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FX Unification in Nigeria: Simple Thoughts, Tougher Mission

Forex	5661 VIEWS
Forex
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Monday, September 23, 2019 / 06:45AM / Proshare Research & TheAnalyst / Header Image Credit: EcoGraphics

Global markets have increasingly learned a fundamental truth; simple is best. Complicated pricing arrangements and sophisticated risk-protection strategies that involve complex algebraic equations look good on paper but are a nightmare to implement. Segun Atere, Head Market Strategy at Apel Assets & Trust notes that, "Investment assets are being pressured to sustain above inflation returns at a time equity asset values are taking a knock and fixed income assets are heading for lower yields as interest rates go up. The FX market is a black box; the deeper you look at it the less you see, but feeling your way to a Naira depreciation appears to be a safe bet".

Not a few market operators believe it is time we take on the big issue impacting the economy. The question remains how and when?

Nigeria would strongly benefit from having a unified and liquid foreign exchange rate it would appear. This is precisely why the Chinese Yuan has been fixed against the US dollar for nearly twenty years; it has created a stable economic environment for Chinese manufacturing.

In this article, our focus is on the current impact of multiple forex rates and the likely impact of a forex unification on markets and the economy.

Understanding the Economics of Unification

Nigerians have become increasingly wary of the government's foreign exchange management policy as a looming global trade meltdown may lead to problems with foreign exchange inflows and bring about hard economic landing if the Central Bank of Nigeria (CBN) does not make up its mind of taking the tough choice of unifying the country's exchange rate windows now.

Local analysts note that current multiple exchange rate regime is like using an elastic band to measure the length of a skirt; the skirt length will depend on how well or how firmly the person measuring the fabric decides to pull the band, in other words, each person pulling the band will have different skirt measurements; the consequence is confusion. This is precisely the problem economists say Nigeria has with multiple exchange rates.

The consequences, they argue, could lead to any or all of the following adverse outcomes:

Currency roundtripping by those with privileged access to foreign currencies at lower rates and 'agency cost' associated with those managing the foreign exchange market.

Distorted price discovery. For example, which exchange rate in Nigeria best reflects the relative scarcity of the United States dollar, the Official rate (N306/$), NAFEX rate (N364/$), IEFX (N366/$) or the Bureau D' Exchange (BDC) rate?

Distortion in production cost. The cost of production, would be reflective of the relative ease of access to either the official exchange rate or the IEFX rate. Manufacturers with access to the official rate would experience lower direct operating costs while those restricted to either the IEFX or BDC windows would experience incrementally higher costs. Large scale manufacturer has been preferred with access to the official window thereby snuffing out smaller competitors. The entry barrier caused by preferential access to FX has resulted in 'unnatural' monopolies (markets with single dominant producer/supplier) or near-monopolies.

Moral Hazard' becomes a craw that needs to be continuously scratched. Erstwhile Central Bank of Nigeria (CBN) Governor and now Emir of Kano, HRH Sanusi Lamido Sanusi, once expressed anger over the 'cheap' money privileged Nigerians were making as a result of access to the official foreign exchange market.

According to Sanusi in a 2016 Financial Times of London interview; "These policies have been tried in different parts of the world and in this country before and they have just never worked. No matter what the stated intention behind them, they are wrong.}

Sanusi insisted, at the time, that the multiple exchange rate regime was in contradiction to President Muhammadu Buhari's anti-corruption drive as intermediation between foreign exchange markets creates an obvious opportunity to those with access to the official market to make millions of Naira in profit without breaking a sweat. He noted that the exchange rate policy, "encourages corruption and rent-seeking similar to the fuel subsidy regime."

The Graphics of Market Distortion

The Central Bank of Nigeria's (CBN's) sustained effort at supporting the value of the naira through weekly or bi-weekly supply of foreign exchange creates a unique challenge for foreign exchange management. The CBN stands in the position of a money supplier of a commodity with several buyers, the standard economic outcome is that the price of the commodity would be higher than if more suppliers existed in the market, in other words the monopolist can dictate either the price or the quantity of FX available but not both.

