Wisdom Nuggets – Rescuing and Defending the Naira

Forex
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Friday, June 17, 2016 8.48 PM / Victor A. Odozi,  Originally Published on May 22, 2016 

INTRODUCTION

This contribution has been triggered by several considerations, including the following:

First, the urging of a long-standing friend of mine who thought that I had something worthwhile to contribute towards the ongo-ing efforts to stabilise the Naira exchange rate. Second, it is in memory of the late maverick, Egheomhanre Em-manuel Eyieyien, fondly called “Ëghes”, a great patriot and close associate of mine. He died on Christmas Day last year, barely three days after publishing an article, entitled: Emefiele is Not the Problem, in which he lamented the travails of the Naira and, inter alia, advocated its devaluation as a realistic step towards restoring exchange rate stability in the Country. Third, the timing has also been informed by the recent phenomenal crash of the Naira in the free foreign exchange markets, with the Naira crossing what might be called the “barlev line’’ of 400 Naira/Dollar. Indeed, until that point, I was of the firm view that the devaluation of the Naira, as urged by many experts, including those of the IMF, was not, per se, the solution to our Country’s foreign exchange crisis.  

Now, however, I firmly believe that Naira devaluation is inevitable and, indeed, mandatory. The real debate now should not be over whether or not the Naira should be devalued, but when and by how much and the elements of a strategic policy framework to make the emerging exchange rate regime stable and sustainable. It should also be clear that failure to act now will merely postpone the evil day and exacerbate the prevailing foreign exchange crisis. In this connection, it is instructive that three past Governors of the Central Bank of Nigeria (CBN) have spoken out in favour of Naira devaluation. Furthermore, some oil-exporting countries, whose economies have been mired by the collapse of international oil prices, just like Nigeria, have been obliged to devalue their local currencies to ease the unrelenting pressure. For instance, the Russian rouble has officially been devalued by over 50% since July 2014 while the Venezuelan Bolivar was officially devalued by 37% in February 2016 for the same reason. So, Nigeria is not alone on this devaluation issue and the authorities need to recognise that it is inevitable, and the earlier it is done the better for the Country.  

Thus, this contribution seeks to make a case for appropriate official downward adjustment of the Naira exchange rate (devaluation) as one of the key elements in a comprehensive and robust macroeconomic policy response by the Federal Government to the prevailing economic and financial crises. It should be reiterated that Naira devaluation, per se, is not the answer and should be undertaken only in the context of a coordinated and coherent fiscal/monetary policy response, backed by complementary supply-side and corrective measures. It should also be stressed that the issues raised and the proposals made in this contribution are not entirely new or original but they remain highly relevant in our present circumstances.  

Above all, it should be recalled that our Country faced a similar dire situation some 30 years ago. Then, in mid-1986, after con-ducting a long-drawn-out and heated national debate whether to devalue or not to devalue, the Military Government under General Ibrahim Babangida mustered the will to devalue the Naira. That was a matter of last resort and a key element in the nexus of economic reform measures introduced under the auspices of the Structural Adjustment Programme (SAP). Although the outcomes of the SAP were mixed, they were, on balance, highly beneficial. Thus, although the SAP is nominally dead, its spirit prevails till this day. Indeed, the SAP ideology of guided market capitalism has continued to inform and inspire policy-making and manage-ment under successive administrations ever since. The learning point here is that we had faced a similar situation before as we are in now and that there is a viable option available if the re-quired political will could be summoned to do what is inevitable and unavoidable. We believe that this Government is not lacking in the courage to devalue if it is clear and persuaded that there is a compelling case for it. An attempt is made to present such a case in this contribution.  

After work on this paper had virtually been concluded, news came that a currency swap deal had been signed between Nigeria and China. Details of the arrangement, in terms of coverage, transaction dynamics, documentation requirements and take-off, etc., have not yet been provided. Accordingly, only tentative comments  on the deal are warranted here. In this connection, it is important to state that any arrangement, such as the one referred to above, that seeks to relieve the prevailing pressure on our external reserves is welcome, provided the terms are right and the benefits are sustainable. Nevertheless, even with the most favourable terms available, the above initiative, which is analogous to a clearing-house arrangement, should be seen as merely complementary to, and not a substitute for, the existing payment arrangements for the settlement of international transactions. Indeed, the US Dollar still looms large in our external transactions and payment obligations and this dominance will remain for long. Thus, the need to deal with the current exchange rate misalignment and the case made for it in this paper remain valid.  

