Parallel markets, the foreign exchange auction, and exchange rate unification in Zambia

- ;~~~'s \'#l - V 'l; ' Policy Research ( WORKING PAPERS Macroeconomic Adjustmuetni and Growth Country Economics Department The World Bank May 1992 WPS 909 Parallel Markets, the Foreign Exchange Auction, and Exchange Rate Unification in Zambia Janine Aron and Ibrahim A. Elbadawi Zambia's failure with macroeconomic reform - including exchange-rate reform - is the result of macroeconomic (espe- cially fiscal) laxity. And the exchange-rate premium is likely to rise as terms of trade worsen, foreign aid declines, and expec- tations of devaluations rise. Policy Research Working lapers disscminate the findings of work in progress and encourageLhe exchange of idear amnngf3ank sLaff and all others interestec in devclopment issues hbese papers, disnbuted by the Research Advisor, Staff carry thc names of theauthors,refIeci only theurviews, and should be used and ciied accordingl) The findings, inierpretations, andconclusions arc theauthors'own Theyshould not be autnbuteid to the World 13;nk, its lioard of Dirctiors, ILK management, or an) of u.s membcr counLnes  Policy Research Macfoeconromi Adjusiment and Growth WPS 909 This paper -a product of the Macroeconomic Adjustment and Growth Division, Country Economics Department- is part of a larger effort in Ihe department to study the macroeconomic implications of multiple exchange markets in developing countries. Copics of the paper arc available frec from the World Bank, 181 8 H Strect NW, Washington DC 20433. Please contact Victoria Barthelimes, room NI 1-025, extension 39175 (May 1992, 115 pages). Since Zambia's independence in 1964, a large, thriving increasing foreign aid Icads to a decline in the premium. parallel market for foreign exchange has coexisted wilh This effect dominates the indirect effects of real wealth a rich menu of official exchange rate policies aimed at and real appreciation, which work to increase the achieving a more flexible, exchange rate and price premium. Expansive fiscp! and monetary policy cause system as well as financial and trade liberalization. the premium to rise. Despite aggressive policies in these areas, particularly Of all the factors that influence the premium and for the exchange rate, Lhe black rnark,t premium have caused exchange rate unification to fail, terms-of- (defined as the ratio of the black market rate to the trade shocks dominate. But Lhc driving force behind official rate) remains high -averaging 10() percent for persistence of the premium was outright laxity in fiscal 1970-88 and more than 400 percent in recent years. and monetary policy - especially ia 1985 and the Aron and Elbadawi examine the origins of Lhe following two years of the exchange rite auctions, and parallel market, the statistical properties of the parallel during the collapse of economic reform in 1987. premium, and the shocks and macroeconomic policy Aron and Elbadawi conclude that exchange rate changes that influence its evolution. Using annual data, reform without fiscal reform may be futile. Fiscal they specify and estimate an eciectic error-correction retrenchment for the first two years of the crawling peg model for the premium. was iifluenccd by political considerations. Zambia is They find that the la?"c parallel market might havc one of the most urbanized countries in Africa: about caused problems in macroeconomic management and half the people live in urban areas, and the urban middle economic reform. A large exchange rate premium as an class wields considerable influence. This explains Lhe indicaton of foreign exchange shortages will have pervasive ensemble of price control and subsidy direct deleterious impact on copper production and schemes that have survived reform attempts. But the export. It can also indirectly hurt copper exports ratio of government revenue to G DP has never been through its negative effect on domnesic incentives for below 20 percent (one of the highest rates in Africa) the officially sanctioned copper economy. A high despite sharp declines in terms of trade. More emphasis premium was also found to encourage overimporting should be given to the political economy and distribu- (and probably overinvoicing) of officially traded tional consequences (especially the rural-urban nexus) imports. in the carly stages of economic reform. Aron and Elbadawi find that foreign inflation and Zambia's economy, heavily dependent on copper depreciation of the black market rate (in a cost-push exports, is particularly susceptibic to external shocks. It manner) directly increase domestic inflation. Deprecia- is important to liberalize major trade and financial lion of the black market rate also signals indirectly Lhat markets in such a way as to compress the parallel economic reform lacks credibility and that macroeco- market and prevent the premium from serving as a nomic policy is unsustainable. Short-term changes in major signal to Lhc economy. the premium reflect expected changes in policy and Increased foreign aid could help mitigate the politics. destabilizing effcts of terms-of-trade shocks. This is The major factor behind the failure of unification likcly to be most helpful in the carly stages of refoim, and economic reform is the fundamental endogeniety of when it can foster credibility and stabilize the free ratc the parallel premium in macroeconomic and tradc - before the forcign sector can begin to rcspond to real policy - as well as in exogenous terms-of-trade and depreciation. Then there will be less need for aid flows foreign aid shocks. Improving the terms of trade or to conLinue at their initial levels. The Policy Research Working llaper Seriesdisserninates the findings of w\ork under \k ay in ilie Bank. Anobjectiveofthe series is to geL these findings out quickly, even if presentations are less than fully polished. Thc findings. inlerprelalions, and Xconclusions in thcsc papers do nct necessarily represent official Bank policy. Produced by the Policy Research D)issernination Center  CONTENTS I. INTRODUCTION . . . . . ... . . . . 1 II. THE DEVELOPMENT OF MULTIPLE MARKETS FOR FOREIGN EXCHANGE IN 2AMIA . . . . . . . o--oo. . *t. *. . . . . . ....... 6 1. A brief survey of official currency arrangements since 1964 . . 6 2. The emergence of an unofficial market in foreign exchange. . . . 9 3. An evaluation of exchange rate policy in Zambia. . . . . . . . 10 III. THE PARALLEL PREMIUM AND THE MACRO-ECONOMY IN ZAMBIA: 1965-1989 . . 