Felted Thoughts

Solving Nigeria’s FX conundrum- peg the exchange rate to the naira value of oil

As pressure on naira continues unabated, exacerbated by the continued dip in oil prices, the call for devaluation has now reached a crescendo. Although the proponents of devaluation have adduced many reasons to support their call, most have failed to take lessons from the outcomes of the two devaluations implemented in the last 15 months.

Nigeria currently operates a fixed-managed FX regime which has a variety of advantages. In recent decades, the leading argument for firmly fixing exchange rates has been to favorably affect the expectations of prices and international capital flows by convincing stakeholders of stable domestic prices, and controlled translation risk. The desire for a credible commitment to a stable monetary policy arose as a reaction to the high inflation rates of the 1970s, which in the 1980s reached hyperinflation levels in a number of developing countries. But fixing the value of the domestic currency in terms of foreign currency is not the only way that a country can seek a credible institutional commitment to non-inflationary monetary policy. A central bank can make a binding commitment to refrain from excessive money creation via a rule, a public commitment to fix a nominal magnitude.

The overall argument against the rigid anchor, however, is that a strict rule prevents monetary policy from changing in response to the needs of the economy. This creates a general problem of mismatch between the constraints of the anchor and the needs of the economy, and can lead to a loss of monetary independence, lack of automatic adjustment to export shocks, and extraneous volatility. Nigeria is currently heaving under the weight of the disadvantages of the rigid anchor which are at variance with the current needs of the economy. By keeping the exchange rate fixed, we are invariably subsidizing the imports from other countries, and making it impossible for domestic producers to compete. This is tantamount to shipping our much needed jobs to other countries.

At this junction, a key question to ask and answer is whether the domestic currency is overvalued, and if it is, by how much? Unfortunately, there is no one single scientific method that is accepted as the holy grail of currency valuation. However, given the current dynamic that oil faces – a strengthening USD and supply glut – and considering its importance to the Nigerian economy, we have thought it appropriate to employ a valuation method that takes cognizance of those dynamics.

We propose pegging the exchange rate to the naira value of oil within a rules-based framework. This can also be easily replicated by countries that are specialized in the production of a particular mineral or agricultural product. The argument for pegging to the export price is that it simultaneously delivers automatic accommodation to terms of trade shocks, as floating exchange rates are supposed to do, while retaining the credibility-enhancing advantages of a nominal anchor, as dollar pegs are supposed to do. Pegging to the local currency export price (PEP) of oil will not only stabilize government revenue, but also the nominal spending growth, and over time, inflation. The most important advantage of this exchange rate determination method is its transparency; it allows both domestic players and foreign investors to define their translation risks and make informed decisions.

A simulation of the PEP using a base year of 2010 suggests an overvaluation of the Naira by 30.98%. This was arrived at by first valuing oil using the dollar index (DXY) basket of currencies, and decomposing the changes in oil prices into two components – changes due to movement in the value of the underlying commodity, and changes due to the currency of valuation, which in this case, is the DXY. Based on this valuation, the NGN/USD exchange rate should be trading around 261.96.

We see this period as an opportunity for the monetary authorities to start engaging in productive FX management, and initiate a complete overhaul of the plumbing works of the FX management and determination framework. The current realities have shown the fixed-managed system to be grossly inadequate for a mono-FX receipt economy like Nigeria. Pegging the export price is a credible alternative to what currently obtains.

 

Olugbenga A. Olufeagba