On Friday, the naira closed at N390/$ down from N500/$ levels in January. The development follows a change of heart by the Central Bank of Nigeria (CBN) in February 2017 to ramp up dollar sales towards the retail segment. The naira appreciation at the parallel market took a lot of people by surprise and while the CBN appears to be winning plaudits by the wider populace, the sentiment in not universal. Among the financial analyst community, the sense is one of cynicism that as long as it is not a market determined 100% floating exchange rate system, the current moves by the apex bank would ultimately fail. In several debates with friends on the issue, many are now tugging at floating or nothing. However, following the over 100% depreciation in the value of the naira relative to the 55-60% collapse in crude oil prices since 2014, I think the righteous indignation over what FX regime Nigeria adopts appears misplaced. Clearly, the NGN has more than adjusted for the tectonic shifts in Nigeria’s current account and its transmitted shock to CBN reserve inflows which are down roughly 55% from 2014 levels. In my view it appears as if we seem focused on the means and not the end in itself.
Anyway to the question, can Nigeria transition to a purely market driven exchange rate system as demanded? To ensure we are all on the same page, a fully flexible FX market is one with an equilibrium price where demand and supply clear and is highly liquid. This liquidity qualifier is helps keep the theoretical ideal of equilibrium to reality as of what use is an equilibrium price in sync with the current account when no one can get dollars. A liquid FX market is one with narrow bid-offer spreads, low transaction costs and sufficiently broad trading activity and turnover such that the impact of individual trades on prices is negligible. By this definition, today’s parallel market is a poor barometer of the Nigerian FX market as the action of the CBN in recent days proves that one single party acting in another market can influence developments in the market. Indeed in hindsight the naira appreciation at the segment appears unsurprising when one examines what happened in 2016. Since the announcement the CBN has sold close to $2billion and specifically targeted the retail segment which was forced to rely on the black market for supply. Thus, after the depressed levels of 2016, when the apex bank sold $58million dollars to BDCs vs $5billion on average previously, it took only a small improvement in CBN sales for the market to re-adjust. The way I see it 2016 is like a year of no rainfall so with only a few showers in 2017 the whole place greens up.
Having defined our goal, I would now attempt to chart a response but first I would be to borrow a leaf from accountants and qualify my opinion. What are these qualifiers? A free market system pre-supposes the existence of many buyers and sellers, with the proviso that one agent is unable to dominate or influence the action of other agents in the market system. There are certain markets where a pure play market outcome is though desirable but yields sub-optimal allocation outcomes. One such instance is the case of a natural monopoly where by legal fiat or economies of scale, one agent (seller) is allowed to dominate the supply side. As I will illustrate, Nigerian FX markets more closely resemble a monopoly outcome and trying to impose a pure-play market system is impracticable unless certain institutional adjustments are made.
First, let us talk about demand. There are many reasons why people demand dollars in every country, two reasons of prime importance are – for payments of imports of goods and services. In Nigeria, in the decade between 2005 and 2015, imports of goods and services accounted for on average 18% of nominal GDP with imports of goods clearly the larger share as in the chart below. In terms of services imports, which curiously receive lesser attention for demand management policies, the key imports are transportation (freight and travel), education and professional services. Of note is that demand side is fragmented i.e. no single individual or company places an inordinate demand on our FX, rather the demand side is highly fragmented though we can group individuals into several classes but none sufficiently wields undue influence on the overall market. On this alone, Nigeria ticks the box of many buyers.
Figure 1: Imports of Goods and Services
How are imports of goods and services financed in Nigeria? The answer provides an illustration of how the supply side of Nigeria’s FX market looks like. Looking at data between 2007 and 2015, one agent, the CBN accounts for roughly 60% of imports of goods and services, if you look at its sales to the FX market. In addition, you have capital flows (defined as FPI, FDI and other capital) which jointly accounts for 16% of total imports if you look at inflows. With over three quarters of import supply spoken for, the CBN is the 800-pound gorilla in FX room. Importantly, as a single agent, the apex bank singularly accounts for over half of dollar supply to the Nigerian FX market while other agents are fragmented. The flaw in evolving to a pure play free float appears obvious as one singular agent accounts for more than half and other agents are minuscule relative to this agent.
