The pains and gains of devaluation

Two developments caused unexpected stir in the Nigerian capital market in the last three weeks.  On May 13, the market capitalization of the Nigerian Stock Exchange (NSE) leisurely crossed the N9 trillion range after practically stagnating at N8 trillion for almost one year.
Investors responded to the partial deregulation of the downstream sector of the oil industry with a measure of confidence that stimulated immense upward surge in share price movements.  Two weeks later the monetary policy committee (MPC) of the Central Bank of Nigeria (CBN) directed the apex bank to commence flexible exchange rate policy.

The day after the announcement of the policy, the market capitalization of the NSE surged by N354 billion. Within five days, share prices rose by N613 billion.  Last weekend, the capitalization missed the N10 trillion mark by a scant N74 billion as it surged to N9.926 trillion.
The surged in the capitalization of the NSE apparently emanated from investors conviction that a flexible exchange rate, though it is expected to escalate inflationary trend in the economy and worsen an already plummeting standard of living in the short term, would give manufacturers more access to foreign exchange for the importation of critical raw materials and machinery.  The measure is expected to ease the worsening unemployment in the economy by stepping up productivity.

The flexible exchange rate plan would involve the opening of a small window in the CBN official market for the sale of forex to manufacturers at an exchange rate to be determined by interplay of market forces of demand and supply.  The forex would be strictly for the importation of essential raw materials and machinery for production.
The policy boils down to partial devaluation of the naira which the federal government under President Muhammadu Buhari had resisted vehemently.
An import-oriented economy like Nigeria, hardly benefits from currency devaluation.  Currency devaluation lowers the prices of a country’s export goods, giving them more competitive edge in the global market.

Nigeria does not enjoy such benefit because its only export commodity is crude oil which it has no control over the price.  Currency devaluation as the one engendered by the proposed flexible exchange rate, would simply escalate Nigeria’s huge import bills, drive up inflation rate and lower an already plummeting standard of living in the short term.
But Nigeria has no option than to devalue its currency.  With the price of oil, the source of 90 per cent of the country’s foreign exchange earnings plummeting by 70 per cent and the foreign reserves dropping to an abysmally low range of N26.6 billion, the only solution to equitable allocation of forex for productivity is devaluation of the currency.
At the official rate of N197 to the dollar, the naira is grossly over-valued.

The artificially high value has drastically reduced the earnings of foreign portfolio investors in the NSE, causing massive capital flight. That probably explains the impressive share price movements in the NSE that followed the announcement of the proposed flexible exchange rate policy.
Local investors expect the policy to ease CBN’s merciless grip on forex supply, allow manufacturers to import raw materials and improve production, thus increasing returns on investments.
A flexible foreign exchange rate would allow market forces of demand and supply to fix the exchange rate of the naira and make forex available for those who really need it.  Under the new policy, the exchange rate of the naira is expected to plunge to N300 to the dollar.

Everyone knows that it is an invitation to high inflation as manufacturers would factor the high cost of forex into the prices of goods.  But the option is the type of scarcity of essential goods that is plaguing Venezuela, a key member of the Organisation of Petroleum Exporting Countries (OPEC). Venezuelan shops are empty as inflation runs at 702 per cent.
The problem with the proposed flexible exchange rate is that it would create a dichotomy in the foreign exchange market and engender fraudulent round-tripping of forex.
The exchange rate to be fixed at the flexible window would almost certainly be lower than the parallel market rate.

Last week, the naira plummeted to N345 to the dollar in the parallel market.   The flexible exchange rate window might sell forex for the importation of essential raw materials and machineries at N310 to the dollar.
That leaves a margin of N35 per dollar between the parallel and flexible market rates.  Given the level of corruption in the economy, banks in collaboration with forex users would turn every applicant to manufacturer and flood the flexible window with demands that would end up in the parallel market for sale at a premium.

The solution is a wholesale devaluation that would open a single official window for all forex users. The demand pressure on the naira would drop when the Dangote Refinery comes on stream in 2018 and conserves the $15 billion spent annually on refined petroleum product imports.  The naira would be stronger when government’s policy on rice farming makes Nigeria self-sufficient in rice production and conserves the $10 billion spent annually on food imports.
Until that day arrives, Nigeria can only go the way of Venezuela if it fails to devalue the naira.

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