Foreign exchange restrictions and the parallel currency market in India

Exchange restrictions are generally observed in externally-indebted, noncreditworthy countries with depleting international reserves, and a foreign trade structure which is presumably nonresponsive to nominal exchange rate changes. To the proponents of exchange restrictions, administrative-based allocation of a scarce resource is a viable economic option for countries that absorb external financial resources primarily in the form of official transfers. To the opponents of exchange restrictions, administrative-based methods of allocating reserves encourage parallel currency transactions. The incentives provided by the parallel premium have adverse resource allocation implications and welfare consequences. The model developed in this dissertation uses a general equilibrium framework to highlight the links between the goods market and the money market in a country where the foreign exchange market is bifurcated into an official and a parallel currency market. ^ Unlike in countries with market-based methods of allocating reserves—fixed or flexible, adjustment to excess demand pressures in nonunified systems occurs through changes which have real and monetary consequences. These changes include changes in the parallel premium, a depreciating home currency in the parallel market and loss of reserves. ^ The theoretical predictions are tested with quarterly data for India using time-series data. The chosen time frame witnessed a distinct shift in strategy in India from inward-orientation to outward-orientation. The model is also estimated for two distinct sub-periods to examine if the policy changes have significantly impacted India\u27s parallel currency market. The results of the study are analyzed for drawing general policy inferences. ^ Exchange restrictions are not effective for realizing the intended objectives. Such restrictions encourage economic-rent seeking activities which entail social welfare loss. Import liberalization and devaluations are shown to be effective for reducing the incentives for transacting through the parallel currency market.