Floating Exchange Rate: The Lessons not Learnt – by Frank Ofili
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In his inaugural speech on May 29, 2023, President Tinubu hinted that the multiple exchange rate system which had hitherto been in operation in Nigeria would be collapsed and unified into one. Mr. President also hinted that there would be other monetary policy reforms.
Two weeks later on June 14, the Central Bank of Nigeria (CBN) through its director of financial markets, Angela Sere-Ejembi announced that all segments of the foreign exchange management system had been collapsed and unified into one, and that “all transactions will now be done through the Investors and Exporters (I&E) window, where the exchange rate will be determined by market forces”.
This simply means that the CBN had re-introduced the floating exchange rate system, and that by implication, the Naira had been devalued. This was confirmed by subsequent developments as the Naira took an unprecedented bashing on 15th June exchanging for N760.00 to the US Dollar. As I write this piece today, 15th August 2023, the Naira exchanges for N937.00 to the Dollar. As the day winds down to usher in tomorrow, the Naira may crash even further.
Before going further, perhaps it is necessary to properly situate a floating exchange rate system. Simply put, a floating exchange rate system refers to a system where the value of a country’s currency is determined by the forces of demand and supply – that is, a situation where the rate at which a country’s currency is exchanged is not determined by administrative fiat and where there is no restrictions whatsoever.
I really do not know what to make of the Federal Government’s adoption of this exchange rate model. I do not know if it is wise, or indeed whether this is the right time to adopt it. I am aware, though, that on paper, it seems to have its inherent advantages – stability in the balance of payments, ease of access to foreign exchange, enhancement of market efficiency, protection of the economy from import-driven inflation, and attraction to foreign direct investment. But that is about it. Theory! Far removed from ground economic realities of our time.
When the Babangida administration introduced the IMF-inspired Structural Adjustment Program (SAP) in September 1986 with Second-Tier Foreign Exchange Market (SFEM), and a floating exchange rate system as part and parcel of the overall reform package, the Naira took a sudden and unprecedented dive. Before then, in the 1970s and early 1980s, the Naira exchanged for N0.90 kobo to $1.00. By the time IBB left office in 1993, the Naira was exchanging for N17.00 to $1.00. It was during this time that Bureau De Change (BDC) sprang up everywhere. Smart Alecs in banks cashed in on the gap between the CBN-determined official rate and market-determined rate prevailing at the BDCs. All they had to do was buy foreign exchange from CBN at official rate, strolled down to Broad Street and sell it off at market rate through the BDCs. The arbitrage was so much as to fund the emergence of “new generation banks”.
We need to think of the bitter side of it. Above all, we need to be practical and realistic and not necessarily resort to Western economic prescriptions.
At introduction of the floating exchange rate system by Babangida regime, the argument then was that a weaker Naira would engender industrialization of the country and less reliance on oil revenue, which by the way, was as unpredictable as it was externally determined. Today we know better.
From all indications, I think President Tinubu’s administration is trying to avoid the pitfalls of Babangida’s floating exchange rate system where there was an official (fixed) rate as determined by the CBN and a market rate as determined by the BDCs – a contradiction of sorts. Still, it seems to me that this government is telling us only one-half of the floating exchange rate story – the sweet theory part of it. It probably adopted it, too, based on that one-half of the story.
But we need to think of the other side. We need to think of the bitter side of it. Above all, we need to be practical and realistic and not necessarily resort to Western economic prescriptions. What are the risks to our economy? What are the realities on ground? Why did the policy fail under Babangida despite growing remittances into the country at the time?
My two-kobo understanding of macroeconomics tells me that a floating exchange rate regime is not suitable to a monocultural economy such as ours, an economy without diversified productive base. The major argument for floating exchange rate is that it offers unrestricted access to foreign exchange. But that is in an economy with multiple sources of foreign exchange; a producing and exporting economy with diversified productive base.
For an under-developed economy, such as ours, with more or less one product (crude oil), and very few other products available for export, I doubt the effectiveness of the floating exchange rate to pull us out of economic doldrums. Perhaps this is the reason Babangida adopted a partially-controlled floating exchange rate regime. But we all saw the result.
If any lesson is to be learnt, we ought to ask why the policy failed under Babangida’s administration even as he did not fully operate it. Well, here is why.
First, there is the risk of volatility. Fluctuations and unpredictability always characterize floating a currency. One currency can decline in value against another currency within a single trading day, and such fluctuations cannot be explained by fundamental principles of macroeconomics because the forces triggering such fluctuations cannot be understood. Nor are they visible, or within the control of the government or the monetary policy managing authority. This manifested during Babangida’s administration because of two critical factors – the exchange rate and crude oil price – both externally determined.
Limited economic growth and recovery. I was reading an article on the web of Market Admirals to the effect that the very lack of strict control over exchange rate – a major characteristic of a floating exchange policy – “places restrictions on the growth and recovery of an economy” with limited sources of foreign exchange. This is because when the currency depreciates, it can easily lead to serious problems of export and import. For instance, if the value of the Naira depreciates against the US dollar, as it is wont to do, it will be difficult to import critically needed goods and services due to high exchange rate. This may in turn stunt economic growth, especially, if critical imports such as expertise, machinery and raw materials needed for domestic production cannot be accessed because of high exchange rate.
Floating Exchange Rate may also not help in solving our country’s current economic challenges of high unemployment, high inflation, low GDP if the Naira continues to take a daily bashing. As demand for commodities increase, inflation will have a field day as local manufacturing is stunted and import seriously impaired due to runaway exchange rate. This is not to mention that planning would become difficult due to unstable exchange rate. Simply put, the problem would become even bigger.
I want to believe that the logic of President Tinubu’s government adopting a floating exchange rate is to find the true value of the Naira by easing off exchange controls and collapsing the official and parallel exchange markets into one. But there also lies the problem. As long as the fundamentals of our economy have not significantly changed over the years, the problem of instability will remain because as demand for foreign exchange continues to go up while supply remains low, there is bound to be inflation eventuated by rush for the little available in the economy. Such will also result in corruption and sharp practices as big men and high net worth individuals in and out of government muscle their way through to hijack available foreign exchange. This, added to the volatility and whimsical nature of crude oil price, will surely make matters worse for the Naira. Again, perhaps this is what informed Babangida’s decision to have a fixed rate and a floating rate. With Tinubu’s exchange rate policy, I hope we do not arrive at a critical juncture in future where the matter becomes political, and the government forced to intervene because the Naira is taking a consistent and continuous bashing. Already, the Naira is in dire straits as it is, and one can only imagine what would happen during election time with our Dollar-dominated electoral system.
Lastly, the argument that a floating exchange rate regime would attract foreign direct investment does not always hold true, in my opinion. For us at the moment, as long as insecurity in our country has not abated, we may have to wait a while. We may want to know why many multi-national corporations have left our country and have not returned.
To pull Nigeria out of her present economic challenges requires more than floating the Naira. It requires a sincere government that would among other things provide security at all costs, pursue infrastructure development consistently, provide justice and fairness, provide a functional healthcare system, provide adequate and continuous funding for education, reform our unwieldy bureaucracy to significantly reduce cost of government/cost of doing business, restore faith in the country and awaken the national consciousness through value re-orientation. If all these are in place, foreign investment would fall in as a matter of course and the Naira would regain its lost glory.