16 1. Macroeconomic linkages by exchange rate episode . . . . . . . . 18 2. A Model of Expected Devaluation. ..... .... . . . 28 IV. A MODEL OF THE PARALLEL PREMIUM ..*...... .......... 32 1. The Basic Model . . . . . . . . . . . . . . . . . . * . . . . 33 2. Endogenizing the RER . . . . . . . . . . . . . .... . . . . 38 V. EMPIRICAL DETERMINATION OF THE PREMIUM . . . . . . . . . . . . . . 43 1. The Annual Model . . . . . . . . . . . . . . . . . . . . . . 43 VI. THE EFFECTS OF THE PREMIUM ON TRADE . . . . . . . . . . . . . . . . 47 1. Reported Trade Flows . . . . . . . . . . . . 47 2. The misinvoicing of foreign trade. . . .. . 55 2.1 Statistical methods for the detection of unrecorded trade. . 58 2.2 An approximate quantification of misinvo$icing in Zambia. . . 59 VII. THE EFFECTS OF THE PREMIUM ON DOMESTIC INFLATION AND FISCAL BALANCE 65 1. Domestic inflation. . . . . . . . . . . . . . . . . . . . . . . 65 2. The fiscal balance. . . . . . . . . . . . . . . .. . . 70 VIII. THE PROBLEMS OF UNIFICATION: SOME CONCLUDING REMARKS ON THE LESSONS FROM ZRENIA . . . . . . ....... ..574 REFERENCES .. .. .. .. .. .. .. .. .. .. .. .. .. ..... .................................... 105  LIST OF TABLES Table 1 (a) Exchange Rate Policy Episodes in Zambia 1964-90 . . . . . . . 79 Table 1 (b) Basic Statistics for the Black Market Premium (monthly data) . . . . . . . . . . . . . . . . . . . . 80 Table 2 (a) Major Parity Changes Since 1964 . . . . . . . . . . . . . . . 81 Table 3 (a) The Parallel Premium and the Macro-economy . . . . . . . . . . 82 Table 3 (b) Zambian Copper Dependence, 1964-89 . . . . . . . . . . . . . . 83 Table 3 (c) Short-run Influences on the Black Market Premium During the Auction Period . ................. . 84 Table 6 (a) Expected Disparities for Import Data Comparisons in the Presence of Trade Policy and a Black Market Premium . . . . . 85 Table6 (b) Partner-country-data Comparisons: Percentage Misinvoicing . . 86 Table 6(c) Quantifying Faked Invoicing Using Import Unit Value Comparisons (1975=100) ................... . 87 Table 6 (d) Statistics for the smuggling incentive and Trade Ratios . . . 88 Table 6 (e) Regressions of the Trade Ratios on the Smuggling Incentives . 88 Table 7 (a) An Anatomy of Possible r 'cal Implications of Exchange-rate Devaluation-driven Unification . . . 89 Table 7 (b) Central Bank Losses Due to Foreign Exchange Transactions . . 90 Table 7(c) An Empirical Assessment of the Location of Unification Episodes on the Seigniorage Laffer Curve . . . . . . . . . . . 91 Appendix Tables Table A.2 (a) A Summary of the Exchange Rate Components of I.M.F. Programmes with Zambia from 1976 . ...... . 108 Table A.3 (a) A Summary of the Weekly Auction Results . . . . . . . . 109 Table A.5 (a) The Parallel Premium and its determinantst Tests for Normality (Annual Data) . . . ... .. . 110 Table A.5 (b) Dickey Fuller and Augmented DLikey Fuller Tests for Unit Roots . . . . . . . . . a . . . . . . . . . . .. 110 Table A.5 (c) The Black Market Premium and Related Macroeconomic Variables in Zambia ... . . . . . . . . . . . . . . 111  LIST OF FIGURES Figure 1 The Quarterly Black Market Pzemium for Zambia showing exchange rate episodes . . . . . . . . . . . . . . . 92 Figure 2 (a) Nominal and Real Effective Exchange rates by Episode (1980-100 for the official rate) . . . . . . . . . . 93 Figure 3 (a) The Monthly Black Exchange Rate Premium: 1970-90 . . . . . . 94 Figure 3 (b) World Copper Prices: LME Prices in U.S. c/lb (Mt Wdeflated, 1963 terms) . . . . . . . . . . . . . . . . . 95 Figure 3 (c) Expectations of a maxi-devaluation: (monthly black market premium Jan. 1982-Jul..1983) . . . . . . . . . . . . . 96 Figure 3 (d) Zambia: nominal official and parallel market exchange rate depreciation: 1984-89 . . . . . . . . . . . . 97 Figure 3 (e) Expected devaluation estimated using monthly data . . . . . 98 Figure 6 (a) A proxy for trade policy in Zambia: ratio of imported to retail manufacturing price indices (1966-100) . . . . . . 99 Figure 6 (b) Smuggling incentives and trade data ratios . . . . . . . . 100 Figure 7 (a) Inflation (CPI, WP) and parallel rate depreciation . . . . 101 Figure 7 (b) Inflation (disaggregated index) and parallel rate depreciation . . . . . . . . . . . . . . . . . . . . . . . 102 Figure 7 (c) The Seigniorage Laffer Curve and the premium/inflation trade-off . . . . . . . . . . . . . . . . . . . . . . . . 103 Figure 7 (d) Inflation and exchange rate depreciation during the auction ..... . . . . ..... . . . . . . . . . 104 Appendix Graphs Figure A-1 Black Market Premiu ..112 Figure A-2 Real Exchange Rate ..113 Figure A-3 Real Money Supply . . . . . ..114 Figure A-4 Interest Rate Parity Differential . . . . . . . . . . . . 115 This paper is pai. of the CECMG project 'Macroeconomic Implications of Multiple Exchange Markets in Developing Countries". The paper has benefitted from discussions with and comments from Stephen O'Connell, Paul Collier, and participants at a CECMG workshop on the project. Also country desk provided helpful comments that have been received and taken into consideration. Any views expressed in this paper are not necessarily those of the World Bank or affiliated organization. The authors would like to acknowledge able research assistance from Nita Ghei.  x *iNRODUCTION The economy of Zambia provides an example of a thriving and large black X market for foreign exchange. This black market ha. co-existed with a rich menu of official policies aimed at achieving more flexible exchange rats and price system as well as financial and trade liberalization. Despite aggressive policies in these areas especially with regard to the exchange rate', the black market premium (defined as the ratio of the black rate to the official rate minus one) remains high. For the 1970-88 period, the premium averaged 100 percent and exceeded 400 per cent in recent years. The presence of sizable parallel markets with substantial premiums, such as the one in Zambia, has Important macroeconomic implications. The theoretical models of dual exchange rates, e.g. Lisondo (1987 a,b) and Dornbusch (1986), and their extensiona and elaboration to the case of black markets, e.g. Dornbusch et al (1983) and Pinto (1987, 88a, 88b), derive a steady state solution for the premium that depends on the fiscal deficit ratio and the parameters of trade and exchange rate policy. Furthermore, key macroeconomic indicators such as inflation, foreign trade flows, and the real exchange rate can also be shown to be influenced by (or jointly determined with) the premium, e.g. Kamin and Elbadawi (1990), Elbadawi (1989). The empirical tradition on this literature however, is still in its infancy. One of the main objectives of this paper is to develop empirical models linking the premium to the above macroeconomic indicators and to use Zambian data to assess the extent and dynamics of these linkages. 