Integrating wholesale, retail alternative FX markets to support unification
When it comes to the Foreign Exchange (FX) markets and the determination of the exchange rate in Nigeria, the Central Bank of Nigeria (CBN) suffers from an illusion of control. The CBN believes that it is the sole determinant of the fortunes of the naira, with the ability to fix the exchange rate at any level desired. The CBN’s obsession with fixing the exchange rate comes from the idea that managing the exchange rate is critical to achieving its inflation target.
More often than not, even when the drivers of the exchange rate change, usually due to increased demand for FX or falling FX supply due to lower exports and foreign investments, the CBN operates under the assumption that nothing has changed. Between 2015 and early 2023, this was the policy approach of the CBN.
This approach works when external reserves are buoyant and can be drawn down to meet demand. When reserves are much lower, the FX market breaks because the CBN loses its power to fix exchange rates. The parallel market exchange rate gradually drifts from the official exchange rate, with the premium rising to a peak of N290/$1 in early 2023.
Businesses and investors lose confidence in the official FX markets since it cannot meet their FX needs and the parallel market assumes prominence. The CBN only controls the regulated official market, where it can compel certain behaviour and exchange rate by its regulated dealers through the threat of sanctions. However, outside this regulated market is the parallel market, which is diversified, unorganised, uncontrolled by a single entity and where the exchange rate is driven by the demand and supply of FX.
Meanwhile, the CBN makes FX policies without due consideration for what truly drives the market and when all else fails, it looks for scapegoats in the parallel market.
Among the biggest scapegoats are players we can refer to as wholesale FX brokers who facilitate access to FX for companies who have been shut out of the official FX market, which includes importers of the 43 items not valid for FX, and those who are unable to access the required amount they need from the official markets such as manufacturers.
These brokers source FX from exporters and other autonomous sources outside the CBN’s framework to meet FX demand. Majority already own Bureau De Change (BDC) licences but operate outside the framework guiding BDCs for wholesale transactions.
Yet despite playing an important role in supporting FX liquidity for the real sector, wholesale FX brokers have been reported to be the majority of the victims of the CBN’s arbitrary Post No Debit (PND) orders that have now been reversed. In other countries, these brokers are typically regulated to ensure proper governance and compliance to rules around FX transactions such as Anti-money laundering and terrorism financing, to eradicate bad actors and to ensure visibility on non-banking FX transactions.
The BDC operators, who are licensed by the CBN to meet the needs of retail users, are also scapegoats. In a market with poor banking infrastructure, the BDCs play an important role.
The BDCs are only a segment of the wider parallel market, but because they are formally regulated and their exchange rates are market determined, they are easy scapegoats. When the exchange rate premium in the parallel market widens, BDCs come under heavy scrutiny and they are ostracised from the official FX market.
This is a familiar dance. The CBN normally sells FX to BDCs on a weekly basis but this was discontinued in February 2016 and later resumed in November 2016 when the CBN saw that its initial action did not cause the premium in the parallel market to narrow. More recently, in July 2021, the CBN discontinued sales to the BDCs but in August 2023 the CBN is mulling resuming sales to control the exchange rate.
Once again, BDCs to the rescue. It is ironic that the CBN created BDCs knowing how important it is to serve retail users and to deepen the FX market but is quick to antagonise them. Course correction happens when the CBN has some firepower and wants to correct the premium in the parallel market, which they do by selling FX to BDCs for onward sale to retail users.
As the CBN moves to resume sales to BDCs, are they doing this with the expectation that this would unify the official and parallel markets and slow the depreciation in the latter segment? Does the CBN have the firepower to fix exchange rates? While the CBN is getting dollar supply through a NNPCL loan of $3bn from the Afrexim Bank, its main sources of dollar inflow – exports and foreign investment – remain weak. With revelations from JP Morgan that Nigeria’s Net External Reserves at $3.7bn is much lower than gross reserves of $33.8bn, the CBN’s capacity to intervene in the FX market is limited.
Looking at the terms guiding the resumption of the CBN-BDC relationship, particularly the expectation for exchange rates not to deviate by more than 2.5% in both directions from the Investors and Exporters’ (I&E) window, the CBN is still seeking to exert control. This would not be much of a problem if exchange rates at the I&E window are market reflective, but recent evidence suggests that the CBN has instructed dealers not to break the N800/$1 threshold on FX transactions.
This behaviour shows that the CBN has not learned its lessons and we can expect the familiar dance with BDCs to still be an issue in the future. If it happens that the CBN does not have enough in its reserves to supply the market in a manner that would stabilise the exchange rate, the BDCs would once again be called saboteurs. The CBN should use the BDCs to serve its end users, rather than an expectation that they would help in fixing exchange rates.
Despite many failures, the CBN has not taken notice of the fact that it is just another player in the FX market. It is only when external reserves are huge that it can shape the direction of the exchange rate. Ignoring this fact is why the recent reform to make exchange rates more market reflective has not worked.
The premium in the parallel market over the exchange rate in the I&E window has widened to N150/$ in a short span despite the initial unification in the early stages of reform. The CBN is yet to completely allow dealers to transact in a fully “willing buyer, willing seller” model despite its initial intention to do so. The restrictions on 43 items for which importers – both businesses and traders – cannot access the official FX market to source FX for imports is another reason why the parallel market exchange rate often deviates from the official market.
Wholesale FX brokers who serve the companies that have been shut out of the official segment or companies whose FX needs are unmet in the official market would often put a premium on the FX sourced and sold to compensate for the risks and inefficiencies involved. Recognising this market could lower the premium for facilitating FX trades out of the formal market and support unification. They would continue to exist after all, as the CBN cannot force non-financial companies who earn or need FX to deal with banks.
Letting the market work like it should, like is obtainable in the parallel market, is the solution to correcting the inefficiencies in Nigeria’s FX market. Until then, the BDCs would continue to have a tenuous relationship with the CBN.
Adesipe writes from Lagos.
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