Wednesday, January 28, 2015 11.34 AM / FDC
In 1985, a dollar was exchanged for less than a naira; but today, it is exchanged for N168/$ at the official market and much less at the interbank and parallel markets (N210/$). While many analysts and financial market operators are not comfortable with this drastic change in the fortune of the naira, others are of the opinion that with the changing economic environment, further devaluation may still be necessary for the naira to trade at its fair value.
The fair value of a currency is the price or rate that equates its supply and demand. The discussion prompts us to revisit the issues surrounding exchange rate determination, government intervention and mechanism for ensuring that a currency trades close to its fair value.
What determines exchange rate??
There are many factors that have been used to explain exchange rates. The common ones are the demand and supply of a currency, and relative price changes (inflation) in the countries of trading partners.
Exchange rate is the price of one currency in terms of another. Similar to any other commodity, factors that affect either or both the demand and supply affect this price. For instance, a reduction in the supply of dollar will lead to an increase in the exchange rate of the local currency and vice versa. Equally, an increase in the demand for dollar will lead to increase in exchange rate; and this implies the depreciation of the local currency.
It is important to see how this mechanism applies to the naira. On the one hand, Nigeria is an import dependent economy. Companies import raw materials and intermediate goods for their production while traders and consumers import several finished goods for final consumption. Due to a low competitiveness and high cost of doing business, a lot of what could have been produced locally is also imported. In addition, many Nigerians consume foreign services like travels, tourism, health and education. All these lead to high demand for dollars to make payments for these goods and services.
On the other hand, Nigeria obtains the bulk of its dollar supply from the exports of a single commodity: crude oil. Consequently, increased supply of dollars is only enjoyed when the global prices and/or domestic production of crude oil rise. Therefore, the country is susceptible to undiversified export base, events that shape global oil prices, and domestic oil production. This explains the tendency for the supply of dollar to fluctuate markedly in the face of a constantly rising demand for dollar. Thus, it explains why the naira is usually devalued or depreciates against the dollar when-ever the global prices of crude oil decline.
On the impact of inflation on exchange rate, the relative version of the purchasing power parity (PPP) framework argues that the currency of a high inflation country will depreciate relative to that of a low inflation trading partner in order to restore competitiveness. This is because excess money in the former country will be used to demand for the currency of the trading partner both for import and speculative purposes. Although significant efforts have been made to ensure price stability in Nigeria in the 6-9% range, the current inflation rate of 8% is well above that of the US which is less than 1%. At this rate therefore, it is understandable that the naira has been weak relative to the dollar.
In situations where these factors hold, increases in domestic prices or growth will raise demand for the dollar and cause an automatic depreciation of the naira; especially if dollar supply is constant. In turn, this depreciation makes foreign goods expensive, leading to a decline in their demand and serving as an incentive to engage in exports. This will lead to another round of appreciation of the naira. Therefore, when left on its own, the exchange rate system has an internal mechanism with which equilibrium fair value of the currency will be established.
This type of exchange rate is market-determined and it is a ’floating system‘. Theoretically, this system is argued to help achieve balance of payments equilibrium by automatically drawing a balance between the demand and supply of a currency. This is because excess demand leads to an appreciation and excess sup-ply causes depreciation. Second, it engenders monetary autonomy which makes it possible for a country to determine its own inflation independent of another. Third, it insulates economies from foreign price shocks. If PPP holds, increase in foreign prices can-not be imported but will only reflect in a stronger currency.
If self-regulating, why then do governments intervene?
It has been established that when left on its own to adjust to the dynamics of demand and supply, the exchange rate will automatically find its fair value. Despite this and the attendant ad-vantages, very few economies are willing to accept the uncertainties accompanying floating exchange and allow their currencies to freely move against other currencies. This is because it is often seen as too important a macroeconomic variable to be left un-guided as its state and movements can have serious implications for the economy. For instance, episodes of depreciation are often accompanied by imported inflation and worsening positions of local firms that borrow in foreign currencies. Conversely, currency appreciation may also lead to the loss of export competitiveness.
With the floating system representing an extreme case of ex-change rate determination, many countries employ the other extreme of fixing their currency either to that of a major trading partner or to a group of trading partners. The hypothetical justification for this is that a pegged/fixed exchange rate system is less vulnerable to speculative attacks. Second, it promotes international trade and investment as there is less risk coming from currency fluctuations. Third, it provides discipline for macroeconomic policies; e.g. excessive monetary growth will be discouraged since the authorities know that it will lead to devaluation.
