The Floating Exchange Rate Policy
Some few days ago, I decided to promote my website’s fan page on Facebook (If you have not yet liked it, be sure to do so by the right hand side of this post…thanks). Facebook accepted advertisers from Nigeria to pay in their local currency which is Naira. I was so excited when I saw this option, I then went ahead to set up my ad. I uploaded my logo, targeted my audience, and was about to select a payment method. When I got to this section, I quickly went to grab my GTB Naira denominated debit card; inputted the number and the cvv2. After, I pressed the OK button and like a little child was smiling and thinking about how wonderful Facebook is for availing us this option. Deep in thought, I didn’t pay attention to the message on my screen. Then I glanced at it and saw an error message, saying that the card had been declined, I should try another card, and if it persists, I should contact my bank. What? I yelled, are they taking a piss? I was so sad.
I dashed to get my phone and called my account manager who later directed me to the card services’ customer care. I narrated my ordeal to the representative and she replied that they had locked the DCC (Dynamic Currency Conversion) on their cards. Apparently, Facebook collects naira from its advertiser, but tasks the bank of the advertiser to convert and send the actual dollar amount to their home base in the United States. This means that since Facebook probably used the Cbn rate at ₦199 to a dollar for their conversion, then the bank would have to pay the shortfall which is the black market (parallel market rate) – official rate. Note the black market rate at the time of transaction was ₦370 to a dollar.
To cut the long story short, I had to close the Naira currency account on Facebook, and open a US dollar currency account. That means I could advertise with only dollars and pay an exorbitant fee when my bank converts it using the parallel market rate. Bollocks isn’t it? Well what choice do I have?. The ads converted well though, and I was pleased with the adverts.
Before this period, the CBN had announced a new forex regime that would commence in about three days time. I was skeptical about the success of it and wanted to run my adverts and pay for it on the same day, but I was sorely disappointed to find out that Facebook billed advertisers in Nigeria at the end of the month or when they meet a minimum threshold. My plan to hedge against the currency risk wasn’t going to work.
What is the new forex regime you ask? Remember I told you about an official rate that was about 46% lower than the parallel market rate? Well CBN pegged their rate between ₦197 – 199 for over 10 months. It meant they sold their proceeds from crude oil at the above rate in a bid to sustain the value of naira and regulate the forex. The issue was that the proceeds from the sale of crude oil was too low to service the total demand for the dollar in Nigeria. Also, they restricted access to the dollar; only a select few could buy at the Cbn official rate. Hence, people started sourcing for their needs elsewhere and this made the Naira fall in the parallel market.
With this new regime, CBN is taking their hands off pegging the exchange rate at an unrealistic rate that eats into our forex reserves. Instead, they have announced that going forward, market forces of demand and supply would determine the exchange rate. This means that it would be left to the invisible hand of demand and supply to allocate resources. The flexible exchange rate option introduced by the CBN seems credible enough, and we are very eager to see the effect of it in the next coming months. They are leaving the local currency to float freely inorder to find its true value through the activities of market forces. However, it should be noted that the CBN has reserved the right to intervene in the market whenever appropriate.
CBN in order to carry out its new forex policy initially planned to appoint 10 banks to act as forex primary dealers. These banks are to be referred to as Grade A dealers, while non-primary dealers would be referred to as Grade B banks. The condition for the appointment of the primary dealers as announced by the CBN would be that the banks are required to have a minimum shareholder’s fund unimpaired by losses of at least ₦200 billion, a minimum of ₦400 billion in total foreign currency assets, and minimum liquidity ratio of 40 percent. Due to the demarketing by banks in order to secure a primary dealer position, CBN deemed if necessary to revise their previously set regulation.
CBN under their revised regulation stated that 15 international and national banks would be eligible to trade with the CBN, and only regional and merchant banks, owing to their size had been excluded and would be made Grade B dealers. Demarketing in this sense is a bank discouraging a demand for dollars to another bank that can’t get quantity needed. As I told my friend some days ago on the phone, my biggest fear of this policy is the integrity of the banks that would be appointed by the CBN. Unethical business practices such as hoarding the dollar, forming a cartel to fix prices, and so on could thwart the CBN ‘s good intentions.
Let me further relay the conversation I had with her on BBM. It first started with me venting on the inability to make payment in my home currency (naira) on facebook. I was so pissed, that I had to tell someone. So after I told her on chat, she called me some minutes later. She was my classmate back in the university, and she is one of the smartest people you would ever meet. She is also on her way to becoming a chartered accountant. She told me she was happy with the new policy that the CBN was going to introduce, and she thinks it would boost the economy. I agreed with her that it was a brilliant idea but it all depends on the integrity of the market players.