Can foreign capital flows dismantle the CBN if Nigeria adopts policies which bolster appetite for naira assets? While this story appears seducing and a lot of people are quick to compare Nigeria to Egypt, Nigeria will need capital flows of more than $20billion – the highest amount of capital flows ever, which occurred in 2012-13 when global central banks were providing stimulus measures to jump-start their economies, to ensure a floating market. Even in the event that we assume QE was in full force, Nigerian capital markets (debt and equity) are simply not deep enough to absorb capital flows to the extent that they dislodge the CBN. In any case they would still not go anywhere towards meeting import dollar requirements.
Figure 2: Dollar supply
Can Nigeria float?
The idea behind full currency flexibility is to allow dollars flow into an economy by optimizing agents transacting in dollars in their natural setting vs. a central bank which does not need to pursue a profit motive in FX trading. Under this scenario which would permit 2-way trading i.e possibility of loss/gain, economic agents would be governed by the invisible hand. Having examined supply and demand, the picture which emanates in the event of a float is likely a monopoly. It is this institutional framework which negates the progression to a fully-fledged FX regime. In the process of researching for this column I stumbled on this IMF paper, where I picked up two key institutional requirements, out of several, critical for a transition to a flexible exchange rate regime:
- A country must phase out or eliminate existing regulations that require agents to surrender foreign exchange receipts to the central bank.
- A country exiting a peg must replace it with another nominal anchor and redesign its monetary policy framework around the new anchor.
Requirement one is necessary as in any market, you need agents acting without benevolence, as Adam Smith put it, in a natural setting demanding and supplying dollars purely on a needs basis with a profit motive. Put simply, only exporters and importers of goods and services, and the odd arbitrageur should exist in the currency markets with futures markets to allow speculative betting.
In Nigeria, the first requirement is perhaps the biggest hurdle in the path of a transition to full naira floatation as it requires a change to our legal code, specifically, laws which currently mandate that Nigeria’s oil proceeds be surrendered to the CBN. By default, this would transform the Nigerian National Petroleum Corporation (NNPC) to the new behemoth in the FX market. Therein lies the challenge, NNPC’s very sleazy history with the organization run like a black box, means that it is less likely anyone will agree to give NNPC near monopoly over dollar proceeds. Some, like Henry Boyo, have argued that let state governments receive their FAAC allocations in dollars and then disperse proceeds to the interbank market. This view has been dismissed to the fringes as the idea fails when one considers the lurid corruption tales of dollar cash real estate transactions and money laundering by certain governors in times past in foreign countries. Clearly, the current institutional setting implies that the CBN is likely to remain the elephant in the room for some time.
Requirement two is largely theoretical and is a distinct feature of advanced economies with liquid futures and forwards market which provide an institutional feature for hedging FX risk. With this institutional framework, currency volatility is less of an issue as everyone can insure themselves for currency risk leaving pass-through to inflation from FX less of an issue. This allows monetary policy focus on its core mandate of price stability.
To those who understand actual Nigerian monetary policy, where the key policy anchor of the CBN is currency stability not price stability. Now in shifting to a flexible regime, the shift implies a total adoption of new anchor in totality with no subtle attempts to influence the currency via interest rates especially when inflation are within target levels. Between 2013 and January 2016, Nigeria’s inflation declined to single digit levels which did not draw any response from the CBN which kept interest rates at a record levels in pursuit of currency stability. What point two implies is that policy makers must consistently stick to price and not FX stability despite political influence or other pressures. However as history shows, Nigerian policy makers (fiscal and monetary) are not mature enough to accept currency volatility. This is because there is no mechanism for panicked agents to insure themselves against volatility which results in demand front-loading during periods of crisis. This fear is largely what forces policy makers to consistently prioritise FX stability. Before we float, we must develop a fully liquid futures market.
Long and short In the absence of any modification in the underlying institutional make-up, the claim for imposition of a floating exchange rate regime looks like theoretical utopian rubbish with no context of the Nigerian setting.
