Exchange Market Reform, Inflation, and Fiscal Deficits


WP/95/78-EA
Exchange Market Reform, Inflation, and
Fiscal Deficits by Pierre-Richard Agénor and E. Murat Ucer

Growing recognition of the costs associated with large differentials
between official and parallel exchange rates has led numerous countries in
recent years to attempt to unify their foreign exchange markets. This paper
reviews some recent experiences with exchange market reform, examines some
conceptual issues associated with the unification process, and extends the
theoretical literature on the dynamics of exchange market unification.

The first part of the paper discusses the experience of Guyana, India,
Jamaica, Kenya, Sierra Leone, and Sri Lanka in the early 1990s with exchange
market reform. The review suggests that exchange market reform, launched in
the context of a comprehensive macroeconomic program targeting most notably
a sustainable fiscal position, significantly reduced inflation and raised
reserve levels. However, in most of these countries, central banks
continued to interfere (sometimes heavily) with the allocation of foreign
exchange--and more generally with the functioning of the foreign
exchange market--in the aftermath of reform.

The second part develops a theoretical framework for studying the
dynamics of the parallel exchange rate, prices, foreign reserves, and the
money supply when either a pure floating exchange rate regime or a managed
float arrangement has been adopted in the postreform period. The analysis
suggests that a variety of paths can be observed, depending on the nature of
the postreform regime, the structural parameters of the model, and the
length of the transition between reform announcement and actual
implementation.

The last part of the paper focuses on the effects of unification on
inflation. The conventional analysis of the unification process argues
that the loss of the implicit tax on exports induced by exchange market
unification may lead to a permanently higher inflation in the presence of
fiscal rigidities. However, a variety of implicit taxes and subsidies must
be taken into account in assessing the fiscal effects of exchange market
reform. The first issue, as emphasized in the conventional analysis, is to
determine whether the public sector is a net buyer or a net seller of
foreign exchange prior to reform. The second and perhaps more important
issue for many countries is to assess the extent to which the use of the
official exchange rate for the valuation of imports for duty purposes
provides an implicit subsidy to importers. It is argued (analytically, as
well as with illustrative calculations) that, if the reduction in implicit
subsidies to importers resulting from levying tariffs at the official
exchange rate outweighs the loss in implicit taxes levied on exports
repatriated at the official rate, exchange market reform may lead to reduced
reliance on seignorage.