Political rights, civil liberties, and the black market premium on foreign exchange

What is it about?

Investigating the impact of institutional factors on macroeconomic variables has gained momentum in recent years. In this paper we investigate the impact of political rights and civil liberties on the black market premium on foreign exchange. After taking account of other important determinants of the black market premium, we show that less political rights and less civil liberties result in a higher black market premium. The empirical results are based on cross-sectional and panel regressions using data from 63 developing countries over the period 1972 – 1998.

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Why is it important?

Political rights and civil liberties are equally important for developed and developing countries. Even though democracy is a political concept, it has important implications for economics as well. The main area of research in economics so far has centered around the impact of democracy on economic growth. It has been argued that democracy fosters economic growth via increased investment, protected property rights, increased rule of law and human rights, increased human capital, and efficient allocation of resources. However, the empirical findings here are inconclusive. In this paper, we extend the economics literature on democracy by investigating its impact on the black market premium. Theoretically, it is argued that democracy could influence the demand for, or the supply of foreign exchange in the black market for foreign exchange. Depending on which effect is stronger, it leads to an increase or decrease in the black market premium. To establish the empirical validity of our conjecture, we borrow a simple model from the existing literature and add a measure of democracy as another determinant of the black market premium. We then estimate the model by simple OLS with cross-sectional observations from 63 developing countries for each year beginning with 1972 and ending with 1998. In almost all years, both measures of democracy (i.e., political rights and civil liberties) carry significantly positive coefficients showing that the lack of democracy results in a higher black market premium. To provide additional support, we also conduct a panel study by pooling the data over the period 1972 – 1998 and across all 63 countries. We find strong support for our hypothesis in five panel estimations. One major policy implication of our results is that a rigorous reform in political structures of developing countries that leads to an increase in political rights and civil liberties will reduce the black market premium and bring the exchange rate more in alignment with other sectors of the economy.