Journal of Policy Modeling
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The Premium in Black Foreign Exchange Markets: Evidence From Developing Economies

Dr. Yochanan Shachmurove

Department of Economics
University of Pennsylvania

July 1996

Please send all correspondence to Professor Yochanan Shachmurove, Department of Economics, University of Pennsylvania, 3718 Locust Walk, Philadelphia, PA 19104-6297. Telephone numbers: Office: (215) 898-1090; Fax: (215) 573-2057; Home: (610) 645-9235. Email address:


This paper examines the determinants of the premia between the black and official exchange rates using monthly data for seventeen developing countries. The premium is hypothesized to be positively influenced by the official depreciation-adjusted interest rate differential and dollar value of domestic assets. It is hypothesized to be negatively influenced by the official real exchange rate, exports, and a seasonal factor associated with tourism. The countries studied are: Bangladesh, Brazil, Fiji, Gambia, Ghana, Guyana, Hungary, Ireland, Jamaica, Kenya, Nepal, Nigeria, Philippines, Somalia, South Africa, Uganda and the former Yugoslavia.

In general, the results are very supportive of the model. It is found that the interest rate differential and assets positively influence the premium as is expected. The official real exchange rate is found to negatively influence the premium.

I    Introduction

This paper develops a model with which to explain the effects of various economic factors on the black market exchange rate premium. This study is targeted at the behavior of the black market foreign exchange in developing countries using monthly data from 1985 to 1989. The vast majority of black markets in foreign exchange are in the developing countries. The empirical investigation is based on a model developed by Dornbusch, Dantas, Pechman, Rocha, and Simoes (1983). The central and most interesting feature of the model is the interaction of stock and flow conditions in determining both the premium on the black dollar and the stock of black money. It is proposed that the black market premium is determined by the official real exchange rate, the official depreciation-adjusted interest rate differential, the level of exports, and a seasonal factor associated with tourism. These factors are interesting to examine because they may provide a foothold for governments of developing countries in trying to restrict activities in the black market. Black money affects public revenues, degenerates the investable surplus, delimits the national productivity, drains the balance of payments, and distorts equity and equality concepts of economic distribution.

The black market exchange rates in the following seventeen developing countries are studied: Bangladesh, Brazil, Fiji, Gambia, Ghana, Guyana, Hungary, Ireland, Jamaica, Kenya, Nepal, Nigeria, Philippines, Somalia, South Africa, Uganda and (the former) Yugoslavia.

Despite the increasing trend toward globalizing the world economy, many developing countries are still living in a chaotic constellation of limitations and controls over foreign currency holdings and transactions and a wide array of black market of currencies. Many developing countries' currencies have so called "legislation for monetary protection", usually limiting the amount of foreign exchange an individual is allowed to hold. Such currency regulations lead to unofficial, parallel, or illegal transactions in foreign currencies.

A parallel, or a black market is an illegal structure that is created in response to government intervention which produces excess supply or demand for a product. When the price of foreign currency is set below the market clearing rate, an excess demand is usually generated for acquiring foreign currency. The government has the choice of either devaluating the currency, or maintaining strict controls over exchange, such as setting quotas on the purchase of foreign exchange. Such currency controls are designed by governments in order to limit the use of foreign exchange in transactions.

The United States' Dollar used to be the only preferred currency on the black market. When the dollar was removed from the gold standard in August 1971, it lost its dominance and other currencies became popular as vehicle currencies in foreign currency black markets throughout the world. The increased demand for such monies as the German Mark and the Swiss Franc reduces the premia for the U.S. Dollar. Nonetheless, the U.S. dollar is still the primary currency traded in most of the globe's black markets, serving as a "pass-through" vehicle to precious metals such as gold, energy uses such as oil, and other monetary units such as the Japanese Yen, the German Mark, and the Swiss Franc.

Only seventeen countries have currencies that are free from internal black market exchange.1 Most other currencies have legislation that limits the foreign exchange available which only serves to generate illegal transactions. Controls over monetary exchange only increase the risk and encourage evasion. The restrictions promote the diversion of scarce money from the official channels to be distributed later in the illegal channels. As long as the risk is tolerable, there are high incentives to sell on the black market to reap the profits. The commodity is purchased at a lower price, but is then sold illegally at a higher price on the market because of the demand generated from shortages. The more inefficient a country's reserves or financial capacities, the greater the likelihood of a vigorously organized black market. The stringent regulations or punishments only serve to increase the premium between the black and the official foreign exchange rates. If a large proportion of foreign exchange transactions are conducted in this manner, the devaluation of official rates can affect consumer prices as well as the entire economy.

Legislative controls and rationing that attempt to fight black markets often contribute instead to higher activities in the black market for foreign exchange. The enforcement of governmental policies, price ceilings, and restrictions on foreign currency help increase scarcity which in turn encourages accumulation for later illegal transactions. Attempts by governments are usually ineffective unless they are also accompanied by increases in productivity, price stability, and availability of goods. Without careful monitoring of these actions, transactions in the black market are going to persist despite government interventions.

The designing of monetary policy in each country depends on the official economy. This economy involves open transactions financed through identifiable sources and generates income within the parameters of government rules and regulations. In addition to the official economy, many countries, particularly developing ones, have developed a parallel economy.

This parallel economy, or black market, emerges through the manipulation of the economic forces of supply and demand for both currency and commodities. A black market also emerges when trade and industry create an artificial situation of scarcity or glut, and in the process amass high returns on their investments by profiteering. As a result of profiteering activity, the black market generates unreported income and wealth which escape detection by official statistics (Culbertson, 1975; Ray, 1981; Nowak, 1985; Manasian et al., 1987; Roemer and Jones, 1991; and Argy, 1994).

Gupta (1981) attributes much of the strength of the black market to the resale of officially allocated foreign exchange holdings and to the incentive to under-invoice and smuggle exports. He argues that an increase in the black market rate, given the official exchange rate, creates an incentive for residents abroad to channel their remittances through the black market. This raises their private receipts in terms of home currency and deprives the central bank of this foreign exchange. Economists studying black market activity in developing countries advocate that it is best to keep the black market premium rate as low as possible (Gupta, 1981). By influencing the determinants of the black market exchange rate, developing counties can keep the black market premium rate low and increase their official foreign exchange currency holdings.

The paper is organized as follows. Section II presents the model for the premium on the black dollar. Section III introduces the data. Section IV details the empirical results. Section V summarizes.


1. The countries are Bahrain, Djibouti, Hong Kong, Kuwait, Lebanon, Malaysia, Netherlands, Oman, Panama, Qatar, Saudi Arabia, Seychelles, Singapore, United Arab Emirates, United Kingdom, and the United States (World Currency Yearbook 1989).

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