PETERSIDE ECONOMIC REVIEW

Chamberlain S. Peterside, Ph.DTuesday, June 6, 2006
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New York, NY, USA

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STABLE FOREIGN EXCHANGE REGIME
…KEY TO SUSTAINABLE ECONOMIC DEVELOPMENT IN NIGERIA


…Popular Indicator

aira exchange rate remains one of the most popular indices amongst most inhabitants in Nigeria. Don’t be surprised if you learn that “money changers” lined up at the international airport, or traders in popular markets around the country are better informed about exchange rate trend than white collar bank employees. This is because foreign exchange has become the life-blood of a nation, whose destiny is strongly tied to the apron string of the US dollar - crude oil export and imports from the international market.


It’s a plain fact that 95% of export earning is derived from a single product – crude oil, while the bulk of both industrial raw material/machinery and finished goods are imported from abroad so when the Pound Sterling, US dollar or Euro sneezes, the Nigerian economy shivers. This has become the situation for decades since the country struck “black gold” and its people developed a penchant for imported goods; ranging from exotic automobiles, stockfish, Uncle Benz rice to “Hollandis” fabrics.

Historically, the over-dependence on imports has exacerbated Nigeria’s debt burden, drained hard-earned foreign exchange, stifled local production, escalated the cost of living for average citizens and hampered successive efforts for industrial growth.

From Gold Standard To…

To give you some background; the current international exchange regime evolved over the last 50 years after the creation of Bretton Woods Institutions like International Monetary Fund (IMF) and World Bank. First it was the gold standard that was prevalent in global financial transaction, replaced in 1971 by the US dollar (as unit of account in international trade), after the United States decidedly untied its currency from the universally accepted precious metal.

Thus far what you see in the global currency market in my opinion is the result of every country aspiring to manage their own exchange rate situation, more often than not at the detriment of less endowed members of the global community - poor countries with weak mono-product or agrarian economies like Nigeria. United States dollar retains the predominant role however in the last few years the “Euro” has emerged as a strong competitor that is posing formidable challenge to that hegemony.

Dynamics of Naira Exchange Rate
Average Official Exchange Rate Of Naira Against US Dollar

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All attempts to address global imbalance in a negotiated manner in the interest of the majority have failed woefully, (not even the so-called Special Drawing Rights – SDR utilized as a settlement standard in the IMF) has helped rectify the asymmetry of dependence by developing countries. Simply put, no country is willing to give up its privilege or act against its own best interest in other to achieve global parity.

Against this backdrop, in a market where new players are emerging and asserting their position, it is imperative that every sensible nation defines her priority and develops a coherent exchange rate policy on the basis of which it will interact with counter-parties. Clearly, the constant bickering between China and the US about the latter’s currency exchange rate (Renmimbi or Yuan) underscores this new reality. China realizes her strength and comparative advantage, therefore is capitalizing on the exchange rate to boost exports to the US.

For developing countries like Nigeria that has suffered tremendously over the years and remain on the fringes of international trade the latest effort to modernize her currency regime through a liberalized exchange system should be considered a welcome development at last.

…Modernization

Few years ago the Central Bank (CBN) adopted the Dutch Auction System (DAS), which has seen the Naira stabilize on a trading range of 129-135 Naira to a dollar in the official market, ($1=145 Naira in the parallel market). Better still in early 2006, the apex bank liberalized the system further by merging the official and parallel market with the Wholesale Dutch Auction (WDAS), thereby creating a level playing field for everyone in foreign exchange market. Since then, the Naira has steadily been gaining ground against major foreign currencies.

The crux of this new dispensation is that it will unmask illegal foreign exchange transactions in the country as it streamlines management of currency rates. It emboldens the Central Bank to eradicate archaic “black-market” in foreign currency. This will also tackle “round tripping” by banks that have thrived through reaping illegal profits from “arbitrage” currency transactions (capitalizing on rate differential in the official and black market).

Most of all, this singular measure brings Nigeria’s exchange rate regime closer to what’s obtainable in the 21st century environment in other emerging and advanced countries.

To be fair, the sliding Naira rate during the preceding 6 years has led some critics to compare the situation now to the regime of General Abacha, when the rate stood at 85 Naira to a dollar. By this measure skeptics aver that the economy was stronger and better previously. Most Nigerians nostalgically recall when the rate was $1 to 0.65 (kobo) in the 1980s. My thinking is that, these comparisons are quite shallow at best and simplistic to say the least. The economy during the 1980s and 1990s was literally on shaky grounds and profusely bleeding money.

The net result was the bloated external debt, which peaked at $35 billion before the Paris Club debt deal. Domestic manufacturing remains comatose, while cost of living has spiraled. It was only a matter of time before the whole system imploded on its own weight, not withstanding the high oil revenue. Nigeria’s economy up till recently could be characterized as a titanic cruise ship carrying millions of passengers and sailing without a navigation system, even worse, the captain/crew had no clue about their destination - sooner or later the ship was bound to hit the iceberg catastrophically.

