Is the Parallel Market Premium a Reliable Indicator of Real Exchange Rate Misalignment in Developing Countries
Is the Parallel Market Premium a Reliable Indicator
of Real Exchange Rate Misalignment in Developing Countries?
by Peter J. Montiel and Jonathan D. Ostry
Real exchange rate misalignment--the occurrence of a sustained
departure of the actual real exchange rate from its equilibrium value--has
been a recurring policy problem in many developing countries. A well-known
difficulty associated with implementing policies designed to reduce real
exchange rate misalignment is that of gauging the degree to which an
exchange rate is out of equilibrium and, in some cases, the direction of
misalignment. This is because information about the extent of misalignment
requires knowledge of the level of the equilibrium real exchange rate, which
depends on a host of structural and macroeconomic factors that may be
difficult to measure.
Economists have frequently used information from the parallel foreign
exchange market to gauge the extent of real exchange rate misalignment.
The existence of a premium on foreign exchange in the free market is taken
as indicative of an excess demand for foreign exchange at the official
exchange rate, which in turn is interpreted as arising from an overvaluation
of the domestic currency at the prevailing official exchange rate.
This paper argues that, from an analytical standpoint, the case for
treating the size of the parallel market premium as an indicator of the
magnitude of real exchange rate misalignment is not obvious. Both the
premium on foreign exchange in the free market and the real exchange rate
in the official market are endogenous variables with complex macroeconomic
roles, and, as such, the correlation between them should depend in general
on the sources of shocks impinging on the economy. Moreover, the parallel
market premium is an asset price, which can be expected to exhibit much
greater volatility than the official real exchange rate, in particular by
responding to transitory shocks that leave the equilibrium real exchange
rate unaffected. The very different time series properties of these two
variables raise some doubt about the reliability of the premium as an
indicator of real exchange rate misalignment.
This paper investigates how, in a developing country modeled along
fairly standard lines, the parallel market premium and the real exchange
rate jointly respond to some illustrative shock, taken to be a permanent
productivity disturbance. The analysis suggests that the informational
content of the premium may be limited because, in response to a shock,
the premium will at various times along the adjustment path be positive
and negative, whereas the degree of overvaluation of the currency is
always positive for a negative shock and negative for a positive shock.
The policy implication is that by itself the premium is not always a
reliable indicator of real exchange rate misalignment. Other variables,
including the various accounts of the balance of payments, may provide
more reliable information.