'Since the country's ndependence in 1964 to present, six distinct episodes of exchange rate regimes - including an auction - can be identified (see Table 1 (a)).  -2- Evidence from the above models can shed light on the recent experience in Zambia of aborted reforms, macroeconomic instability and recurrent policy reversals.2 The failure of the Zambian economic reform of the last decade, especially those aspects of the reform related to the foreign exchange auction experiment and the attempts at exchange rate unification, has been suggested to be the direct outcome of macroeconomic laxity, particularly with regard to fiscal policy, (Pinto, 1987). The evidence of our paper upholds this view. In addition, exogenous factors that operate through the trade accounts such as the terms of trade and foreign aid, and expectations reflecting asset market considerations, are important as potential determinants of the premium in Zambia. The empirical results of this paper predict a rising premium as a result of worsening terms of trade, declining foreign aid, or higher expectations of future devaluation. Official dual markets have twice been cr-ated in Zambia: a two tier auction operated for two months in 1987, and in February, 1990, a dual exchange rate system was established. These episodes are either too short-lived or recently instituted to merit analysis. Thus, the structure of multiple markets for foreign exchanle considered in this study will consist of an official market with an officially managed or auction-determined rate. and an illegal unofficial market with a freely floating rate. During the auction period, a quasi-legalization of the unofficial market occurred with the introduction of "own funds" import licenses. The quarterly black market premium for Zambia is shown in Figure 1 where the considerable regime shifts of the last two decades are clearly reflected in the evolution of the premium. 21n fact Pinto and van Wijnbergen (1987) argued that the fail- e to adjust policy for the existence of par&llel markets may be the main cause behind recent macroeconomic instability in SSA.  - 3 - A statistical analys's of the premium and black rate capturing broad changes in size and variability across exchange rate episodes is given in Table 1 (b). Black market rates are available from mid-1970 which omits the period of the copper boom (1964-74). It is likely that the premium from 1964 to 1971 would reflect incentives for capital flight due to political uncertainty post Independence, the presence of exchange controls and an increased demand for foreign assets during the copper boom. The premium rose after the negative copper price shocks of 1971 and 1974, thereafter following an upward trend in tandem with the incroasingly over-valued fixed exchange rate. In the controlled float episode from July, 1976, a continuous dcvnward trend in the premium ensued which was maintained under the crawling peg, after 1983. A sharp rise for 1985 was due to the break with I.M.F. late in 1984, but the auction in its early stages saw a low premium. The premium fluctuated considerably during the auction, but the trend was to higher values after August, 1986. Across exchange rate episodes the average premium has declined, though rose by a factor of ten in the final episode. The black market rate has continuously depreciated across the five episodes. Both the premium and the black market rate exhibit decreasing stability across exchange rate episodes (though variability declined during the auction). In part this may be related to bubbles and crashes reflecting agents' reactions to accumulated mismanagements and to speculation. Speculative aspects and the distribution of the premium are analyzed in Section V. Three key aspects will be examined in this paper. First, the origin of the parallel market and the statistical properties of the premium are analyzed. The factors influencing the premium in various episodes are  -4- considered and the premium is stimated using annual data. Secondly, the effects of the premium on inflation and on recorded avd unrecorded (illegal) trade fli w are considered. There in a paucity of empirical research on the role of smuggling and misinvoicing of exports and imports in response to the premium and trade policy. An attempt is made here to quantify these responses and to link them to changes in policy and the premiun. A premium on foreign exchange serves as a tax on exports and a subsidy on imports. The fiscal impact of the premium in Zambia is important in the uniflcation of official and unofficial exchange rates, where a lose of revenue implicit in the demise of the unofficial market may have induzed inflation tax to be substituted for it in the early stages of the auction (Pinto, op cit). Finally, Zambia has attempted unification of official and unofficial rates of exchange in two distinct episodes: first, by pre-announced monthly devaluations in the crawling peg episode (1983-85), and secondly, using a market defermined rate in the foreign exchange auction (1985-87). What distinguishes the two episodes is the timing of unification, sequencing of accompanying measures of liberalization and portrayal of commitment to liberalization (i.e. credibility aspects). The episodes may usefully be contrasted and lessons drawn from the aborted auction episode. The paper is organized as follows. A detailed narrative tracing the development, structure and operation of multiple foreign exchange markets is contained in Section II. In Sec*ton III the link between the premium and the macro-economy is examined, and in Sections IV and V, a model for the premium is specified and estimated. Section VI analyses the effects of the premium on recorded and unrecorded trade flows using econometric models for key foreign  trade aggregates, and In the case of unrecorded imports, data was constructed from estimates of overinvoicing ratios computed in this section. Yn Sectlon VII, the impact of the premium on Lnflation was eatimated using a simple, empirical inflation model$ also, the fiscal lmpact of the premium, *epecial'y exchange rats unifLcation a la Plnto (op. cit.), is estimated and analyzed. Finally, Section VIll concludes.  -6- 1. *- DEVELOPMNT OF MULTIPLE MAURKT FOR FOREIGN EXCHANGE SN ZAMEZA 1. A brief survey of official currency arrangmeants Erom 1964. Parity changes since 1964 are disc_ajed with reference to Table 2 (a). At Independence in 1964, Zambia's currency was pegged to the pound rnd was fully convertible. The kwacha replaced the Zambian pound on 16th January, _968, halving the official rate (to KO.714/$ or Xi.7/ST) whilst retaining the link to the pound sterling. From 1964 until the early 19703 this fixed exchange rate was ataintained. On 3rd December, 1971, the kwacha's ties to the pound were severed and it was linked to the U.S. dollar at the rate KO.714/$. This represented a devaluation, given the kwacha's appreciation againat the dollar following a de facto devaluation of the American uni, on 15th August, 1971. The gold content of the kwacha was reduced to 7.89 per cent on 22nd December, which paralleled the U.S. dollar's devaluation of 18th Decemi-z, thus leaving the official rate of exchange unchanged. The kwacha did not follow the February, 1973 devaluation of the U.S. dollar, and was realigned to KO.643/$ on 15th February, based on an unchanged gold content. Thereafter, with the increase in the dollar's value in consequence of floating and the devaluation of various currencies, the kwacha appreciated against the currencies of all major trading partners (save the Deutsche mark). By mid-1976, the value of the nominal effective exchange rate (trade-weighted) had risen over 25 per cent. On 8th July, 1976, ties with the dollar were severed and the kwacha linked to the SDR at SDR1.08479 on a controlled, floating basis, a de facto devaluation of 20 per cent. This rate was devalued by 10 per cent on 17th MArch, 1978 to SDRO.976311 and by a further 20 per cent on 7th January, to SDRO.78125. The link to the SDR was broken on 6th July,  -7- 1983: a crawling peg based on a basket of currencies of maior trading partners, rather than the basket determining the value of the SDR, was introduced. A controlled devaluation was to be achieved of 1 per cent per monvh; the rate was increased to 2.5 per cent in 184. Dissatiefaction with the downw_rd rate of ad4untment and the inefficiencies of the accompanying manual exchange allocation system led to the adoption of a foreign exchange auction system in October, 1985. The rate to the dollar on 3rd October was K2.2, reaching KS.01 in the first of the weekly auctions, on 11th October, and K8.30 a year later on 11th October, 1986 in the 53rd auction. Thereafter the rate declined sharply reaching K15.25 in the 60th auction on 29th November, 1986 (an 86 per cent depreciation of the kwacha from the inception of the system). From the 41st auction, new documentation was required to accompany bids, and from the 43rd auction (2nd August, 1986) a "Dutch Auction" replaced the former system.3 The Central Bank increased the amount of foreign exchange for auction three-fold from 2nd August, but this policy was not oustainable. These modification. failed to arrest the kwacha rate of depreciation. Following riots on the Copperbelt and in Lusaka on 5th December, 1986, with the rate at K14.92 in the 68th auction, the auction was temporarily suspended (28th January, 1987). The rate was set at K9.00 . Thereafter six auctions were held, beginning on the 28th March, 1987, under a two-tier auction system: an official window at !.9.00 was restricted to debt service, essential imports and receipts of loans and grants, whilst the auction rate was allowed to fluctuate between this rate and an upper ceiling of K15.00 3In the "Dutch Auction", successful bidde..s paid the full amount of their bid regardless of the excess over the marginal bid, and this sum was surrendered as government revenue.  (this restriction was abandoned after four weeks). In the fifth of theme auctions on the 24th April, the kwacha rate fell to its lowest value, K21.02; President Kaunda abolished the system on 1st May, after a final auction which served only to allocate foreign exchange at the rate of K15.00. From 5th May, a fixed rate of K8.00 was installed. Requests for foreign exchange were filed through the commercial banks, and allocation of foreign exchange and isbue of import licenses decided simultaneously by a Foreign Exchange Management Committee (FEMAC). Non-traditional exporters were allowed to retain 50 percent of their export earnings. Free trade of title to the reta'ned foreign exchange occurred at a premium on the official rate, but required prior approval from FEMAC. A third, legal foreign exchange market was limited to larger non-traditional exporters and allowed the use of export earnings to purchase Zambia's commercial (pipeline) debt at a discount on international financial markets, then exchanged at the Bank of Zambia .'or kwacha equal to the official rate times the face value of the debt inatrument. A devaluation to X16.00 occurred in June, 1989, and a further devaluation to K24.00 in December of that year. As of February, 1990, a two-tier currency was re-introduced: an official rate of exchange was initiated at K27.80/$, with the "market exchange rate" at K40.00/S. The Bank of Zambia sold foreign exchange through the First Window (the official rate) under existing FEMAC procedures for imports, and purchased all foreign exchange earned by ZCCM. The Second Window operated at the market rate and was used for those goods eligible for foreign exchange allocation under the Open General License System (OGL). The sources to fund this window were non-traditional exports earnings and remittances received from donors. only 10 per cent of Imports by volurtie were eligible for OGL allocation at  -9- the inception of the system. By the 31st March, 1991, most imports had been transferred from the First to the Second Window, due to the gradual expansion of the OGL to cover over 92 per cent of imports. Donor funding accounted for 54 per cent of the funding of the Second Window in 1990 and all of it in 1991. In April, 1991, the rates were unified at K58/$. 