Rescuing and defending the naira – Part 2

Continued from yesterday

Given their widespread impact, it is not surprising that exchange rate developments are a matter of great interest and often concern to Governments, the business community and the general public. In some situations, exchange rate devaluation becomes the government’s concern and is beyond the purview or discretion of the central bank. That is why this contribution is being placed in the public domain. Rescuing and defending the Naira is to ensure that the exchange rate regime is not left to the vagaries and devices of free, unfettered markets which are often manipulated and driven by greed and criminality. It is also to ensure that the exchange rate performs its resource-allocation function efficiently and that the emerging regime is stable and sustainable. Indeed, given its critical role in macroeconomic management, the Naira exchange rate needs to be stabilised and subsequently sustained within an appropriate band or target zone, to make for better planning by economic agent.

First, the exchange rate is a price. Like all other prices, in a free-market environment, it is determined by the forces of supply and demand. Consequently, and as past and present experiences have amply demonstrated, trying to fix it arbitrarily is an exercise in futility. Indeed, as asserted by Jacques Polak, IMF Director of Research (1958 – 1979), “It is not in the best interest of any country to seek to maintain a disequilibrium exchange rate and no country in the end, succeeds in doing so.” Second, macroeconomic management invariably entails delicate balancing acts and difficult trade-offs among key fiscal and monetary variables, e.g.: price stability versus growth; interest versus exchange rates; consumption versus savings; and the short versus long term; etc. Thus, achieving a stable exchange rate might require raising interest rates; devaluation is sometimes required to restore external balance; and devaluation might be unavoidable to achieve a realistic and sustainable exchange rate regime. The policy or operational discretion the fiscal and monetary authorities have depends on the prevailing economic conditions; the degree of divergence of the variables from optimality; and the magnitude of corrective measures called for in order to restore normalcy. Thus, unduly delaying corrective action often results in bigger and more painful adjustment in future.

Third, since the de-monetisation of gold in the early 1970s, there has been a generalised system of floating exchange rates. However, in practice, there is nothing like a “clean” or “pure” float whereby the exchange rate is left entirely to the vagaries of market forces. Although there is a continuum of exchange-rate regimes worldwide, ranging from fixed to flexible arrangements, the predominant system is the “dirty” or “managed” float. This entails periodic intervention by the monetary authorities in the foreign exchange markets to achieve certain strategic objectives, such as buoying up the value of the local currency in periods of severe market pressure or reducing its value to restore export competitiveness or improve the trade balance. A few countries have a fixed exchange rate regime either in the context of a monetary union (as in the case of Europe) or under a currency board system (as in Hong Kong and Argentina). Nevertheless, irrespective of the regime chosen, it is important that exchange rate determination is technically sound and realistic and that the rate is stable.

Fourth, after nearly 30 years that stringent trade and exchange controls were abolished in Nigeria as part of the reform package under the auspices of the Structural Adjustment Programme, there has been a gradual return to such controls in recent times, ostensibly to deal with the prevailing foreign exchange crisis. Although these measures may be defended as a last resort and short-term emergency measure, it should be noted that both trade and exchange controls have been firmly established as inferior macroeconomic management tools that have not recorded any success story anywhere in the world. Nigeria’s experience during most of the pre-SAP period (1967 to mid-1986) amply demonstrates that such controls are a costly and useless bureaucratic exercise as they are susceptible to serious abuse, corruption and evasion. Furthermore, in the more sophisticated business environment of today, stringent trade and exchange controls will be more easily circumvented by market participants.

Fifth, rescuing the Naira would require the adoption of a comprehensive and robust reform agenda, an important component of which is exchange rate unification as proxied by significant reduction in the prevailing parallel-market premium from about 60% to the generally-accepted threshold over time. It should be stressed that although by itself, the parallel market rate is not all that important as it is not the true rate for the entire economy and only a relatively small volume/value of transactions gets executed at that rate, the difference between the official and parallel market rates (parallel-market premium) matters a great deal.

Sixth, although the prevailing large parallel-market premium is a matter of policy concern, the authorities should be circumspect in dealing with the problem. In particular, the approach to be adopted in the efforts to drastically reduce the premium should be legal, transparent and technically sound. Thus, the temptation to intervene in the parallel market by injecting official foreign exchange therein in order to induce an appreciation of the rate, as some have advocated, should be resisted. Although such an initiative was taken in the mid-1990s, it should be discouraged for the following reasons: it is illegal; it lacks transparency and is susceptible to abuse; and it is of doubtful efficacy and unnecessary given that, once the rates converge in the official market, the parallel-market rate would crash and fall in line with the unified exchange-rate regime.

• To be continued

• Odozi, Financial Consultant and company Director, is former Deputy Governor of the Central Bank.