Arbitrage With Unofficial Exchange Rates

If a firm charges more than customers are willing to pay for a product, volume sold suffers. If a firm charges less than what customers are willing to pay, revenue earned suffers. But what happens when the price that a government sets for its own currency deviates substantially from willingness to pay?

For the past couple of years, toilet paper has become a scarce commodity in Venezuela. This isn’t due to a manufacturing or purchasing power deficiency, but rather the large discrepancy between the official and unofficial exchange rates for the Venezuelan bolivar.

Whereas many currencies float and have their prices set by the market, the exchange value of the bolivar is fixed and currently stands at 6.35 to the dollar. The unofficial rate, however, is nearly 900 bolivars to the dollar, over 140 times the official rate. Much of that increase has occurred just in 2015, as evidenced by this historical chart from DolarToday.com.

(To complicate the matter further, there are multiple official exchange rates for different types of goods).

Much of this has to do with poor economic policy, the low price of oil (upon which much of Venezuela’s exports depend), and the strong dollar. In such situations, dollars become even more valuable to hoard, which in turn creates more inflation in the bolivar, leading to a positive feedback loop. But how does this lead to shortages of something as basic as toilet paper?

The answer lies in the different exchange rates and the ability to game them. Business Insider provides an instructive example:

Assume that an importer brings into the country $1mn of toilet paper using official dollars obtained from the government at the preferential rate (toilet paper is an essential that receives preferential dollars and is also highly scarce at its regulated price). Faced with the prospect of selling the good at regulated prices at a maximum 20% nominal profit rate, there are very high incentives for the importer or associated arbitrageurs to re-export the good and resell it abroad.

Let us assume that 50% of the imported good is re-exported under these conditions and resold at the original $500,000 price. If the importer uses those dollars to import iPhones (a good which receives no preferential dollars and is sold at unregulated prices consistent with the parallel market rate in Venezuela), then the importer will be able to capture a handsome 13,400% return and be able to consume the proceeds in Venezuela.

This is a prime example of arbitrage, in which one takes advantage of a price differential in the same product in different markets. In well-functioning markets, the existence of arbitrage opportunities sends a strong signal to adjust prices and therefore such opportunities typically are short-lived. When prices cannot adjust, however, there is the sustained opportunity for arbitrageurs to make an enormous sum simply playing the differential. In such situations as Venezuela, this can lead to shortages of goods because re-exportation and hoarding becomes much more profitable than simply selling the product or providing a service.

Argentina also has multiple exchange rates, with the official being around 9.6 pesos to the dollar and the unofficial 14.8. The government simply doesn’t have enough foreign reserves to defend the official rate, causing in effect a dollar shortage and driving up the price to buy dollars. Having a higher unofficial rate creates constant pressure to increase the official rate, which then requires stronger currency controls to manage. While toilet paper is still easy to come by in Argentina, having multiple prices for the same currency is still harmful.

In both situations, arbitrage is a drag on the entire economy. Persistent arbitrage means that people are being rewarded for unproductive economic behavior, capitalizing on their connections or access to different exchange rates rather than the goods or services that they can offer consumers. With a floating exchange rate, the price of the currency can rise or fall, eliminating opportunities for arbitrage. But when the currency rate is fixed, such automatic mechanisms can no longer function.

Propping up their currencies at an artificially high rate may be motivated by a desire to improve the economic well-being of citizens, but it ends up having the opposite effect. The underlying fact is that prices, whether considered too high or too low by whoever is making that consideration, play an important role in transferring information. Prices signal the relative value of goods and services (including currencies) across the economy, providing opportunities to increase overall wealth by moving from less valuable to more valuable applications. Strange things happen when this flow of information breaks.

Whereas having the wrong price for a product can lead to a suboptimal outcome for a company and its customers, mandating a bad price for a currency will cause damaging reverberations throughout the entire national economy. With Argentina’s recent presidential election and promises to ease currency controls, it will be interesting to see how they may try to manage bringing the price of the peso more in line with what people already know it is worth.