2. The emergence of an unofficial market in foreign ex-hange. The origins of Zambia's unofficial market in foreign exchange lie in the control regime introduced and extended from Independence in 1964. Political uncertainty in the decade of nationalizations post 1964 and deterioration of the economy after the copper price shocks in the early 1970c provided further incentives for capital flight. At the dissolution of the Federation of Northern Rhodesia, Southern Rhodesia and Nyasaland (1953-63), Zambia had been the only country of the three to relax exchange control restrictions imposed in 1961; however, these liberalization measures were minor. After a negative copper price shock in 1971, foreign exchange reserves were protected by tightening exchange controls. The overvalued exchange rate and foreign exchange controls created excess demand in the market for foreign exchange, and thu parallel market burgeoned. Import licensing, originally devised to avoid congestion after the closure of transport routes in the 19606, increasingly served to control import levels. In 1972, a restrictive import licensing system was introduced. Certain categories of imports were banned, but capital and intermediate goods imports were liberally licensed. Import licensing was further tightened early in 1975 following the precipitous decline in copper prices in 1974. These  - 10 - measures continued to be strictly enforced until the liberalizing reforms of the early 1980s. Price controls had been applied from Independence to producer prices of agricultural goods, the prices of "essential commodities" and some parastatal company products. Interest rate controls rendered real interest rates negative from 1966 onwards, reaching below -10 percent between 1976 and 1980, and just preceding and following the auction. Evasion of price and trade controls by smuggling and misinvoicing, and consequences for the size of the parallel market and the premium are discussed in the section on unrecorded trade (Section VI.2). Various liberalization measures were implemented preceding the foreign exchange auction and during its operation. Most price controls were lifted in December, 1982 and interest rates decontrolled late in 1985. The trade account was liberalized in October, 1985 concomitant with the floating of the exchange rate. External capital controls remained in place throughout the nineteen month auction period. Quasi-legalization of the black market was also effected just prior to the auction with the introduction of export retention schemes and "own funds" import licenses.' At its termination most of the liberalizing measures were reversed. The impact of the liberalizing reforms on the premium is considered in Sections III and VI, and quantified in Section VII.2. 3. An evaluation of exchange rate policy in Zambia. Six distinct exchange rate episodes have been identified for Zambia since Independence in 1964 (see Table 1 (a)). Exchange rate policy is analyzed with ' Remittance of foreign exchange held abroad, or payment for imports of goods and services out of funds held abroad, was allowed without restriction or declaration as to the source of the funds.  - 11 - referencs to Figure 2 (a) where nominal and real effective exchange rates for the official rate are contrasted with the parallel real effective exchange rate.5 The official REER and NEER are set to 100 in 1980 while the parallel REER is 60 in 198G to reflect the actual premium. The premium is the distance between the two REER indices divided by the height of the parallel REER index. As they move closer together, so the premium declines. The lower the parallel REER and the higher the official REER indices, the higher the premium. The parallel rate is expected to display more short-term volatility (this is discussed in Section III), but discounting for the risk of illegality, may serve as a proxy for a market rate. Thus the effective rates in Figure 2 (a) may be used both descriptively to contrast the official REER and NEER, and to assess the misalignment of the official REER from a "market rate" (parallel REER). In episode 1 (1964-1976Q2), the exchange rate was fixed, initially to the posind sterling, and subsequently to the dollar. Exchange rate policy was inactive in this period. From 1971 the nominal rate became increasingly overvalued, culminating in severance from the appreciating dollar. The appreciation contributed to the deterioration in trade and current account balances following the severe negative shock to copper prices in 1974 and rise in oil prices after 1973. At the same time wage costs were rising and mining 5 The real effective exchange rate (REER) La the geometric average of trade-weighted real exchange rates (RERi) ior the six major trading partners, excluding South Africa, where RERi=NERi.CPI(Zambia)/CPIi , and NERi is the nominal bilateral exchange rate in foreign currency per kwacha. The weights, Wi, are import weights, based on partner-country recorded exports, to avoid the misinvoicing bias (South Africa does not record exports to Zambia). Weights were redefined for 1968-72, 1973-77, 1978-82 and 1983-88. The CPI rather than WPI was used as there are less likely to be definitional discrepancies across countries (IFS, I.M.F.).  - 12 - profitability falling with increased production costs and transport dLfficultis. The overvalued rate further encouraged capital intensive production methods towards which a bias already existed given the nature of tariff policy. Little variation is apparent in the official REER (inflation averaged 6 per cent for 1970-73) save for a muted response to the shocks of 1971 and 1974. The parallel REER is considerably devalued relative to the official REER and tracks the terms of trade shocks closely. Progressive devaluations of the kwacha from 1976 until the auction of 1985, had their origins in conditionality associated with International Monetary Fund credit agreements with the government. Their aim was to redress external imbalance in the Zambian economy by enhancing the competitiveness and profitability of the export sector and encouraging the development of new exports and import substitutes. The IMF's involvement with economic policy management in Zambia began in 1971 with the negotiation of a compensatory financing facility for SDRl9 million, following a negative copper price shock and the flooding of Zambia's second largest min. Financial flows between Zambia and the IMF have since been considerable. The first stand-by agreement was negotiated in 1973 covering one year and was accompanied by mild conditions. The post-1975 stabilization programs with the IMF in 1976, 1978, 1981, 1983 and 1984, with the exception of the 1976 program, all involved higher conditionality (Ndulo and Sakala, 1986).7 In episode 2 (1976Q3-1983Q3) the rate was pegged to the SDR and two 6The Rhodesian border with Zambia was closed in 1973 while civil war in Angola rendered the Benguela Railway route unusable. 