José Saul Lizondo
A number of countries use more than one exchange rate to settle their foreign exchange transactions. While most of these countries use two exchange rates, some of them employ three or more. At the end of 1984, 25 Fund member countries were maintaining multiple exchange rate systems (see table). (The Fund’s Articles of Agreement prohibit members from engaging in multiple currency practices without the Fund’s approval.)
Exchange rates, here defined as the domestic currency price of foreign currency, are set differently in different countries. In some, all the exchange rates are determined officially—being fixed to one currency or to a basket of currencies, allowed to crawl, or managed without a specific intervention rule. In other countries, rates determined by official intervention coexist with an exchange rate freely determined by market forces. Differentials among the various exchange rates also vary widely; in some countries, they are only a few percentage points, but in others the highest exchange rate is equal to several times the lowest one.
Under a multiple exchange rate system, the different rates are used for different types of transactions. In general, activities that the country’s authorities want to encourage are allowed to buy foreign exchange at a relatively low exchange rate, or to sell the foreign exchange they earn at a relatively high exchange rate, while the opposite is true for activities the country wants to discourage.
A variety of taxes, subsidies, regulations, and restrictions can produce the same effect as a multiple exchange rate system. For example, the effects of a given multiple exchange rate structure can be reproduced by using a given uniform exchange rate and: (1) subsidizing the purchase and taxing the sale of foreign exchange for transactions that under the multiple system would take place at an exchange rate lower than the uniform exchange rate; and (2) taxing the purchase and subsidizing the sale of foreign exchange for transactions that under the multiple system would take place at an exchange rate higher than the uniform exchange rate. In each case, the tax or subsidy rate must be equal to the difference between the relevant exchange rate under the multiple system and the uniform exchange rate. Other types of regulations with the same effect as explicit multiple exchange rate systems include provisions for advance import deposits that pay no interest, or pay interest below market rates. These provisions increase the effective domestic currency price of the foreign currency used for the imports they cover. And, abstracting from the legal issues involved, illegal markets for foreign exchange pose similar issues to those posed by officially recognized multiple exchange rates. (For a discussion of illegal foreign exchange markets, see “Black markets in foreign exchange: their causes, nature, and consequences,” by Michael Nowak, Finance & Development, March 1985.) The present article, however, is mainly concerned with explicit multiple exchange rate systems, the reasons for their adoption, their effects, and the issues that must be faced when they are replaced by a uniform exchange rate.
Reasons for adoption
Multiple exchange rate systems are usually adopted for balance of payments reasons. Some countries with a weak balance of paymerits position adopt a multiple exchange rate system as an alternative to a uniform exchange rate adjustment and the use of restrictive demand policies. The types of transactions covered by the different exchange markets and the structure of the exchange rates differ among countries, reflecting countries’ particular characteristics and their priorities regarding the allocation of international reserves.
|Country||Number of exchange rates2|
|Lao People’s Dem. Rep.||4|
|Syrian Arab Republic||3|
Excluding subsidies, taxes, discounts, and premiums resulting in implicit multiple exchange rates.
Excluding illegal parallel rates that are not officially recognized by the authorities.
Excluding subsidies, taxes, discounts, and premiums resulting in implicit multiple exchange rates.
Excluding illegal parallel rates that are not officially recognized by the authorities.
The pattern, however, is similar in most cases. Many countries have tried to prevent large depreciations from affecting the domestic price of “essential” commodities, by continuing to allow their importation at a relatively low exchange rate. Similarly, to tax away the additional profits that exporters would obtain from a uniform exchange rate depreciation, proceeds from “traditional” exports are generally subject to a low exchange rate. Workers’ remittances, by contrast, may generally be converted at a high exchange rate, as a way of promoting this inflow of foreign exchange. The short-term capital flows of the private sector are also usually assigned to a free exchange market in an attempt to prevent sudden one-way pressures on the capital account from affecting international reserves.
Multiple exchange rate systems are not always adopted entirely for balance of payments reasons. In recent years, several countries have allowed the private sector debt contracted up to some specified date to be serviced at a relatively low exchange rate, in an effort to prevent a significant portion of the private sector from going bankrupt. Some countries have also used a preferential exchange rate for public sector transactions as a way of influencing the public sector budget; for example, a low exchange rate for public sector imports reduces public sector expenditure, while a low exchange rate for public sector exports reduces public sector revenues. Any resulting gain or loss for the public sector budget, however, is matched by a loss or gain for the central bank, which provides or receives the foreign exchange at a low price.
