0.45<br>Argzentin<br>(3.04)<br>olvia<br>0.06<br>(0.96)<br>Brasil<br>0.49<br>(5.04)<br>Chile<br>**0.**<br>(206)|-0.26<br>(-1.73)<br>0.09<br>(1.30)<br>-0.19<br>(-1.97)<br>0.17<br>(167)|0.39<br>(4.45)|1. 06<br>(5.91)<br>0.27<br>(11.42)<br>0.'0<br>(5.92)<br>0.02<br>(553)||0.51<br>0.69<br>0.74<br>0.26|1.66<br>2.17<br>2.01<br>2.34|
|.<br>Demnidcan Rep.<br>.0.03<br>(027)|.||.<br>0.12<br>(460)||0. 1)|1.96|
|..<br>Egpt<br>0.19<br>(1.16)<br>hana<br>0.03<br>(026)|||.<br>0t11<br>(2.17)<br>0.01<br>(391)|-0.09<br>(-1.70)|0.06<br>0.10|2.03<br>1.98|
|.<br>Nigeria.<br>0.40<br>(402)|||.<br>0.02<br>(272)||0.21|1.92|
|.<br>Peru<br>0.32<br>412|||.<br>0.24<br>768||0.45|1.7$|
|(.)<br>Tanzaia<br>_,_<br>0.30<br>(247)|||(.)<br>0.09<br>(604)|-0.07<br>(-393)|0.34|1.96|
|.<br>V<br>1^WAOU<br>I<br>.0.05<br>( i030)|||.<br>(273)|.|0.08|2.02|
|..<br>Zambia<br>I0.003<br>1(0.03)|||.<br>0.02<br>(3.41)||0.03|2.03|
|Moderate PrF<br>Comtriest|||||||
|Colombia<br>0.90<br>(2090)|||0.04<br>(223)||0.75|1.96|
|.<br>94uado2||0.221|.<br>0.12||0.37|2.09|
|OeXIC0<br>2<br>0.15||(2.46)|(4.09)<br>0.42|-0.33|0.26|1.48|
|(0.91)<br>Turkey<br>014<br>(1.40)|||(3.64)<br>0.46<br>(7.674)|(-2.65)|0.26|1.71|

Source US. World Curreny Yearbook. Pick's Currency Yearbook. Pain(1991) for Argentina. Data **r** qurterly, nd of period for 1970-1990. ecept for Argentina, Mexco and Ven eula (*ee text for deteils). The period for unified exchange rates to excluded for Chie.

**4Piures** o parentheses arm t-s*atUtice DQUs Dwalatin In the official exchange rate. PI **IWs** Parallel Nate/Offioiel **Pate** - 1.

Is DOI 2. Equaton for Kexio itnlude, a conatant torm with va 0.10(2.57)
to provide. It probably allowed the authorities to postpone devaluation in some circumstances, and in this way do not accommodate fully changes in the parallel exchange rate. However, on the whole this insulation was at best partial.

# b. Insulation on Domestic Prices

A second way to examine the ability of the dual exchange rate system to insulate domestic prices is to estimate directly the relationship between the parallel exchange rate and domestic prices. In an open economy in which all goods are tradeable domestic prices should roughly follow purchasing power parity (adjusted for tariffs and other restrictions to trade, transport costs, etc.). The relevant exchange rate for the purchasing power calculation is mainly an empirical question which to a large extent depends on the ability of agents to circumvent existing restrictions. Chhibber and Shafik (1990) argue that in the case of Ghana the parallel exchange rate played a key role in determining domestic prices.

The way we proceed in this section is to look directly at the relationship between changes in domestic prices and in the parallel rate. In particular, we estimate the following specification for the same sixteen countries as before: A'Pt=Y1AZV.+Y2ARB,>^. (19) where P is domestic CPI and E, is the nominal parallel exchange rate. The period of estimation is identical to that used for the previous estimation. Since there are problems of multicollinearity, an instrumental variables procedure was used in the estimation. Instruments used included lags of the depreciation in the parallel rate and lagged (in some cases, current) rate of change in money stock. Results from the estimation are reported in Table 5. In every case, we find that the coefficient for depreciation in the parallel rate is statistically
Table St The Inulation Equation