7 The exchange rate components of the agreements are summarized in Appendix A.  - 13 - devaluations enacted, of 10 per cent in March, 1978 and a maxi-devaluation in January, 1983 of 20 per cent. The NEER fell steadily until 1980, in tandem with the official REER (inflation from 1976-80 averages 15 per cent, but reached 10 per cent by 1980). The parallel REER appreciated in 1979 reflecting the more realistic official REER and a positive terms of trade shock in 1979/80. In the aftermath of the 1979/80 copper boom, inflation rose (it averaged 13 percent, 1980-83) and nominal rate depreciation was insufficient to prevent misalignment of the official REER and NEER. The premium narrowed after 1979 as a function of devaluation, terms of trade changes and increased foreign borrowing, reaching 30 percent in 1983. The large devaluation of January, 1983 heralded a new exchange rate episode, episode 3 (1983Q4-1985Q3), where from mid-1983 the SDR link was substituted by a basket of currencies of major trading partners and a crawling peg employed. Given high levels of inflation (averaging 26 percent from 1983- 85), the official REER continued to be overvalued, but the premium narrowed reaching 40 percent in the month preceding the auction. During 1984 and 1985 the importance of role of the exchange rate as an economic policy instrument to induce the required structural adjustment was increasingly emphasized, culminating in the foreign exchange auction (episode 4 (1985Q4-1987Q2)). The stated objectives of the foreLgn exchange system and its accompanying measures (Bank of Zambia, 1985) were to ensure the responsiveness of the rate to changes in the demand for and supply of foreign exchange and to provide foreign exchange in a timely manner. Foreign exchange would be attracted into the banking system while the parallel market would have reduced importance. Subjectivity and the reliance on administrative mechanisms in the allocation of foreign exchange would be eliminated. A larger  - 14 - volume and broader range of exports was expected to result. Further, foreign investment would be encouraged by facllitatic if the remittance of dividends and profits. The principal feature of the weekly foreign exchange auction was that the auction rate applied to all foreign exchange transactions. Predetermined amounts of foreign exchange were allocated outside the systeme but at the auction rate, for the governmentls imports, ZCCM and non-traditional exporters' export earnings retention quotas, crude oil imports and related port charges and IATA payments by Zambia Airways.' Foreign exchange for all other imports and service payments, including the remittance of profits, dividends and transfers were obtained through the auction. The source of funds for the auction was foreign exchange from the commercial banks arising from exports of goods and services and external loans and grants. Wide support was received from the international community, especially the World Bank, the IMF and bilateral donors. Both the parallel and official REER fell during the auction, and the gap between them narrowed.9 Thus the premium fell to about 30 percent in 1986, a level considered compatible with the maintenance of exchange controls. Nevertheless, high levels of inflation (see Section 7 on the Pinto Effect) induced overvaluation in the official REER. The reversion to a fixed rate with periodic devaluations for over two years after the auction constituted episode S (1987Q3-1989Q4) with persistently high inflation, the official REER was progressively more s Petroleum and IATA payments were included in the auction from February, 1986. 9 This is seen more clearly with monthly data (discussed in Section 7).  - 15 - overvalued and the real depreciation gains of the auction episode were eroded. Meanwhile the premium soared, exceeding 400 percent in 1988. This regime was superimposed by an official multiple rate *ystem from early 1990, which was unified in the first quarter of 1991.  - 1r. - III. TEE PARALLtL PR36U1 AND TEE NACRO-ECONOWY XN ZAMBIA: 1965-1989 The premium and the etock of black market currency are generally considered to be jointly determined by the interaction of stock and flow conditions in the black market for foreign exchange (Dornbusch et al, 1983). Portfolio balance considerations, given expected yields on domestically and foreign-held assets, will govern the stock of assets willingly held; that is, there is a level of the premium that w!'l establish stock equilibrium. Current and expected changes in econom - jolicy or changes in exogenous variables, such as terms of trade and foreign aid, will affect the portfolio composition through the wealth effect. Flow considerations are especially emphasized in black market models: the level of the premium will influence the flows into and out of foreign currency by altering profit opportunities for smuggling, the faked invoicing of trade, tourism and the remittances of migrants. Factors affecting flow conditions, and therefore the spread, include trade controls and the risks and costs of engaging in illicit activity. In the Introduction, the considerable changes seen in the annual black market premium were briefly discussed with reference to Figure 1. Statistics for the premium by exchange rate episode (Table 1 (b)) showed a decline in the mean premium until episode 5, while variability tended to increase with the exception of the auction perlod. Examination of monthly data organized by exchange rate episode in Figure 3 (a) shows that some periods have experienced more volatility than others. The increased variability reflects the short-run impact of "news" on the premium. The black market is integrated with forward looking asset markets so that the assumption of rational expectations in conjunction with portfolio  - 17 - decisions means that expectations about political events and changes in economic policy may be apparent in the premium before they occur, while political and economic shocks have an immediate impact. Whether this variation in the premium will be positive or negative depends upon the change induced or expected to be induced in the private sectors' desired holdings of foreign exchange. Dornbusch et al (1983) find expectations of major devaluations, in addition to variables capturing changes in asset stocks