• Saturday, June 15, 2024
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Charting a new course for the Nigerian foreign exchange market

Executive summary 
1.  The announcement of the deregulation of the downstream oil & gas sector has been widely acclaimed as a step in the right direction. 

2.  However, hard realities remain with respect to the country’s foreign exchange management system. Supply of foreign currency is currently constrained until there is clarity on the foreign exchange policy of the Central Bank of Nigeria and the reversion to a more flexible exchange rate system. 

3.  This paper seeks to establish a roadmap for the establishment of an Autonomous Foreign Exchange Market which will facilitate the smooth functioning of a deregulated downstream oil and gas sector as well as the entire economy. 

Hitherto, the oil & gas sector had been plagued with many inefficiencies.

 These inefficiencies include the scarcity of foreign exchange at the interbank markets and at the CBN Window; the inability of NNPC to pro-vide crude oil for refining; the low capacity utilization of the country’s refineries; and the inability of the FGN to fund the differential between the PMS input cost and the sales’ price. All these culminated in prolonged queues for fuel by Nigerians at petrol stations and the attendant effect of the lost man-hours on the country’s economy and national psyche. 

Generally, there is positive sentiment in the local and international financial community about the de-regulation of the oil & gas sector. 

The reforms announced by the Honourable Minister of Petroleum (State) have been met with positive sentiments and generally seen as a bold and laudable move. These reforms include the review in pump prices of PMS, sourcing of dollars from secondary sources, and allowing everyone with the capacity to import products that meet the standards set by the DPR thereby eliminating the allocation system that was in existence. 

However, the success of these reforms is predicated on a functioning foreign exchange management system. 
There has been a significant reduction in the volume of supply of foreign exchange in the official for-eign exchange markets given the pegged exchange rate that currently exists. The ability of the CBN to defend the pegged rate is seriously hampered by the low oil prices.
Moreover, the attendant inability to meet the demand for dollars have brought about a 50% spread between the official pegged rate and the rate available in the autonomous markets. As indicated in the chart below, this is the first time since the return to democracy in 1999 where the spread between the official and the autonomous rate is this wide.

This time is different. 

The last oil shock in 2008/9 coincided with a period in which the country had built up significant reserves. At the time the decline in oil prices started in September 2008, the country’s reserves was in excess of USD60 billion. About USD25 billion was lost until early 2012 when a combination of factors – espe-cially the rebound in oil prices and the improved international appetite for local currency bonds following the inclusion of the FGN Bonds in the JPMorgan Emerging Index brought some stability to the reserve level.
Currently, there are deep-seated concerns on the ability of the monetary authorities to continue to use administrative measures to keep the exchange rates at the current level without either burning through the reserves or stifling economic growth. As 11 May 2016, the published reserves was less than USD27 billion, which is the lowest value in the past 10 years and represents about 5 months of imports. 

 In some instances, the administrative measures introduced by the Central Bank appear to be counter-productive in the current situation.

 Since September 2014, the CBN had released about 24 Circulars and Press Releases with respect to the foreign exchange markets. Perhaps the most significant changes are (1) the suspension of the interbank 2-Way Quoting System and (2) the unannounced but rigorously enforced cap of ex-change rates in the Interbank Market. Apart from the added bureaucracy that these regulations bring, this has effectively shut down the interbank markets leaving CBN as the only key supplier of FX in the official markets. CBN market share is now northwards of 90% from an average of about 40% in the previous 5 years up to December 2014. 

Autonomous sources continue to be the single largest source of positive net flow of foreign currency in-to the country. 
There is no let up in the continued outflow of foreign currency through the CBN as monthly net flow through the CBN has consistently been negative since August 2014. The fact that the CBN parts with more dollars than it gets is evident in the monthly reductions in the country’s external reserve.
However, the net deficit of foreign currency in the country is essentially being plugged by the net inflows through Domiciliary Ac-counts and Other Autonomous Sources. It is therefore important that any currency management regime takes into consideration this important segment of the FX Market. 

