A Flexible Exchange Rate Policy Is Still Right, By Olu Akanmu
There is an emerging debate that since the Nigerian government buckled to float the naira, with the parallel and official rates of exchange still widely far apart, whether the flexible exchange rate policy was the right thing after-all. This view argues that the much-expected private capital flows to the Nigeria with a market-driven exchange rate, which will complement government supply of the dollar to the currency market, has not materialised as largely theorised and expected. The parallel market rate continues to fall even as the naira does same in the official market. Reinforcing this argument of whether a flexible exchange rate policy is right, is the view that all emerging market currencies are falling relative to the dollar anyway, due to capital flows out of emerging markets to dollar denominated US Government treasury bonds that provide safety and value preservation in a period of crashing commodity prices and uncertainty.
The argument observes rightly that the best period of capital (especially portfolio) flows to Nigeria and an attendant strong naira were during periods of high oil (commodity) prices and low interest rates in advanced economies. The extrapolation of the argument therefore is that the problem was not with the naira or the fixed exchange rate policy but a challenge of the global economy at this time.
In this essay, we argue that while there is a problem of general attractiveness of emerging market currencies at this time, the particularities of the Nigerian naira within this general context have been worse than those of its peers. This makes the naira even more unattractive than other unattractive emerging market currencies. A Bloomberg analysis on August 23 this year, showed that the naira has lost most value of all oil based economies’ currencies since the oil price crash in June 2014. The naira has lost almost half of its value against the US dollar, making it worse than the Russian rouble, Kazakhstan’s tenge or Angolan kwanza. The Bloomberg analysis described the naira as the worst performing currency among 150 globally depreciated currencies since June 20. The question really should be why the Nigerian naira is the worst performing of all the oil currencies and among its emerging market peers? Why has the Nigerian naira not responded positively to the flexible exchange rate policy? It should be noted that the poorest performance of the naira among world oil currencies is based on the official depreciation of the exchange rate. If we use the parallel market rate, which is the price most non-connected, non-privileged people and business source the naira, the Nigerian currency will be in a particular class of its own.
The argument remains valid that investors will not move assets to the naira when it is overvalued relative to their current currencies and asset holdings. A lot of previous analysis have put the fair value of the naira to the dollar at about N290. Yet there remains significant premium on this rate or anything close to it in the parallel market rate, which is now above N400. The market in its collective wisdom is clearly putting an additional risk premium on what would have been the fair value of the naira at least in the short term. This additional risk premium continues to account for the wide gap between the official and parallel market rates. This additional risk premium effect is also corroborated by the fact that the naira has depreciated the most of all the major oil currencies. This indicates that there are additional risk factors beyond oil prices that have made the naira depreciate beyond the normal average of world leading oil currencies. What are the additional risk factors that need to be addressed urgently to get naira closer to its fair value, which reflects Nigeria’s long-term economic fundamentals much better?
The first risk factor putting additional premium on what should have been a fair value of the naira is the uncertainty of the market that Nigeria is fully committed to market reforms and that state actors will have the courage to pursue market reforms through to the desired end. The market took notice when President Buhari said in one his national independence anniversary interviews that he does not believe in a flexible exchange rate policy. This was just barely three weeks after the monetary authorities floated the naira. Given market perceptions that the Nigerian Central Bank is not truly independent, such open communication of policy misalignment within government can only create market uncertainty and amplify investor risk perception.
The second risk factor is national security and the capacity of the Nigerian state to sustain oil production and revenue by ensuring peace in the Niger Delta. Nigerian oil production has fallen from its peak capacity of 2.2 million barrels per day to 1.5 million barrels, with the potential for such negative trajectory to continue if we cannot secure enduring peace in the Niger Delta. The security issue in the Niger Delta is complex and can only be solved with toughness, wisdom and political sagacity. There are clear limitations of the capacity of the armed forces to secure peace and fight internal terrorism on two fronts simultaneously – in the North-East and the Nigerian creeks.
The third risk factor pertains to policy flip-flops and un-coordination between the monetary and fiscal authorities such that they neutralise each other’s actions or elongate the lag time for positive policy effect to come through. A good example is that while the fiscal authorities are pursuing a policy of reflating the economy, pushing liquidity into the system with the much delayed budget implementation, the same liquidity is being sucked out of the economy by high yields on government bonds and treasury instruments. The high yields on government bonds crowd out the private sector from accessing loans from banking system. Why would the banks lend to the real sector when they can get risk free returns on government bonds at rates close to twenty percent? The monetary authorities are however pushed to this extreme to defend the naira because of the long delay in liberalising the currency market because they were watching the body language of the fiscal authorities.
In conclusion, the low attractiveness of the naira to international investors is not just typical of an emerging market currency problem at this time of investor preference for the dollar denominated US government bonds. The naira has been one of the most unattractive of the unattractive emerging market currencies because of the anti-market economic policy we have pursued in the last seventeen months. The improved attractiveness of the naira that should have been occasioned by the new flexible exchange rate policy has been mitigated by mixed policy signals by state actors, mutually neutralising monetary and fiscal policies and security issues, which have put additional risk premium on what should have been a fair value of the naira.
The recent action of the reserve bank to withdraw the remaining national oil corporation foreign currency deposits from the banking system in one fell swoop, clearly an action directed by the fiscal side of government, has created new spikes in dollar illiquidity in the market and a new trajectory of downward pressure on the naira. Such developments clearly suggest that that the fiscal and monetary sides of government need to be coordinated much better to get us out of recession and get the naira to appreciate closer to its fair value. The flexible exchange rate policy is therefore still right even when its salutary effects are yet to come through strongly in the short term. Staying with the abandoned fixed exchange rate policy could have been worse. Strong actions to address the three additional risk factors described above that put additional risk premium on the naira will ensure that the expected salutary effects of the flexible exchange rate policy come through quickly and more strongly.
Olu Akanmu publishes a blog on Strategy and Public Policy.