Long-run nature of the relationship between the black market and the official exchange rates

What is it about?

Previous research that investigated the relationship between the black market and the official exchange rate employed cointegration analysis to establish the long-run relationship and Granger causality to detect the short-run causality between the two rates (for a small number of countries). In this paper, we employ annual data over the 1955–1995 period from 31 developing countries to show that indeed in most cases the two rates are cointegrated. Application of Johansen’s weak exogeneity test reveals that in the majority of the countries, the black market exchange rate is weakly exogenous, supporting the argument that in the long-run depreciation of domestic currency in the black market induces government officials to devalue the domestic currency and unify the two rates.

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Why is it important?

Due to foreign exchange control in many developing countries, there exists a black market for foreign currencies where the black market price of foreign currencies is much higher than their official price. Establishing cointegration between the two rates not only implies market efficiency, but also adjustment of the official rate toward the black market rate in the long-run. Previous studies that attempted to establish the cointegration between the black market exchange rate and the official rate did not test for the exogeneity of these rates. In this paper we employ annual data from 31 developing countries to investigate the weak exogeneity of each rate within Johansen’s cointegration framework. The cointegration technique could be applied to only 22 countries out of which 15 countries showed evidence of cointegration. In 8 of these 15 countries, we found the black market rate to be weakly exogenous implying that in the long-run, movement in the black market rate induces central banks to adjust the official exchange rate and eventually unify them.