United Foreign Exchange Regime

Modern economies rely on a healthy foreign exchange (“FX/Forex”) reserve much like medieval states relied on their war chests; to defend themselves in tumultuous times against external pressures. Through a more contemporary lens, exchanging currency with trading partners impacts a nation’s balance of trade – an essential indicator of its economic health. It makes sense then, that good foreign currency policy is a magnet for foreign investment.

Nigeria has historically ‘danced’ between forex regimes. On the balance, the Buhari-led government’s policies did not inspire much investor confidence. During its last days, the administration assured global investors and the World Bank that it would unify the exchange rate window to tackle the issue of supply of FX in the market. On June 14, 2023, its successor administration, led by President Bola Tinubu, unified the forex market rates; allowing the forces of demand and supply to determine the currency rates for all segments of the market. The wisdom of this bold initiative and its likelihood of achieving policy goals, can only be properly understood in the context of its impelling forces and likely ramifications. That is the subject of this article.

Looking backward
Nigeria’s government introduced a policy in 1986, allowing forex rates to be determined by market forces. By 1994, the system returned to currency pegging and forex centralization in the Central Bank of Nigeria (“CBN”). This policy shift restricted Bureau De Change (BDC) and declared the parallel market illegal. Relief returned in 1995 with the liberalization of the market which allowed forex to be sold to end-users by CBN through selected authorized dealers (including BDCs) at market determined rates.

In 1999, the government introduced an Inter-bank Foreign Exchange Market (IFEM) and the Interbank Rate System Regime followed in 2015, allowing CBN to intervene as the need arose. Soon after 2016, CBN introduced a managed floating system which is characterized by a segmented forex market; with CBN playing a role in determining certain applicable exchange rates as in the case of specialised windows like the Personal/Business Travel Allowances (“PTA/BTA”) window; while steering clear of others as in the case of the Investors & Exporters (I&E) window, which rates were determined by market demands.

This way, Nigeria operated a dual exchange rate regime which was not without its problems. Limited forex at official CBN rates created challenges in accessing forex through the banks. Customers with forex needs would usually resort to the parallel market. This in turn stoked arbitrage, and round-tripping whereby banks obtained FX at official rates and diverted it to the parallel market, breeding artificial scarcity.

Operational impacts of forex unification
Since the abolishment of currency pegging and the multiple exchange rate system in June 2023, the margin between the I&E market and the parallel market has fallen considerably. For example, on July 7th, 2023, the official I&E window recorded a closing exchange rate of N786/$1 compared to N790/$1 average sold at the parallel market.

But years of the often-unpredictable multiple exchange rate regime have eroded investor confidence and contributed to poor forex inflows. Can the unification policy be sustained, and will it precipitate an adequate supply of foreign currency? This will be examined in consideration of some of the sources of foreign currency as stipulated in section 4 of the Foreign Exchange Act, below.

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Export: Increased export of goods and services ordinarily drives forex liquidity; but the unification policy has highlighted Nigeria’s import dependence. Exports have declined sharply in recent years, most notably under the Buhari administration. Export revenues which peaked between 2011 – 2013 with recorded revenues of $99.8, $96.6 and $97.8 billion respectively, dropped to about $45.9 billion in 2021 (Nairametrics). For the unification regime to yield greater results therefore, Nigeria’s trade policy must be strategically oriented to unleash export potential. Real effort must be channeled into economic diversification – away from the reliance on oil-related exports. Fast-tracking export processes at our various ports, strengthening political cooperation and other business integration initiatives would also provide a much-needed boost.

With the unification foreign remittances are likely to. increase, with banks now trading at the market rate.

Authorized dealers: Foreign remittances historically represent a predominant source of forex inflows into Nigeria, sometimes exceeding inflows from FDIs. However, this inflow is fast depleting. According to CBN, net current transfers in Nigeria for 2020 were the lowest for at least 12 years, partly attributable to poor forex policies (Cenfri Report). It was also recently reported that half-year remittances recorded so far in 2023 represent a 21% decline, by comparison with 2022. Election uncertainties and, of course, CBN cash and forex drama may have contributed to the falling numbers (Nairametrics).

