In a landmark move on June 16th, 2023, the Central Bank of Nigeria unveiled sweeping reforms to its foreign exchange operations, consolidating multiple rate windows into a singular, unified system: the Investor and Exporter Window, commonly referred to as the I&E Window.
This shift has ignited spirited debates, with analysts and experts deliberating over the exact nature of Nigeria’s newly adopted foreign exchange rate policy.
While many contend that the country has embraced a free float, the central bank has categorically emphasized that Nigeria is navigating a managed float regime.
Yet, amid these discussions, there’s a vocal cohort of critics lobbying for a fixed float, asserting that the nation’s economic climate isn’t ripe for either a free or managed float approach.
In this explainer article, Nairametrics delves deep into this discourse, examining the spectrum of foreign exchange rate policies and evaluating their fit for Nigeria’s current economic landscape.”
1. Definitions
Fixed Exchange Rate System – Under a fixed exchange rate system, Nigeria’s currency’s value is pegged to another currency, a basket of currencies, or a commodity like gold.
The central bank intervenes in the currency market to maintain this peg, buying or selling its currency as necessary.
Crawling Peg – This is an exchange rate regime that allows for periodic adjustments in the peg or fixed rate of the national currency in relation to another currency (or a basket of currencies).
The adjustments are usually pre-announced and can be based on specific parameters, such as inflation differentials between the home country and its major trading partners.
Nigeria tried this during the Soludo era.
Managed Float – This is an exchange rate system in which a country’s currency’s value is largely determined by market forces (supply and demand), but the central bank or monetary authority intervenes periodically in the foreign exchange market to stabilize or influence its currency’s value.
According to the central bank, this is what Nigeria is currently practising.
Free float – refers to an exchange rate system in which the value of a country’s currency is determined solely by market forces, namely supply and demand, without any government or central bank intervention. Nigeria has never practised this role
2. Characteristics of each exchange rate system
Fixed Exchange Rate System
Pegged Value: The currency is anchored or pegged to another major currency, a basket of currencies, or a commodity such as gold. This fixed rate provides a standard of value.
For example, the exchange rate was pegged at N460/$1 for most of 2022 as the central bank preferred capital controls.
Central Bank Intervention: To uphold the pegged value, the central bank commits to buy or sell its currency in the forex markets, intervening as needed to ensure the currency does not deviate from its pegged rate.
The central bank often intervened but preferred to sell forex to industries they thought are critical to the economy.
Currency Reserves: Central banks must maintain substantial reserves of the currency (or commodities) to which they’re pegged. These reserves are utilized to intervene in the forex market to sustain the peg.
While Nigeria’s central bank did maintain over $35 billion in reserves, most of it was encumbered.
Monetary Policy Constraints: The commitment to a fixed rate often limits the central bank’s ability to enact independent monetary policies. Instead, the policy must often be designed around maintaining the peg, even at the expense of other domestic economic objectives.
Unfortunately, the central bank did not have effective control of monetary policies.
Vulnerability to Speculative Attacks: If there’s a belief that the currency is incorrectly valued or that the central bank might not have sufficient reserves to defend the peg, it can lead to speculative attacks.
Investors might bet against the currency, expecting it to be devalued, which can cause financial instability.
This perhaps explained why there was a huge disparity between the official and parallel market rates.
Crawling Peg
Gradual Adjustments: In a crawling peg system, the peg or fixed rate of the currency is adjusted periodically. This adjustment can be either upward (appreciation) or downward (depreciation) but occurs in small, incremental steps.
Pre-determined or Formula-driven: The rate adjustments are often pre-announced and may be based on a set formula or specific economic indicators, such as inflation differentials between the home country and its major trading partners.
Central Bank Intervention: Just as in a fixed peg system, the central bank intervenes in the forex market to maintain the peg. However, in the case of a crawling peg, the target rate changes from time to time, reflecting the pre-determined adjustments.
The objective of Maintaining Competitiveness: The primary rationale behind the crawling peg is to gradually adjust the currency’s value to account for differing rates of inflation or other economic factors, ensuring that the country remains competitive in international trade.
Reduced Shock: By allowing for gradual adjustments, a crawling peg can mitigate the abrupt economic shocks and speculative pressures often associated with a sudden devaluation or revaluation in a strictly fixed exchange rate system.
Managed Float
Market-Driven with Intervention: While the currency’s value is primarily determined by market forces like supply and demand, the central bank occasionally intervenes in the foreign exchange market to stabilize or influence its value.
The objective of Stability: The central bank’s interventions aim to reduce short-term volatility, prevent excessive currency appreciation or depreciation, or achieve other economic objectives, like maintaining export competitiveness.
