Liquidity, price discovery in Nigeria’s FX market
It is the norm to hear talks around the need for convergence in Nigeria’s foreign exchange (FX) markets. This implies that there is mispricing. Historically, this mispricing has always been between the parallel market rate, which trades at a premium to the CBN’s managed rates across different FX windows.
There are many of these FX windows in Nigeria, including the official rate at which the government conducts FX transactions, rates for pilgrimage, rates for SMEs, Bureau De Change (BDC) rates, International Money Transfer Operators( IMTO) rates, and the interbank rates, to mention a few. These windows were created as the CBN sought to offer reprieve to selected segments of the economy during a crisis. In recent times, Nigeria’s FX liquidity crisis has been driven by a mix of oil prices, production shocks, and capital flights that reduce FX receipts.
While these have always been temporary, because there is a recovery in the short-term, the FX windows remain for longer, even during periods of stability. And indeed, convergence in rates across the different windows of the CBN has been sought but ultimately unmet since the crisis of 2015/2016.
The law of one price is an economic concept that says that identical assets should trade at a similar price in the absence of friction. On this basis, it should be clear that the Naira trades differently across the different FX markets due to certain reasons. This is mainly due to the CBN’s rigid management of rates in some segments, with the different rates creating arbitrage opportunities. However, in an efficient market, arbitrage opportunities are not around for an extended time. Market participants are quick to buy cheap in the market with a lower exchange rate to sell at a higher exchange rate in the premium market. Higher demand in the discounted market puts upward pressure on the exchange rate while increasing supply in the premium market puts downward pressure on exchange rates. The interaction between the two forces creates a new equilibrium exchange rate that clears the market and corrects mispricing.
However, because the market is broken and inefficient in Nigeria, arbitrage opportunities persist for a long. This does not encourage the pursuit of valuable economic activities because FX trading can yield significant returns. Currently, the return is as high as the difference between the parallel market rate of N485/$ and the official rate of N380/$, which is N105/$ or 27.6%- for doing nothing!
Why this is the case in the absence of price discovery in the CBN’s managed segments. Price discovery is the process that determines prices at which currencies are exchanged in the marketplace. It is market-driven in the sense that willing buyers and sellers, based on the information available to them, and other important factors, interact and conduct transactions. The entire point is that price discovery determines the equilibrium price that allows for the greatest liquidity. Price changes based on new information and how market participants interpret it. When there is significant divergence in how new information is interpreted, volatility increases. In this situation, clear communication by the Central Bank can calm nerves. Volatility also declines with time when market participants have more time to digest the news and gain more clarity. The information can be anything, ranging from new macroeconomic data, elections, economic and socio-political policies to unpredictable events such as geopolitical developments, among others.
The Nigerian economy has been here before, recently in 2016, and way before that. The Investors and Exporters’ window (I&E) window, which was created in April 2017, helped with liquidity and price discovery. This market allowed market participants, including banks, exporters, investors, the CBN, and end-users to trade in that space. The interaction between the sellers and buyers determined price, encouraging participants that they were going to get the best value for their money. The forward market also helped manage exchange rate expectations while allowing end-users to hedge risks. These new structures improved liquidity and price discovery in one swoop. While the CBN was a participant in the I&E window, buying and selling just like the others, its intervention was not heavy. It was a masterstroke, until COVID-19.
Fears about the impact of COVID-19, especially given the collapse in oil prices, led to capital flight. The CBN had to intervene to provide liquidity in the market, but its reserves were not sizable enough and unable to support the intervention required at the existing rate. Effectively, the I&E window became a market of a single seller, because the CBN did not allow the exchange rate to adjust to changing information like slowing foreign investment, changing interest rates, weaker exports, among others. This is why, eventually, investors, exporters, and remittance receipts ignored official channels, worsening the liquidity crunch. E
xemptions of items permitted at its FX windows also affect price discovery as end users are pushed to other segments. Hence, the parallel market was the only segment supporting price discovery, although this too is imperfect given the tendency for speculative activities driven by the CBN’s approach.
What should the CBN have done instead? When there is friction, the market fails to support price discovery. The role of the central authority is to calm the markets and support liquidity. The CBN can intervene in a time of crisis to aid price discovery but it must not be fixated on a particular rate, which may be difficult to maintain.
The obsession with a fixed rate affects a timely adjustment to a new equilibrium price, given that this is even unclear, as information is changing rapidly. Instead, the CBN should intervene through volume and transact at market price. This should be timely, for a limited time, until it supports orderly adjustment to a new equilibrium. The CBN must seek to bring more players into the market rather than alienate them as it has frequently done.
While FX liquidity challenges affect markets, this could be temporary if policymakers allow for price discovery, which is the adjustment of rates to a new equilibrium that is determined by and is satisfactory to buyers and sellers. The CBN derives its powers from controlling the majority of FX receipts in the economy even though it does not earn them. If the market is liberalised such that earners of FX – businesses, FG, and states – are free to sell in whatever segment they can receive the best value, liquidity and price discovery would improve substantially.
Oladipo is a Lagos-based financial analyst.