Playing God In Nigeria’s Foreign Exchange Market
“In trying to control both the demand and supply of dollars, the CBN plays god in Nigeria’s forex market, and scares off investors”
By Tokunbo Afikuyomi, Jr.
There is an economic model to explain almost everything.
The Economic Naturalist is a book by Robert H Frank that uses economics to answer questions like why is there a light in your fridge but not in your freezer? and why is it easier to find a partner when you already have one?
It makes for a fun read, but economists also have more complex models which they use to answer the more significant questions that governments and businesses face.
Today, Nigeria’s central bank is facing a currency crisis. We’re all facing it. And in many respects, it is doing more harm to the economy that the others problems on the 2020 list: Nigerian Covid-19 cases and a shortfall in government revenues.
The pandemic is new, but Nigeria has been here many times before. Only four years ago, the naira was in trouble. Everyone knew about the “dollar scarcity”, and it forced us to devalue the currency from $1/₦200 to $1/₦360.
That “dollar scarcity” is back in town again and the government is scrambling. This time, the policy decisions we make (or not) will determine how well we recover when the pandemic ends. As economic growth has been tepid for the last five years, a strong recovery is even more crucial this time around.
But as Buhari and Emefiele announce policies almost daily, how can we assess how well they will navigate us out of the crisis?
Well, there are economic models to explain.
Demand and Supply
Technology companies have been quietly hiring several economists in recent years. Amazon recruited over 150 PhD holders, and this analysis describes a team of more than one dozen economists as Uber’s “secret weapon”.
In Uber’s case, the economists have been vital in using demand and supply, the grandmother of economic models, to design the company’s “surge pricing” framework.
Simply put, when demand (riders requesting Ubers) exceeds supply (drivers available), prices rise, and only those willing to pay will book a ride. Drivers that were on a break see higher fares and make themselves available again (supply) for bookings.
Eventually, the riders willing to pay the surge prices reduce (as they reach their destinations), and the flood of new drivers (from breaks) pushes demand to equal supply again until prices go back to normal.
Everything happens naturally; that’s how markets work.
This basic theory also drives Nigeria’s exchange rate (the price of the currency). People need dollars to import, and Nigeria gets its supply of dollars from foreigners (either oil sales, the diaspora, or investors).
If we leave everything to happen naturally, there will be some volatility. We all know too well how oil prices bounce around, and so Nigeria’s supply of dollars will keep changing.
That will have an immediate impact on our exchange rate. And it will also become very volatile.
Now, volatile exchange rates are not fun for anybody. Importers, exporters, and investors won’t be able to predict the price at which they can exchange their currency. That discourages business activity.
So, to address this, many commodity-exporting countries opt to operate a fixed exchange rate regime where the central bank controls the supply of foreign currency in the market to keep the exchange rate fixed*.
Note the reference to “supply” and not demand. Let’s go back to the Uber example. In theory, Uber could tell its drivers (supply) when to operate. But it would be much more difficult and controversial for the company to dictate when customers can make bookings (demand).
*A few countries like Switzerland are the exceptions to this. In rare cases, the supply of foreign currency is so much that the central bank needs to buy it (demand) to stabilise the exchange rate.
Fighting the wrong fire
In the naira’s demand and supply story, the Central Bank of Nigeria (CBN) is famous for trying to go down the more challenging route of manipulating forex demand, while still controlling supply.
For them, the approach seems intuitive. If the CBN can reduce the demand for dollars, then it doesn’t have to supply as much of it from its foreign reserves. But this is “overdoing it”. It’s like Uber telling both riders and drivers when to operate—essentially playing god in the market.
This demand control is what led the CBN to impose several restrictions on accessing dollars when the greenback became scarce in 2016.
Notably, as the crisis was forming in 2015, the apex bank created a list of 41 items that people were no longer allowed to get dollars for in official channels. The list included things like wheelbarrows, rice, private jets, and clothes.
More recently, the central bank (through Buhari’s twitter account) said that it would no longer provide forex to anyone importing food.
The bank announced other peculiar forex restrictions, and they all essentially make it harder to get dollars. Of course, people still need dollars to make their purchases, so they are forced to use the parallel (black) market. When many people get pushed to this market, the demand for dollars further exceeds its supply—cue the constant drop in the value of the naira we see every day on AbokiFX.
