What countries need to consider when dual exchange rates are a problem

As World Bank economists, we are often asked to advise in situations where dual exchange rate systems in a client country become a major distortion, whether in the implementation of World Bank operations or overall macroeconomic management. Devaluation with the objective of unification of multiple exchange rates is usually part of the solution, but the speed of adjustment can be a balancing act. Here are some insights on what we have learned.

Dual exchange rates can be the consequence of various official exchange rates for different imports in an effort to subsidize key imports; they can be associated with fixed (or tightly managed) exchange rate regimes where the official exchange rate deviates from the market exchange rates (an exchange rate premium exists); or both. A premium is the outcome of market restrictions that drive the non-official supply and demand for foreign currency. And it is a symptom of the inconsistency of fiscal and monetary policies and, in particular, the lack of credibility of de jure exchange rate policy given the level of foreign reserves. Dual exchange rates provoke distortions by manipulating relative prices in the economy and open opportunities for rent-seeking behavior for those who have access to preferential rates. Eliminating dual exchange rates thereby would lead to a more efficient application of market-driven relative prices to allocate resources in the economy.

There are two approaches toward unifying an exchange rate gap: big bang and gradual devaluations. The first approach is to do a large one-off devaluation. The second approach is to devalue gradually and credibly (Geiger et al. 2018).

• A big-bang devaluation will bring disruptions to trade, as exports suddenly become cheaper, and imports become more expensive. It will raise the value of foreign debt and generate difficulties in servicing international debt. If domestic banks are heavily dollar-denominated in their liabilities (“currency mismatch”), it could eventually lead to a banking crisis (and ultimately cause a credit crunch). Spikes in import prices, particularly food, could lead to severe social implications. A key advantage for big-bang devaluation is that it does not reinforce expectations for further rounds of depreciations (Katseli 1988).  
• A gradual devaluation approach will only trigger incremental changes in relative prices. This is important when the country has a large liability position in foreign currencies (e.g., a high level of external debt or large import share of domestic consumption). A downside is the difficulty in managing depreciation expectations. Hoarding foreign exchange could be the consequence and/or speculative capital outflows could lead to a spiral of repeated rounds of self-fulfilling currency devaluations, or worse, a currency crisis. Taming and managing expectations are key when choosing a gradual approach to devaluation (McKenzie 1969).

Recent empirical analysis of devaluation periods between 1960 and 2015 identified 217 big-bang and 92 gradual devaluation episodes (Geiger and Nguyen 2018). Big-bang devaluations were associated with large and significant drops in output, investment, and consumption in the same year that the devaluation occurred. Gradual devaluations were not associated with a drop in output, investment, or consumption but with a contemporaneous improvement in the trade balance. The paper concluded that exchange rate devaluation is preferred if conducted in a gradual way over a credibly established and defendable path. A series of case studies conducted on countries with gradual devaluations revealed the factors that usually determine the outcomes:

• Positive outcomes in gradual exchange rate reforms are associated with situations where: (1) the central bank is able to keep inflation stable throughout the depreciation path; (2) there is a favorable external environment, for instance, in that there is enough world demand to absorb higher levels of exports from the country; (3) the central bank adopted a crawling-peg exchange rate arrangement that can be adjusted for the inflation differential; (4) the country has relatively high levels of foreign exchange reserves that provide positive signaling to the markets; and (5) where complementary policies to increase the competitiveness of a country are being pursued simultaneously. Exchange rate reform in isolation is not likely to bring long-lasting effects.
• Negative outcomes are associated with situations where: (1) debt ratios in the economy were already high and the exchange rate-induced increased debt burden represents a burden at the country and firm levels; (2) there is a high import content of exports; (3) the country commands a global market power position in the economy’s main export, which leads to a situation of price erosion when exports are increased; (4) the devaluation came at the wrong time, for instance, when global food prices are high and inflationary pressures mount already going into the devaluation; and (5) the central bank pursues unsound monetary policy, for instance, monetization of the deficit, which leads to inflation that “eats-up” competitive gains through devaluation.

