FX Outlook: When can we expect uninterrupted supply in the market?
The exchange rate of N305/$ is neither a realistic nor an effective price of the currency at this time. This is because you cannot get dollars at this price unconditionally. In the parallel market, the naira is trading at N495/$, whilst transfers are going at N505/$.
Any market structure where the same product is selling at different prices at the same time is described in economics as a price discriminating monopoly market structure. Typically this market is characterized by barriers to entry that allow those with influence or connections to buy in the cheaper market, e.g. N305/$ and sell in the more lucrative market, e.g. N500/$. This is what is probably happening right now (round tripping).
However, before we look at the outlook for the naira in 2017, we need to examine the fundamentals that determine exchange rates. We also have to understand why Nigeria’s attempt at unifying its exchange rates has proved abortive so far.
The forex market is a product of policy-making regulatory and market player interaction. Many fundamentals go into the determination of an exchange rate. These include balance of trade, the terms of trade, investment flows and the international competitiveness of the economy. There is also the interest rate/ inflation differential, which impacts the purchasing power parity of the currency.
When a currency is appropriately priced, it will be in equilibrium and will have minimum deviation from the real equilibrium exchange rate path. When you test the Nigerian case against a number of these indicators, it is not far fetched to see why the Nigerian currency value is misaligned from its monetary policy anchors. It is also clear why there has been a slow but consistent erosion of confidence in the naira.
Rational investors and domestic economic agents always make decisions in their own enlightened self-interest and not because of emotional and irrational considerations. Historically the Nigerian economy, and by implication the naira, has been a beneficiary of oil windfalls and a victim of oil shortfalls. History shows that after a windfall, the naira remains relatively stable for an average of 5-6 years before the next oil shock. Immediately after every shock, the government embarks on adjustment measures including a devaluation. However, since 2008 the shocks have become more frequent and shattering. The time frame of the shortfalls has also been much longer and the impact more devastating.
Outlook for the naira in 2017
The naira under the current market regulatory framework will remain unstable until the market is allowed to operate efficiently. I wish to draw from a paper delivered many years ago by Charles Enoch at a seminar in Abuja. He said that investors were then excited that Nigeria was now willing to establish a unified flexible foreign exchange system that will foster financial market development and global integration. He goes further to point out that the adoption of multiple exchange rates involves the use of different exchange rates for different transactions (as is the practice today, my words).
It usually forms an important component of an interventionist or state led economic development model. The consequences include pervasive state intervention in the economy, financial repression, restrictive trade regimes and closed capital accounts. According to Charles, the benefits of multiple exchange rates are largely illusionary (as can be seen in Nigeria today, again my words). The costs are high in terms of
- Distortionary trade regimes, exchange controls leading to the stunting of the export sector and reduced forex earnings
- Misallocation of resources
- Lower fiscal revenues and a smuggling boom
- Rent seeking activities driven by a complex set of administrative controls e.g. Travelex, BDCs, etc
What next and outlook
For Nigeria to escape from this forex trap, the authorities need to understand that there is a need for a properly functioning market. A well functioning forex market allows the exchange rate to respond to market forces and reduce market distortions. Russia and Kazakhstan recently did this and their currencies sank for a short period and then recovered sharply. On the other hand, Venezuela fell into the trap and has become a basket case. The CBN will need to
- Eliminate or phase out regulations that stifle market activity
- Create a sense of two-way risk in the market
- Reduce its market making role and stop indirect or overt rate determination
- Increase market information on the sources and uses of foreign exchange
- There must be liquidity, transparency and openness
- The CBN as a regulator must be firm in dealing with market infractions
Forex policies usually complement trade and investment policies. The Nigerian government will in 2017 strive towards greater coordination of these policies, and will move from its current bias for a command economy monetary policy towards a mixed economy. I believe that with oil prices at $55pb and production back up to 2mbpd, the naira will slip in the interbank markets to N350-N380/$. It will fall in the parallel market to N520/$ before recovering sharply to N425/$. These projections are based in the assumption that the market will be reformed and that sanity will return to what is now essentially a foreign exchange asylum.
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