What is a Dual Exchange Rate
A dual exchange rate is a situation where a currency has a fixed official exchange rate and an illegal, market-determined parallel exchange rate. The different exchange rates are used in different situations, either in exchanges or evaluations, as mandated by the government.
BREAKING DOWN Dual Exchange Rate
A dual or multiple foreign-exchange rate system can be a short-term solution for a country to deal with an economic crisis. In a dual exchange rate system, currencies can be exchanged in the market at both fixed and floating exchange rates. A fixed rate would be reserved for certain transactions such as imports, exports and current account transactions. Capital account transactions, on the other hand, would be is determined by a market driven exchange rate.
A dual exchange system can be used to lessen pressure on foreign reserves during an economic shock that results in capital flight by investors. Such a system can also alleviate inflationary pressures and enable governments to control foreign currency transactions.
Argentina adopted a dual exchange rate in 2001, following years of catastrophic economic troubles marked by recession and soaring unemployment. Under the system, imports and exports were traded at an exchange rate approximately 7% below the one-to-one peg between the Argentine peso and the U.S. dollar that remained in place for the rest of the economy. This move was intended to make Argentine exports more competitive and provide a burst of much-needed growth. Instead, Argentina’s currency remained volatile, leading initially to a sharp devaluation and later the development of multiple exchange rates and a currency black market that have contributed to the country’s long period of instability.
Limitations of Dual Exchange Rate
Dual exchange rate systems are susceptible to manipulation by parties with the most to gain from currency differentials. These include exporters and importers who may not properly account for all of their transactions in order to maximize currency gains. Such systems also have the potential to trigger black markets as government-mandated restrictions on currency purchases force individuals to pay much higher exchange rates for access to dollars or other foreign currencies.
In dual exchange systems, certain parts of an economy may enjoy advantages over others, leading to distortions on the supply side based on currency conditions rather than demand or other economic fundamentals. Motivated by profit, beneficiaries of such systems may push to keep them in place well beyond their period of usefulness.
Academic studies of dual exchange rate systems have also concluded that they do not fully protect domestic prices due to the shifting of more transactions than mandated to the parallel exchange rate as well as the depreciation of the parallel rate compared to the official rate.