I was reading news articles about people in Venezuela and Iran getting a poor exchange rate for US dollars on the black market. Why do these people need to buy dollars? Why is it still worth while to buy dollars at an unfavorable black market rate? Why would Venezuela want to block the sale of dollars?
A falling exchange rate is an indication of falling confidence in a currency. Countries like Iran or Venezuela, with a managed exchange rate, set their exchange rates at a higher value than the market accepts.
Such market expectations may be influenced by poor government management, interventions into markets (such as nationalising businesses) or general instability / scarcity. The governments act to manage that uncertainty by limiting the availability of foreign exchange and pegging the exchange rate.
Since there is an inadequate supply of trusted foreign currency people turn to informal exchanges in order to hedge their currency risk. This creates a positive feedback loop. People in government who have access to foreign exchange start to trade on informal markets, pocketing the difference in the official and unofficial rates. The increasing gap between the two rates drives increasing informal market exchange and can result in speculative bubbles.
Driving instability (or economic contradiction) is that the massive and increasing difference between the official and market exchange rates becomes a powerful form of rent for government officials. This drives further state-led rent-seeking behaviour and causes the economy to become even more unstable.
If you're interested in a more formal academic study of how such parallel markets in currency arise, "Zimbabwe’s Black Market for Foreign Exchange" by Albert Makochekanwa at the University of Pretoria is a useful source.
Today's edit (negative feedback -> positive feedback) highlights an issue with this answer. If people are selling US dollars on the informal market, that would tend to reduce the discrepancy between the official and unofficial exchange rates. This is similar to other forms of arbitrage, which cause markets to converge, not diverge. Thus, negative feedback is an accurate description, but the answer is not clear about this.– nanomanJul 23, 2019 at 14:11
The link appears to be broken. This one should be more persistent: hdl.handle.net/2263/4396 Mar 25, 2021 at 9:32
As a Venezuelan who used to buy USD, I believe there is no better explanation than the one given by someone who actually lives and works here in Venezuela.
Back in 1998, when Hugo Chavez took the presidency, we had a good economy. Fast forward 10 years and you could see how poor management, corruption and communist measures had wreaked havoc in our economy. It was because most of the money (USD) coming to Venezuela was not invested here but, instead, given away to "pimp countries" like Cuba. Remember, communism lasts while you have money. Back then, we had an oil barrel going over 100 USD and crazy amounts of money were coming into the country. However, little to no money was invested in the country itself. That is why some of the richest people with bank accounts in Switzerland are Venezuelans who stole huge amounts of oil money. I know this is a lot to take in, but all of this led to the Venezuelan economy being the worst in the American Continent and because there isn't enough money inside the country to satisfy the inner market, people would pay overprice to have anything that is bought abroad. You have to consider that only a very small amount of people can actually buy USD here in Venezuela. Back in 2013, I was doing it. I could buy about 80 USD per month with my monthly income. However, nowadays that's nearly impossible for about 99% of Venezuelans.
Minimum wage = 10.000 bolívares / month Black market exchange rate (as of January 2016) = 900 Bs per 1 USD
10.000/900 = 11,11 USD. <<< that is what about 50% of Venezuelans earn every month.
That's why this happens. The guy is holding a huge stack of money of the highest Venezuelan note, which he got from exchanging only 100 USD.
I am a computer science engineer, the monthly income for someone like me is about 30.000 bolívares — so that is about 34 USD a month.
So finally, answering your question
Q: Why do people buy USD even at this unfavorable rate?
A: There are many reasons but being the main 2 the following
Inflation in Venezuela is crazy high. The inflation from 2014-2015 was 241%. Which means that having The Venezuelan currency (bolívares) in your bank account makes no sense. In two weeks you won't be able to buy half of the things you used to with the same amount of money.
A huge amount of Venezuelans dream with living abroad (myself included). Why, you ask? Well, sir, it is certain that life in this country is not the best:
You can't easily find basic products like food and toilet paper
Crime rates are way too high (90 violent deaths per 100.000 inhabitants)
It is nearly impossible to buy a car or an apartment with current inflation rate.
- the list goes on and on.
I hope you can understand better why people in 3rd world countries and crappy economies buy USD even at an unfavorable rate.