and the flow of 2oreign exchange, to be significant in explaining the Brazilian black market premium, while politics and interest rates were major determinants of the Argentinian premium (Dornbusch and Moura Silva, 1987). In the short-run, portfolio considerations and expectations are likely to be the major determinants of the premium. The long-run steady state premium has been shown in models employing the above theoretical framework to depend on such fundamentals ae the terms of trade, the budget deficit, capital flows and the trade regime (see for example Lizondo (1987b), Pinto (1988a) and Section V of this paper). In what follows, first, the Zambian experience is considered in the light of the above cited literature. Linkages between the premium and the macro-economy are examined for each exchange rate episode, with recourse to macroeconomic indicators in Table 3 (a) and monthly premium trends in Figure 3 (a). Secondly, we specify and estimate a simple monthly model of expectation of future devaluation, drawing on the discussion of episodes. This model accommodates the reactions to anticipated economic policy as well as to political and economic events, and can be used to study the evidence on the determinants of expectations in Zambia. Furthermore, if expectations of  - 18 - future devaluations are important for the determination of the premium and our model of expectation is correctly specified, the derived series of expected devaluation should closely approximate the actual behavior of the premium. 1 * acroeconoamic linkag e by excange rate opisode. 1.1 Eoiggde I: 1964-197602 Zambia attained independence from Britain in 1964, the first year of the copper boom, at the dissolution of the Wederation of Northern Rhodesia, Southern Rhodesia and Nyasaland (1953-63). A very small industrial base was inherited, with manufacturing contributing les than 7 per cent of GDP and 10 per cent of formal sector employment in 1964. Agriculture contributed 12 per cent of GDP in 1964, due largely to the output of the 1200-1300 expatriate, commercial farms along the line of rail to the copper belt, most agriculture being rural and subsistence-based. Dominant in the economy from the 1920s was the copper sector, owned and managed by foreign interests and providing the major impetus for the development and settlement of the economy. At Independence copper contributed 40 per cent of GDP, 20 per cent of formal sector employment, 90 per cent of goods exports and over 60 per cent of tax revenues. Zambia's early economic development was characterized by an increasing role for government in the economy and the imposition of economic controls. The origin of these controls lies in the practical implementation of the Zambian philosophy of "Humanium", a version of African Socialism developed in the pre- Independence political struggle by Kaunda and the United National Independence Party (articulated ln Kaunda (1974)). It was considered a political necessity to address pre-Independence health and education (racial)  - 19 - differentials and to provide housing, to "Zambianise" employment, and gain from expatriates economic :ontrol of agriculture, mining and industry, creating Zambian entrepreneurs. Diversification of the economy away from copper was accorded priority, a long-held view, the first allusione to which were in the 1930. (King (1987)). Agricultural and industrial development were therefore emphasized. The 1968 Mulungushi Reforms expanded the government holding company for industry, finance and real estate by means of a 51 per cent state participation in 26 existing private enterprises, and it grew rapidly thereafter due to further take-overs and new investment. In 1976, the public share in manufacturing was over 50 per cent. Nationalization of the two major mining companies (a 51 per cent equity share) followed in 1969 with the compensatory issue of 6 per cent bonds, unconditionally guaranteed by the government and serviced out of dividends. The financial sector proved unamenable to nationalization, but various state financial intermediaries have since been created. State involvement in agriculture was via State farms and subsidized statutory monopolies dealing with the largest marketed trade. Substantial subsidies and loans were extended to parastatAls while food subsidies guaranteed a quiescent urban population (politically Important, comprising 50 per cent of the population). Economic controls were introduced and steadily extended post Independence, particularly after the first negative copper price shocks of the early 19709. These included interest rate controls, wage controls, price controls in agriculture and industry, exchange controls and quantitative restrictions on trade. The pattern of copper prices from 1950 to 1990 is shown in Figure 3 (b). A positive shock to copper prices from 1964 induced a trade surplus. Foreign  - 20 - reserves were accumulated reaching a maximum in 1970 while capital inflow was modest. Government savings were positive until 1970 and amounted to about a third of national savings. Public sector capital and current expenditures rose strongly in line with the ambitious First National Development Plan (1964-71), but the budgetary position was sustainable until 1970, given high mineral revenues. From 1965-76 real income grew at an annual average rate of 2.4 per cent. The aggregate figure reflects a decline in mining growth over the period due to rising costs and transport difficulties (-2 per cent), and slow growth in transport and communications and construction ((1.8 per cent and 1.4 per cent, respectively). Although emphasis had been given to agricultural development, output growth was low with continued reliance on Imported food and agricultural raw materials. The domestic terms of trade were against agriculture with producer prices set below border prices. Services expanded rapidly at 6.7 per cent with government demand while the manufacturing sector achieved the highest rate of growth from a low base at 7.7 per cent. However, wage increases, low interest rates, generous investment and depreciation allowances, low tariffs on capital goods and an over-valued exchange rate encouraged an import-substituting, capital intensive mode of production. By 1976, the manufacturing sector received almoot 40 per cent of visible imports of which about 15 per cent were capital imports. Thus despite an increasing government role and stated commitment tc diversification, the negative copper