Naira Convergence: Impact and Imperatives

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Monday, January 10, 2022 / 02:21 PM / by FDC Ltd / Header Image Credit: TheCable

 

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In 2021, manufacturers were forced to adopt a blended exchange rate of both official and parallel market rates. This blended rate ranged from as low as N430/$ at the start of the year before deteriorating to as high as N550/$. This had an impact on the prices of consumer goods. In reality, the impact of an adjustment of the official rate and rate convergence could lead to an adjustment of the blended rate used by manufacturers.

 

The official exchange rate moved sharply (N435/$) on the last day of 2021, after trading relatively stable around N415/$. This is the second consecutive year in which the rate was arbitrarily moved on the last day of the year. This brings to fore the question on everyone's minds, if indeed there is really a crawling peg or are we just playing with mirrors? This is also occurring at a time when oil prices are trading at $80pb. However, for the Nigerian external sector, there seems to be no direct correlation between the price of oil and the level of forex supply and appreciation of the naira. Adjusting the official exchange rate albeit temporarily could send the wrong signal to investors and further stoke the flames of market uncertainty.

 

SSA: How did the Currencies Perform?

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Most African currencies have depreciated in value in the last three years, with the Angolan Kwanza and Nigerian naira recording the highest loss. However, in 2021, the Angolan Kwanza reversed its downward trend to be the only African currency under our review to appreciate in value in the last year.

 

Trend of the IEFX-parallel market spread

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Impact Of Forex Rates Convergence

 

Reduces the spread between the IEFX and parallel rates

Naira convergence will help reduce the IEFX-parallel market spread which will in turn decrease 6 FMDQ and FDC Think tank 15 the incidence of speculative trading at the parallel market. A reduced spread will decrease the incentive (arbitrage) for speculators to obtain forex at the official market and resell at the parallel market. This may result in panic dumping of dollars at the parallel market due to the concern of lower demand for forex and appreciation of the dollar at the parallel market.

 

Encourages traders and investors to source forex at the official market (IEFX)

Closing the gap between the official and parallel market rates is likely to reduce the demand for forex at the parallel market, pushing investors and traders to the official market. This will lead to increased forex transactions at the official market (IEFX).

 

Positively impact foreign trade and investment

The wide IEFX-parallel market spread and the low forex supply at the official market have been the main factors driving investors and traders to source forex at an expensive rate from the parallel market. Reducing this spread, coupled with an improved forex supply at the official market, will decrease uncertainty (volatility) at the forex market and bolster the ability of the IEFX window to meet a higher demand for dollars. The resulting impact of this is that a reduced exchange rate volatility and improved forex supply will make it easier for foreign investors to repatriate their funds. It will also ensure that traders and manufacturers can access forex at a uniform rate from both the official and parallel markets. Reduced naira volatility and improved forex supply are positive for foreign direct investments and foreign portfolio investments as well as the country's external trade. This is because of the increase in the volume of dollar available for foreign trade and investment.


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What Needs to be Done?

 

Flexible or floating exchange rate system

Incorporating a flexible or floating exchange rate system would allow the value of the naira to be determined by the invisible hand of demand and supply at the official (IEFX) market. Countries like Zambia and South Africa use the floating exchange rate system; this strategy could partly explain the positive performance of their currencies. According to Bloomberg, the Zambian kwacha is the second best-performing currency globally in 2021, as it has appreciated by 27.04% YTD

 

Improve the supply side of the economy

Nigeria must complement shifting to a floating exchange rate system with increasing its forex supply. To achieve this, the productive side of the economy must improve. This improvement would increase the volume of goods and services available for domestic consumption, thereby reducing the country's import costs which are a major drain on the external reserves. It would also increase the goods available for export to other countries and the inflow of revenue from export could be used to boost the external reserves and forex supply at the official forex market. Countries with a wide balance of trade surplus have relatively stable exchange rates. For instance, Zambia and Angola maintain a trade surplus of $269.12mn and $4.95bn respectively, which are positively impacting their external reserves and exchange rate stability relative to Nigeria who has a trade deficit of N3.02trn ($7.28bn). Angola's kwanza has appreciated by 15.73% in 2021 compared to the naira which has depreciated by 16.96% (parallel market) and by 5.69% at the IEFX window.

 

Revisit the country's import restriction list

More than 40 commodities, including agricultural goods, are on the CBN's forex restriction list. This drives traders and investors to the parallel market to satisfy their forex obligations, which adds to the forex demand pressure. The forex restriction policy will only be effective if the productive side of the economy is significantly improved. The CBN may have to relax some of these restrictions in the short term, as Nigeria is a net-importer of most of these commodities. This may be a short-term solution to reducing the forex demand pressure at the parallel market and could result in the reduction of imported inflation.

 

Conclusion

Although the CBN has implemented some forex management policies, like the naira4dollar promo and the recent exchange rate adjustments to improve naira stability and forex inflow, they are insufficient to ensure a naira convergence. Hence, there is the need to improve the productive side of the economy and leave the official forex rates to be market-determined. This will promote naira convergence in the medium to long term.


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