The last question was:
Q: Why would Venezuela want to block the sale of dollars?
A: Centralized currency management is an economic measure that should last 6 months tops. (This was Argentina's case in 2013) but at this point, reverting that would take quite a few years. However, Turukawa's wikipedia link explains that very well.
The main reason people buy dollars (or other currency) on the black market is because they are prevented from exchanging currency on the official government market. Venezuela for example restricts citizens to a maximum number of dollars the citizen can buy or sell per year, depending on various factors such as whether or not the person is studying at a foreign university.
If the citizen wants to exchange more dollars than legally allowed, that person must buy or sell at the "black" market rate, rather than through the official/government market.
To understand why people of other nations buy US dollars on the black market, we have to take a step back and understand that the US dollar is the worlds reserve currency and has been so for over a quarter of a century I believe.
Now, to understand the US dollar as a reserve currency, we must understand Triffin's Paradox. The basic idea is that when one nation's fiat currency is used as the world's reserve currency, the needs of the global trading community are different from the needs of domestic policy makers.
Prior to 1971, the dollar was backed by gold, which acted as a supra-national anchor to the dollar's reserve status. The gold standard inhibited both massive trade deficits and money creation, so it was jettisoned.
The Triffin paradox is a theory that when a national currency also serves as an international reserve currency, there could be conflicts of interest between short-term domestic and long-term international economic objectives. This dilemma was first identified by Belgian-American economist Robert Triffin in the 1960s, who pointed out that the country whose currency foreign nations wish to hold (the global reserve currency) must be willing to supply the world with an extra supply of its currency to fulfill world demand for this 'reserve' currency (foreign exchange reserves) and thus cause a trade deficit.
So, what does that mean?
It means that the US dollar is considered the most stable currency on the planet and as such, acts as a reserve against all the other currencies and thus nations like Venezuela, Iran, etcetera, must hold US dollars as a safety net against their domestic fiat currency.
There is also the issue of their governments being required to pay their debts in US dollars.
So, why do these people need to buy US dollars on the black market? Well, they used to buy their US dollars at a currency exchange store in order to preserve the value of their savings. Similar perhaps to how Americans may buy gold, stocks or bonds.
However, their local government passed a law to control the exchange rate, or how many dollars they can buy or just plain and simple made it completely illegal to buy these dollars.
So, like with all laws that make a product illegal, people don't just go away and say okay I will never touch it again, they just go and get it on the black market.
Why is it still favorable to buy US dollars at an exorbitant black market rate?
The black market rate is actually quite reasonable when you consider that by making the US dollar illegal to hold, you have just increased its value by turning it into something scarce or difficult to obtain and people continue to pay black market rates because no amount of law will stop a human being from doing his best to preserve the wealth he worked hard to obtain, especially when you need that money to pay for baby food.
So, your baby goes hungry because nobody wants your worthless bolivares or because you need to bring a truck load just to buy a couple of jars of beech-nut and some formula, or have an easier time obtaining these with dollars because once the person who has all the baby formula hears you got dollars, they are throwing themselves at you to sell you the baby food you desperately need.
You used the term unfavorable, so now based on what I wrote. What is more unfavorable, paying through the nose or your child going hungry?
Why would Venezuela want to block the sale of dollars? Why would China? Why would India? Why would Iran?
Because it leads to financial insecurity and instability of its local economy. As people trade in their local currencies for US dollars, they now have a currency that they can even export abroad as they look to high-tail it out of the economic death spiral their nation is in. Their dollars can be waiting for them at the other end of that plane ticket, while their nations local economy continues to sink like the Titanic, in other words, capital flight is one biggie.
Capital flight is people and enterprises moving their capital (cash and liquid assets) to an overseas "safe haven" to avoid devaluation of the currency or confiscation of their capital/assets. (Devaluation can be seen as one method of confiscation; high taxes are another.)
Capital controls, also known as the question: why would Venezuela want to block the sale of dollars? is the Central State's way of stemming the flood of cash leaving the country. Why do they want to stop money leaving? If we think of each Central State as a neo-feudal fiefdom, we understand the motivation: citizens are in effect serfs who serve the State and its financial nobility. If the serfs move their capital out of the fiefdom, it is no longer available as collateral for the banks and a source of revenue for the State.