SOME CONCEPTUAL AND LEADING ISSUES

i. Factors at Work  

The exchange rate, in general, reflects the underlying health or otherwise of an economy, particularly the economic fundamentals of foreign exchange demand and supply, interest and inflation rates, balance of payments position, and growth prospects. The psychology of the market (expectations and speculative activity) and socio-economic and political factors also exert a significant im-pact on the exchange rate.  

The following factors have, to varying degrees, been the driving forces behind the persistent depreciation of the Naira exchange rate since the last quarter of 2014:

1.    The collapse of oil prices which started in June 2014, resulting in the sharp decline in petrodollar receipts and depletion of our external reserves.

2.  Gross inadequacy of supply relative to demand for foreign exchange. This has been exacerbated by the removal of 41 items from the list of imports eligible for foreign exchange sourcing from the official market, with those affected being left with no choice but resort to the bureaux de change and parallel markets to meet their otherwise legitimate needs.

3.      The increasing incidence of hedging and speculative transactions which have swollen an already bloated demand for foreign exchange.

4.      With the persistent Naira weakness and the spectre of imminent Naira devaluation, there has been increased incentive to hold foreign currency rather than the Naira. Thus, while investors and other potential suppliers of foreign exchange withhold their funds in order to make more profits (gains) later, foreign exchange users are desperate to buy now before the Naira depreciates further or is devalued. This “Naira pessimism” or preference for dollars is a major factor in the continued slide of the Naira in the free segments of the foreign ex-change market in recent times.  

In summary, increased “Naira pessimism”, severe supply con-straints in the face of unrelenting heavy demand, the ensuing huge and increasing backlog of unsettled past-due import bills and invisible trade transactions, a large and widening parallel market premium, etc., have all engendered increased uneasiness about Naira exchange rate stability and the well-founded view that the prevailing official rate cannot be sustained for too long, without depleting the external reserves. Consequently, there has been a huge speculative attack on the reserves. Furthermore, the lingering insurgency in the North East and socio-political unrest and violent crimes in some parts of the Country, coupled with weak near-term growth prospects, have all induced increased capital flight, thereby exacerbating the woes of the Naira.

ii. Why Rescue and Defend the Naira?

In making a case for rescuing and defending the Naira, we should begin by stressing the critical role of the exchange rate in the economy.  

For a country, such as Nigeria, with an open economy where foreign trade accounts for a significant proportion of the Gross Domestic Product, the exchange rate links the domestic economy with the outside world. Furthermore, it is the most important price which influences most other prices and, indeed, the general level of prices. Consequently, exchange rate levels and movements have far-reaching implications for inflation, price incentives, fiscal viability, export-competitiveness, efficiency in resource allocation, international confidence and balance of payments equilibrium.  

Given their widespread impact, it is not surprising that exchange rate developments are a matter of great interest and often concern to Governments, the business community and the general public. In some situations, exchange rate devaluation becomes the government’s concern and is beyond the purview or discretion of the central bank. That is why this contribution is being placed in the public domain.  

Rescuing and defending the Naira is to ensure that the exchange rate regime is not left to the vagaries and devices of free, unfettered markets which are often manipulated and driven by greed and criminality. It is also to ensure that the exchange rate performs its resource-allocation function efficiently and that the emerging regime is stable and sustainable. Indeed, given its critical role in macro-economic management, the Naira exchange rate needs to be stabilised and subsequently sustained within an appropriate band or target zone, to make for better planning by economic agents.  

AN AGENDA FOR ACTION

i. Some Fundamental Principles   

To put the proposals being made in this contribution in context, the following fundamental observations or principles may be advanced.   

First, the exchange rate is a price. Like all other prices, in a free-market environment, it is determined by the forces of supply and demand. Consequently, and as past and present experiences have amply demonstrated, trying to fix it arbitrarily is an exercise in futility. Indeed, as asserted by Jacques Polak, IMF Director of Research (1958 – 1979, “It is not in the best interest of any country to seek to maintain a disequilibrium exchange rate and no country in the end succeeds in doing so”.  