At this juncture, while I am willing to agree to the merits of a market determined FX regime, I believe that an exchange rate system is not an end in itself but a means to an end or ends, which are a fairly reasonable FX allocation system and a fairly valued exchange rate. I used the word fairly valued as exchange rate markets are never perfect in that they do not lead to a price which reflects the fundamental value of a currency as dictated by purchasing power parity. Indeed, despite its rationally pleasing merits, no one is yet to empirically observe PPP convergence, it’s a purely long run concept which is meaningless in the realm of mere mortals. That said, how we do allocate FX as the present system looks made up for corruption. It allows the CBN pick winners and losers and for underhand dealings and is merely a sitting duck for the next current account crisis.
In truth, I do not have any answer to this but I believe the solution to our FX problems requires a more common-sense thought driven process vs a dogmatic adoption of theoretically rooted ideas. But I will proffer a few ideas on how we can adapt to the prevailing institutional arrangements.
- Permit flexible interbank FX trading around a range but be flexible enough to adjust the range higher when changes in the external sector mandate these changes: Given our economic structure and the nature of FX markets, it is pointless to have a pre-set rate as the apex bank is currently tugging at with the N305 or is it N360 number. Indeed our recent experience has shown that commitment to hard pegs lead to ruin. As I have always stated the exchange rate is a price and prices must move. Rather adopt the concept of band determined on the CBN (as well as possible 3rd party independent assessment of where the FX trading range should be to ensure credibility) around which CBN sales to the market would take place. While the apex bank can and should intervene, this should be guided by the notion of stemming volatility and preventing overshooting. Importantly, the CBN should help foster the notion of two-way risks remain which should guide more measured pricing by economic agents. Do not pre-commit to any level for the exchange rate.
- Transparency: Given its position, the CBN should provide more data on demand and non-CBN supply conditions and encourage analysis of key macroeconomic variables to allow better development of price discovery notions in FX markets. The apex bank should also provide greater transparency on its interventions. Some countries publish this information readily. Importantly, is that the apex bank should ensure that as much FX market reporting takes place under systems that can be readily reported and captured. A more transparent interbank FX market helps liquidity and diminishes the importance of the parallel market.
- Continue to encourage independent FX valuation and reporting: This is perhaps controversial as forecasting exchange rates is fraught with difficulty. However, while short run forecasts often miss the point, evidence exists that medium to long term currency forecasting based on trends in the balance of payment is directionally accurate. Some agency, perhaps a team of Nigerian economists, should provide a bi-annual report submitted to the fiscal side or some serious body on the currency market. This is particularly important during periods of rapid changes in the external environment eg oil prices.
- Monitoring and compliance: Nigerian banks often see FX as a leeway out of their underlying asset quality and slack earnings growth issues. Although the numbers are still trickling in most financial reports for 2016 out thus far show that banks relied on FX gains to ride through the macro storm. In most jurisdictions, a separate body not the CBN clamps down on FX market violations. I think banks should be made to feel the full wrath of the law for any infractions on FX and a separate body should be on hand to investigate and hand out punitive sanctions with board level jail-like ramifications for culprits. Since the days of Joseph Sanusi, we have been hearing reports of bank FX infractions and nothing happens, no one goes to jail and hand scratch fines are handed out. Till infractions become punitive, there will still be very strong incentive for banks to game FX markets.
- Commit to transition timeline to floating: No country floats overnight, it begins as a process with key checklists before eventual full floatation. Nigeria can set out a 3-5year timeline to transit to a flexible exchange rate regime. Floating for Nigeria is inevitable as the massive expansion in the size of our populace and the growing sophistication in their tastes implies that reserves cannot catch-up with import demand overtime. We need the flexibility option and would need to transit at some point. Setting out a schedule for an exit date allows participants plan and adjust appropriately. It allows the chance to garner consensus and set out key tasks on the path to floating.
While there are fears about delays, jumping into float without resolving the issue of CBN FX suppy dominance full floating will be foolhardy and will lead to dead-end as we’ve seen with floating last year. I close with this line from the IMF article I mentioned earlier-. No single exchange rate regime is appropriate for all countries in all circumstances. Countries will have to weigh the costs and benefits of floating in light of both their economic and their institutional readiness. Duttagupta et al (2005)
Duttagupta. R, Fernandes G, and C Karacadag (2005) Moving to a Flexible Exchange Rate: How, When, and How Fast? IMF Economic Issues No 38.