price shock in 1974 impinged upon an economy still highly dependent upon copper (see Table 3 (b)). The first negative shocks of the early 1970s had induced balance of payments and budget  - 21 - crises. The copp r price recovered from 1973, but after the crash Ln mid-1974 persistent budget and trade deficits were the norm. Theme were sustained by decumulation of reserves, borrowing arl the appreciation of the currency. Zambia's link with the I.M.F. was initiated with extended facility agreements in 1971-72 followed by a standby agreement in 1973. Zambian borrowing appeared to be pro-cyclical with nominal copper pricess borrowing was heavy in the 1970-75 period while Zambia wac rationed by creditors during 1976-77. The imposition of more stringent in-port and exchange controls was discussed in Section 11.2. Black market rates are available from mid-1970 (averages of monthly rates). The trends for misinvoicing in Tables 6 (b) and (c), however, suggest considerable over-invoicing from 1964. The premium from 1964-70 is likely to reflect this increased de'uand for foreign assets during the copper boom as well as the effects of stringent exchange controls and political uncertainty in the first decade after Independence. The flow of illegal foreign exchange is responsive to the terms of trade, inducing a rise in the premium when the terms of trade deteriorate. In 1971 following a negative terms of trade shock the level of the premium was over 50 per cont. Thereafter it responded appreciably to changes in the terms of trade, falling with the 1972-74 improvement and rising after the 1974 crash. From 1973 the exchange rate fixed to an appreciating dollar became increasingly over-valued which exacerbated the premiumse sharp rise to a maximum in 1977, only exceeded in the late 1980s after the auction.  - 22 - 1.2 Eoisode 2: 197603-198303 In the aftermath of the precipitous decline in copper prices from 1974, the government entered into several conditional credit agroements with the I.M.F. In line with the 1976-77 I.M.F. stand-by facility the tax base was altered, wages were frozen, subsidies cut by 30 per cent and development expenditure decreased by a third. The budget deficit was reduced but three-quarters of it was funded domestically, which added to inflationary pressures, as evidenced in Table 3 (a). With a highly restrictive import policy and a small rise in the price of copper the current account balance showed some improvement. Thereafter the pattern of large budget and trade deficits continued, mitigated only by the rise in copper prices from 1979. The 1978-80 I.M.F. stand-by facility reduced credit and inflationary pressures, but crowded out the private sector, most credit being absorbed by the government and mining companies. From 1975, there was little cap.tal inflow, but payments arrears built up (by 1980 amounting to $600 million) and net foreign assets declined. Foreign reserves had by thie time largely been eroded. The foreign exchange constraints forced a contraction in the manufacturing sector, services declined with government demand and agriculture continued to stagnate. Although a 1981-83 extended facillty was successful in reducing the budget deficit in 1981, it became inoperative in 1982, in which year the attempt to maintain government services and employment in the face of falling revenue induced a deficit of 18 per cent of GDP. The payments deficlt was financed mainly by the accumulation of arrears. The black market premium exhibits two phases of behavior within this episode: in the first, until mid-1979, the level remains on average above 150 percent; In the second, the premium falls by 70 percent and thereafter  - 23 - gradually declines, with decreased volatility. The first phase is characterized by sharp rises in inflation and large budget deficits. Zambia was rationed by foreign creditors, reserves were eroded and the terms of trade continued to decline. Tight import and foreign exchange controls compounded these effects in keeping the premium high. The second phase begins with a recovery of the copper price in 1979, resulting in a relaxation of borrowing constraints. More reotrictive macroeconomic policies were peraued which together with inflows of foreign borrowing sustained the low level of the premium, even when copper prices fell in 1981 (though volatility briefly increased). Exchange rate policy was passive during the entire period, save for two devaluations. The devaluation of March, 1978 has a negligible impact but in January, 1983 a maxi-devaluation of 20 per cent provides a classic instance of expectational response in the premium (this is the only example of a one-off maxi-devaluation throughout). The theoretically predicted time path for the adjustment of the black market to current expectations of a future devaluation of the nominal exchange rate is shown in Figure 3 (c) (Dornbusch et al (1983)). Speculators expect that in the long-run a convergence to the initial steady state level of the premium will ensue; this would necessitate a future depreciation of the black market rate. The profit opportunities this presents induces an immediate increase in the demand for foreign exchange and hence a jump in the premium from A to A'. Thereafter, the premium rises over time to A'', in combination with a growing stock of foreign currency. When the official devaluation is realized, an immediate fall in premium from A'' to A''' occurs, due entirely to the fall in the official rate. T,&e black rate does not alter concomitantly with the official rate since this change was  - 24 - anticipated in the initial jump to A'. Thereafter, the transitory accumulation of foreign currency is gradually depleted, and the premium returns to its initial steady - state level. The behavior of the premium in Zambia around 1983 is shown in Figure 3 (c) to follow the theoretically predicted path. The black market rate did not alter at the time of the devaluation, but depreciated subsequently. The derived expected devaluation series covering the period before and after the January 1983 devaluation is depicted in Figure 3 (e) (discussed in III.d). It is noteworthy that both series confirm the prediction of the theoretical model. This supports two assertions mentioned at the beginning of this section. First, expectations are important as determinant of the free rate premium; and secondly, our empirical model of expectation seems to be well specified, at least for the period in question. '