The strange thing with the CBN’s approach is that it is restricting individuals and businesses that are just trying to go about their daily activities. And the process by which it does this makes the initial problem—the supply of dollars—even worse.
How? It damages confidence in the economy.
Animal Spirits: The power of confidence
Remember, the only reason a foreign investor brings dollars into Nigeria is that they believe they can make money from doing so (and also get their cash out). They do this either through long-term investments in a company or use the short-term route of buying financial instruments like bonds or equities.
In this world, confidence is everything. Once it’s lost, investors exit and the supply of dollars falls. Unfortunately for us, whenever oil prices fall, investors start to lose confidence in the economy.
Worse, there is a fear that the exchange rate might depreciate, meaning they will lose some of their returns on investment.
Many investors will leave in such a situation, and there is not much to do to stop them. But what the government tends to do is to further confuse and alienate everyone that remains in the markets, whether domestic or foreign players.
When the supply of dollars reduces as a result of a drop in oil earnings, the exchange rate faces pressure. Unless the CBN has enough reserves to replace the lost oil revenue, something has to change.
As we mentioned earlier, the CBN tends to tackle this by restricting the demand for dollars, but what this says to investors is that the apex bank is desperate and doesn’t have the reserves to replace the lost dollar supply. It sends a bad signal.
As an investor, when you hear news of food import “bans” or stories of the CBN cutting down trees to stop parallel market dealings, you’re bound to get spooked.
Couple this with reports of a backlog of dollars that the CBN is yet to serve, and you have a scared investor.
Even if you initially only wanted to divest a fraction of your Nigerian investments, these stories could influence you to exit the country entirely. There is the additional fear that you might not be able to access your dollars when you need to.
An investor can account for devaluations when deciding to invest, but that modelling goes out the window if the money gets trapped.
Nobel Prize winners Robert Shiller and Goerge Arkelof wrote a book explaining how important confidence and stories are in influencing an economy. The CBN itself wrote a paper outlining how a 1% increase in the consumer confidence index can result in a 2.5% increase in GDP growth.
Yet, restoring confidence does not seem to be high on the CBN’s agenda. It prefers to take more anti-market policies like bans or creating multiple exchange rates.
Fighting supply with supply
The more credible way to address a dollar supply problem is by focusing on supply, not demand. For a fixed exchange rate regime, the first point of call is to spend your foreign reserves. This is how the likes of Saudi Arabia have been able to keep a constant exchange rate with the dollar for the last three decades. Its rate hasn’t changed since 1986.
To do this, you need a credible amount of reserves, meaning you can always supply foreign exchange even when supply from other sources (like oil) fall.
If there is confidence in your ability to maintain the exchange rate, then investors are happy to keep bringing in dollars. Unfortunately, this is not Nigeria’s current situation. In the last 15 years, our reserves have peaked at over $60 billion in 2008 and trended downwards since. We are currently around the $35 billion mark, which is not a healthy position.
So if we can’t replace dollar supply with foreign reserves, what can we do?
Another approach is to increase interest rates to attract foreign investors who come bearing gifts: dollars.
In fact, according to the basic theory of fixed exchange rates, the interest rate must always adjust whenever there is an imbalance in the market. This is why one of the disadvantages of a fixed exchange rate is that you lose the ability to set interest rates independently.
But the CBN tries to eat its cake and have it. Earlier this week, the CBN reduced its primary Monetary Policy Rate, which will discourage investors—the opposite of what we need to increase dollar supply.
The bank avoids raising interest rates because it doesn’t want to increase the rate of borrowing in the economy, which makes life harder for businesses. That’s a fair concern, but the CBN lost its ability to influence the economy through interest rates when it decided to have a fixed exchange rate.
Under a fixed regime, your policy target automatically becomes the exchange rate. Inflation and output go under the purview of the federal government because the central bank loses its power to control them.
But Nigeria’s central bank doesn’t agree with this age-old economic theory. It wants to do everything itself.
