What is a Dual Exchange Rate?

A dual exchange rate is a setup created by a government where their currency has a fixed official exchange rate and a separate floating rate applied to specified goods, sectors or trading conditions. The floating rate is often market-determined in parallel to the official exchange rate. The different exchange rates are intended to be applied as a way to help stabilize a currency during a necessary devaluation.

Key Takeaways

  • A dual exchange rate system is seen as a middle ground between a fixed rate and a market-driven devaluation.
  • The system allows certain goods to be traded at one rate while others at a different rate.
  • This kind of system is criticized for spawning black-market trading.

Understanding a Dual Exchange Rate

A dual or multiple foreign-exchange rate system is usually intended to be a short-term solution for a country to deal with an economic crisis. Proponents of such a policy believe that it helps the government by maintaining optimal production and distribution of exports, while keeping international investors from rapidly devaluing the currency in a panic. Critics of such a policy believe that such an intervention by the government can only add volatility to the market dynamics as it would increase the degree of fluctuation in normal price discovery.

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, may 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. The hope would be that such a system can also alleviate inflationary pressures and enable governments to control foreign currency transactions.

Example of Dual Exchange Rate System

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 Rates

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.