Trade and Exchange Rate Policies
Smugglers: the invisible hand?

A real exchange rate devaluation is frequently advocated as a means to improve the trade balance. By reducing the relative price of domestic output, such a policy tends to encourage consumers to switch from imported to home goods and firms to switch from production for the domestic market to export. This prescription assumes that there is a high degree of substitutability among final goods in consumption and among inputs into production: elasticities of import demand and export supply with respect to the real exchange rate must be high. In Discussion Paper No. 161, Research Fellows William Branson and Jorge de Macedo argue that these assumptions may be inappropriate in some LDCs, especially in Sub-Saharan Africa. Most imports are intermediate inputs (such as oil) and capital equipment. The structure of production processes is determined by the existing capital stock: this limits opportunities for substitution and reduces the short-run price elasticity of the demand for imports. In addition African countries' exports are often dominated by agricultural output, whose supply is inelastic in the short run.

In this situation a real devaluation will not be appropriate: it will tend to expand export revenues and import receipts in proportion to their initial values in home currency, while leaving them unchanged in foreign exchange. If the trade balance is initially in deficit, the real devaluation may thus increase the deficit, in terms of home currency, deflating domestic demand with little gain in foreign exchange.

Devaluation may not work, but maintaining a fixed nominal exchange rate in the face of domestic inflation may also be counter-productive, Branson and de Macedo argue. Such a policy tends to cause an appreciation of the real exchange rate (the relative price of home- and foreign-produced goods) and shrinking exports. To prevent an erosion of the trade balance, import duties and export subsidies must rise at an increasing rate in order to offset the increasing divergence between the prices of non-traded and traded goods, caused by domestic inflation. This illustrates the dilemma faced by LDCs that attempt to fix nominal exchange rates in the face of domestic inflation: higher export subsidies increase incentives to falsify sales as exports in order to obtain the subsidy, and higher import tariffs increase incentives to import illegally. The escalation of trade barriers therefore generates a rising black market premium and offers increasing incentives to smuggling. This is already a pervasive problem in many African countries. As a consequence, the central bank finds it more and more difficult to hold the nominal exchange rate constant. The authors analyse data from Sudan which, they argue, suggests that attempts to stabilize the nominal exchange rate, rather than matching movements in the nominal exchange rate to relative inflation, sharply destabilized the real effective exchange rate after 1980. This discouraged investment in the traded goods sector and provided increasing incentives for illegal activity.
Branson and de Macedo analyse an alternative: a passive exchange rate policy of stabilizing the real exchange rate by adjusting the nominal rate in line with domestic inflation. This 'insulates' the traded goods sector from domestic inflation, since the home currency price of imports and exports rises at the rate of inflation, and avoids a profit squeeze in these sectors. Unless such a passive policy is accompanied by the elimination of trade barriers, however, the black market premium will not disappear. An importer will tend to smuggle if the tariff is so high that it pays to purchase foreign exchange in the black market at a premium. It is therefore necessary to operate consistent exchange rate and trade policies, which set tariffs at a level that creates a long-run black market premium consistent with balanced legal and illegal trade. If this consistency of policies is not achieved, the black market may offset the effects of official exchange rate policy.

In Discussion Paper No. 162, Jorge de Macedo constructs a more detailed model of the relationship between trade taxes, smuggling and black markets in foreign exchange. The behaviour of importers and exporters, and their choice between legal trade and smuggling, is the basis of de Macedo's analysis. Smuggled imports are paid for with black market foreign exchange obtained from undetected smuggled exports: the behaviour of importers and exporters thus determines both the black market premium and the ratios of smuggled to legal exports and imports.

De Macedo first analyses the choice between legal and illegal trade, for a given black market premium: importers and exporters choose their mix of smuggling and legal trade by equating marginal revenue to marginal cost in both activities. Since smuggled imports must be paid for with black market foreign exchange, importers' choices between smuggling and legal trade depend not only on the level of the import tariff and the probability of detection, but also on the black market premium. The ratio of domestic to world prices and the ratio of smuggling to legal trade will thus be determined simultaneously, in the light of the levels of trade taxes and the black market premium. De Macedo demonstrates that, if the probability of successful smuggling is determined within the model, the import price mark- up will lie between the tariff factor (one plus the tariff rate) and the black market premium, and the export price mark-up will lie between the premium and the export tax factor.

De Macedo extends the model to allow for the interaction between the foreign exchange black market and smuggling. An increase in the export tax increases the supply of black market foreign exchange: the premium falls but both smuggling ratios still rise. Thus higher trade taxes induce smuggling, but their effect on the black market premium depends on whether they affect supply or demand on the black market.

De Macedo then combines his model of the black market premium and the shares of smuggled imports and exports with a model of the economy as a whole, which explains total legal and illegal imports and exports, production and consumption of traded and non-traded goods, and welfare. He shows that, even when trade is balanced, the existence of a black market premium and a non- traded goods sector makes it possible that the imposition of trade taxes may cause consumption to rise due to induced smuggling: trade taxes need not therefore reduce welfare.


Smugglers' Blues at the Central Bank: Lessons from Sudan
William H Branson and Jorge Braga de Macedo

Currency Inconvertibility, Trade Taxes and Smuggling
Jorge Braga de Macedo

Discussion Papers Nos. 161 and 162
March 1987 (IM/IT)