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Outlook 2021: Eyeballing Major Economic Indicators in 2020 - Exchange Rate

Reviews & Outlooks	1269 VIEWS
Reviews & Outlooks
1269 VIEWS

Thursday, February 11, 2021 /05:00 AM / By Proshare Research/ Header Image Credit: EcoGraphics

There has been increased clamour for the CBN to unify its multiple exchange rate as local analyst have become increasingly wary of the government's foreign exchange management policy as a looming global trade meltdown may exacerbate 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 the 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 reservation economists have with multiple exchange rates.

The Problem with Multiple Exchange Rate

Some of the challenges associated with multiple exchange rates include currency roundtripping, distorted price discovery, distortion in production cost, and moral hazard (see Illustration 27).

Distorted price discovery: For example, which exchange rate in Nigeria best reflects the relative scarcity of the United States dollar, the Official rate (N380/$), NAFEX rate (N392/$), IEFX (N394/$), or the bureau de change (BDC) rate?
Distortion in production cost: The cost of production, will 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 will experience incrementally higher costs. Large scale manufacturers have 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 a 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 once expressed anger over the 'cheap' money privileged Nigerians were making because of access to the official foreign exchange market. 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 tail.

Illustration 27: The Problem with Multiple Exchange Rate

The Graphics of Market Distortion

The Central Bank of Nigeria's (CBN's) sustained effort at supporting the value of the naira through the 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 appears in the chart below:

Illustration 28: The Nigerian Economics of Multiple Exchange Rates

A flexible adjustment of the FX rate would (in the short run) see the Naira to dollar rate rise above recent exchange values. As foreign reserves decline based on slow crude oil demand and CBN's efforts at stabilizing the exchange rate around N380/$ wane, the FX rate will rise as the quantity of dollars on offer decline (from Q1 in the chart to Q0). The current official rate ofN380/$ creates arbitrage opportunities (the shaded area in the chart to the right of triangle 'abc') and some 'deadweight loss' because of the absence of a 'market-clearing' price (the left portion of triangle 'abc').

Table 13: CBN, NAFEX and BDC FX Rates (January-December 2020)

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 the multiplicity of rates is a weak argument.

Supply-side analysts further note that developments in the uncollateralized loan market and international remittances through social rather than financial networks (involving remittances to Nigeria of about $24bn annually) remains instructive. The CBN in an attempt to address the supply side challenges of FX in its most recent circular noted that "Beneficiaries of diaspora remittances through International Money Transfer Operators (IMTOs) shall henceforth receive such inflows in foreign currency (US Dollars) through the designated bank of their choice. Such recipients of remittances may have the choice of receiving these funds in foreign currency cash (US Dollars) or into their ordinary domiciliary account.

The large spread in rates reflects supply-side rigidities. Therefore, increasing FX supply should bring about lower rates in both markets and end 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 increased 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 N380/$; but if the CBN allows discriminatory pricing and dollar subsidies (as occurs presently), economic agents will have an incentive to obtain dollars at cheaper rates and sell them to third parties at higher rates. The subsidy would discourage private sellers of the dollar who feel hard done by because of the artificially created spread, hence leading to a cut-back in the supply of private dollars and a gradual rise in the N/$ rates in private markets.

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

The school for a dismantling of the scaffolds of the CBN's multiple exchange rate structures believes that improved liquidity must be accompanied by a policy 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.

Several 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 de change market relative to NAFEX and IEFX windows (see Illustration 29).

Illustration 29: FX Rates YTD Percentage Change

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

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.

Table 14: CBN, NAFEX, IEFX AND BDC FX RATES

The Pleasures and Pains of Nigeria's Exchange Rates

There are numerous factors that will shape Nigeria's exchange rate in 2021. A recovery in oil price will help shore up foreign revenue and hence reduce the pressure on dollar demand. Furthermore, an increase in capital importation, improvement in interest rate and port clearance will help strengthen Nigeria's naira. On the other hand, if the export continues to decline, oil price slumps further, and Nigeria's port challenges worsens, then, the naira against the dollar will weaken in 2021 (see Illustration 30).

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