CBN Policy: Foreign Reserve Diversification and Exchange Rate Unification for Exchange Rate Stability II

By Chinedu Okoye 

Main Thesis:

Exchange rate stability is essential for price stability as international prices for goods and services affects local prices through international Trade and investment transactions. Just as well price stability is essential for economic stability, growth and development.

This makes monetary and exchange rate policy important to support sustainable development and economic growth. 

The mode and form this policy takes is however more important, different exchange rate policies are appropriate for different economies and what seems logical for one country's economy maybe entirely different for another.

The current Nigerian Central Bank policies in exchange rate aims to unify the market by eliminating the tightly managed (official) rates regime. 

The previous policy pegged the official currency exchange rate between N400-N550/$1, certain segments of the economy isolated (the 43 key-goods) and a N99 -N140 spread between the official and parallel markets ensued.

The current leadership at the Bank have pursued a different policy, which aims to unify exchange rates, and eliminate restrictions for the 43 key-goods making Forex available to all at a market determined rate. However, we have seen spread widened in the months following the policy reversal.

Whilst the official rate is more reflective of market realities and available FX, a continual downward trend for the Naira against the greenback even in the advent of the new Refineries (which is expected to reduce the demand for US Dollars to finance importation of refined Petroleum). This is because the market is now unrestricted and both essential and non-essential importers have equal access to the market.

In a developing economy with scarce FX reserves and relatively low earnings, a floating exchange rate regime exposes the currency to external markets shocks. 

Where it's FX earnings aren't enough to meet demand on a "willing-buyer willing-seller" model, or are depleted, an unrestricted float puts the currency in free fall, negating all efforts of the government to improve growth.

Exchange Rate, Price Stability and Growth:

Exchange rate stability is essential for price stability as the value of a country's currency affects prices of imports for consumption and production (i.e. finished and component goods and essential services). A currency depreciation creates inflationary pressures and exerts downward pressures in the local currency.

Price stability on the other hand is a foundation for economic stability and growth. Consumers and investors can plan accordingly and demand dynamics are strong given sustained strength in purchasing power (the aim of the Central Bank is to promote price stability, full employment and output growth).

Businesses (investors) and consumers are assumed to be subjectively rational and budget according to the strength size of their available capital and real disposable income. Price fluctuations affect these projections and distorts overall aggregate demand and economic growth.

The outlook for the Naira at Zero Analytics, given certain fundamental changes in the economy had previously been upgraded to neutral at current levels within the N700 - N1000/$1 range at the Official market and N950 - N1250/$1 at the parallel markets. But in light of recent considerations, further declines are now expected.

Friday December 8th saw the official rates fall to a record N1012/$1 amidst dollar shortages. Although the refineries are expected to give the Naira a boost as pressures on the scarce USD reserves are alleviated. Future shocks however are expected and a case is made for a different approach and a less costly way of increasing our Foreign Reserves whilst reducing the dependence on the Dollar for international transactions.

Suggested moves for Exchange Rate Unification:

It would be next to impossible to unify exchange rates without incorporating the Association of Bureau de Change Operators in Nigeria (ABCON) into the monetary system. The premium at which the greenback is sold for in the market is evidence of the reliance on that outlet for foreign exchange. 

Incorporating BDCs into the system would help ensure that what you get on the streets in what you get in the bank or slightly different, if Naira is devalued to N1500/$1, and the Central Bank works with BDCs, it could comfortably sustain the Naira at those levels thereby enacting a Managed-Float exchange rate at a level that is sustainable. As stated above, a stable exchange rate would encourage price stability which is essential for economic stability and growth.

Diversifying to alleviate potential future shocks:

There are possibilities of external and unforeseen shocks and also potential factors that could increase volatility e.g. the forfeiture proceeds from NLNG dividends, OPECs imposed quota at 1.34 million barrels as opposed to 1.78 assumed in the budget, and BRENT Crude sitting below the $77.89 price assumed at $75.72 (as at 14:25 8/12/23) and security issues that could affect oil production.

This called for a case for diversification of our reserves, a seemingly ill-thought and risky move by the Apex Bank if it's scarce USD reserves are used to finance the policy. Using less costly currency swaps though, might seem a viable option.

Currency Swaps:

A currency swap is a transaction in which two parties exchange an equivalent amount of money with each other but in different currencies. These parties can be private institutions or between Central banks.

