Shining a Light on Currency Black Markets

From Winton:

Unique data spanning 50 years’ of monthly black market rates reveals insights ranging from the extent of the Soviet Union’s dependence on the shadow economy to the consequences of Colombia opening its “sinister window”.

Black markets conjure up images of shady characters in dark alleys with suitcases of dollars.

Although such activity exists, illegal currency transactions have often been conducted openly by otherwise law-abiding citizens. In Venezuela, where rampant inflation has left the national currency unable to hold its value, millions of consumers and businesses have been using black market US dollars to buy essentials. In situations such as these, black market rates often provide a more accurate reflection of a country’s economic circumstances than official exchange rates.

Because of its nature, data on the black market is hard to source. But Winton’s databases include unique records of monthly black market rates from 1947 to 1993 for around 100 currencies, from the Albanian Lek to the Zambian Kwacha, along with unofficial gold prices for a selection of global cities.

This data can be used to make observations about the nature of currency black markets. How do they arise and disappear? What form do they take? What determines black market premia for hard currency and how can such information be used by investors? Many economic studies are based on official rates that were fixed and chronically overvalued. By contrast, the parallel rates analysed by Winton provide a more nuanced narrative on postwar financial history, demonstrating the importance of consulting alternative sources of data that are extrinsic to markets when conducting financial research.

1. Foreign exchange restrictions spawn currency black markets
Black markets come about when controls on foreign exchange restrict access to the official markets, forcing people to resort to unofficial channels. This typically gives rise to a premium over the official rate known as the black market premium. Currency restrictions are primarily intended to prevent debilitating capital outflows during periods of macroeconomic weakness. They include banning the use and possession of foreign currencies within a country, banning residents from purchasing foreign securities or holding bank balances abroad, and restricting the amount of currency that can be imported and exported.

Another form of currency control involves the use of dual exchange rates. Governments sometimes introduce dual exchange rates during balance of payments crises to limit the short-term impact of capital outflows on domestic prices and international reserves. Priority current account transactions, such as industrial inputs, are assigned to the pegged official rate while all remaining legal transactions, including private capital account transactions, are supposed to proceed at an officially floating parallel exchange rate. Sometimes, countries use a complex array of multiple exchange rates in an attempt to resolve specific imbalances.

Sudan’s Multiple Exchange Rates

Rate Type	Rate
Basic Rate	0.357
Official Fixed Rate	4.50
Commercial Bank Rate	12.20
Export Rates (General)	12.20
Export Rate (Gum Arabic)	8.35
Export Rate (Cotton)	6.81
Remittance Rate	5.62
Clearing Rates	8.00, 7.50, 4.50, 4.10
Tuition Rate	15.00-20.00 [1992]
Murabaha Import Rate	16.00-25.00 [1990]

Although such arrangements are intended to reduce the pressure on the official rate, a black market may still exist along with dual or multiple exchange rates if insufficient currency is allocated to the official parallel exchange rate or if certain transactions, such as for narcotics, are excluded.

Under the Bretton Woods monetary order (1946-1971), most countries imposed controls since its system of fixed exchange rates and monetary independence could only be maintained at the expense of capital mobility. Consequently, most countries had black markets to some degree. Only a handful of countries were completely devoid of parallel markets, including, ironically, Venezuela – previously held to be a paragon of monetary virtue.

After the collapse of Bretton Woods in 1971, many countries still retained controls to navigate the financial chaos unleashed by the oil shocks, commodity price swings and the early 1980s recession and debt crises. This was particularly the case for developing nations in Africa and Latin America, but even developed economies continued to impose restrictions. Until 1979, British holidaymakers were not permitted to take more than £50 spending money out of the country and passports were marked with the amount of foreign exchange bought at the bank.

The US dollar had traditionally been the most desirable black market currency. When its link to gold was severed in 1971, as well as during the broader inflation of the 1970s, it lost some of its allure and other currencies such as the West German Mark and Swiss Franc, and gold, gained in popularity. The dollar’s desirability was also dented by the 1970 introduction of mandatory reporting by banks of all monetary transfers in and out of the US.

With the move towards economic liberalisation in the 1980s and 1990s, capital controls have been the exception rather than the rule and black markets have mostly withered away. But they still flourish in certain countries including Nigeria and Iran, as well as Venezuela. In Argentina, tourists can obtain “blue pesos” at illegal cuevas for twice the rate they can from ATMs.

2. The black market premium primarily reflects the severity of the restrictions 
Black market premia over the five decades studied were typically below 100%, but they could rise far higher. China and the Soviet Union, along with their respective satellites, had premia in excess of 100%, with Poland’s routinely reaching 2400%. What set them apart from other economies was the stringency of their currency restrictions. Their monetary systems were designed to be hermetically sealed from the capitalist world and “crimes against the national currency” were punishable by death. The high premia reflected the risks and sheer difficulty of obtaining hard currency....

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