Exchange rate regimes

Last week the naira hit record lows against the USD with the interbank rate weakening to N173/$ intraday before the Central Bank of Nigeria (CBN) stepped in to shore up the currency. Although the CBN governor insists he will not devalue the naira, the steep declines in oil prices ā€“ which have fallen to four year lows raises doubts over the ability of the Mr. Godwin Emefiele to keep his promise. Indeed FX reserves have begun to contract significantly as the CBN steps up interventions at the interbank market to shore up the naira.

To the uninitiated, you might wonder but I purchase USD from the mallam at N174/$ what record low is N172/$? I digress slightly to explain. In contrast to most developed countries who allow their currencies to float i.e. allow the forces of demand and supply to determine how much the currency goes for Nigeria uses a managed exchange rate floating regime whereby the equilibrium rate is ascertained by the CBN not market forces then allocation across all market tiers is via market forces. Most world currencies are floated: dollar, pound, euro, yen and most currencies of leading economies except China.

Under the freely floating system, monetary authorities leave determination of exchange rate to the forces of demand and supply and try to influence these forces using interest rates and other monetary policy tools. The advantage of this system is that the exchange rate reflects underlying fundamentals of the economy which makes sense. In contrast, the major disadvantage is that exchange rates are volatile.

On the other hand you have the fixed change rate regime where monetary authorities fix or peg the value of a currency to another currency or a basket of currencies and commit to buying or selling the currency when the exchange rate is in disequilibrium. The argument here is a fallout of the weakness of the floating regime: inherent volatility in the former prevents economic agents from being able to form expectations about the future. Furthermore, wild swings on the downside pose risks to consumption of the poor especially in third world countries. Thus, fixed regimes tend to be the norm across the former. The main disadvantage is that you have to hold huge reserves of the other currency a process which might be costly. Additionally, as pegs tend to be misaligned with equilibrium exchange rates, they distortions skew economic activity unnecessarily. For instance an overvalued peg gives the impression that an economy can efficiently produce goods which if false could hurt the competitiveness of a nations exports abroad. Put simply your goods become more expensively priced relative to others which by law of demand will force others to buy less of it. On the flip side, your citizens are likely to acquire a taste for foreign goods which worsens the domestic picture. Does this read like Nigeria? Exactly, our parents and some elderly folk will tell you back in the days naira was at par with the dollar and then proceed to lecture you that this means the economy is really bad.

The problem with fixed exchange rate systems is that you’re forced to maintain sizable reserves of a currency you don’t print to ensure parity. It tilts you destiny to the state of your exports. Quite frankly a bad idea if your exports are basic commodities whose prices fluctuate. This explains the exception to the rule ā€“ if on the other hand you manufacture things cheaply like China then even better as your exports are priced cheap.

From this you can see the issue with Nigeria, our exports comprise a commodity whose price is internationally determined and as such leaves us exposed to bouts of currency crises when the prices of those commodities plummet as in the mid-1980s, 2009 and more recently: now.

Although we modified the fixed peg to a managed one under which the CBN i.e. the CBN uses a crystal ball to ascertain where it feels the equilibrium exchange rate should be thereafter it boldly declares the rate. This form leads to tiered exchange rates: one official, one for the interbank, one for BDCs etc. If all goes well all rates should trade within narrow bands representing transaction costs of doing business across. When things go south these spreads widen and create opportunities for arbitrage which lead to a devaluation as in 2009.

As in an earlier post, I’ve often wondered why Nigerians want a strong currency when it does us more harm than good. I will not attempt to try to answer that, however I will say this: a nation’s leaders must articulate a vision which connects to the aspirations of its citizens. A commodity based economy has inherent problems and wealth distribution in inequitable. A manufacturing based on however ensures all the flexibility and though wealth is not equitable is a scenario far better than a commodity based one.

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