Against the backdrop of debilitating domestic and exogenous shocks to the Nigerian economy in recent years, the foreign exchange market has experienced notable challenges which have elicited the attention of different stakeholders and economic agents. These challenges have included mounting pressure on the exchange rate and foreign exchange reserves against the backdrop of excessive demand for foreign exchange concerning supply (limited export earnings and capital inflows, and weak accretion to foreign exchange reserves).
Options have been proffered to address the foreign exchange market crisis and the one that seems to be gaining traction recently is the call on the Central Bank of Nigeria (CBN) to liberalise or deregulate the foreign exchange market by letting the exchange rate be determined by market forces. The proponents put it forward as “a necessary option to achieve a dynamic equilibrium as opposed to the static equilibrium that pervades the current arrangement”, courtesy of a report on the front page of The Guardian of Monday, April 4, 2022 titled, ‘Amid pressure on the naira, experts proffer options to shore up forex”.
Some even argue that “the foreign exchange market should operate like a commodity market where every operator buys and sells currencies at market price”. In this piece, I front-load my conclusion that foreign exchange market deregulation is a quick-fix and escapist option that does not address the fundamental factors of the foreign exchange market crisis.
Essentially, what the proponents of foreign exchange market deregulation are advocating is what economists call a clean float exchange rate system in contrast to the managed float system that the Central Bank of Nigeria (CBN) has operated for quite some time. In a clean float system, the government or monetary authority does not intervene in exchange rate determination to establish its level or maintain a given rate. Rather, the exchange rate at any time is determined by the interaction of the market forces of supply of and demand for foreign exchange. The monetary authorities trust the market to manage the exchange rate which can change from day to day or even minute to minute. The fact that the government does not intervene in the market implies that no official foreign exchange reserves will be necessary. Besides, since all private foreign exchange transactions will be cleared through the market, there will be no balance of payments deficits or surpluses that would require official settlement. This is where the challenge is as what is portrayed here is not the case in practice. Balance of payments deficits/surpluses do occur and official settlements with reserves do take place.
In contrast, the managed float exchange rate system approximates what obtains in reality and has become quite common for some time now, right from the early 1970s after the collapse of the Bretton Woods Fixed Exchange Rate Monetary System. Under a managed float exchange rate system, the government intervenes in the foreign exchange market (through the use of interest rate and/or foreign exchange supply) to influence the exchange rate to the desired level. Considering the effects of exchange rate fluctuations on trade and domestic inflation, governments seek to intervene in the forex market in the hope of moving the exchange rate in the appropriate direction. When considered against reality, it is clear that the clean float exchange rate system is academic as it hardly exists anywhere in the world. Even if the government intervention is not overt, it may be done covertly. Importantly, the industrialised countries including those whose currencies are convertible, practice floating with different degrees of government intervention. And so, the CBN’s managed float system is in sync with other countries, perhaps, to different degrees.
In light of the foregoing, how do the arguments advanced in favour of clean floating of the naira in the Nigerian foreign exchange market stand? The arguments, perhaps borne out of frustration with the current challenges, are weak and constitute a quick fix to a serious problem that has structural underpinnings. It is a quick-fix and a rather panicky option because, allowing the market forces of supply and demand to solely determine the level of the exchange rate, under the conditions of excess demand for foreign exchange, will shoot up the exchange rate to unacceptable levels. Such a rate, if the current parallel market and Bureau de Change rates are suggestive, is most likely to be far higher than the empirically determined Purchasing Power Parity rate estimated by the Monetary Authority, which underscores the unreliability of those illegal rates. Under the circumstance, desperate economic agents will buy up the available forex in the promotion of capital flight at the expense of operators in the priority sectors of the economy. In other words, the macroeconomic implications will be very severe on economic stability, inflation, real sectors and growth, and social welfare.
