Exchange Market Reform, Inflation, and Fiscal DeficitsWP/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. |