THE RELATIONSHIP BETWEEN THE BLACK MARKET AND OFFICIAL EXCHANGE RATES: AN EXAMINATION OF LONG‐RUN DYNAMICS IN INDIA
| Date | 01 May 2007 |
| Published date | 01 May 2007 |
| DOI | http://doi.org/10.1111/j.1467-9485.2007.00415.x |
| Author | Ramesh Chandra,Jim Love |
THE RELATIONSHIP BETWEEN THE
BLACK MARKET AND OFFICIAL
EXCHANGE RATES: AN EXAMINATION
OF LONG-RUN DYNAMICS IN INDIA
Jim Love and Ramesh Chandra
n
Abstract
This study is the first to use Johansen’s cointegration approach for India in the
analysis of the long-term dynamics between the black and official exchange rates
for the period 1953–1993. The study also estimates the long-run elasticity of the
official rate with respect to the black market rate. As monthly data over 40 years
are used, and a more robust methodology is employed, the results are likely to be
more reliable as compared with the earlier work on India. The results of our study
suggest that while there is a long-term relationship between the two rates, the
direction of causality is from the black rate to the official exchange rate. This is
plausible in the Indian context where policy has generally lagged behind events in
the black market. The hypothesis of a constant black market premium is rejected,
implying that there is a mismatch between the percentage change in the official
exchange rate and the percentage change in the black market rate.
I Intro ductio n
One of the consequences of the import-substituting industrialisation (ISI)
strategy in the post-war developing world was the emergence of black markets in
foreign exchange.
1
As the emphasis of ISI was on saving rather than earning
scarce foreign exchange, many controls – both direct and indirect – were placed
on the markets for foreign exchange. When the exchange rate is set by
government and is kept below the market rate, a situation of excess demand for
foreign exchange is likely to develop and may result in some of the supply of
foreign currency being illegally traded at a price higher than the official rate.
Black markets for foreign exchange emerge because of intervention in the
market for foreign exchange: the greater the intervention, the greater is likely to
be the scale of the black market.
2
Many authors (e.g. Culbertson, 1975;
n
University of Strathclyde
1
Balassa (1980) has highlighted such consequences of ISI strategy particularly when it is
carried beyond the easy first stage.
2
Intervention in the foreign exchange market may involve both the current as well as capital
account transactions.
Scottish Journal of Political Economy, Vol. 54, No. 2, May 2007
r2007 The Authors
Journal compilation r2007 Scottish Economic Society. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
283
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