Academic journal article Contemporary Economic Policy

Black Market Exchange Rates and Capital Mobility in Asian Economies

Academic journal article Contemporary Economic Policy

Black Market Exchange Rates and Capital Mobility in Asian Economies

Article excerpt

I. INTRODUCTION

Since the early 1980s, many developing countries in the Asian Pacific region have been under pressure to open their domestic financial markets and dismantle their capital controls. Singapore and Malaysia abolished foreign exchange controls in the late 1970s. Japan embarked on a liberalization scheme in 1981, followed by Indonesia and the Philippines in the early 1980s. Thailand, Korea, and Taiwan are latecomers and did not start to open their economies until the mid to late 1980s. While financial liberalization can promote the efficiency of resource allocation, it also makes the domestic economy more vulnerable to external economic conditions. Increasing openness of the capital account has reduced the ability of the domestic monetary authorities to conduct monetary policies independent of external considerations. Many countries in the Asian Pacific region - such as Taiwan, Malaysia, and Thailand - have to deal with the monetary consequences of massive capital inflows, even with more flexible exchange rates. They are torn between controlling domestic inflation, on the one hand, and maintaining a competitive real exchange rate, on the other (Glick and Moreno 1994). Because of these problems associated with financial liberalization, most developing countries have been slow to remove various restrictions on capital flows for fear of undermining macroeconomic stability and weakening autonomy in the conduct of monetary and exchange rate policies. These capital controls include strict limits on the inflows and outflows of portfolio investment, narrow foreign exchange exposure ceilings imposed on banks, various kinds of trade restrictions, and administrative controls over interest and exchange rates. Some central banks believe that these measures are necessary and more efficient than sterilization to insulate the domestic economy from external shocks, to retain monetary autonomy, and to stabilize the real exchange rate.

However, the effectiveness of capital controls in developing countries has been widely questioned. By restricting capital flows, the central bank has relegated these flows to the foreign exchange black markets, which have increased the effective degree of capital mobility. Black market erosion of these controls not only has reduced the effectiveness of stabilization policy (Quirk et al., 1987) but also increased the risk of capital flight and the cost of defending the official exchange rate (Gulati 1988). It also has led to currency substitution, which results in loss of seigorage for the government (Agenor 1990). Finally, the effectiveness of restrictive trade policies also is reduced since capital controls usually are needed to maintain such policies. The connection between capital mobility and foreign exchange black markets has been well established in the literature. In the monetary models (Blejer 1978, Agenor 1991) and portfolio-balance models (Dornbusch et al. 1983) of black market exchange rates, foreign exchange is viewed as a financial asset. The demand for foreign exchange can arise from loss of confidence in the domestic currency, inflation tax from holding domestic currency, and low real domestic interest rates. These models have received empirical support (Agenor 1991, Phylaktis and Kassimatis 1994), especially for middle income countries.

Despite the implication of foreign exchange black markets for capital mobility in developing countries, few empirical studies have examined whether these markets have rendered capital controls ineffective. (One exception is Phylaktis (1992) who finds a significant relationship between foreign exchange controls and black market premium for the dollar in Chile.) The answer to this question has important policy implications. First, the effective degree of capital mobility has an important bearing on short-run effects of stabilization policy. Second, if capital controls are ineffective because of black markets, then removing the controls may not exacerbate adverse effects of capital flows on the aggregate economy. …

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