Adoption and Abandonment of Dual Exchange Rate Systems

Abstract

When facing persistent balance of payments problems, some countries have resorted to a dual exchange rate system as an alternative to a uniform exchange rate adjustment. Typically, under the dual system, certain selected transactions take place at a fixed official exchange rate, while the remaining transactions are effected at a more depreciated rate, which is usually determined by market forces. This paper examines the circumstances that lead to the adoption of a dual system, and the conditions under which the foreign exchange market can be unified successfully at a later stage. In this paper, the adoption of the dual system is linked to the unsustainability of a crawling peg (or a fixed exchange rate) system in the presence of large budget deficits. We show that the initial spread between the financial and the commercial exchange rates and the extent of capital flight largely depends on whether the switch in regime is anticipated or unanticipated. Although the dual system improves the external position of the economy, to the extent that there is no change in domestic policies the country will continue to experience a deficit in the balance of payments. A correction of these policies is the only enduring solution to the external imbalance, and a precondition for a successful unification of the foreign exchange market. If the economy unifies the foreign exchange market into a crawling peg, the financial exchange rate could be an adequate indicator of the initial level at which the new exchange rate should be set if a capital outflow is to be avoided. If the economy instead moves to a flexible exchange rate system, the initial value of the exchange rate could be higher or lower than the prevailing financial exchange rate.