Resolving the Exchange Rate Regime Conundrum


Wednesday, March 23, 2016 9:55 AM / By Temitope Oshikoya** 

At the height of the controversy on Nigeria's exchange rate regime generated by The Economist last year, this writer in an article dated 22nd July, 2015, on The Economist and the CBN, made the following concluding remarks as the way forward towards resolving the exchange rate regime conundrum that the country was facing then and still faces now.

 occupying the middle ground of monetary policy trilemma, with flexible managed exchange rates, intermediate levels of monetary policy and widespread, but incomplete, capital account transactions, experienced lower output volatility than other countries in the past two decades. "

"Several other studies have also shown that countries that do not rely only on a single policy instrument such as devaluation, but implemented a comprehensive policy package have been the most successful in dealing with external shocks and enhancing their competitiveness.  For long-term productivity and competitiveness, what Nigeria needs is a comprehensive policy package of monetary, exchange rate, trade, fiscal and structural reforms."

These concluding remarks in that article essentially proposed that the best policy option is for the Central Bank of Nigeria to pursue a combination of an intermediate regime for exchange rate, monetary policy, and partial capital controls.


Unfortunately, it appears that some of the market intelligence gurus have failed to wear their strategic intelligence and economic intelligence hats. As a result, a puerile debate ensued more on devaluation rather than on the choice of an appropriate  comprehensive policy regime to address external shocks, competitiveness and productivity. 


Strategically, they were not helping the CBN to position itself to pursue an intermediate policy regime or a middle ground approach to exchange rate regimes. They were also essentially pushing the political authorities to the wall; hence the administration kept stating that "Read our read lips: No Devaluation"


Economics theory relating to devaluation is logically consistent. As this writer noted in the article of July, 2015, Economics principles suggest that devaluation has the advantage of efficiency and administrative simplicity as an across-the board expenditure-switching policy. However, for devaluation to be effective, it must achieve real exchange rate depreciation, and not simply nominal exchange rate depreciation.  Devaluation also has income distribution consequences.


The argument of the proponents of massive devaluation simply lack empirical evidence.


In the article on Currency Woes and Capital Flows in Emerging Markets, we have clearly noted that more than 75 countries have devalued their currencies in the past twenty four months, yet capital outflows from emerging markets, especially from the BRICS, reached $735 billion in 2015, according to the Institute for International Finance, an association of over 500 global banks and other institutions including Citibank, JP Morgan, HSBC, World Bank, and Standards & Poor's, e.t.c.


Further, The Economist, citing recent studies by staff of the World Bank and IMF, points out that it is not enough to have a price change: First, you have to produce something that someone wants to buy.” The Russian rouble’s weakness is an opportunity for industries that already exports such as chemicals and fertilizers. But boosting other exports requires investment in new production, which takes time…. Devaluations in other countries including South Africa and Turkey, have also disappointed”


Thus, the debate on devaluation has been quite misplaced. What we should focus on is appropriate exchange rates regime. In this context, Macroeconomics suggest the need for pragmatic intermediate exchange rates regimes. There are four possible scenarios. First, under a combined zero capital mobility and a fixed exchange rate regime, both monetary and fiscal policies are rendered impotent.


Second, with perfect capital mobility and a fixed exchange rate regime, monetary policy is still impotent, but fiscal policy multiplier is more effective. Third, with a zero capital mobility and a free floating exchange rate, both monetary policy and fiscal policy regained some potency. As the degree of capital mobility increases, fiscal policy multiplier increases.


Under the fourth scenario with perfect capital mobility and a free floating exchange rate regime, monetary policy is more effective while fiscal policy is rendered ineffective. As the degree of capital mobility increases with flexible exchange rate regime, fiscal policy multiplier declines while that of monetary policy increases.


How about policy responses to shocks? If the economy is very prone to monetary shocks, a fixed rather than flexible exchange rate regime is more desirable. On the other hand, a flexible exchange rates regime is more appropriate with a goods market shocks.


It is worth noting that neither fixed nor flexible exchange rates provide a defense against a change in the world interest rates; and neither provide protection against domestic supply shocks or shocks that simultaneously raises inflation and lower output, which is the current state of our economy.


It is in this context that we have consistently maintained that the task of the monetary authorities have been a bit complicated. The latest MPC Communique points to this fact. While the MPC desires to support economic growth with accommodative monetary policy, it cannot completely take its eye balls off price stability with inflation at over 11%, above its price target range and with negative real interest rates.


The macroeconomic implication of these various scenarios and shocks is that the CBN should not commit policy to  a rigid fixed exchange rate regime or to pure floating exchange rate regime; nor to zero capital mobility or perfect capital mobility. When you throw in our earlier discourse on the political economy dimension of the desire to meet the needs of different electoral constituencies and interest groups, the desirability of an intermediate regime becomes clear.


In the short to medium term, a combined policy cocktail of managed floating exchange regime, partial capital controls, and a limited degree of monetary autonomy is the most appropriate. We have also proposed that a crawling peg based on inflation differential could be the starting point towards the managed floating regime.


This monetary policy stance would be supported by a medium to long term comprehensive policy package of fiscal, institutional, and structural reforms to unleash infrastructural constraints, competitiveness, and productivity.


This intermediate monetary and exchange rate policy stance is not only backed by macroeconomic issues discussed above, but by empirical studies on other countries by other authors and specifically by an empirical study conducted in 2015 by this writer on Economic  Policy Trilemma and Exchange Rate Management in Nigeria as well as by the prior policy exposure and experience of having headed an international organization that works with Governors of Central Banks across West Africa.


We, therefore, write from the vantage point of understanding the economics, the empiricism, markets dynamics, and policy constraints relating to exchange rate regimes.

**Dr. Temitope Oshikoya, an economist and chartered banker, is the CEO of Nextnomics Advisory.   

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