Adjustments towards naira’s ‘fair value’ – Lessons for the CBN
The two extreme cases have been shown to possess some limitations, thereby justifying operating at the intermediate level: a managed float system.
Empirically, Gosh, Ostry and Tsangarides (2010)1,2, in an IMF‘s analytical study helping members choose optimal exchange rate regime, validate the trade-off between the benefits of the two major systems of exchange rate determination. They show that countries that practice the pegged system enjoy a relatively stable inflation environment as well as improved trade and capital flows. Conversely, they find that these countries are constrained in their abilities to employ countercyclical fiscal policy and are slow to adjust to macroeconomic and external shocks. Generally, they establish that economic growth is best achieved in countries that adopt intermediate exchange rate regimes, that is, maintaining a relatively rigid exchange rate that is not formally pegged to a single currency.
The current system of exchange rate determination in Nigeria fixes the mid-point official exchange rate at N168/US$ while allowing movements of +/-5% margin in either direction. This is a managed float regime. However, the marked gap between the official and parallel market rates is a signal that the naira is not trading at its fair value. This presents arbitrage opportunities and encourages speculative attacks on the country‘s currency. Therefore, delays in currency adjustment presents profit making opportunities for market watchers. Worse still, an anticipation of adjustment, whether real or not, is often accompanied by speculative demand and capital outflows which in turn make the impact of such adjustments more severe.
Economic agents are averse to being taken by surprise. In anticipation of such surprises, they are likely to overreact and display some unintended behavior. It is the duty of the monetary authority to control this. One way is by making adjustments in the currency less ad-hoc with the adoption of a more transparent and scientific approach. Although it is not easy to determine the fair value of a currency, it will be desirable to tie the exchange rate to some economic fundamentals. Thus, changes in these fundamentals will then inform the proportional changes that are required to bring the currency closer to its new fair value. This may calm the nerves of market players since they can also objectively anticipate the direction of the currency at the official window.
The fundamental factor often considered in other economies is the traditional PPP variable: the relative inflation between Nigeria and its major trading partners. This will represent the long run value of the naira against these currencies. Meanwhile, it is crucial to recognize that there will be deviations from this long run value in the short run; hence, the inclusion of other fundamental variables in the proposed model. These variables will include real outputs, real interest rates, foreign asset/liability positions and current account positions (Astley, Deverell and Shah, 2013)3.
The reader may be concerned about two issues. How bad is deval-uation and for how long will the naira remain weak relative to the dollar?
In answering the first question, it should be noted that the impact of exchange rate devaluation differs across different economic agents. While it harms importers of commodities because they have to pay more naira to purchase the same number of dollars, it favors exporters as they obtain more naira for the same dollar they receive from their exports. Existing foreign investors in the domestic economy are adversely affected because the dollar value of their investments has fallen; but devaluation presents an op-portunity for new foreign investors to acquire assets which prices have become relatively cheaper in dollar terms.
Since devaluation raises the price of goods and services, consum-ers‘ purchasing power is eroded; hence, a decline in their welfare. However, if such consumers are working in a company that produces exports, their welfare may improve if they are able to obtain increased wages as a result of improved revenue. Domestic firms and individuals that borrow in foreign currency are harmed by devaluation because they need more local currency to service and offset their debt.
On whether the naira will perpetually remain a weak currency, the answer is no. The current trend will likely cease as Nigeria becomes more competitive and diversifies its production and export base. This way, the supply of dollar will rise, and it will be demanded to purchase only those imports that the country cannot competitively produce. In the interim however, the current man-aged-floating system should be sustained. The only improvement is that adjustments should be more structured and rule-based.
1Ghosh, A. R., Ostry, J. D. and Tsangarides, C. (2010). Toward a Stable System of Exchange Rates, IMF Occasional Paper (Washington: International Mone-tary Fund).
2Also see Ghosh, A. R. and Ostry, J.D. (2009). Choosing an Exchange Rate Regime. A new look at an old question: Should countries fix, float, or choose something in between? Finance & Development; December.
3Astley, M. Deverell, R. and Shah, B. (2013). In Search of FX Fair Value: Credit Suisse Fair Value Model 2013. Credit Suisse Fixed Income Research