Despite the empirical results, there are conditions that can call for a big-bang devaluation as opposed to a gradual adjustment. A country with a fixed exchange rate regime that is in crisis may have to abandon the rigid exchange rate peg as a pressure valve to avoid a complete meltdown of foreign exchange reserves in an unsustainable situation. Such a country in crisis that already has used significant foreign exchange reserves to defend its peg will likely not be in a position to convince market players that there is a credible and defendable path for a gradual devaluation. Such a big-bang devaluation is more likely to be successful if expected balance sheet effects are small, in that a country’s liabilities are not predominantly denominated in foreign currency. Large devaluations suddenly increase the real value of foreign-denominated liabilities, which could lead to banking crises, credit crunches, and a drop in lending, inevitably leading to further declines in investment and output. Likewise, a country that has relatively small levels of imports for essential food or capital goods is likely to fare better in a big-bang devaluation.

Global experience also shows that it is not sufficient to focus on unification of the official and parallel rates without addressing the restrictions and policy inconsistencies that give rise to the parallel market. The parallel market by its nature determines a differential with the official rate, with the differential arising from the incompatibility of the official rate with macroeconomic fundamentals. Agenor (1992), who reviewed several episodes of exchange rate unifications across the world, found that devaluation of the official rate at best only partially closed the gap between the official and market exchange rates. Indeed, such experiences in Latin America in the early 1990s became the basis for eventual exit from an exchange rate peg and forced adjustment of fiscal policy, as defense of the peg was seen as futile.

In addition, a significant expenditure adjustment is likely necessary. In the presence of a structural imbalance between revenues and spending due to lower medium-term oil prices and rigid spending, a chronic financing gap will continue to stress the macroeconomic policy framework. Given import dependence, the reserve situation will remain highly fragile, which would seem to warrant the continued administrative rationing of foreign exchange, despite its ineffectiveness. Thus, the logic of such a situation would point to increased revenues or expenditure reductions. In turn, this means that exchange rate unification needs to be tackled within a credible overall economic reform package, including reforms to close the fiscal financing gap.

In summary, what we have learned is that if a country is in a relative position of strength (i.e., with manageable devaluation pressure and sufficient foreign exchange reserves), a gradual devaluation tends to achieve better economic outcomes than a big-bang devaluation.  On the other hand, a country in crisis will usually not be in a position to enforce and defend a credible gradual exchange rate path, and a large adjustment would be necessary. Furthermore, an adjustment that does not consider the need for the exchange rate to reflect macroeconomic fundamentals and that is not enshrined in a broader economic reform package will probably not succeed.

As World Bank economists, we are often asked to advise in situations where dual exchange rate systems in a client country become a major distortion, whether in the implementation of World Bank operations or overall macroeconomic management. Devaluation with the objective of unification of multiple exchange rates is usually part of the solution, but the speed of adjustment can be a balancing act. Here are some insights on what we have learned.

Dual exchange rates can be the consequence of various official exchange rates for different imports in an effort to subsidize key imports; they can be associated with fixed (or tightly managed) exchange rate regimes where the official exchange rate deviates from the market exchange rates (an exchange rate premium exists); or both. A premium is the outcome of market restrictions that drive the non-official supply and demand for foreign currency. And it is a symptom of the inconsistency of fiscal and monetary policies and, in particular, the lack of credibility of de jure exchange rate policy given the level of foreign reserves. Dual exchange rates provoke distortions by manipulating relative prices in the economy and open opportunities for rent-seeking behavior for those who have access to preferential rates. Eliminating dual exchange rates thereby would lead to a more efficient application of market-driven relative prices to allocate resources in the economy.

There are two approaches toward unifying an exchange rate gap: big bang and gradual devaluations. The first approach is to do a large one-off devaluation. The second approach is to devalue gradually and credibly (Geiger et al. 2018).

• A big-bang devaluation will bring disruptions to trade, as exports suddenly become cheaper, and imports become more expensive. It will raise the value of foreign debt and generate difficulties in servicing international debt. If domestic banks are heavily dollar-denominated in their liabilities (“currency mismatch”), it could eventually lead to a banking crisis (and ultimately cause a credit crunch). Spikes in import prices, particularly food, could lead to severe social implications. A key advantage for big-bang devaluation is that it does not reinforce expectations for further rounds of depreciations (Katseli 1988).  
• A gradual devaluation approach will only trigger incremental changes in relative prices. This is important when the country has a large liability position in foreign currencies (e.g., a high level of external debt or large import share of domestic consumption). A downside is the difficulty in managing depreciation expectations. Hoarding foreign exchange could be the consequence and/or speculative capital outflows could lead to a spiral of repeated rounds of self-fulfilling currency devaluations, or worse, a currency crisis. Taming and managing expectations are key when choosing a gradual approach to devaluation (McKenzie 1969).

