The Central Bank of Nigeria floats the naira

With hydrocarbons accounting for 90% of Nigeria’s foreign exchange, sustained low oil prices in 2014 and 2015 reduced the availability of dollars and other major foreign currencies. This reverberated throughout the economy, given the need for dollars to buy imports for key staples ranging from rice to diesel fuels. As a result, Nigeria teetered for months on the edge of a currency crisis, with a widening gap between the official and unofficial exchange rates, before the authorities dropped the peg to the dollar in June 2016 and allowed the naira to float.

Following some volatility in the rate, the Central Bank of Nigeria (CBN) reinstituted capital controls and embarked on a path of interventions that have set a de facto band around the official rate of N304-N317 per dollar, up from an average of N200 in 2015 and 2016. While the parallel market rate has continued to exceed that range, at closer to N375 (after reaching a high of N520 in February 2017), the managed float has allowed the authorities to reduce the incidence of black market dollar purchases.

Exchange Windows

A number of measures have been taken to maintain the official trading band and reduce parallel trading, and in turn support certain sectors of the economy. For example, the CBN has instituted a series of exchange windows, which offer different rates based on the purpose of the transaction. For instance, in addition to the primary official rate, there are also separate rates for school fees and medical expenses incurred abroad, pilgrims, and domestic retail customers at exchange bureaux.

In February 2017 the federal government moved a subset of those varying rates closer to parallel market rates, and the CBN then allowed those seeking dollars for travel or for school fees abroad to purchase at a rate of N366 to the dollar. This helped bridge the gap between the official rate and that determined on the parallel market, and in addition potentially paves the way towards full convertibility.

Parallel Market

The parallel market has long been a distortion of currency trading in a number of African markets, including Nigeria. This creates problems of arbitrage, as those with access to dollars at one of the various official rates can easily turn a profit by purchasing dollars and then selling them on the parallel market.

“We need to reduce the number of market rates because it is encouraging arbitrage,” Damilola Akinbami, head of research at Financial Derivatives Company, told OBG. “If I know that I can get dollars at N305 or even N360 and sell them for N391 on the parallel market, it’s a no-brainer what to do.”

Convertibility

In its Article IV Consultation document, the IMF urged the government to eliminate the remaining currency controls and unify the various exchange rates. This would likely result in the elimination of the parallel market, providing a much-needed boost to investor confidence.

There would be other additional benefits as well, with the IMF calculating that a 10% depreciation of the naira would lead to a reduction of the fiscal deficit by 0.1% of GDP and add 0.4% to real GDP through higher net exports.

“Allow the naira to float fully and freely. This will cause some short-term pain, but confidence in the system means capital will flow into the country again. Free flow of capital is of paramount importance for restoring investor confidence in the country,” Vlassis Liakouris, managing director at ARM Capital Partners, told OBG. “Nigeria could attract at least $50bn-60bn a year in foreign direct and portfolio investment. Foreign investors, especially portfolio investors, are prepared to take the capital risk, but they cannot also take the liquidity risk.”

However, the government has long stated its support for a strong naira, which is one reason why the decision to shift to a managed float took such a long time to materialise. Equally important, according to IMF estimates, that same 10% depreciation in the naira would also lead to a 1% hike in inflation, which stood at 17.8% as of February 2017.

Foreign Reserves

Crucially, the currency situation is beginning to stabilise. “In 2017 we have seen a steady accretion in external reserves to above $31bn, supported by higher oil prices and borrowing proceeds,” Akinbami told OBG. “However, the gross reserves level has depleted below $31.8bn as forward contracts sold in early February and even in March are beginning to mature. If the CBN continues with its intervention, assuming that these factors remain positive, we are optimistic that external reserves will remain at around $30bn. Also, once the CBN adjusts the currency, it will not need to intervene as much.”

This comes after the country spent heavily over the course of 2016 to support the naira and maintain imports. Assuming there are no further shocks to the economy, such as disruption to oil supply from militant activities in the Niger Delta, foreign reserves are expected to remain at adequate levels into 2018. Furthermore, as the economy rebounds, the currency should begin to strengthen on its own, reducing the need for the CBN to intervene.

Policy Rate

The CBN kept the monetary policy rate (MPR) steady at 14% up to the end of the second quarter of 2017, but lending rates to the private sector remain far higher, reaching 25% in some cases. While this is lower than in other West African markets – such as Ghana, where rates can reach above 30% – it is problematic. “The MPR is supposed to be an anchor, but it is not really serving that purpose at the moment,” Akinbami told OBG. “We expect them to move to a more accommodative stance. The central bank can keep the MPR at 14%, but maybe adjust the cash reserve ratio. Sending the signal to the market that monetary policy will become more accommodative over the next couple of months will lead to an adjustment in portfolios and their thinking to that level. Borrowing rates that average 23-25% are unsustainable.”

The IMF has advocated a tightening of monetary policy to entice foreign capital back into the country. However, there are some concerns that this recommendation in particular may have the opposite effect due to cost factors – raising interest rates also increases financing costs. If Nigeria’s manufacturers face a rise in costs of finance, they are likely to pass it on to consumers, leading to an increase in the price of consumer goods.

Business As Usual

The CBN is expected to continue its interventions in the currency market until market forces place the naira within reach of the bank’s unofficial target band. Despite recent moves to address the issue, the Nigerian economy remains heavily import dependent. A rapidly depreciating currency would likely further increase market lending rates and consumer prices, dealing a blow to low-income Nigerians. These and other concerns weigh heavily on the decisions of the CBN. Going forward, the bank is likely to further a policy of business-as-usual until the economy takes a significant turn, either for the better or for the worse.