Multiple exchange rates have often failed to achieve some of the objectives that motivated their adoption. In particular, they have not succeeded in preventing speculative capital flows from affecting international reserves. For example, frequent changes in the structure of exchange rates and in the transactions covered by different exchange markets have created leads and lags in imports and exports, with the same effect on international reserves as explicit capital flows. (Leads and lags refer to anticipated payments for imports or delayed repatriation of proceeds from exports.) Second, the large differentials that often arise among the various exchange rates encourage the over-invoicing of imports and the under-invoicing of exports in those markets with relatively low exchange rates, and thus contribute to the erosion of international reserves. Third, the implicit subsidies and taxes that arise from the multiple exchange rate structure are sometimes inconsistent with national policy objectives. For example, commodities that receive export promotion incentives are sometimes assigned to a market with a relatively low exchange rate, thus implicitly taxing their export and defeating the initial purpose of export promotion.
The use of multiple exchange rates may also have undesirable consequences for resource allocation. When domestic relative prices between traded goods differ from international relative prices, decisions regarding consumption, production, and investment are distorted, leading to inefficient patterns of production and consumption, and hindering economic growth. Multiple exchange rates introduce this type of distortion, but since they are generally used in the presence of other distortions, such as trade taxes and subsidies, it is not clear on an a priori basis whether they worsen or improve the allocation of resources. However, there is a presumption that when the differential between exchange rates is relatively large the efficiency of the economy declines. Moreover, under a multiple system, resources are devoted to finding ways to profit from the differentials among the various exchange rates, either legally (for example, by obtaining the transfer of some transactions from one exchange market to another) or illegally (for example, by over-invoicing or under-invoicing imports or exports and selling the additional foreign exchange thus obtained in the free market). Lastly, the maintenance of multiple exchange rates generally requires a complex and costly system of controls administered using public sector resources.
Given the variety of problems just alluded to, it is not efficient for a country to maintain a multiple exchange rate system permanently—particularly a system in which the various rates differ widely. As a temporary measure, the use of multiple exchange rates may be justified under certain conditions. For example, some countries with an overvalued uniform exchange rate have authorized certain transactions to be settled in a parallel free exchange market, allowed to function temporarily so as to suggest the range within which a new uniform exchange rate should be established. In addition, some countries in the process of adjusting a uniform exchange rate have preferred the temporary use of multiple exchange rates over quantitative restrictions or other controls with more distortive effects on resource allocation. In general, however, in countries with a multiple exchange rate system, it will be necessary to examine the possibility of unifying the exchange markets.
Unifying exchange markets
A number of issues should be considered in the unification of exchange markets:
• Will the unified exchange rate be fixed, crawling, subject to some other form of official intervention, or floating freely?
• Will the exchange markets be unified gradually or in one step?
• If the unified exchange rate is to be determined by official intervention, what is its appropriate level?
What system? The extensive literature on unified exchange rate systems shows that no one system is universally appropriate. The choice depends upon country characteristics, such as the relative magnitude of monetary versus real shocks, and the size and openness of the economy, and upon how the authorities view the relative costs of the various sources of instability, such as fluctuations in prices versus fluctuations in output.
Gradual or in one step? Whether to unify the exchange markets gradually or in one step is another decision dependent on country conditions. The unification of the markets modifies the entire structure of relative prices between traded goods by eliminating the implicit set of taxes and subsidies that a multiple exchange rate system produces. A gradual process of change may avoid some costs in terms of unemployment and business failures, by allowing resources to be transferred gradually from some sectors to others. A one-step approach, on the other hand, would reflect sooner a better structure of relative prices and may prevent sectoral pressures from unnecessarily delaying or from precluding the unification of the markets.
While a one-step unification implies an immediate adoption of one exchange rate for all transactions, the gradual unification of the markets requires a preliminary period that generally involves: (1) the gradual transfer of most transactions to the market with the exchange rate that is considered to represent best the underlying conditions of the economy; or (2) the implementation of policies designed to reduce the differentials among the various exchange rates; or (3) a combination of these two sets of policies. The effects of transferring transactions from one market to another, and the effectiveness of various policies in reducing differentials between exchange rates, are examined in the following example.
In a country with a typical dual exchange rate system, the official rate is fixed or crawling and applies to a selected group of transactions, while the “free” rate is determined by market forces and applies to the remaining transactions, including private sector capital flows. The set of transactions in the official market determines the overall balance of payments outcome—measured by movements in reserves—since the exchange rate is fixed (or the crawl is maintained) by central bank intervention. By contrast, the set of transactions in the free market determines the free exchange rate but does not affect the overall balance of payments outcome since, in principle, the central bank does not intervene in this market. In general, the free exchange rate fluctuates above the official exchange rate.