Standard economic reasoning of an 'imperfect' market condition for FX is as appear in the chart below:

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A flexible adjustment of the FX rate would (in the short run) see the Naira to dollar rate rise to between N400/$ and N420/$ or about 11% or at worse 16% above recent exchange values. As foreign reserves decline based on slow crude oil demand and CBN's efforts at stabilizing the exchange rate around N360/$ wane, the FX rate will rise as quantity of dollars on offer decline (from Q1 in the chart to Q0). The current official rate ofN306/$ creates arbitrage opportunities (the shaded area in the chart to the right of triangle abc) and some 'deadweight loss' as a result of the absence of a 'market clearing' price (the left portion of triangle abc).

Consequences of A Multiple Exchange Rate Regime

Countries tend to use multiple exchange rates as temporary measures to reduce the adverse effect of external commodity shocks on the domestic economy. Multiple rate regimes are expected to be ad hoc and a stop gap towards the reversion of a stable unified exchange rate regime. Local financial analysts believe that the Nigerian monetary authority has gotten too comfortable with a multiple exchange rate regime that it has little enthusiasm towards unification of the multiple rates.

The consequence of continuing to maintain a multiple exchange rate into the year 2020 are dire, and will likely lead to the following unsavoury outcomes:

Devaluation of the Naira: As international oil prices continue to fall and Nigeria's dollar earnings drop, the ability of the CBN to take money from the external reserves to prop up the local FX market will wane.

Discouraging of FDI: Foreign direct investors have been discouraged from investing in Nigerian assets because the potential conversion rates are uncertain and with the weakening of external dollar-denominated revenue flows the potential decline of the Naira is strong.

High Corruption (arbitrage): The persistent tolerance of multiple exchange rates creates an incentive for sustained arbitrage and short-selling of the local currency. Multiple exchange rates create a one-way financial bet that the Naira would decline and the CBN will continue to intervene to support current rates. The official CBN rate of N306/$ does not reflect the relative cost of the dollar to the Naira based on demand and supply factors and underlying economic strengths. At N306/$ the local currency is clearly over valued but the gradual convergence of the NAFEX, IEFX and BDC exchange rates at about N360/$ expresses the relative value of the Naira to the dollar (see infographic 1 below).

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The official CBN rate, therefore, is more of a benchmark for economic rent or what amounts to taking unearned profit off the economic table by virtue of privilege. Piles of money have been made over the last few quarters by taking advantage of selective access to the foreign exchange market at the official rate of N306/$.

A top business executive, who understandably, requested for anonymity noted that, "the official exchange rate is a terrific contraption for building cash empires for the powerful and the privileged; therefore, suggesting that the CBN should behave in a manner consistent with decent market practice around the world is like telling a man whose wife collects protection money on his behalf to stop harassing poor traders. The intention of the appeal is good but the barrel of a gun down your throat is an unpleasant outcome. Nobody gives up privilege without a fight".

"In a policy environment where the CBN is the only Sherriff in town with the fiscal overlords gone AWOL, one should not expect reprieve from the monetary bosses any time soon. Multiple exchange rates as a tool for shielding the economy from external trade shocks is too easy a default mode to encourage any alternative policy action at the moment, especially any policy action that suggests further devaluation of the Naira." He insists.

For moderation sake, this argument may be exaggerated; but the fact that government and privileged economic agents take advantage of the spread between the official exchange rate and the NAFEX and IEFX rates is incontrovertible and perhaps dangerous as it consigns the naira to a one-way shorting bet, a situation where fund managers buy up dollars in a wager that the naira will continue to fall, or a classic case of a dog chasing its own tail.

Another School of Thought

Economists and other thought-led analysts have argued that the problem with the exchange market and by extension - the country's primary concern, should be liquidity and not unification or convergence. This school of thought believes that with more foreign exchange in supply, arbitrage opportunities gradually disappear and the tiered exchange rate structure will naturally disappear.

The school points to the average daily market volume (ADMV) as a metrics of importance. By way of elaboration those canvassing the supply side solution to tiered exchange rates not that ADMV was $754m in 2018 (representing 2.5% of Africa and 0.0155 of global activity). This they argue is materially insignificant and attributing it to multiplicity of rates is a weak argument.

Supply side analysts further note that developments in the uncollaterised loan market and international remittances through social rather than financial networks (involving remittances to Nigeria of about $24bn annually) remains instructive. Rates in the uncollaterised loan market range between 2.5% flat and 25% flat and rates in the remittances of foreign exchange range from a conversion rate of N307/$ and N365/$.

The large spread in rates reflect supply side rigidities. Therefore, increasing FX supply should bring about lower rates in both markets and eliminate the need for multi-tiered rates as presently exist.

