From bad to worse? Assessing CBN’s new forex policy

Much controversy has trailed the Central Bank of Nigeria’s (CBN) new foreign exchange policy. It would be recalled that the new policy was introduced last June to move the country away from a fixed exchange rate regime, to one that reflects market forces. In technical terms, the new policy is known as a “managed float,” in which the CBN intervenes occasionally (mainly by selling foreign currencies to banks) in order to tilt the exchange rate in an economically desirable direction.

While the debut of the new policy has been imbued with controversy, especially as regards to its effectiveness, it is unclear what analysts regard as an effective exchange rate policy. I have heard analysts pass conflicting judgments on the new policy, but they often don’t explicitly specify their assessment criteria. As with many economic questions, there are no objective parameters for evaluating the effectiveness of exchange rate policies. In the following paragraphs, however, I suggest some indicators for evaluating the effectiveness of the CBN’s new foreign exchange policy.

The new policy should be perceived as effective if the multitude of calculator-carrying and danshiki-wearing black market currency dealers at airports, hotels and dark alleys disappear. Their disappearance would mean that there is no longer room for currency speculation, and also that the spread between the black market rate and rates offered elsewhere has evaporated. Another implication of their disappearance is that the new policy has eliminated the perverse practice whereby a few privileged individuals and companies obtained foreign currencies at below-equilibrium rates from the CBN (through designated currency dealers and various nefarious sources), and resell them within minutes at huge profits. The cessation of these unproductive rent-seeking activities would result in efficient resource allocation, as these speculators would now have to engage in more productive activities in other sectors of the economy.

So, next time you get off the plane at any international airport in Nigeria, be sure to look out for the number of black market dealers still hanging around there. That would give you an idea of whether or not the new policy is working. I don’t expect them to all disappear overnight, but their number should decrease significantly over time. Regardless of the effectiveness of an exchange rate policy, some black market activity would remain, not least for money laundering and other illicit financial transactions. In other words, the size of the black market, rather than its existence, is an appropriate yardstick for assessing the effectiveness of an exchange rate policy.

One of the most important indicators of an effective exchange rate policy is stability and predictability. I often hear people lament the high exchange rate between the Naira and hard currencies. But what really matters for economic growth, development and macroeconomic performance is not the rate per se. It does not matter whether one US dollar exchanges for 1000 Naira; the problem is whether it can remain within that range for a long time.

If the rate keeps gyrating very wildly, without an end in sight, then there is something fundamentally wrong with that exchange rate policy. Of course, nobody wants 1000 Naira to exchange for one US dollar, but it is a possibility that cannot be ruled out. If that happens, there will be an adjustment in domestic prices, and the prices of import-dependent goods and services will rise precipitously. In a well-functioning market economy, most prices will rise (including wages and assets). But what damages an economy is not so much the increase in prices, but the volatility of the exchange rate.

Exchange rate volatility makes it difficult for individuals, businesses and investors to plan. People adopt a wait-and-see attitude, believing that the rate is yet to attain market-clearing equilibrium. Those who remit money from abroad, such as Nigerians in the Diaspora, would postpone remittances, causing a short-term fall in the supply of foreign exchange. Foreign businesses would postpone business transactions in Nigeria, following uncertainty in the foreign exchange market. Speculators will continue to hoard foreign currencies (and depleting supply), while those awash with Naira would mop up whatever foreign currencies they could find – thereby exerting pressure on demand.

The end result would be an upward spiral in the exchange rate. If the exchange rate continues to depreciate inexorably, people lose confidence in the Naira and instead prefer to hold foreign currencies (especially the US dollar), leading to a de facto dollarisation of the economy – as in the case of Zimbabwe and Ecuador. It is an extreme case that is unlikely to happen in Nigeria soon, but it is a possibility if not stemmed by sound economic policies.

A long-term consequence of prolonged exchange rate volatility is currency redenomination. If the CBN’s new policy is ineffective in heading-off volatility, then Nigeria may have to re-denominate the Naira, at some point in the future, in order to avoid hyperinflation. By expunging a couple of zeros from the currency (1000 Naira becomes 10 Naira, for instance), the psychological burden of holding on to a depreciating currency is relieved. That is exactly what happened in Ghana in 2007, when the Ghanaian Cedi was drastically redenominated from 10,000 Cedi to just 1 Cedi. Prior to redenomination, a whopping 10,000 Cedi exchanged for US1 dollar! My guess is that one needed at least two big “Ghana-must-go” bags to carry an equivalent of $5000 worth of Cedi notes. Almost 10 years after redenomination, $1 now exchanges for about 5 Ghanaian Cedi – effectively putting sellers of “Ghana-must-go” bags out of business.

An unambiguous evidence of the ineffectiveness of the new exchange rate policy would be a situation in which an increasing number of Nigerians and local businesses conduct transactions in foreign currencies, rather than the Naira. The use of multiple currencies in a country is emblematic of a dysfunctional exchange rate policy. To mitigate risks and shield their assets from losing value, rational individuals and firms often avoid unstable currencies. The CBN recently noticed a tendency toward dollarisation, and issued stern warnings against it. But preference for hard currencies will be abated only when the new policy succeeds in stabilising the exchange rate. No amount of threats and intimidation will force people to watch the value of their assets and earnings dissipate, in the light of a rapidly depreciating currency.

In the final analysis, what determines the stability and effectiveness of a country’s exchange rate regime is the state of the economy. Tinkering with the exchange rate is ipso facto a reflection of a troubled economy. People should not expect the new exchange rate policy to work wonders. The Naira will become more stable only when the country attracts new investors and tourists; diversifies the economy, and also begins to export non-oil products to increase the supply of hard currencies.

While the CBN’s new policy addresses Nigeria’s foreign exchange problems from the demand side, a long-term solution is the supply side. Only time shall tell whether the new policy has been successful, or whether it has moved the foreign exchange market from bad to worse. Any attempt to evaluate the effectiveness of the new policy now will be too premature.Onyeiwu is Professor and Chair, Department of Economics, Allegheny College, Meadville, Pennsylvania, USA.