Second, macroeconomic management invariably entails delicate balancing acts and difficult trade-offs among key fiscal and monetary variables, e.g.: price stability versus growth; interest versus exchange rates; consumption versus savings; and the short versus long term; etc. Thus, achieving a stable exchange rate might require raising interest rates; devaluation is sometimes required to restore external balance; and devaluation might be unavoidable to achieve a realistic and sustainable exchange rate regime. The policy or operational discretion the fiscal and monetary authorities have depends on the prevailing economic conditions; the degree of divergence of the variables from optimality; and the magnitude of corrective measures called for in order to restore normalcy. Thus, un-duly delaying corrective action often results in bigger and more painful adjustment in future.  

Third, since the demonetisation of gold in the early 1970’s, there has been a generalised system of floating exchange rates. How-ever, in practice, there is nothing like a “clean” or “pure” float whereby the exchange rate is left entirely to the vagaries of market forces. Although there is a continuum of exchange-rate regimes worldwide, ranging from fixed to flexible arrangements, the predominant system is the “dirty” or “managed” float. This entails periodic intervention by the monetary authorities in the foreign exchange markets to achieve certain strategic objectives, such as buoying up the value of the local currency in periods of severe market pressure or reducing its value to restore export competitiveness or improve the trade balance. A few countries have a fixed exchange rate regime either in the context of a monetary union (as in the case of Europe) or under a currency board system (as in Hong Kong and Argentina). Nevertheless, irrespective of the regime chosen, it is important that exchange rate determination is technically sound and realistic and that the rate is stable.  

Fourth, after nearly thirty years that stringent trade and exchange controls were abolished in Nigeria as part of the reform package under the auspices of the Structural Adjustment Programme, there has been a gradual return to such controls in recent times, ostensibly to deal with the prevailing foreign exchange crisis. Although these measures may be defended as a last resort and short-term emergency measure, it should be noted that both trade and exchange controls have been firmly established as inferior macroeconomic management tools that have not recorded any success story anywhere in the world. Our own Country’s experience during most of the pre-SAP period (1967 to mid-1986) amply demonstrates that such controls are a costly and useless bureaucratic exercise as they are susceptible to serious abuse, corruption and evasion. Furthermore, in the more sophisticated business environment of to-day, stringent trade and exchange controls will be more easily circumvented by market participants.  

Fifth, rescuing the Naira would require the adoption of a comprehensive and robust reform agenda, an important component of which is exchange rate unification as proxied by significant reduction in the prevailing parallel-market premium from about 60% to the generally-accepted threshold over time. It should be stressed that although by itself, the parallel market rate is not all that important as it is not the true rate for the entire economy and only a relatively small volume/value of transactions gets executed at that rate, the difference between the official and parallel market rates (parallel-market premium) matters a great deal. For, apart from serving as an indicator of the magnitude of excess demand for foreign exchange and the potential or prospect for eventual devaluation, an unduly large parallel-market premium, as is the case now, engenders destabilising speculative activity and serious malpractices, including capital flight and the diversion of funds and repatriable export proceeds from the official to the parallel market. Thus, exchange rate levels and trends in this informal segment relative to the official rates, cannot be a matter for benign neglect but should be of policy interest and action.  

Sixth, although the prevailing large parallel-market premium is a matter of policy concern, the authorities should be circumspect in dealing with the problem. In particular, the approach to be adopted in the efforts to drastically reduce the premium should be legal, transparent and technically sound. Thus, the temptation to intervene in the parallel market by injecting official foreign exchange therein in order to induce an appreciation of the rate, as some have advocated, should be resisted. Although such an initiative was taken in the mid-1990s, it should be discouraged for the following reasons: it is illegal; it lacks transparency and is susceptible to abuse; and it is of doubtful efficacy and unnecessary given that, once the rates converge in the official market, the parallel-market rate would crash and fall in line with the unified exchange-rate regime. However, the parallel market could only pale into in-significance but would not be completely eliminated even with the efficient and superior performance of the formal market. Further-more, invoking draconian anti-black market laws and raids by security agents are unlikely to put the informal market currency traders out of business for good. This is because the parallel market accommodates “those left out” either because they are unable to meet their legitimate needs in the formal market or are engaged in ineligible or illegal/criminal transactions. Above all, for many parallel-market operators, currency trading is deeply-embedded in their genetic code and has become a way of life or part of their culture!  