No Pre-determined Level: Unlike fixed or pegged exchange rate systems, there isn’t a strict pre-determined level or range the currency is bound to. However, there may be an implicit target range or desired value the central bank seeks to maintain.
Monetary Policy Flexibility: Compared to a fixed exchange rate system, a managed float provides more leeway for the central bank to pursue domestic monetary policy objectives, such as controlling inflation or supporting growth. However, the central bank’s commitment to currency stability can sometimes limit this flexibility.
Balancing Act: The central bank needs to strike a balance between allowing market forces to play out and stepping in when deemed necessary. The criteria or triggers for intervention are not always transparent, which can lead to uncertainties for market participants.
Free float
Market-Driven: In a free float system, the currency’s value is determined entirely by market forces, such as supply and demand, without government or central bank intervention.
Volatility: Since it’s solely driven by market forces, a free-floating currency can be subject to short-term volatility. Factors like macroeconomic data releases, geopolitical events, interest rate differentials, and investor sentiment can cause fluctuations.
Monetary Policy Independence: A significant advantage of a free float system is that it allows the country to pursue an independent monetary policy. The central bank can focus on domestic objectives like inflation control, employment levels, or economic growth without being constrained by exchange rate considerations.
Self-adjusting Mechanism: Economic imbalances, like trade deficits, naturally get corrected in a free float system. For instance, a trade deficit might cause the currency to depreciate, making exports more competitive and imports more expensive, thereby helping to reduce the deficit over time.
No Need for Large Reserves: Unlike fixed or managed float systems, there’s no need for the central bank to maintain large foreign exchange reserves to defend a specific exchange rate, as the currency adjusts freely based on market conditions.
3. Conditions for implementing
Fixed Exchange Rate System
Strong Foreign Exchange Reserves: Nigeria would need to have substantial foreign exchange reserves to defend the pegged exchange rate. These reserves can be used to buy or sell the Nigerian naira as necessary to maintain its fixed value against the pegged currency (or basket of currencies). This is currently not the case.
Trade Stability: A fixed exchange rate can be beneficial if Nigeria has stable and predictable trade patterns, especially with countries to which it might peg its currency.
If Nigeria’s main trading partners have stable currencies, then pegging the naira to these currencies can reduce transaction uncertainties for exporters and importers. This is currently not the case.
Economic Stability: It’s crucial for Nigeria to have a reasonably stable economic environment. High inflation, compared to the country (or countries) to which the naira is pegged, can lead to an overvalued currency, making exports less competitive.
Hence, low and stable inflation can support the sustainability of a fixed exchange rate. Nigeria is facing an economic crisis, making it difficult to implement a fixed exchange rate system.
Capital Controls: Given the vulnerability of fixed exchange rate systems to speculative attacks, Nigeria might need to impose some form of capital controls to regulate short-term capital flows.
These controls can deter speculative movements that might threaten the peg.
Political and Institutional Commitment: Maintaining a fixed exchange rate requires strong political will and institutional support.
Authorities must be committed to the necessary monetary and fiscal policies to support the peg, even when these policies might be politically challenging.
For instance, defending a peg might require raising interest rates, which can slow down economic growth.
Under the Buhari administration, the political will was inclined towards a fixed exchange rate system.
Crawling Peg
Moderate Inflation Differential: The crawling peg system is often adopted when a country experiences a predictable inflation differential with its major trading partners.
If Nigeria faces sustained inflation rates that are consistently higher than those of its trading partners, a crawling peg allows for regular adjustments of the exchange rate to maintain competitiveness.
This appears to be the case in Nigeria.
Reliable Economic Data: Implementing a crawling peg requires up-to-date and accurate economic data.
The peg adjustments, whether based on a formula or other metrics, rely heavily on factors like inflation differentials, productivity changes, or trade balances.
Having reliable data allows for precise and timely adjustments.
Foreign Exchange Reserves: While the adjustments in a crawling peg system are more predictable than in a purely fixed system, there’s still a need for a considerable amount of foreign exchange reserves.
These reserves are crucial for defending the peg and intervening in the market, especially if the adjustments are not in line with market expectations.
Unfortunately, Nigeria’s exchange rate reserves are low, however, it is adequate for a crawling peg.
Robust Financial Infrastructure: The central bank should have the necessary tools and mechanisms in place to intervene in the foreign exchange market and guide the currency towards its desired path.
This includes robust monetary policy instruments, communication channels, and relationships with key financial institutions.
This is still unfolding as the central bank continues to implement new monetary policy tools
Public and Market Communication: Transparency and clear communication with the public and market participants are vital. Announcing the adjustments in advance or clarifying the formula/methodology behind the peg movements helps in managing expectations and reducing uncertainties.
