CHAPTER ONE

INTRODUCTION

1.1 BACKGROUND OF THE STUDY

The causes, effects and policy implications of the parallel economy, in both developed and developing countries have attracted attention in recent years as the expansion of this economy has been found to have adverse effects on the economy. These effects are of particular concern to policy makers in developing economies, who are confronted with growing informal employment, parallel markets in goods and financial assets, specifically in foreign exchange, and capital flight. Degefa (2001)

The parallel premium for foreign exchange is the percentage by which the parallel exchange rate exceeds the official exchange rate, that is, Z=[ PE\OE) _1]X100, where Z, Pe and Oe, respectively, stands for parallel premium, parallel exchange rate and nominal official exchange rate. Following the division of Ghei and Kiguel (1992), a country is said to have high parallel premium when the spread between the official and the parallel exchange rate is above 35%, moderate premium when it is between 10% and 35%, and low premium when it is below 10%. Ghei and Kiguel (1992).

The parallel market for foreign exchange has reached a remarkable size in some developing countries. The existence of a large parallel foreign exchange market in developing countries is attributed to the deficiency of the legal institutions, which make operation in the formal sector excessively expensive.

It is argued that a large parallel market for foreign exchange with a high premium is an indication of a basic disequilibrium in the foreign exchange market and trade regimes (Dordunoo, 1994) and, hence, involves substantial social and economic costs. The expansion of the parallel market for foreign exchange leads to the loss of government control over the economy as more and more of the official transactions are diverted to the parallel market. The parallel premium for foreign exchange functions as an implicit tax on exports, serving at

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once as a disincentive to export production as a source of hidden fiscal revenues (Pinto, 1988).

According to Elbadawi(1994:488).

…the parallel premium is an important relative price influencing key macroeconomic variables. Furthermore, the parallel market premium acquires importance not only from this direct linkage, but also as an important indicator of inconsistency between macro economic policy and the foreign trade and exchange rate regimes; this signal role is likely to feed back into macroeconomic outcomes by influencing government policy and private sector expectations of such policy (e.g. expectations of devaluation). In addition to the often-cited efficiency costs associated with the dual regime, a high and persistent parallel market premium can substantially undermine the allocation role of the real exchange rate in the economy by exposing the credibility problem of macroeconomic policy.

In the light of this general picture of the linkages of the parallel market premium to macroeconomic variable, Elbadawi (1994) arrived at the following conclusion:

…a rising premium is shown to have negative impacts on official exports and foreign trade taxes, as well as a positive effect on capital flight. Therefore, a rising premium and expanding black market could have serious fiscal and commercial policy implications by squeezing the tax base in foreign trade transactions and by expanding the opportunities for large scale rent seeking activities. A high premium also aggravates the debt problem and the foreign exchange constraint through its effects on capital flight and the recorded current account balance…controlling inflation could become more difficult under high premium regimes. (p. 508).

Kiguel and O’Connell (1995) agree that the parallel exchange rate feeds back into the economy through illegal trade and prices. Beside these, authors (Dordunoo, 1994) and Pinto, 1988) conclude that large premiums have detrimental effects on official exports and hence on growth while providing only limited insulation from external shocks. Rough estimates

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indicate that a 10% premium is likely to reduce GDP growth by 0.4% points a year. While the impact wanes as the premium goes up, and a 100% premium cuts GDP growth by 2% points a year (World Bank, 1994), a high parallel premium for foreign exchange nevertheless has an adverse impact on economic growth.

It is also important to note that authorities of some developing countries argue that parallel foreign exchange markets may be socially desirable because these markets accommodate transactors whose demand for foreign exchange is not met by official market or they increase employment by increasing the domestic availability of imported inputs. But this line of argument has little empirical support (IMF, 1993).

However, the economy of Nigeria provides an example of a thriving and large black market for foreign exchange. This black or parallel market has co-existed with a rich menu of official policies aimed at achieving more flexible exchange rate as well as a stable price system. What remain unclear is the amount and magnitude of distortions caused in the monetary policy targets and transmissions. This likely distortion raises the danger and worry about the effectiveness of foreign exchange rate market in Nigeria as a second transmission mechanism from CBN’s minimum rediscount rate MRR or policy rate PR to the real sector (changes in aggregate demand-supply gap and changes in prices).

U.J. Ekaette(2002) noted that one major challenge that had confronted this administration since it assumed office in may 1999 was how to quickly put the economy back on the path of sustainable growth. According to him, most of the banks are suspected to have abandoned real banking for “round tripping” (the diversion of official foreign exchange to the parallel market). O.O Soleye(1985) then Honorable minister of Finance stated that conscious effort aimed at the management of the Nigerian foreign exchange resources began in 1962 with the inception of the EXCHANGE CONTROL ACT which was directed at freeing the management of our FE from its erstwhile colonial pattern. T.A Oyejide (1985) stated that the Nigerian pound was introduced in 1959. Its external value was fixed at par with the British pound sterling which, in turn, defined its United States Dollar (USD) value as $2.80. Nigeria joined the International Monetary Fund (IMF) after Independence, and the Nigeria pound had

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its parity defined, in June 1962, in terms of Gold at one Nigeria pound equals 2.48828 grams of fine Gold. This confirmed its original USD par value. The Naira replaced the Nigeria pound as Nigeria’s currency in January 1973, its par value was set at half that of the pound. Hence the exchange rate became $1.52 to the naira. In February 1978, the system of determining the naira exchange rate against a basket of currencies of Nigeria’s main trading partners was finally adopted. According to Ugbebor, the Oil Glut of 1981 led to a crisis in the Foreign Exchange Market (FEM) in 1982. in December 1983 there was a change in government. With effect from January 1984 and again in May 1984 additional exchange control measure were introduced. In September 1986, the Second_ Tier Foreign Exchange (SFEM) was introduced. Under SFEM, the exchange was floated when it became clear that a rigid or controlled exchange rate would not ensure internal balance. The principles of the Structural Adjustment Programme (SAP) were adopted leading to a market- oriented approach to price determination. The Second-Tier rate was determined by auction at the SFEM using (a) the average rate pricing method,(b) the marginal rate pricing method, (c) the Dutch Auction System(DAS) which was introduced in April 1987, whereby CBN bought and sold FE in this market and supplied the demand of the authorized dealers in full. According to Akinmoladun (1990), the gap between the two rates began to grow shortly after. In 1995, the Autonomous Foreign Exchange Market (AFEM) was introduced, under a policy which allowed for Central Bank of Nigeria intervention on a predetermined basis instead of arbitrarily. Despite the introduction of AFEM, its dominance of the exchange rate market was not sustained. The official exchange rate in 1995 was N21.88/$1.00 while AFEM and parallel market rates were N79.90/$1.00 and N78.30/$1.00 respectively. Since 1999 the impact and development in the parallel exchange market has become highly uncontrollable as the average official rate was N100.84/$1.00, AFEM rate averaged N94.88/$1.00 and parallel exchange rate maintained an average of N122.5/$1.00. Ugbebor O.O and Olubusoye O.E (2002)