ii. Elements of a Policy Package for Rescuing the Naira  

Policy Options for Exchange Rate Unification

The unification of the foreign-exchange markets, entailing the significant reduction in the parallel-market premium to achieve a unified exchange-rate regime, is a strategic imperative that needs to be executed in a competent and credible manner. There are several possible options for achieving such unification, including the following: merger at the parallel market rate or bureaux de change rate; merger at the CBN/interbank rate; merger at the prevailing autonomous rate which is assumed to be currently well above the official CBN/interbank rate; or merger at a weighted average of the CBN/interbank rate and either the autonomous rate or a rate indicated by the Purchasing Power Parity (PPP).  

The above options may be appraised as follows:

A merger at the prevailing parallel market, bureaux de change or even the autonomous market rate would mean a big devaluation of the Naira and is not recommended because of the severe inflationary repercussions.  

A merger at the prevailing CBN/interbank rate, which would have been desirable because it carries the least inflationary potential, is not realistic or sustainable, given that it would require drastic demand management measures - a severe liquidity squeeze and fiscal retrenchment – which would drive up interest rates to worrisome and unsustainable levels. Furthermore, in the face of the massive volume of unmet demand and trade arrears, it would re-quire a chunk of our already depleted external reserves to make merger at the prevailing CBN/interbank rate sustainable.  

A merger at a weighted average of the prevailing CBN/interbank rate and either the autonomous rate or a rate indicated by the Purchasing Power Parity (PPP) , the latter of which is assumed to be currently well above the CBN/interbank rate, would appear to be the most credible and sustainable option. This preferred option would entail the devaluation of the official exchange rate by about 10 to 15%. It is also envisaged that this measure, which could potentially suck up a substantial amount of liquidity from the system, would significantly reduce the overall demand for foreign exchange and exert a downward pressure on, or induce an appreciation of, the parallel-market rate.  

However, it should be stressed that one single dose of devaluation cannot guarantee a stable and sustainable unified exchange rate regime unless it is backed by robust demand management, fiscal measures and supporting supply-side initiatives. Also, what is envisaged is exchange rate convergence or unification which excludes a dual exchange-rate regime, the latter of which implies an official rate for favoured transactions existing side-by-side with an autonomous (second window) rate for others. Let it be stated here in passing that introducing a dual exchange-rate regime is an exercise in futility!  

It is appropriate at this juncture to note that the debate over the devaluation of the Naira is long-standing and rages on today, with advocates and opponents of devaluation remaining resolute and vehement in their respective stands. Having made a case for Naira devaluation in this paper, it is only fair that the case of the opponents also be examined here. The case made against de-valuation is often based on technical grounds, namely that: Nigeria is highly dependent on imports the demand for which is inelastic while the Country’s exports are supply and demand inelastic. Thus, devaluing the Naira would not result in any significant decline in imports nor would it induce meaningful export growth. Furthermore, devaluation would result in imported inflation, with adverse consequences for the ordinary man.  

In response to the above devaluation concerns, the following countervailing arguments may be made: First, although demand for basic imports may be inelastic, this does not hold good for lux-ury and non-essential items. In any case, when the prices of even basic imported items rise unduly high, there would be price resistance by consumers and greater incentive to look inwards and source locally for substitutes, thereby boosting domestic production and employment. Second, with respect to the inflationary repercussions of Naira devaluation, it should be noted that businesses have already factored the devaluation of the Naira in the free segments of the foreign markets into their pricing decisions and that the prevailing prices reflect parallel market rates rather than CBN rates.  

Thus, devaluation will not result in much higher prices for goods than the prevailing levels which could, indeed be moderated by the effects of disciplined demand and induced supply expansion. In this connection, the recent deregulation of the down-stream sector of the oil industry, should result in improved supply and stabilisation of petroleum product prices below the prevailing general level pre-deregulation, with potential positive impact on inflation. Second, the argument that devaluation would not have any meaningful impact on our exports may be faulted on the ground that devaluation would definitely enhance the price competitiveness of our export products. In this connection, it should be noted that various studies have established that our farmers and exporters do respond to price incentives. Thus, over time devaluation, combined with appropriate export promotion measures, should call forth a significant supply response. Third, devaluation is being proposed here in the context of comprehensive policy reforms, encompassing not only official exchange rate adjustment but also the supporting fiscal, monetary and other measures highlighted below, to make devaluation work. Indeed, the approach here is dynamic as against the static and populist orientation of the anti-devaluation ideologues.  

