A sideways look at economics
500g of beef shekla tibs: 450 birr
4 beers: 150 birr
Total: 600 birr
At official exchange rate: $11 US
At parallel exchange rate: $6 US
The restaurants of Addis Ababa fill up at the end of each year, with conversations switching between American-accented Amharic and English. A combination of domestic and international holidays, and the particularly fine weather compared to the shivering northern hemisphere, makes it a popular time to visit. Colloquially known as ‘diaspora season’, it runs into January, where it meets the traditional wedding season. It was on a sun-filled December afternoon that a friend corrected me when I converted the cost of our meal back into dollars: “That’s using the official exchange rate. At the black-market rate, it’s half that.” During the rest of my stay, it became clear that exchanging money on the black market, although illegal, was pervasive. It’s not just Ethiopia. The COVID shock has sent the number of countries with parallel exchange rates to a twenty-year high, with politicians often disagreeing with international institutions on what to do about it.
Parallel exchange rates arise when the official exchange rate doesn’t bring the demand and supply of foreign currency into balance. It normally implies an overvalued domestic currency, resulting in demand for foreign currency that cannot be met. When this happens, economic agents look beyond official banks to currency dealers who are willing to exchange their foreign currency but at a higher price. The spread between rates can run from the single digits (%) to thousands. In a March 2022 report, the World Bank noted that almost one fifth of EMDE countries had parallel exchange rates, and this was the highest in two decades. Dislocations from the pandemic, the increase in commodities prices and the Russia-Ukraine war were all cited as reasons behind this development.
Parallel exchange rates cause a long list of distortions that can damage the economy. The same World Bank post notes that almost all the countries with the highest inflation rates tend to have parallel exchange rates. Indeed, the authors find that a third of countries with parallel exchange rates experienced inflation rates greater than 40% over the period January 2020 to December 2021. And the number of countries without parallel exchange rates that suffered such high inflation rates? Zero. History paints a similar picture, with inflation six times higher in countries with parallel exchange rates over the years 1970-2001. These countries tend to have much weaker growth rates, and ‘multi-year secular contractions’. Corruption tends to be higher, too, with those who have access to FX at the official exchange able to use that for personal benefit – incidentally, whether this can be applied to visitors from abroad was a topic of heated debate among friends and family.
Corruption, economic crisis, inflation and loud visitors ordering too much food and drink: why would any country tolerate parallel exchange rates? Mostly, government officials accept that something needs to be done but are concerned about the short-term impact. A common argument is that a sudden devaluation would risk a big increase in inflation, and that globally traded commodities such as food and oil would be particularly impacted, hitting the most vulnerable hardest. A sudden exchange rate devaluation also risks exacerbating debt sustainability concerns. Meanwhile, there is the risk that a devaluation leads to expectations of further devaluations, thus further de-anchoring inflation expectations.
In an IMF report titled Accepting Reality: Unification of Official and Parallel Market Exchange Rates, Simon Gray outlines the experience of countries who devalue to unify their official and parallel exchange rates. His evidence shows that the parallel exchange rate is often already heavily influencing prices and so the pass-through from devaluations is not necessarily that large (see table below). The paper looks at the difference between the peak in inflation post-unification versus its rate prior to unification, and then calculates how that compares to the exchange rate adjustment. It finds that, on average, 11.5% of the exchange rate adjustment feeds through to higher inflation.
Summary of country case studies where exchange rate has been unified
|Country||ER devaluation||ER devaluation||Inflation||Inflation||Pass-through|
|Date||Per cent||Pre-unification, per cent||Post-unification, per cent||Per cent|
|Oct 19-Sep 20||68||16.3||23.8||11|
|Dec 15-Mar 17||62.4||3.6||14.5||17.5|
|Egypt||Oct 15–Apr 17||103||14.1||32.9||18.3|
|Feb 15-Feb 16||21||16.4||19.2||13.3|
|Jun 18-Aug 19||18.1||9.9||9.4||-2.8|
|Jul 15-Jan 16||95.8||4||17.4||14|
|Malawi||Jul 11-Mar 13||156||7.4||34.6||17.4|
|Jun 15-Feb 16||71||21.2||24.9||5.2|
|Myanmar||Mar 12-Apr 12||14500||-1.1||7.1||0.1|
It seems clear to me that Ethiopia’s currency will be devalued at some point. The implied exchange rate adjustment, using the parallel rate, suggests that one dollar would buy just over 100 birr, compared to 54 at the current official exchange rate. Taking the IMF paper as a baseline, that would add 11.5 percentage points to already high levels of inflation (33.8% in December). It makes sense to try to design a policy that ensures any such adjustment shields those that are most vulnerable. However, the bigger issue there and elsewhere is probably not parallel exchange rates but the underlying economic woes that cause them.
It’s not a coincidence that the number of countries with more than one exchange rate increased to multi-decade highs after the pandemic (a large negative shock). In the longer run, countries such as Ethiopia will benefit in a broad economic sense from attracting foreign investment and boosting exports. One potential source of revenue is tourism. With great weather and lots to see for both culture and nature buffs, Ethiopia has a lot to offer. The local food is delicious, and reasonably priced, too – whether you convert it at the black market exchange rate or not.
 Beef, sauteed with chilli, onion and rosemary and served in a clay pot with burning charcoals underneath
 If the sample period is extended to January 2022. Turkey, which doesn’t have a parallel exchange rate, joins the list, highlighting the extremely unorthodox nature of monetary policymaking there in recent years.
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