Recent empirical analysis of devaluation periods between 1960 and 2015 identified 217 big-bang and 92 gradual devaluation episodes (Geiger and Nguyen 2018). Big-bang devaluations were associated with large and significant drops in output, investment, and consumption in the same year that the devaluation occurred. Gradual devaluations were not associated with a drop in output, investment, or consumption but with a contemporaneous improvement in the trade balance. The paper concluded that exchange rate devaluation is preferred if conducted in a gradual way over a credibly established and defendable path. A series of case studies conducted on countries with gradual devaluations revealed the factors that usually determine the outcomes:

• Positive outcomes in gradual exchange rate reforms are associated with situations where: (1) the central bank is able to keep inflation stable throughout the depreciation path; (2) there is a favorable external environment, for instance, in that there is enough world demand to absorb higher levels of exports from the country; (3) the central bank adopted a crawling-peg exchange rate arrangement that can be adjusted for the inflation differential; (4) the country has relatively high levels of foreign exchange reserves that provide positive signaling to the markets; and (5) where complementary policies to increase the competitiveness of a country are being pursued simultaneously. Exchange rate reform in isolation is not likely to bring long-lasting effects.
• Negative outcomes are associated with situations where: (1) debt ratios in the economy were already high and the exchange rate-induced increased debt burden represents a burden at the country and firm levels; (2) there is a high import content of exports; (3) the country commands a global market power position in the economy’s main export, which leads to a situation of price erosion when exports are increased; (4) the devaluation came at the wrong time, for instance, when global food prices are high and inflationary pressures mount already going into the devaluation; and (5) the central bank pursues unsound monetary policy, for instance, monetization of the deficit, which leads to inflation that “eats-up” competitive gains through devaluation.

Despite the empirical results, there are conditions that can call for a big-bang devaluation as opposed to a gradual adjustment. A country with a fixed exchange rate regime that is in crisis may have to abandon the rigid exchange rate peg as a pressure valve to avoid a complete meltdown of foreign exchange reserves in an unsustainable situation. Such a country in crisis that already has used significant foreign exchange reserves to defend its peg will likely not be in a position to convince market players that there is a credible and defendable path for a gradual devaluation. Such a big-bang devaluation is more likely to be successful if expected balance sheet effects are small, in that a country’s liabilities are not predominantly denominated in foreign currency. Large devaluations suddenly increase the real value of foreign-denominated liabilities, which could lead to banking crises, credit crunches, and a drop in lending, inevitably leading to further declines in investment and output. Likewise, a country that has relatively small levels of imports for essential food or capital goods is likely to fare better in a big-bang devaluation.

Global experience also shows that it is not sufficient to focus on unification of the official and parallel rates without addressing the restrictions and policy inconsistencies that give rise to the parallel market. The parallel market by its nature determines a differential with the official rate, with the differential arising from the incompatibility of the official rate with macroeconomic fundamentals. Agenor (1992), who reviewed several episodes of exchange rate unifications across the world, found that devaluation of the official rate at best only partially closed the gap between the official and market exchange rates. Indeed, such experiences in Latin America in the early 1990s became the basis for eventual exit from an exchange rate peg and forced adjustment of fiscal policy, as defense of the peg was seen as futile.

In addition, a significant expenditure adjustment is likely necessary. In the presence of a structural imbalance between revenues and spending due to lower medium-term oil prices and rigid spending, a chronic financing gap will continue to stress the macroeconomic policy framework. Given import dependence, the reserve situation will remain highly fragile, which would seem to warrant the continued administrative rationing of foreign exchange, despite its ineffectiveness. Thus, the logic of such a situation would point to increased revenues or expenditure reductions. In turn, this means that exchange rate unification needs to be tackled within a credible overall economic reform package, including reforms to close the fiscal financing gap.

In summary, what we have learned is that if a country is in a relative position of strength (i.e., with manageable devaluation pressure and sufficient foreign exchange reserves), a gradual devaluation tends to achieve better economic outcomes than a big-bang devaluation.  On the other hand, a country in crisis will usually not be in a position to enforce and defend a credible gradual exchange rate path, and a large adjustment would be necessary. Furthermore, an adjustment that does not consider the need for the exchange rate to reflect macroeconomic fundamentals and that is not enshrined in a broader economic reform package will probably not succeed.

A version of this blog post was published in the World Bank