# Dependet Variables XU1.

|Country|DSUB|DDCI-|DW|Q|
|---|---|---|---|---|
|31ghPr<br>uwComtrdss|||||
|Argentina<br>Bolivia|0.71<br>1.74|0.31<br>0.37|2.00<br>2.34|2.50<br>15.49|
|Brarfl|0.i793<br>(704)|0.20<br>(213)|1.78|20.92|
|**Chile**|.<br>0.44<br>(293)|.<br>0.05<br>044)|2.11|6.21|
|Domnien<br>Republic|.<br>0.81<br>249|.<br>0.15<br>112|1.40|31.63|
|ypt|(.)<br>0.67<br>(256)|(.)<br>0.13<br>(126)|1.77|27.90|
|Ghana|.<br>0.47<br>(205)|.<br>0.17<br>(235)|1.57|36.67|
|Nieria<br>Nigeria|.<br>(0.64<br>~~~~~~|.<br>0.16<br>~<br>~~(2.12)<br>(1.69)|1.98|14.40|
|<br>Peru|0.96<br>(680)|<br><br>0.18<br>(Z70)|1.61|62.14|
|Tazania|.<br>0.59<br>(205)|.<br>0.11<br>(150)|1.98|25.99|
|Venezela|.<br>0.83<br>(191)|.<br>-0.18<br>(076)|1.56|9.42|
|ZEmbia<br>~dratePr_.<br>Coomtriaas|.<br>0.31<br>(3.31)|-.<br>0.14<br>(2.88)|1.45|37.96|
|Colambia|0.69<br>(4.66)|0.24<br>(2.73)|1.24|76.49|
|eador|<br>0.80<br>(471)||1.39|45.17|
|mexco|.<br>0.67<br>(336)|0.21<br>(165)|1.37|8.65|
|Tntkey<br>Notes$|.<br>0.73<br>(5.60)|.<br>0.29<br>(4.20)|1.94|39.20|

Soarces It8 World Currecy Yearbook. Pick's Currecy earbook. Kaoin(1991) for Argentia.

Data **are quarterly,** ed of period for 1970-1990, *zeept for Argentin. Mexco and Venesla (oco tex. for details). TSo perid for unifid exanbel rates is excludd for **Chile.**

**tiguree** in **paroetbooe are t-.tatiatica**

lUlL, Alit?! flU Deprcdation In the parallel rate. AIMt" AlL eotletion Usaing intruenntal vartAble. Inat omete **are** lagged DOB _and_ laggd or current rate of cbane of M2 (MI for Argntin).
significant. In most cases the size of the coefficient exceeds 0.70 or is close to it. Somewhat smaller coefficients are obtained for Chile(0.44), Ghana(0.47), Tanzania(0.59) and Zambia (0.31). In the last three countries one should expect that the estimated coefficient will underestimate the true coefficient due to the imposition of extensive price controls. The official CPI was used to estimate inflation in all cases. For these countries, this procedure would understate thelevel of actual inflation. From the results, it is possible to say that the dual exchange rate system arrangements provides very little insulation to domestic prices. The largest coefficient we obtain is for Peru at 0.98, which would indicate that the DER provides no insulation whatsoever.

Given that most coefficients we obtained are less than 1, this could be taken as an indication that the DER system provides some insulation in the short run. This interpretation, however, in some cases will be misleading for two reasons. First, flexible exchange rates typically adjust faster than prices, thus suggesting that even if the effect were large, this might take several quarters to be fully reflected in domestic prices. Second, because over time there are changes in the prices of tradeables to nontradeables, one would expect some changes in the exchange rate not to be accompanied by proportional changes in domestic prices. In summary, the empirical evidence indicates that the DER system provides partial insulation on domestic prices.

# V. Summary and Conclusions

This paper examined and tested some macroeconomic implications of multiple exchange rates arrangements for a large sample of developing countries. We tested the influence of certain macroeconomic fundamentals ( the money supply, the stock of international reserves and the real exchange rate) on the behavior of the parallel premium. We also tested the hypothesis that a DER arrangement provides insulation to domestic prices by enabling the authorities to postpone a maxi-devaluation which could be inflationary. The countries in the sample were classified either as high premium (if mean annual premium exceeded 35 percent) or moderate premium (if mean annual premium was between 10 and 35 percent). We expected the relationship between the parallel premium and the macroeconomic
fundamentals to be empirically stronger for high premium countries relative to moderate premium countries.

Overall, we find remarkably similar results for the factors that determine the behavior of the parallel premium across a wide cross-section of developing countries, with substantial differences in the nature and duration of DER arrangements as well as the size of the parallel market and the level of the parallel premium. For countries with very high premia, the macroeconomic fundamentals are extremely important in determining the parallel premium. However, we find evidence to support the importance of portfolio factors for the short runibehavior of the premium even in moderate premium countries. From the panel estimation, it is clear that whether the DER is official or not is irrelevant to the determination of the parallel premium. Restrictions on the capital account are important in determining the level of the parallel premium, but restrictions on payments on the current account are not. This is consistent with the observation that a parallel market in foreign exchange has not emerged in the CIA zone countries, where restrictions on trade exist but there are no restrictions on capital account transactions.

Dual exchange rate systems,, at best, provide partial insulation to domestic prices. The extent of insulation diminishes as the authorities use the level of the parallel premium to determine the timing of devaluation of the commercial (official) exchange rate. Effectiveness of the dual exchange rate system in terms of insulation of domestic prices decreases as leakages between the two markets become more extensive.
# Referencos:

