Exchange Rate Pass-Through from Parallel Foreign Exchange Markets

Abstract

Recent global interest rate hikes and corresponding currency depreciations have raised concerns about inflation in open developing economies. Yet, much empirical research paradoxically reports quite low exchange rate pass-through (ERPT) to domestic prices. This study contends that overlooking the presence of parallel foreign exchange markets, which are increasingly prevalent worldwide, contributes to the underestimation of true pass-through in conventional analyses. Using Egypt as a case study, we show that incorporating parallel market movements yields consistently higher pass-through estimates from bilateral dollar-to-EGP official rate movements over 6, 12, and 18 month horizons. Moreover, our findings indicate an independent transmission mechanism from the parallel market to aggregate retail prices—even when the official rate remains unchanged—suggesting that inflation can manifest prior to official devaluations. We find that pass-through from parallel premium movements to domestic prices is consistently positive and significant at 0.121, 0.175, and 0.276 for 6, 12, and 18 month horizons, respectively.