Analysis of Exchange Rate Policy In A Weak Economic Environment
(Low Versus High Exchange Rate)

# Economic Impact On Low Exchange Rate High Exchange Rate
1 Capital Flight/Export of Funds Decreasing Increasing
2 Consumption Of Imported Goods Decreasing Increased
3 Balance of Payment More Favorable/ Balanced Negative Balance
4 External Debt Burden Low or Decreasing High or Increasing
5 Domestic Industrial Production Higher Incentive Low Incentive
6 Domestic Industrial Employment High Local Employment Low Employment
7 Foreign Exchange Reserve Growing/High Decreasing/Low
8 Import Bill For Goods/Services Low/Decreasing High/Increasing

…Case For Balanced Exchange Policy

The progress achieved so far in normalizing the currency market is a major step toward more stable economy. Essentially, purchasing power parity (PPP) has become a standard barometer for determining fair exchange rate in the international market. Attempts have even been made by experts to use the so-called “Big Mac Index” (cost of Mac Donald Restaurant’s Big Mac Burger in various countries) to define exchange rate/cost of living parity. Nevertheless, the value of a currency against another could still be considered a subjective parameter and matter of national policy. For Nigeria the critical question should be - what is in the best interest of the national economy?

There are two schools of thought on exchange rate policy – proponents of floating and fixed rates. The act of floating a currency is simply to allow rates to slide freely based on demand/ supply dynamics and balance of payment. There are a few countries (if any) that can afford that luxury today, hence countries now strive to fix and manage their rates. On the other end of the spectrum, a rate that is too rigid, without taking cognizance of market conditions can hardly withstand the vagaries of current global trend.

Which brings us to the middle ground - whereby currency rates are determined not only by the forces of demand and supply but also through the prism of macro-economic indicators within a country, like balance of payment, consumer price index, unemployment rate, cost of imports, strength of domestic manufacturing and export earnings.

The situation when the Naira rate was strong and fixed by administrative fiat was quite inimical to the domestic economy, conversely a weak and unstable Naira in an import-dependent economy resulted in spiraling cost of living. The realistic approach therefore should be to maintain the rate at current level, but peg it against a basket of five major currencies – US Dollar, Euro, Swiss Franc, Pound Sterling and Yen, (our major trading partners). Then allow the rate to swing on a narrow margin of say 5-10%, (depending on market conditions) over the long haul.

It will be wise if/when necessary to deploy the foreign reserve war-chest as a support mechanism for the exchange rate, to help ease demand pressure. A predictable exchange rate will eventually stimulate corporate activities, spur foreign direct investment and accelerate the emergence of option and derivative products in the capital market – hedging techniques would become widely in use by local and international institutional investors to minimize currency exposure/risks

Such measures if put in place will take time to yield results. Ordinarily in a conducive environment, there could be hope for long-term investing. According to analysis, the current $35 billion forex reserve is equivalent to 30 months of Nigeria’s import bill, up from historical single digit. The higher this reserve given the current volume of import, the longer it might last, but if you for instance succeed in drastically reducing the import bill and stemming capital flight, any reasonable amount of foreign reserve will go a long way.

Impact of Realistic/ Stable Exchange Rate on a Developing Economy

# Economic Indicator Impact On National Economy
1 Foreign Direct Investments High or Growing
2 Capital Flight/Export of Funds Low or Decreasing
3 Import of Finished Goods Low/Local Substitutes
4 Domestic Production Capacity High/ Robust
5 Consumption/Price of Imported Goods Low and Unaffordable
6 Domestic Productions/ ConsumptionDomestic Productions/ Consumption High or Growing
7 Balance of Payment Favorable and Stable
8 Export Price of Finished Goods Low and Affordable

…The Task Ahead

The task therefore shouldn’t be to necessarily amass reserves to satisfy frivolous import bills. The strategy should be multi-pronged – continuously build up reserve through prudent fiscal management (while oil prices remain high), then gradually wean the economy away from over-dependence on imports. Outright ban of imported goods like textile and poultry wouldn’t perform magic overnight. Stimulating local production of these basic needs through credit facilities on favorable terms should be complemented with high tariff barriers in the long-run.

For instance, the fight to flush out adulterated drugs is leading to a rebound of domestic manufacturing capacity for pharmaceutical products and processed food/drugs. This campaign would offer a much-needed impetus to conserving foreign currency in the long term. As the predominant income earner and potential foreign exchange "black-hole" in Nigeria, if local content policy in the oil/gas industry could also be successfully pursued this will result in huge savings for the country and alleviate the hemorrhaging of scarce resources.

In recent months interest rates have been plummeting as more long-term capital becomes available in the market. Agro-allied and cottage industries as well as other local manufacturers could utilize the cheap funds to churn out valued-added goods for which hard currency is spent importing from India, China and Europe.

Given its pivotal role, it is my view that any serious effort in the currency market can generate multiplier effect on the economy if aggressively implemented. Any half-hearted measure that doesn’t go far enough will amount to simply spinning the wheels.

Chamberlain is the Founder & President of New Era Capital Corp. and MyCompleteFinance.com, a New York based financial services group. He was previously a Financial Advisor in the Global Private Client Group, of Merrill Lynch.