As the current exchange rate crisis in Nigeria deepens following the decline of the Naira in the black market where it has topped N400 to the dollar, it has become imperative for Nigerians to understand the fundamentals of exchange rate, writes Osaze Omoragbon

nigerian-naira-us-dollarConcerns have grown over Nigeria’s exchange rate policy following the decline of the Naira especially in the black market where it has topped N400 to the dollar for the first time in the history of the country. Expectedly, Nigerians have expressed worry over the purchasing value of the Naira even as some observers have called for the head of the Governor of the Central Bank of Nigeria (CBN), Mr Godwin Emefiele.

However, only few Nigerians know how the exchange rate is determined let alone foreign exchange policy management. Some analysts blame President Muhammadu Buhari for the misunderstanding that has earned CBN public opprobrium, for his tacit interference in the autonomy of the CBN when he said “he would not support any more devaluation of the Naira,” and his since debunked electioneering campaign promise of making the Naira at par with the dollar. All these spooked investors and speculators took positions against the direction of CBN exchange rate policy.

Fundamentals of exchange rate
In theory, the fundamentals of every exchange rate are determined by the demand and supply of a particular foreign currency against the local currency. However, for the purpose of trade, most developing countries such as Nigeria peg their exchange rate to the dollar, euro or pound sterling. Indeed, most countries in the world peg their exchange rate to the dollar. So, in order to keep that peg and maintain exchange rate stability, which is one of the goals and mandate of the CBN, the apex bank keeps dollar reserves. This dollar reserve is intended to smoothen exchange rate fluctuations in times of disequilibrium in demand and supply. Intuitively, only few Nigerians know that the dollar as a currency, is owned and printed by the United States. That is why you often hear uninformed comments such as “the CBN should just supply dollars to the market and let this Naira depreciation end.”

Nigeria only earns dollars through trade and capital inflows. This dollar reserve serves the purpose of financing import transactions which is the main reason of demanding dollars. However, speculators also take positions to profit from currency trade, whereby they borrow Naira to buy dollar from official sources pretending to import items only to turn around and sell in the black market, a practice known as round-tripping. This speculative demand for dollars places pressure on the Naira which leads to a widening gap in the official and parallel markets.

The current exchange rate crisis
Unfortunately, the current global macroeconomic condition is not favourable to Nigeria and this has negatively impacted the exchange rate regime. The price of crude oil, Nigeria’s main foreign exchange earner, in the international market has plummeted and has led to a reduction in government receipts. Consequently, the CBN has fewer reserves with which to intervene in the foreign exchange market to smoothen fluctuations in demand and supply for dollars. The question is: why don’t the CBN sell dollars from its reserves? There is a level of reserve that is considered safe for meeting international obligations such as financing imports and meeting other disbursements. The international threshold considered safe is three months of import cover; below which the country would begin to face a financial crisis. It will be difficult meeting obligations such as honouring lines of credits and servicing debts according to the CBN, Nigeria’s current foreign reserves which stands at about $28 billion can finance about four months of import and with the oil price still dipping, it could get worse. That could be the reason the apex bank is stingy with its dollar reserves. The unintended consequences are that some legitimate businesses (especially SMEs) could suffer from scarcity of foreign exchange.

Private capital inflow — another source of foreign exchange — has dwindled as investors took flight due to fast changing dynamics of the global economy. It is instructive to note that in the wake of the global financial crisis, private capital in search of better yield trooped to emerging markets and developing countries as returns in the advanced economies remained subdued. However, as the tables turn on these economies, they are finding their way back into the advanced countries which are faring better than their less developed counterparts. Indeed, Nigeria’s terms of trade have deteriorated and this is reflective of the prevailing exchange rate regime. Data from the National Bureau of Statistics (NBS) shows exports witnessing the most fluctuation which mirrors the exchange rate movement in the foreign exchange market. The United Nations Conference on Trade and Development (UNCTAD) data on Foreign Direct Investment (FDI) flows to Nigeria shows a steady decline between 2011 and 2014. FDI in 2011 stood at $8.9billion, 2012 raked in $7billion, and 2013 recorded $5.5billion while 2014 garnered $4.9billion. Reduction in these inflows will negatively impact the CBN’s reserve position. In January 2014, the external reserve was about $43billion but plummeted to about $37billion in November same year. By end of December 2015 it stood at about $29billion.

To salvage the dwindling fortunes of the Naira, the CBN and the deposit money banks had moved in mid-2015 to tame speculative demand for dollars by imposing capital control measures such as restricting sales of foreign exchange to Bureaux de Change (BDCs), imposing withdrawal limits on dollar-denominated credit cards outside the country, stopping dollar money transfer services and restricting deposit dollar-denominated bank accounts, among other measures. These measures, however, failed to pacify speculators, hence the drastic decision of the apex bank to stop funding BDC operators. Some experts have lauded the apex bank for stopping sale of dollars to BDCs, saying their operations aided speculation. “The directive would also put an end to round-tripping and rent seeking as dollar demand from the system would reduce,” says Sewa Wusu of Sterling Capital.
Analysts are of the opinion that there is little the CBN can do to fend off speculators as far as the price of crude oil stays low. To be sure, this is not the first time Nigeria will face foreign exchange crisis, as it often does so whenever the price of crude oil crashes. During the outbreak of the global financial crisis, the price of crude oil crashed from a peak of $147 to a barrel to about $34. Consequently, Nigeria devalued its currency in 2008 from about N116 to a dollar to about N146 to the dollar under the then CBN Governor, Professor Chukwuma Soludo. However, with a huge external reserve of about $50 billion and an excess crude account of about $20 billion, the country was able to weather the crisis largely unscathed. Experts advise Nigerians to brace up because the exchange rate regime could get worse before it gets better.

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