MSMEs’ access to forex would further be curtailed while the cost of forex and production may be prohibitive, thus eroding competitiveness. Already, the headline inflation rate is high at 15.70 per cent. A strictly market-determined exchange rate will further escalate inflation through the pass-through effect of imported goods prices to domestic prices. A Ph.D thesis written at UNN by Chuba Anebamine (2015) on “Exchange Rate Pass-through to Consumer goods Prices” confirmed that exchange rate depreciation is transmitted directly to the consumer price index through an increase in the prices of final goods and services that are imported from foreign countries and indirectly through an increase in net exports of goods and aggregate demand. The negative impact of high inflation on welfare is obvious: reduced purchasing power, increased poverty, etc.
The argument that a highly depreciated exchange rate through the market will promote capital inflow is neither here nor there. Foreign capital brought into the country at a very high exchange rate will also be taken out at the same high exchange rate. What foreign investors desire is a stable exchange rate? In a highly import-dependent economy, exporters that seem to benefit from a highly depreciated exchange rate would also have to import their inputs at the same rate or higher. And the advocacy that the foreign exchange market should operate as a commodity market, for example for agricultural commodities, manufactured goods, etc, where every operator buys and sells currencies at market price, seems to compare incomparably. Foreign exchange in the context of global trade and finance is a very significant resource to a non-convertible currency country that is struggling to earn it through the export of goods and services and capital inflows. It needs to be efficiently managed to meet the country’s development needs rather than allow unbridled market forces to allocate it to capital flight. This is one reason why governments take a keen interest in foreign exchange reserves and the exchange rate.
One thing that needs to be appreciated is that the CBN has not been operating a fixed exchange rate system as some analysts would want to believe. Rather, the Bank has operated a market-based managed float exchange rate system, the latest variant of it being the Investors and Exporters (I &E) foreign exchange market that was introduced in April 2017 to boost liquidity in the foreign exchange market and ensure timely execution and settlement for eligible transactions as stipulated by the CBN. The I & E exchange rate is the official exchange rate for investors, exporters and end-users. In the I & E-market, foreign exchange is traded (sold and bought) based on prevailing market conditions.
Once in a while or periodically, the monetary authority intervenes in the market with supply to ensure the stability of the exchange rate. The market is currently functioning under the difficult challenge of limited forex supply about very high demand. Since the introduction of the market-based exchange rate system under the Structural Adjustment Programme (SAP) in 1986, excessive demand for foreign exchange has been one of the factors causing the depreciation of the naira exchange rate. In the 23 years, 1986 – 2008, demand for foreign exchange by authorized dealers exceeded supply in the foreign exchange market in most of the years with adverse implications for exchange rate stability. Recent times have witnessed an intensification of demand for forex. It is hardly surprising then that the naira has tended to depreciate.
Now, the case against full deregulation of the forex market rests not only on the grave macroeconomic implications but also that the advocacy ignores the structural weaknesses of the economy/fundamental factors in exchange rate depreciation which have not been helpful to macroeconomic management. Among these are i) weak production base and undiversified economic base in terms of production and exports. An export-oriented production base contributes substantially to foreign exchange supply which in turn strengthens the local currency. But Nigeria’s export structure is narrow, dominated by highly volatile crude oil export and a few weak non-oil export earnings; ii) low productivity of the economy.
Available productivity data support this. Low productivity hinders international competitiveness, limits export earnings and weakens the exchange rate; iii) High propensity to import and import-dependent production structure. Nigerians’ propensity to import is scandalously high while the manufacturing sector imports most of its raw materials and equipment but ends up with little value added to GDP and little export earnings. The agricultural sector’s contribution to foreign exchange earnings is also very low; and iv) Comatose capital goods industry, like the petroleum refineries, such that nearly all machinery, equipment and spare parts used by the in-ward looking production sectors are imported, thereby putting much pressure on available foreign exchange.
Also ignored by the proponents of full forex market deregulation are the tough times of economic crises that the economy has passed through in recent years. Domestic and mostly external shocks have buffeted the economy since 2015 and pushed it into recession in 2016 and 2020. The collapse of the global oil market triggered the first recession in 2016 while the second recession was driven byCOVID-19-induced recession worldwide following the implementation of pandemic containment measures. The collapse of crude oil prices and the economic impact of covid-19 adversely affected the country’s major sources of foreign exchange inflow, namely: proceeds from oil exports, proceeds from non-oil exports, diaspora remittances, and foreign direct/portfolio investments.