 Developing a new FX regime 

Under Nigerian law, as codified in the Foreign Exchange Management Act, the responsibility for the design, management and control of the foreign exchange market lies with the CBN. When faced with similar challenges in the past, the CBN had always demonstrated its institutional capacity to develop a Foreign Exchange Market that is suitable to the issues faced at the time.
In order to safeguard and project the independence of the CBN, the CBN must be seen to be the driver of the design of a new foreign exchange market even though it must actively collaborate and seek the input and buy-in of critical stakeholders. These stakeholders include the government (both legislative and executive arms), banks and other financial sector participants, end-users etc. 

The new Autonomous Foreign Exchange Market, once successfully implemented, will form the bedrock for the fundamental restructure of the Nigerian economy.

 It will engender the supply of foreign currency that will enable independent marketers of petroleum products to fill the existing gap between demand and local production on a sustainable basis 
 Elements of the autonomous foreign exchange market. 

In designing the new foreign exchange markets, several factors must be taken into consideration in order to ensure that it is effective, fit for purpose and sustainable. These elements include: 
·         Liquidity: All participants in the foreign exchange markets must be able to have access to executable market prices throughout the trading hours. Essentially, there must be adequate supply to meet all effective demand at all times. 
·         Currency convertibility: It is important that the new currency management framework sets the country firmly on a path towards currency convertibility and an integration into the global FX markets. It must sup-port the aspiration of the CBN for the country to be the currency trading hub for international currencies in the West African region.
·         Transparency: There should be no controls other than the documentary requirements as it relates to the trade finance policies of the government. There should be no perceptions of manipulation of the currency. Monetary policy stance must be communicated effectively and regulatory decisions and directions will be ex-pected to feed into the pricing available in the markets. 
·         Price Discovery: Market participants should be able to easily determine market levels at every point in time with minimal slippages. There should be no ambiguity with respect to observable market data. 
·         Price stability: Given that maintaining a stable exchange rate is a statutory obligation of the CBN, it is important that there should be minimal volatility in the exchange rate. While a level of volatility can be accommodated in the initial phase when the new system is introduced, there must be a safety valve for CBN intervention to ensure stability in the exchange rate in the long run. 
·         Clarity: There must be clarity in the communication of monetary policy intention and direction. The role of the CBN must also be very clearly communicated. 
 Transiting from a pegged exchange rate to a floating rate foreign Exchange market 
Since 1999, the country had operated a free floating exchange rate system. Upon the advent of democratic rule in 1999, the country transitioned to what is essentially a free floating interbank foreign exchange market, albeit with expectations of exchange rate managed by CBN pronouncements, policies and rates.
For most of this period, there was near convergence between the CBN Rate, the Interbank Rate and the Autonomous (“Free Funds”) Rate.
Between 1993 and 1998, when the country adopted a fixed exchange rate system where the official rate was pegged at USD-NGN22, the spread between the CBN Rate and the Autonomous Rate was as high as 250%. The adoption of the free floating ex-change rate system not only eliminated this huge incentive for rent seeking but also brought a significant volume of transactions into the official markets with its attendant positive effects on taxation and statistics. It also enabled the CBN to ensure that the interbank rate is within a tolerable margin from the Real Effective Exchange (REER).
REER is a measure of the trade-weighted average ex-change rate of a currency against a basket of currencies after adjusting for inflation differentials. Latest data from the CBN indicates that the Real Effective Exchange Rate for the country was USDNGN265.85 as at February 2016 which rep-resents a 35% premium on the prevailing Interbank Rate. 

