Special Exchange Rates for Capital Account Transactions

The governments of developing countries are constrained in the effective implementation of domestic policy by the interlinkages of national and international financial markets. Domestic macroeconomic conditions are influenced by the interaction of national and world interest rates and prices, and through the impact of real exchange rates on employment. The domestic responses to changes in these factors are often strong and rapid. In an attempt to sever these ties, governments have adopted dual exchange rate systems in which capital account transactions are conducted at a depreciated exchange rate while an otherwise overvalued rate is maintained for commercial trade. This article suggests that dual rates can indeed be used successfully as a strictly transitory policy to offset sudden shocks in capital markets. The article develops models which indicate why these dual systems are able to prevent inflationary or recessionary pressures caused by a misaligned exchange rate in the short term. While free capital account rates can cut the flow of capital flight, however, a dual rate system cannot prevent a possibly equivalent loss of foreign reserves that will ultimately result because of the impact of the overvaluation of the commercial rate on the trade balance. In the longer term, a dual rate system with a misaligned commercial rate exacerbates the government's deficit; ultimately, real wages must be cut and real interest rates raised to generate sufficient foreign exchange to finance the external debt. Thus a dual rate works well if the commercial rate is maintained close to the equilibrium level.