We went on further in our discussion and ended it on phone. Some days later we revisited the issue on chat and I explained to her why the policy might not work. I told her about the possible appointment of 8-10 banks to act as the forex primary dealers, and the current demarketing strategies adopted by the banks to secure a spot. I then went ahead to tell her that even the CBN doesn’t trust them anymore, and they had to revisit the issue because the demarketing by the banks showed early signs that the banks when chosen, could form a cartel to maintain high prices and increase their profits at the expense of citizens.
I commended the idea by the CBN governor, Godwin Emefiele, but I expressed my concern that I do not trust the integrity of the Nigerian Banks. If they can be charging monthly fees on savings account without paying interest on our money they use for investments, what stops them from hoarding the dollar to create an artificial price to boost their profits. I went on further to tell her that Nigeria is not transparent enough for the new forex regime, and corruption and greed may destroy the CBN’s good work.
She brought in sentiments into the discussion, saying that it is a brilliant idea, and she prays it works because it would portray the economy as a sound one and boost investors’ confidence to invest in the country. According to her, she foresaw it being the turning point of the nation. She has a point though, since the exchange rate is flexible and determined by the market forces of demand and supply, foreign investors would have confidence to bring in their funds to invest in the country with the guarantee that they would be able to repatriate their profits back to their home base. But I countered by saying that people and institutions (banks) are unpredictable, they might become selfish, and chase after their own pockets rather than the welfare of the citizens.
I also reminded her that the forex rate will be based on the market forces of demand and supply, and then asked rhetorically that “what are we producing and exporting in Nigeria apart from oil?” So how are we to increase our demand for the Naira?. Although this policy may stabilize the Naira and make it less volatile, it doesn’t guarantee that the value of the Naira would rise. It might still settle at a high between ₦270 -₦290 for a dollar. I told her that a positive result of this policy would be the opening of a currency futures market on June 27, which coincidentally is my birthday day…yaay!!!. I later explained that it would at least reduce the amount of hoarding and panic buying of the dollar as investors, manufacturers, or retailers can enter into a futures contract at a given price in order to hedge against the risk of currency exchange rate fluctuations.
I explained to her that for a long term solution, Nigeria needs to find another export product that can beef up our foreign exchange revenue. We depend solely on oil which in recent times hit a 12 year low of $26 dollar per barrel, before recently picking up to about $50 per barrel. I shared my concern regarding the future of oil production in Nigeria because Niger delta militants have been vandalizing pipelines and have succeeded in reducing production from 2.2 million barrels per day to a current production of 1.6 million barrels per day.
She maintained her position that she has hopes that the country would get out of the economic crisis and stand as financial giants someday. She also added that agricultural exportation could be another way to increase the demand for the Naira. Then she asked me what a future market is, and I told her that a futures market is a market where participants buy and sell commodities or futures contract at a given price for delivery at a specified date. I went on further saying that future contracts are similar to forward contracts, but while a forward contract is between two knowledgeable parties that take either a short or long position, a futures contract is done on a futures exchange. For example, stocks are traded on stock exchange, likewise futures on a future exchange.
I also explained that while there is counterparty risk (risk that either party could default) in forward contracts, there is no such risk in a futures contract. This is because there are clearing houses that guarantee transactions. A forward contract is mostly used by people who want to hedge risks while a futures contract is mostly used by speculators looking to gain on the price of an asset. Read more on forward contracts and futures contracts.
Possible effects of the new forex regime in Nigeria
- There would be increased liquidity in the foreign exchange market, and multinationals and foreign investors would find it easier to convert their revenue to dollars, and repatriate their funds back to their home country.
- Possible lifting of limits on depositing into domiciliary accounts or limits on spending when abroad or online.
- If the policy fails, it might worsen the inflation in the country which is already at an high of about 15%.
- The backlogs of between $4billion – $9 billion would have to be cleared before the foreign exchange market truly stabilizes and finds its true value. Clearing these backlogs may eat into our already dwindling foreign exchange which is about $26 billion.
- Aboki’s would go hungry as people leave the black market to start buying at the inter-bank market.
- The Naira would almost certainly crash from the Cbn official rate at the early stages before rebounding later on.
Andrea Roncoroni., Gianluca Fusai., Mark Kummins., Handbook of multi commodity markets and products
Don M. Chance., Analysis of Derivatives for the CFA program
Oleg V. Bychuk., Hedging Market Exposures : Identifying and Managing Market Risks
Brian Coyle., Hedging Currency Exposures: Currency Risk Management (Risk Management Series)
Dan Osborne., FX Mentors Secrets to protecting and profiting from foreign currency exposure (audio)