The use of currency swap agreements argued for in an earlier article on Zero Equilibrium, they carry less risk and cost to the Apex Bank as opposed to FX forward contracts used in the past. These currencies can then be used to finance trade between partners and alleviate pressure on the Bank's USD reserves.

This acts as a risk management as well because reliance on the greenback exposes the economy to Federal Reserve monetary policy.

Currency Swaps Arrangements gain steam:

The BRICS alliance have made strides in the de-dollarization campaign with trade deals in local currencies favored over the greenback, currency swap agreements between these countries are now gaining steam and used as a buffer to boost the value of their currency and also finance transactions between them.

Currency swaps in process within the alliance include; the Kingdom of Saudi Arabia and China, and the recent 35 billion Yuan currency swap between China and the UAE as well shows China's willingness to stretch the currency alliance via these Swaps with Non-Bric strategic nations.

A Currency Swap with China, India and BRICS Nations:

Nigerian falls in the category of Non-Brics strategic countries given the level of trade with countries within the alliance, and it's position as Africa's latest Crude Oil producer. 

A currency swap arrangement where part of our Oil will be sold to China in Yuan, as China holds some Naira in its foreign reserve, would provide Yuan purchased with a currency we control, Naira. This is pending the settlement date for which the contract could be closed or extended. 

This gives us the ability to finance transactions with China in Yuan at a very low cost. It also relives pressure on our limited foreign reserves in USD and other traditional reserve currency.

This provides adequate level of reserves for The Central Bank of Nigeria, and sustains liquidity for USD transactions.

Transactions with BRICS:

Nigerian trade with six BRICS countries analysed for the year 2021 (China, India, Saudi Arabia, UAE, Brazil, and Russia) totalled $36.39. With Imports totalling $30.76 and Exports at $5.63 billion, trade deficit of over $25 billion.

China: In 2021 Nigeria imported $21.9 billion from China and exported $3.05 billion to the Republic. Making total trade between both countries $24.95 billion. Petroleum gas amounting to $1.42 billion dollars was our top export to China in the year.

India: In the same year, Nigeria exported $9.07 billion to India and imported $4.75 billion worth of goods. Most of these imports from India were refunded petroleum ($991 million), whilst our top export was Crude Oil ($8.11 billion).

Brazil: Imports from Brazil for the year 2021 was $959 million and exports to the country $1.08 billion. The top export to Brazil was Crude Oil ($594 million), and our top import, Raw Sugar ($598 million).

Saudi Arabia: In 2021 Nigeria trade with Saudi Arabia was $569 million. Our top export to the Kingdom was Scrap Aluminum ($8.31 million) with a total export value to the Kingdom at $28.4 million whilst importing a total of $541 million from the Kingdom. Propylene Polymers was out too import.

United Arab Emiates (U.A.E): total exports to the UAE stood at $276 million with gold toping the list at $144 million. Nigeria imported a total of $1.36 billion from the UAE with broadcasting equipment typing the charts at $213 million.

Russia: Trade between Nigeria and Russia was $1.63 billion in the year 2021, refined petroleum was the top import from Russia at $503 million from a total import value of $1.25 billion. Our top export was Cocoa beans ($29.5 million), and total exports to Russia for the year, $38.8 million.

Viability of a Currency Swap based Monetary Alliance with BRICS:

At $30.76 billion imports in 2021, BRICS nations contribute 69.84% of our imports. A systematic de-dollarized trade, financed by currency swap arrangements with these countries seems a viable strategy for exchange rate stability.

Local currencies would be used to finance these transactions (starting with India and China) with our biggest trade partners. Currency Swaps provide each party with sufficient volumes of the other party's currency which would then be used to settle these transactions in the period prior to the settlement date of the contract.

It reduces dependence on the US Dollar and addresses foreign exchange issues. In the past it had been used by the likes of the Federal Reserve, the European Central Bank, Swiss National Bank etc to address foreign currency funding issues and strains in the money market

Sufficient local production of Refined petroleum reduces Nigeria's imports from these countries by almost 5%, (according to projections at Zero Analytics), and this contributes immensely towards reducing the trade deficit.

The viability of a Currency Swap based Monetary Alliance with BRICS nations, starting with India and China, holds promise. As we navigate future uncertainties, the judicious use of local currencies, risk-mitigating currency swaps, and a focus on reducing the trade deficit offer a roadmap towards economic resilience and sustained growth.