Agenor, P-R (1990a), "Parallel Currency Markets in Developing Countries: Theory, Evidence and Policy Implications", _Unpublished, International Monetary Fund, Washington DC ._ (1990b), "Monetary Disequilibria and Parallel Market Exchange Rates", _Unpublished, International Monetary Fund, Washlngton DC._ Ansu, Y. (1991), " Macroeconomic Aspects of Multiple Exchange Rate Regimess The Case of Ghana", _Unpublished, The World Bank. Washington DC ._ Bhandari, J.S. and C.A. Vegh (1990), " Dual Exchange Markets Under Incomplete Separations AN Optimizing Model", _Staff Papers (International Monetary Fund), Vol 37 (March 1990), pp. 146-167._ Blejer, M.I. (1978), " Exchange Restrictions and the Monetary Approach to the Exchange Rate", in _"The Economics of Exchange Rates", edited by J.A.Frenkel and H.G.Johnson (Addison-Wesley)_ Chhibber, A. and N.Shaffik (1991), "Devaluation and Inflation with Parallel Markets: An Application to Ghana", _Unpublished, The World Bank, Washington DC._ Culbertson, W. (1975), "Purchasing Power Parity and Black Market Exchange Rates", _Economic Inquiry, Vol 13, pp. 287-96._ Dornbusch, R., D.V.Dantas, C.Pechman, R. Rocha and D.Simeos (1983), " The Black Market for Dollars in Brazil", _Quarterly Journal of EconomiCs, Vol 98, pp 25-40._ Edwards, S. (1989), "Real Exchange Rates, Devaluation and Adjustment: Exchange Rate Policies in Developing Countries", _MIT Press (Cambridge,Mass.)._ Elbadawi,I.A. (1991), "The Black Market for Foreign Exchange and Macroeconomic Management in Sudan", _Unpublished, The World Bank, Washington DC._ Engle, R. and C. Granger (1987), "Co-integration and Error-Corrw ctiont Representation, Estimation and Testing", _Econometrics, Vol 55, pp. 251-276._ Hausman, J.A. and W.E. Taylor (1981), "Panel Data and Unobservable Individual Effects", _Econometrica, Vol.49, pp. 1377-1398._ Hausmann, R. (1991) , Adoption, Management and Abandonment of Multiple Exchange Rate Regimes with Import Controls", _Unpublished, Caracas, Venezuela._ Kamin, S.B. (1991), "Argentina's Experience with Parallel Exchange Markets: 19811990", _Unpublished, Board of Governors of the Federal Reserve, Washington,DC._ (1988), "Devaluation, External Balance and Macroeconomic Performance in Developvig Countries: A Look at the Numbers", _Princeton Studies in International Finance, Number 62 (Princeton, NJ)._ Kaminsky, G. (1991), "Dual Exchange Rates: The Mexican Experience 1982-1987", _Unpublished, University of Callfornia, San Diego (La Jolla, CA) ._ Kaufman, D. and S.A. O'Connell (1990), "The Macroeconomics of the Unofficial Foreign Exchange Market in Tanzania", _Unpublished, The World Bank, Washington DC._ Kiguel, M.A., and J.S. Lizondo (1990), " Adoption and Abandonment of Dual Exchange Rate Systems", _Revista de Analisis Economico, vol. 5, pp. 2-23._ Lizondop S.J. (1990) " Multiple Exchange Rates and Black Market Exchange Ratest A Nontechnical Survey of Theoretical Results", _Unpubllshed, University of Tucuman, Argentlna._ (1987) " Exchange Rate Differential and Balance of Payments Under Dual Excchange Markets", _Journal of Development Economics, Vol. 26, pp. 37-53._
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Appendix Table 1: PARALLEL MARKET PREMIUM (PERIOD AVERAGE)

|COUNTRY|1970-1989|1970-1979|1980-1989|<br>TREND|
|---|---|---|---|---|
|Algeria<br>Egypt<br>Ethiopia<br>|199.93<br>96.77<br>83.36<br>|74.47<br>77.36<br>50.33<br>|324.78<br>116.19<br>116.38<br>|26.24<br>67.51<br>47.18<br>|
|Ghana<br>Malawi|437.05<br>52.47|179.68<br>56.45|697.40<br>49.04<br>|142.14<br>34.40<br>|
|Nigeria<br>Sudan<br>Tanzania<br>Zaire<br>Zambia|93.90<br>99.54<br>150.65<br>95.14<br>92.66|34.81<br>85.13<br>102.22<br>136.14<br>1 6.47<br>|152.99<br>113.96<br>199.08<br>54.14<br>78.85<br>|24.30<br> <br>66.23<br> <br>73.02<br>32.03<br>57.45<br>|
|Argentina|62.54|85.40|39.68|21.93|
|Bolivia|43.79|21.26|66.33|9.77|
|Brazil|37.91|17.89|57.93|19.73|
|Chile<br>|104.41<br>|191.13<br>|17.69<br>|<br>12.94<br>|
|Dominican Republic<br>Ecuador<br>Mexico|41.43<br>25.36<br>10.46|28.50<br>7.26<br>0.84|54.36<br>43.46<br>20.08<br>|24.69<br>13.05<br>7.55<br>|
|Peru|64.l00|54.67|82.33|10.73|
|Venezuela|43.06|0.54|85.58|1.94|

NOTES: Source: IFS tapes, World Currency Yearbook, Pick's currency Yearbook, Currency Alert, various issues Premium - (Parallel Exchange Rate/ Official Exchange Rate) - 1 Premium is expressed as a percentage.

TREND: average for 1970-1989, excluding episodes with a.bove trend premium.