CBN naira policy – a choice between price stability and an efficient foreign exchange market

Over the past week, Nigeria’s financial markets have seen heightened volatility following from the uncertainty around the country’s political future. Investor confidence in the country fell after the elections were postponed, giving rise to fears that the transition of power between administrations could be the undoing of democracy in Africa’s most populous nation and largest economy.

Following from the spike in uncertainty, the Nigerian stock market replayed a semblance of the November 2014 slide. Stock prices plunged by up to 6 percent from the start of the week, reminiscent of 2009 levels, as another round of sell-off ensued.

The end of Friday’s equity markets trading saw the index dip further by 1.25 percent the previous day. 12-month returns of the NSE all share index at the time of writing stood at -27.12 percent, while YTD returns stood at -20.41 percent.

Further, the speculative attack on the currency seemed to be worsening as the markets refused to be satiated intervention after intervention by the CBN. One primary cause of speculative attacks on the currency has been the window of arbitrage that exists between the different foreign exchange markets – the official, the interbank, and the parallel. While the official rate stands at N168/$, the interbank and the parallel markets hover around N200/$.

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Calls have come from several quarters to unify the exchange rate markets to put an end to volatility and speculation. But preferring the policy option of price stability above all else, the current monetary policy regime has maintained an artificial or managed ‘official’ exchange rate while the other 2 markets, driven by demand and supply factors, have reasonably adjusted to new realities.

The CBN has moved most dollar demand to the inter- bank market, while it still meets dollar demand for raw materials, PMS and kerosene imports at the official rate to keep inflation on check. Raw material and petroleum products dollar demand accounts for between 10 percent and 15 percent of total dollar demand.

“Nigeria is currently on a managed float. It is not appropriate at this time to consider trading the Naira very freely as some people have advocated”, says CBN governor Godwin Emefiele. “Nigeria is a highly import dependent economy”. “When it is allowed to float in an import dependent economy that would mean that the exchange rate will spiral out of control”.

The CBN therefore has to step in from time to time to support the currency. The rationale of the policy is to protect the economy from an exchange rate engendered inflation by protecting the key value adding segments (raw material imports), as well as energy input, from the high cost of forex. The policy is no doubt noble in its intentions, but it engenders a distorted system, which the markets will ceaselessly seek to exploit until loopholes are sealed. As with most other good policies, it is also very vulnerable to being usurped by sharp practices.

Reports of the forex system being abused by dealers in connivance with port officials have already started to emerge. Finished products are purportedly being imported and falsely labelled as either spare parts or semi- finished goods, to take undue advantage of the official rate of N168/$.

The result of this is that large sums of dollars are acquired at the official rate and resold at the parallel market at between N205 and N210 to a dollar, creating room for round-tripping which puts further unjustified pressure on the Naira. Because of its fixed (or man- aged) exchange rate regime, the CBN must continue de- fend the currency and will continue selling its reserves to buy back the Naira. But un- less the leakages at the official window are addressed, artificial demand will continue which will require the interventions to continue until foreign exchange reserves are exhausted, causing the currency to eventually devalue, and enriching market players at the expense of government savings. As long as the arbitrage opportunity remains, speculation will remain. Continuing to hold on to a managed, or distorted system will definitely come at huge costs to the central bank.