SUPPORTING MEASURES  

1.     Adopt a flexible, market-oriented exchange rate regime based on the target-zone approach.

2.      Create a truly autonomous inter-bank foreign exchange market whereby the CBN ceases to be the dominant player. Instead, the CBN would be more of a market referee and facilitator, intervening periodically to achieve certain strategic objectives and ensuring compliance with the rules of the game.

3.      To ensure the depth and viability of the new interbank-based foreign exchange market, it should be funded not only with non-oil export proceeds and other private inflows but also funds sourced from oil-marketing and oil-servicing companies and remittances of oil-producing companies for payment of taxes and royalties while Government receives payments due to it in Naira. The implication of this scenario is that petro-dollar earnings would be kept by the CBN after monetisation and used to boost production and generate exportable surplus. In this connection, the strategy of export-led recovery or the new “Zero Oil” Economic Agenda now being promoted by the NEPC should be diligently pursued.

4.     Make concerted efforts to deal with the various infrastructural constraints in order to boost supply, enhance efficiency and re-duce the high cost of doing business in the Country.

5.  Create a stable, business-friendly environment based on effective public-private partnership, with the private-sector as the engine of growth. Also deal firmly with insurgency, corruption and abuse of court processes by litigants and criminal opportunists. 

CONCLUSION
In summary, devaluation, if undertaken in the context of a comprehensive and robust policy reform, would yield the following significant benefits: arrest and reverse the depletion of our external reserves; discipline demand for foreign exchange and imports and reduce our vulnerability to external price shocks; induce net foreign inflows; enhance export-competitiveness and growth; enhance government revenue from petro-dollar receipts and taxes; check round-tripping and other rent-seeking behaviour; restore credibility to our international payment arrangements; and pro-mote the diversification and growth of the economy. The important caveat here is that devaluation should be undertaken as a key element of a comprehensive and robust policy reform backed by diligent implementation.  

Whether by design or by default, Nigeria is now approaching the dawn of the post-petroleum age. For a country so heavily dependent and for so long on petroleum, it is difficult to contemplate a future without petroleum – so pervasive and critical has been the role of petroleum in our national economy! However, this is the stark reality that we need to embrace. The post-petroleum age in Nigeria comes with both risks and opportunities which policy-makers and other key stakeholders need to be aware of and respond to by appropriately managing the episodic and traumatic transition from fossil fuels to renewables. It cannot be business as usual, with the typical lack of a sense of urgency. In many ways, the measures advocated above for stabilising the Naira exchange rate, provided they are pursued diligently, would facilitate the orderly transition to the post-petroleum era.  

Meanwhile, saving the Naira from its prevailing travails would re-quire comprehensive and robust initiatives, some of which have been highlighted in this contribution, together with an identification of the forces at work. The measures mandated include the devaluation of the Naira but it should be reiterated that this is just one, albeit a key element, in the nexus of actions required to be taken. Some of the initiatives would have long gestation periods. However, coordinated and diligent implementation of these and many other initiatives by Government, working with key private sector stakeholders, should yield a realistic, unified exchange rate regime and restore confidence and stability in the foreign exchange markets in the short run. Long-term sustainability, together with reaping the benefits that would accrue from there, will require strong political will by Government and consistent efforts on an ongoing basis by all.  

Above all, we need to embrace change, big change! One important implication of the creation of a new interbank foreign exchange market advocated above is that the private sector opera-tors would cease to rely on the CBN for their foreign exchange needs, subject to a transitional phase of not more than six months. This would, no doubt, come as a shock and, for many businesses, it would mean “export or perish”! Although this appears to be a rather risky, even worrisome proposition, it is warranted and inevitable in our present dire circumstances. Indeed, “export or perish” is not a curse, a mere slogan or exhortation. It is a strategic imperative for our economic survival and transformation!   

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