To sum up, the multiple forex rate policies in place did little to repose confidence in foreign remitters as they would rather utilize informal channels to access the more favourable market rates. The parallel market thus dominated supply channels at the expense of the formal market, contributing to significant rate discrepancies. With the unification however, it is believed that foreign remittances will increase, with banks now having the ability to trade at the market rate.

Portfolio and direct investors: One of the glaring effects of multiple exchange rates under previous administrations has been the loss of Foreign Direct and Portfolio Investments (“FDI/FPI”). For example, the share of foreign investors’ participation in the domestic equity market was reported to have constantly declined, from 53.8% in 2015 to 10.4% in February 2023 (This Day). This decline can be linked to unfriendly investor policies and is rooted in CBN’s inability to provide forex liquidity to offset high repatriation demand for capital imported via certificates of capital importation. This compelled investors to exchange at the parallel market, thereby incurring huge costs. For these reasons, new investors have shied away from Nigeria and huge capital flights from Nigeria, have been an investment goldmine for neighbouring countries. It is believed that with the forex unification, FPIs will return to its historical levels.

It is difficult to share similar optimism about FDIs. In 2016, CBN introduced the Naira-settled OTC FX Futures (“Futures”) to the Nigerian derivatives market to address the forex challenges plaguing the country. However, CBN has been unable to meet even its Futures obligations due to the problem of lack of forex and this has added to the forex market’s unattractiveness. Therefore, to make participation in the forex market more attractive to investors, it is important that CBN’s outstanding Futures obligations are settled quickly.

The CBN: CBN remains a source of forex supply and one of its roles is to act as a regulator of the I&E window by using the country’s external reserves (under its management) to maintain liquidity and stability in the Forex market. A question therefore remains regarding the forex rate floatation type the government intends to implement. There are generally two types of currency floatation; a pure or managed float each depending on the degree of government’s intervention in the forex market to manipulate the rate.

Going by current indications, specifically the rapid rate of devaluation of the Naira, it seems that the market has been left entirely to the forces of demand and supply. But old habits die hard. As events unfold, CBN may yet feel compelled to intervene should a pure market float prove too abrupt and unsustainable. Moreover, for a developing country like Nigeria that depends on imports, a pure market float regime may prove challenging to sustain.

Should CBN choose a managed float however, it would be challenged to continue supplying liquidity to the market considering its fast-depleting foreign reserves. Crude Oil makes up about 90% of Nigeria’s forex revenues and except daily oil production is increased, the volatility of oil prices may pose a challenge to providing liquidity. In the same vein, there has been a sharp increase of Nigeria’s public debt profile within the past years and this means that much of the nation’s forex reserves go to debt servicing. With the current grim debt servicing outlook, CBN’s capacity to sustain a market intervention is severely compromised.

Conclusion
Forex unification generally reflects sound and sustainable macro-economic policy. But it is glaring that this policy, in itself, will neither spur nor guarantee the needed supply of forex in the economy. As recommended, nationally coordinated investor friendly policies are the best way to attract FDI and reverse the negative stigma of the past several years in Nigeria’s business climate. President Tinubu recently signed four Executive Orders for: the suspension of the 5% Excise Tax on telecommunication services; escalation of excise duties on locally manufactured products; and deferring the effective date of the Finance Act from May 23, 2023, to September 1, 2023. Another commendable policy is the CBN-issued circular directing oil companies to henceforth sell forex to Banks in a bid to inject liquidity into the I&E window.

In addition to such policy initiatives, the government must also show good faith by creating a road map on discharging its outstanding Futures contract obligations owed to foreign investors. It must also explore paths to improving daily oil production on the one hand and diversifying the economy by removing focus from crude oil on the other.