Managed Float
Adequate Foreign Exchange Reserves: While a managed float does not require as robust reserves as a fixed exchange rate system, it’s still essential for Nigeria to have a substantial amount of reserves.
This provides the central bank with the necessary ammunition to intervene in the forex market to prevent excessive volatility or to guide the currency towards a desired level.
This is currently not the case in Nigeria; however, the current administration believes it can increase the exchange rate reserve
Effective Monetary Tools: The central bank must have effective monetary policy instruments at its disposal.
This includes the ability to adjust interest rates, implement open market operations, and use other tools to influence money supply, liquidity, and ultimately, the exchange rate.
While this is currently not the case, the apex bank can still raise interest rates through the sale of open market operations.
Sound Financial System: A robust and resilient financial system can absorb shocks and reduce the need for frequent interventions.
This includes well-regulated banks and financial institutions that are not overly exposed to foreign currency liabilities.
A stable financial system can help moderate the impacts of capital inflows and outflows.
Nigeria does not have a sound financial system but it is on the path to stability.
Transparent Policy Framework: Clarity in the central bank’s intentions and policy goals can help manage market expectations.
Even if the central bank does not commit to a specific exchange rate target, clear communication about its priorities (e.g., controlling inflation, supporting growth) can guide market participants.
Transparency has been the cornerstone of the current central bank as it strives to reestablish confidence in the exchange rate system.
Flexible Economic Structure: Nigeria should have a relatively diversified and flexible economy that can adapt to external shocks.
If the economy relies heavily on a few commodities or sectors (like oil), the country becomes more susceptible to terms of trade shocks.
A diversified economy provides more leeway for the central bank in its interventions and reduces the frequency and magnitude of needed interventions.
Unfortunately, the country still relies on oil as its main foreign exchange earner, however, the government’s economic policy focuses on diversifying its income base.
Free Float
Resilient Financial Markets: A free float system works best when a country has deep, liquid, and well-regulated financial markets.
This ensures that the exchange rate is determined by a broad range of market participants and that there are no significant distortions due to limited liquidity or market manipulation.
Nigeria does not have a fully developed resilient market making a free float difficult to implement.
Diversified Economy: Over-reliance on a single export, like oil in Nigeria’s case, can lead to heightened volatility in a free float system when there are global price fluctuations in that commodity.
A diversified economic base helps mitigate such risks and ensures that currency value isn’t too tightly linked to the fortunes of a single sector.
The Tinubu government is determined to diversify its income base and is still a long shot from comprehending a free float.
Sound Macroeconomic Policies: Given that the currency value will be exposed to market sentiments, having a stable macroeconomic environment (e.g., reasonable fiscal deficits, moderate inflation, stable growth) will boost investor confidence and reduce excessive currency volatility.
Nigeria currently lacks a solid macroeconomic environment making a free float highly improbable.
The credibility of the central bank: Even in a free float, the central bank’s credibility plays a crucial role in ensuring confidence in the currency.
While active intervention isn’t a feature of a free float, the central bank should still effectively manage monetary policy, oversee financial market stability, and provide clear communication to market participants.
The current central bank is focused on restoring credibility after much of it was wiped out under the leadership of Emefiele.
Capital Market Transparency Since the currency’s value is determined by market forces, it’s beneficial for the country to have an open capital account, allowing for free inflows and outflows of capital.
Such openness ensures that the currency value reflects genuine economic fundamentals and investor sentiments.
What is best for Nigeria?
Nigeria is currently facing several economic challenges, such as low oil prices, high inflation, fiscal deficits, and external imbalances.
A crawling peg could be suitable for Nigeria because it could help to achieve the following objectives:
Maintain competitiveness: A crawling peg could allow the naira to depreciate gradually in line with the deterioration of Nigeria’s terms of trade and productivity.
This could help to boost non-oil exports and reduce import dependence, thus improving the trade balance and the current account.
Anchor inflation expectations: A crawling peg could provide a clear and credible nominal anchor for inflation expectations, as the central rate would reflect the underlying inflation differential between Nigeria and its trading partners.
This could help to reduce inflationary pressures and enhance monetary policy credibility.
Avoid speculative attacks: A crawling peg could reduce the risk of speculative attacks on the naira, as the monetary authority would have more control over the exchange rate movements and could intervene in the foreign exchange market when needed.
This could help to preserve foreign exchange reserves and avoid sudden and disruptive currency adjustments.
Unfortunately, the fall in external reserves and the disparity between the official and black-market rates, suggest a crawling peg might be inadequate considering this and other economic conditions.
Thus, a combination and a crawling peg and a managed float appear expedient to ensure exchange rate stability and predictability.