Currency Trading On The Black Market

By Investopedia Staff | April 03, 2013 AAA
Currency Trading On The Black Market

The black market in currencies refers to the illegal or parallel market in foreign exchange in various countries around the world. The currency black market forms part of the underground economy by virtue of operating outside legal banking channels. In a currency black market, cash transactions are almost always the norm, since participants would be obviously reluctant to leave any trace of their involvement in such transactions.

Why Do Currency Black Markets Exist?
Currency black markets typically spring up in countries that have the following characteristics in common:

  • Weak economic fundamentals, such as a high rate of inflation and limited foreign exchange reserves.
  • Strict currency controls that limit the amount of foreign currency available to residents.
  • A fixed exchange rate regime where the domestic currency is pegged at an unrealistically high exchange rate to the U.S. dollar or another global currency.
  • A lack of confidence among the citizenry in the value of the domestic currency.

As a result, substantial demand for foreign currencies is created in a nation with these attributes, as its citizens seek to hedge the value of their cash holdings. However, the currency controls make it extremely difficult for people to buy foreign currencies with their domestic currency at the official exchange rate. A black market, therefore, develops for foreign currencies that would generally be priced at a significant premium to the official exchange rate, because of its artificial value and the demand-supply imbalance.

Where Is It Becoming Prevalent?
Black market currency trading is prevalent in a significant number of countries worldwide. However, some of the larger economies where it is currently proliferating include Egypt, Iran, Argentina and Venezuela, as summarized below.

Egypt
The currency black market in Egypt has been flourishing since former President Hosni Mubarak was toppled in February 2011. The Egyptian pound lost 13.4% of its value against the U.S. dollar in the subsequent two years, as foreign currency inflows from tourists and investors dried up because of political instability and violent protests. By January 2013, the nation’s foreign exchange reserves had fallen to $13.6 billion, from $36 billion two years earlier. While the Egyptian pound was officially quoted at 6.7 to the USD in February, it was at about 6.9 in the black market, having recovered from a low of 7.5 in late January when street protests sent the currency plunging.

Iran
The Middle Eastern nation’s currency, the Iranian rial, has been in free fall since new economic sanctions were imposed on it by the United States and European Union in July 2010. These sanctions have cut Iran’s oil exports by half, severely curtailing foreign currency inflows, thereby devaluing the rial and pushing up inflation. While the official exchange rate is 12,260 rials to the U.S. dollar, the black market value of the rial plunged 60% to 39,000 in a single week between Sept. 24 and Oct. 2, 2012, after the Iranian government said that the official rate would only be available to importers of essential items such as food and medicine. The unofficial rate subsequently improved to 31,000 as the Iranian government cracked down on the currency black market.

Argentina
The currency black market in Argentina has been operating for more than a decade, ever since the nation defaulted on its external debt in 2002. While Argentina has currency controls in place to conserve precious foreign exchange reserves and prevent capital flight, these restrictions have only served to stimulate black market currency trading in a nation where inflation is approaching 25%. In the black market, 6.7 Argentine pesos are required to purchase a U.S. dollar, a premium of about 35% to the official rate of 5 pesos per USD.

Venezuela
In this South American nation, dwindling foreign exchange reserves and an annual inflation rate of 28% have led to unprecedented demand for U.S. dollars. The Venezuelan bolivar has resultantly fallen to a value of 9.25 versus the USD in the black market, less than half the official rate of 4.3 bolivars per USD.

The Bottom Line
A currency black market in a nation will exist as long as the adverse economic factors mentioned earlier remain in force. However, its importance may gradually erode as the economy becomes more open, foreign exchange reserves increase and confidence in the domestic currency returns. India is a classic example of a nation that has managed to all but eliminate its currency black market over the past two decades as it transitioned to a market economy and implemented a floating rate policy for its Rupee. Booming international trade and healthy economic growth have resulted in India’s foreign exchange reserves amounting to US$295 billion by February 2013, compared with a low point of about $1 billion in 1990.

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