SHADOW EXCHANGE RATE (basic concepts useful for Economic analysis, Competitive exams and M. Phil Economics course)
The Shadow Exchange Rate is a numeraire which is used to calculate the foreign currency into the domestic currency. The use of this exchange rate is practiced because the market exchange rate may not reflect the economic value in the units of the domestic currency of a unit of the foreign exchange.
Say, if there is any distortions in the foreign exchange market and the official exchange rate doesn't reflect the true opportunity cost of the foreign exchange.
The various trade policies such as subsidies, export subsidies, export taxes, etc distort not only the individual prices of the goods, but also the prices of the foreign exchange foe the economy as a whole.
Say, if there are any serious distortions the border prices need to be converted into the domestic currency equivalent using a shadow exchange rate but not the official or the market exchange rate.
Lets understand, the need to determine the foreign exchange premium arises because in many of the countries, as a result of the national trade policies (such as tariff and subsidies). people pay premium(extra or less than the actual price)on the traded goods whether its imported or exports over what they pay for the non traded goods.
So, the case is this premium is not adequately reflected when the prices of the traded goods are converted to the domestic currency equivalent to the official exchange rate. The premium represents the additional amounts paid by the users of the traded goods.
It's evident to all the all the costs and benefits in the economic analysis are valued on the basis of the opportunity costs or the willingness to pay. it is the relation between the willingness to pay for the traded goods as opposed to the non traded goods which establishes their relative value.
Thus, the mispriced traded goods are converted to the price of the non traded goods by the use of shadow exchange rate, likewise, lets say shadow exchange rate is a numeraire used for the accounting real prices of goods/services.
NUMERICAL DOMAINS
SER = OER * (1 + F * PREMIUM)
SCF = 1 / (1 + F * PREMIUM)
Now, ADB practice [(Mainali, 2021), TU] in estimating SCF\
SCF = [Imports (cif) + Exports (fob)] / [(Imports +Imports taxes- subsidies) + (Exports - Exports Taxes +Subsidies)]
which becomes, SCF = 1 + Net trade Taxes / Total Trade
Thank You
P.S Comments are lauded.
Aditya Raz Pokhrel
Asst. Director - Nepal Rastra Bank
MBA, MA Economics, MPA(rng)
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