 Introduction of caps on the interbank exchange rate in February 2015 appears to have led to illiquidity in the FX Markets and the re-appearing of a wide spread between the CBN Rate and the autonomous rate. There has been a divergence between the CBN/Interbank Rate and the Autonomous Rate and also between the CBN/Interbank Rate and the REER. Majority of Frontier and Emerging Economies have a shadow market where FX transactions are consummated outside of official rates and channels. There are different reasons that support the existence of the shadow markets but are outside the scope of this paper.
The larger the Shadow Market, the greater its relevance to the official markets and the greater its ability to pull the official market rate to that of the Shadow Market. One of the demonstrable capabilities of the CBN is its success in shrinking the size of the shadow markets for currencies in Nigeria by ensuring that most legitimate transactions, irrespective of the level of documentation, were assimilated into the official markets.
Since 1999, transactions such as mortgages, medical bills, Bills for Collection, credit card payments and small volume imports that are not backed by letters of credit are now eligible transactions in the foreign exchange market. The introduction of Price Controls in February 2015 reduced the supply of dollars in the official markets and hence a larger number of legitimate demands for FX and now being fulfilled at the Shadow Market prices. Reversion to a free float is critical to the restoration of liquidity in the FX Markets and the elimination of the huge spread between the Interbank Rate and the Free Funds Rate. 
Implementation road map 

As indicated earlier, ownership of the design and implementation of the new Autonomous Foreign Exchange Markets lies with the CBN. However, it must ensure that it engages and secures the buy in of critical stakeholders. We believe the steps towards implementing the necessary reforms should be in line with the following sequence: 

1. CBN policy directorate engages and consults with relevant stakeholders for inputs into the design of the Autonomous Foreign Exchange. 

2. The designed framework is approved by the Committee of Governors of the CBN. 

3. The Framework is presented to the President, and the Federal Executive Council, for their buy in and
sustained support for implementation. 

4. Consultative Forum is held with market operators 

5. Autonomous Foreign Exchange Policy is issued by the CBN 

6. An timetable for the implementation of the Autonomous Foreign Exchange Policy is issued and communicated to all market participants. 

7. Market transitions to the new FX regime from the status quo. 

 The timelines for carrying out these steps can be as short as possible without endangering the confidence of market participants in the process. 

 A Proposed autonomous foreign exchange market: 

i) There shall be an Autonomous Foreign Exchange Market. The CBN will not be an active participant in the market, save for interventions when required. 

ii) Authorised Dealers will be allowed to deal amongst themselves and with their customers at negotiated ex-change rates acceptable to parties to the transaction. 

iii) Transactions between Authorised Dealers shall be in line with guidelines issued by the FMDQ OTC and the FMDA or any other SRO that the Authorised Dealers subscribe to. 

iv)Transactions between Authorised Dealers and their customers shall be subject to documentary required by the CBN. Authorised Dealers bear the responsibilities that they comply with all relevant KYC/AML rules, laws and guidelines in dealing with customers. 

v) The Autonomous Market shall be open to resident and non-resident individuals and body corporates. 

vi) For market guidance, The CBN, either through its MPC or an authorised officer, shall announce a band within which it expects the currency to trade. This is expected to be a guide and not a market directive. Operationally, this will be via announcement of a midrate and a corridor around the mid-rate. This should not be changed often and ideally should be aligned to other MPC discussions, decisions and announcements. 

vii) The CBN rate so announced can be used for official government transactions such as conversion of government receipts for the purposes of statutory allocations, duty payments, tax computations etc. 
viii) Where the CBN, for any reason whatsoever, decides to intervene in the market, it shall be via a general announcement to the Authorised Dealers. Intervention must be few and far between in order not to give an impression that CBN is an active trader in the markets. 

ix) For the Intervention, Authorised Dealers shall submit their quotes, which shall indicate amount and quotes based on the Closing NIFEX as published by the FMDQ on the same day. For example if NIFEX was USDNGN199.50 on the day, an Authorised Dealer that wants to buy USD from the CBN at 199.45 will quote -0.45 and the Authorised Dealer that wants to buy at USDNGN200 shall quote 0.50. 

x) All funds purchased from the Intervention are transferable and available for sale to other Authorised Dealers. However Intervention funds must be utilised within 24 hours. 

xi) Full details of the Intervention including the Authorised Dealers that won and the rate at which they were successful shall be published immediately after the Intervention 

 CBN will continue to supervise banks’ foreign exchange transactions and is at liberty to conduct routine and tar-get FX examinations at its own discretion