The unification of the exchange markets obtained through a gradual transfer of transactions from one market to another affects the balance of payments and the differential between the exchange rates. For example, a transfer of imports from the official to the free market reduces the demand for foreign exchange in the official market and increases the demand for foreign exchange in the free market. As a result, the overall balance of payments improves, but the free exchange rate depreciates, increasing the differential between the two exchange rates. In contrast, transferring exports from the official to the free market would worsen the balance of payments but would reduce the differential between the exchange rates. These effects must be taken into account when unifying the exchange markets since an unbalanced transfer of transactions may have undesirable consequences for the balance of payments or the differential between the exchange rates.
A variety of other measures can be used to reduce the differential between the exchange rates as part of a gradual unification of exchange markets. Not all these measures are equally effective on their own, however.
A devaluation of the official exchange rate to the level of the free rate or to some intermediate level would generally reduce the differential in the short run but, unless supported by other policies designed to restrain the growth of aggregate demand, could not prevent the free rate from depreciating, soon widening the differential again. Any resulting improvement in the balance of payments would also be only transitory unless supporting policies were implemented.
As an alternative to a once-and-for-all devaluation, the rate of crawl of the official exchange rate could be increased (or, if the official exchange rate has been kept fixed, a crawling peg could be introduced). How this would affect the differential between the exchange rates, however, is uncertain. While, in general, a faster rate of crawl would increase the country’s competitiveness and probably improve the current account of the balance of payments, it would also increase the domestic rate of inflation. To the extent that domestic interest rates do not rise enough to compensate for the higher inflation, wealth holders will reallocate their portfolio toward foreign assets and the free exchange rate will tend to depreciate faster, perhaps increasing the differential between the exchange rates.
Restrictive monetary and fiscal policy, by contrast, have proven effective in reducing the differential between exchange rates and in improving the balance of payments, by restraining the growth of aggregate demand and avoiding excessive liquidity in the economy. Occasional central bank intervention in the free market has also been effective in reducing the differential, but only temporarily, and sometimes at the expense of large losses of international reserves for the central banks involved.
Setting the new rate. If a new uniform exchange rate is to be set by official intervention, an appropriate level must be found for it. The level must be consistent with the authorities’ various policy objectives, including in particular a satisfactory balance of payments outcome. A number of methods have been used to determine the appropriate level for the exchange rate in countries with balance of payments problems. They include reference to indices of real effective exchange rates, studies of the profitability of certain activities, and the use of general equilibrium macroeconomic models (see “Determining the appropriate exchange rate in LDCs,” by A.H. Mansur, Finance & Development, December 1984).
In countries with multiple exchange rates, reference also can be made to the level of a freely determined exchange rate. It is some-times argued that, in a dual system, the free exchange rate represents the “equilibrium” level at which the uniform exchange rate should be set. A somewhat different view holds that the “equilibrium” exchange rate lies between the official exchange rate and the free exchange rate. Neither of these views is necessarily correct.
The free exchange rate is an important indicator of the conditions in the foreign exchange markets, but there is nothing to ensure that setting the uniform exchange rate at that level (or at any level between the free and the official exchange rates) will achieve, say, a given balance of payments objective, particularly in the short run. The main reason for this is the possibility of unexpected private sector capital flows. The free exchange rate under a dual system depends on a variety of factors, including the coverage of each ex-change market, monetary and fiscal policy, the past evolution of the official exchange rate, and, in particular, expectations regarding the future evolution of all these factors. The unification of the markets changes the way in which the various policies affect the economy, and, unless the timing and the level of the unification are exactly predicted, expectations about the likely evolution of the economy will be revised. This will change the desired portfolio composition of wealth holders, and will be reflected in private sector capital flows. No particular level of the uniform exchange rate will allow for a precise estimation of these flows.
The free exchange rate should thus be used together with all the other available indicators to determine a uniform exchange rate that provides a certain degree of competitiveness to the economy, while monetary and fiscal policy under the unified system should be designed to be consistent with the particular exchange rate policy that is chosen. This consistency, however, can only be expected with some confidence to apply in the long run. In the short run, the structural change brought about by the unification of; the markets makes the estimation of private sector capital flows, and thus the achievement of any balance of payments objective, extremely difficult.
If the new rate is not to be set by official intervention but is to float freely, the problem becomes one of predicting the evolution of the exchange rate once the markets are unified. Just as nothing ensures that by setting the uniform exchange rate between the free and the official rate a given balance of payments objective will be achieved, there is no guarantee that by letting the uniform exchange rate float freely it will stay between the previous official and free exchange rates. For instance, expectations of expansive monetary policy in the future could push the uniform rate above the free rate of the dual system even in the short run.
Theory thus does not indicate where the uniform exchange rate will go, or where it should be set. Since the precise consequences of unification will always depend upon particular circumstances, policy makers thus need to make informed judgments about the circumstances at hand.