Multiple rates and bad signalling
So, without finding ways to increase the supply of dollars, the CBN continues to focus on restricting demand. But another major issue with this stance is the creation of a black market or a multiple exchange rate system.
If you tell people that they can’t buy items they need to import using forex from the central bank, then they will get it from somewhere else: the parallel market.
Now, Nigeria has always had a parallel market, even during some of our most successful economic periods. The problem arises when the parallel market rate diverges significantly from the official rate.
The first issue is what it does to confidence. Because the black market has many individuals who have been pushed out of official channels, and there is no central bank supply, there is a lot of excess demand. The exchange rate in this market becomes weak.
Many perceive this parallel market rate as the “real” value of the naira because it’s where we see the free movement of demand and supply. But unfortunately, this sends another bad signal to investors.
In essence, it is always telling them that the official exchange rate is overvalued, and if the actual demand for dollars (including those on the parallel marker) was met, then the central bank will not be able to maintain the official rate.
So, whenever the black market rate diverges from the official windows, investors and individuals alike are expecting the official rate to depreciate at some point.
Some investors take this as a sign to exit, worsening the dollar supply problem. Others decide that it is a perfect time to make some money by speculating on the naira.
Speculation and arbitrage
Currency speculation is a simple and well-known trick. In Nigeria’s case, you keep buying dollars and hoarding them, putting pressure on the central bank to spend more of its reserves and eventually devalue the naira. You then convert your dollars back to naira at the devalued rate, making a handsome profit.
Many major economies have faced this type of attack, including the UK, which led to a day known as Black Wednesday, after which Britain was forced to abandon its fixed exchange rate with the Euro.
These speculators are always demanding dollars from the system for the sole purpose of forcing the CBN to devalue. It is why you hear stories of the CBN requesting access to people’s bank accounts or stating that third parties are not allowed to get forex on behalf of businesses. They want to make sure that speculators don’t get a hold of any dollars. If someone wants dollars, then the CBN wants to see how that person plans to use it.
This strong-arm behaviour towards restricting dollar demand is what feeds the flames of rumours like the recent suggestion that the CBN would try and change everyone’s dollars in their domiciliary accounts into naira.
But markets are still wary that some form of restrictions on bank accounts could come. One forex dealer I spoke to confirmed this sentiment and revealed that people had been taking dollars out of their domiciliary accounts. That is sure to put even more pressure on the system.
People are already putting Nigeria and Argentina in the same sentence (or tweet).
The South American country has gone from one currency and debt crisis to the next. It once changed people’s dollars to pesos at a worse rate, but that didn’t save the country from further problems. The actions by the government led to a social tragedy, and the currency-conversion act was deemed illegal by a court.
But, back to Nigeria.
The other issue with having multiple exchange rates is the arbitrage opportunities created. The game here is that you find a way to get dollars from the CBN at the official rate and sell it on the parallel market at a higher rate—one of the easiest ways to make money in the country.
Unfortunately for the CBN, this means that some of the reserves it spends are not even being used to satisfy real dollar demand. It’s purely used by individuals to make extra money. It’s hard to blame these people if the CBN opened the opportunity by creating multiple markets in the first place. That is what you get when you try and go against economic theory; the same would happen in any country.
Sadly, there’s nothing to suggest that things will go any differently from 2016 when the CBN implemented currency restrictions. Investors fled, inflation rose, and the CBN devalued the currency—twice. Looking at 2016 and today’s situation, the worst thing about the CBN’s operations is the lack of communication and guidance regarding its plans with the exchange rate.
Earlier this year it promised it would not devalue the currency and then went on to do it, further losing credibility.
In terms of communication, we hear quite a bit about the central bank’s plans regarding the Monetary Policy Rate (MPR), but even the bank knows that the MPR isn’t half as important as exchange rates. By choosing to have a fixed exchange rate regime, its policies and guidance have to be geared towards exchange rates, not the other policies it tries to implement.
It’s a confusing situation.
I have read many economic theories, but I am yet to find a model that explains Nigeria’s forex decisions.
This article was edited at 10:25 on the 25th of September 2020 to remove the claim that the CBN had denied the domiciliary rumour.
Tokunbo Afikuyomi JR. is the editor of Stears Business Magazine, London