Crude oil prices fell by more than 70 per cent, and as of 20 April 2020, the price of crude oil fell below zero dollars per barrel. Considering the heavy dependence of the Nigerian economy on the oil sector, the impact of the oil market crash was severe on export earnings, foreign exchange reserves, the government’s naira revenue and other macroeconomic aggregates including economic growth. The engendered foreign exchange supply shortages limited the Central Bank’s ability to effectively intervene in the foreign exchange market amid increased demand; this exacerbated pressure on the local currency, the naira.
Now, the question may be asked as to why the exchange rate is not stable in the current situation of high crude oil prices. The answers are straightforward: first, is that the country’s oil production is limited and much lower than the OPEC’s relatively low quota of 1.72 mbpd because of scandalous crude oil theft and secondly, heavy importation of refined petroleum products. Crude oil production reduced from 2.07 mbpd in quarter 1, 2020 to an average of 1.31 mbpd in 2021 due mostly to oil theft and difficulties in some oil terminals. Reports indicate that crude oil thefts in 2021 reached 200,000 barrels per day – a quarter of onshore production – and are currently about 500,000. Stolen oil volumes have cost the country over US$ 3.3 billion and investors in the upstream oil sector are bemoaning their losses from oil thefts. Thefts combined with export terminal and pipeline shutdowns have limited Nigeria’s ability to increase production and take advantage of the high oil prices. The other factor that has limited the impact of high oil prices on government revenue and foreign exchange reserves is the continued heavy importation of refined petroleum products to meet domestic consumption needs such that the net accretion to foreign exchange reserves is marginal if any.
In conclusion, what seems clear is that the key challenge to effective forex management remains the pronounced low productivity of the economy and because of this, the economy is not able to generate enough foreign exchange to meet the high demand for import goods and services; hence continued excess demand has heightened pressure on the foreign exchange market and exchange rate. This suggests the strong necessity to boost the productivity and earning capacity of the economy. Thus, the solution to the foreign exchange market challenges is not clean floating of the national currency. Rather, the solution derives from what needs to be done in the short- and medium/long term to increase foreign exchange reserves and hence strengthen and stabilise the naira exchange rate. In the medium/long-term, it is important to address issues relating to low productivity and limited diversification of the economy in terms of exports, high import-dependent production structure, high propensity to import and excessive demand for imported goods and services, and the comatose capital goods industry, among others.
The short-term solution, assuming that the political will is there, relates to the oil sector, oil exports and taking advantage of the current regime of high crude oil prices in the global oil market. For a long time, the oil sector has contributed over 90 per cent of the nation’s foreign exchange earnings and external reserves accretion. It has also been a significant contributor to the government’s naira revenue through crude oil and gas export receipts. But for some time now, this has not been so due to two factors: a huge volume of crude oil theft which has prevented the country from meeting even the OPEC-approved production quota, and the inability of the NNPC, for many months, to make any remittance from direct oil export sales into the Federation Account and external reserves account.
These are alarming developments that have adversely impacted the government’s finances, external reserves accretion and exchange rate stability. The inhibiting factors are what the Government can check in the short term. It is inconceivable that all the foreign exchange earned from the export of crude oil and gas is used to import refined petroleum products or that ‘under-recovery’ / petroleum subsidy absorbs all the foreign exchange earned from oil sales. I will therefore strongly appeal to the Government to appreciate the grave implications of the oil sector and NNPC’s underperformance and effectively deal with the oil thefts and non-remittance of foreign exchange/naira revenue. If in the presence of the array of security forces in the oil-producing areas, monumental oil theft is taking place to the detriment of the economy, then drastic measures are called for. Government should check the untoward developments, through effective security and monitoring, and the positive impact on government finances, external reserves and exchange rate stability will be visible in a short period.
By Obadan, a professor of economics, a former director-general of the National Centre for Economic Management and Administration, Ibadan.