The argument of a supply-side approach to FX management is persuasive but inconclusive as another school of thought holds firmly to the belief that the supply side argument is necessary, but not sufficient.

Looking at the Other Policy Arm

As much as increase liquidity in the FX market is a major factor in ensuring that market rates converge, other analysts believe that the multi-layered architecture of the CBN needs to be removed to prevent arbitrage and to allow the market value of the naira reflect the underlying realities of demand and supply of FX. This school of thought argues that, although FX liquidity is a necessary condition for market rate convergence, it is not adequate to ensure stability as preferential rates allowed by the CBN would create room for market distortions.

As an example, the school of thought argues that - if supply were adequate from private sources, this would see the naira appreciate and force the price of the dollar closer to N306/$; but if the CBN allows discriminatory pricing and dollar subsidies (as occurs presently), economic agents will have an incentive to obtain dollars at cheaper rates and sell them to third parties at higher rates. The subsidy would discourage private sellers of the dollar who feel hard done by as a result of the artificially created spread, hence leading to a cut-back in supply of private dollars and a gradual rise in the N/$ rates in private markets.

As Yogi Berra once famously said, "it's deja vu all over again".

The school for a dismantling of the scaffolds of the CBN's multiple exchange rate structure believes that improved liquidity must be accompanied by a policy clearly adverse to arbitrage and high velocity speculation.

Bravery in The Face of Expediency

The monetary policy strategy of multiple exchange rates is usually used as a short term technical measure to smoothen the path towards exchange rate unification and lead to greater transparency in the allocation of scarce resources, but so far the CBN has been seduced into using the tiered exchange rate approach to maintain policy balance, but the 'Cobra effect' of the solution leading to unpleasant consequences is both real and compelling.

A number of consequences arising from the current FX management architecture reveals a weak economic underbelly, viz:

The maintenance of multiple exchange rates has seen 'hot' money go in and out of the FX market as portfolio managers try to second guess the extent of depreciation of the Naira as oil prices gradually decline. This plays up in the higher percentage change in the price of FX in the Bureau d'Change market relative to NAFEX and IEFX windows (see infographic 2 below).

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Between December 2018 and September 2019, the official exchange rate has gained +0.02%, the NAFEX rate +0.51%, the IEFX rate +0.60% while the BDC has appreciated +1.37% or twice the IEFX rate. Apart from the official rate all other rates have clustered around N360/$.

With the global economy cued for a recession (see Fasten Your Seatbelts There Is Turbulence Ahead---LBS-Executive-Breakfast-Session---Sept-2019) the regular market intervention by the CBN to keep exchange rates around current values will become increasingly difficult.

Falling foreign exchange revenues will put pressure on the Naira and require the financial regulator to allow a drop in the external value of the local currency.

The following will be the resultant effects:

Domestic Inflation will rise (recent rate for July 2019, 11.08%);
Nominal Interest rates will go up (lending rates will settle between 22% and 24%);
Money supply will tighten;
Government budget deficit and debt service will widen;
Tax net will expand (to reduce the impact of growing debt on fiscal position);
Government borrowing will grow (pressure of recurrent expenditure vs. declining revenue from export inflows);
Private sector access to credit will shrink (as government tries to meet debt obligations); and
Unemployment (recently 23.1%, Q3 2018) and underemployment (recently 20.1%, Q3 2018) will rise (as manufacturers face weak domestic demand).

Being Brutal, Lovingly

If Nigeria is to head off the harder problems of a global recession, the CBN must be prepared to bite down on the bullet of rate unification, and the best time to do it is now when virtually all market-sensitive rates are clustering around a N360/$ value; however, the convergence has been mildly disrupted since July 2019 as rates broke out of the narrow band witnessed between March and June 2019 (see infographic 3 below).

The more the economy suffers lower reserves, higher inflation and wider budget deficits the more difficult it will become to take the tough love needed to eliminate exchange rate subsidies.

The use of demand management strategies such as limiting certain categories of importers from accessing the banking system for FX purchases can only be temporary, the reality of economics makes it impossible for regulators to control both demand and supply at the same time just as they cannot control quantity and price simultaneously (see CBN To Expand List Of FX Restrictions On Imported Items).

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Sometimes the hard way is the only way to resolving complex situations, even the road to hell is paved with good intentions despite the fiery pains.

For further details or/and contributions on the subject, kindly write to the Managing Editor vide content@proshareng.com.