Benefits of Moving Towards Currency Exchange Rate Flexibility in Nigeria by Ayodele Ojo

Opnion: Benefits of Moving Towards Currency Exchange Rate Flexibility in Nigeria by Ayodele Ojo

The long awaited flexible exchange rate regime should be a welcome development. This is an era in a Nation's economy when exchange rate will be determined by the market forces. Investors can, at least plan where and when to invest in the future!

One of the ways to enhance the value of Naira is to some extent is through an export-oriented economy. This will put less pressure on dollar. The new exchange rate regime could enable export-led growth. Having identified the flexible exchange rate, I do expect the Central Bank of Nigeria (CBN) to come up with a trade and economic policy with the aim to speeding up the industrialization process in Nigeria by exporting goods for which the nation has a comparative advantage. Agriculture and solid minerals are a good examples.

More importantly, institutional and private users may take advantage of a number of money market instruments they  have at their disposal with which they can fully hedge currency fluctuations for the duration of the period they seek to finance their businesses. One of such is currency swapping.

 Foreign Exchange Swap allows sums of a certain currency to be used to fund charges designated in another currency without acquiring foreign exchange risk.  

Swap contract is an agreement between two parties to exchange a cash flow in one currency against a cash flow in another currency in accordance with a set of pre-determined terms and conditions. This protocol permits companies that have funds in different currencies to manage them efficiently. 

Currency swaps have three main uses:

-    To secure cheaper debt (by borrowing at the best available rate regardless of any currency and then              swapping for debt in desired currency using a back-to-back-loan)

-       To hedge against (reduce exposure to) exchange rate fluctuations.

-         To defend against financial turmoil by allowing a country beset by a liquidity crisis to borrow money from others, with its own currency.

The currency swap between counter-parties could be protected through hedging. A hedge is an investment position intended to offset potential losses and or gains, as the case may be, that can be incurred by a companion investment. In simple language, a hedge is used to reduce any substantial losses and gains suffered by an individual or an organization.

For instance, a US-based company needing to borrow Naira, and a Nigeria-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging  to swap either the principal loan or the subsequent cash-flow or both.

According to the Bank for International Settlement, in June 2015, the notional amount of outstanding Over The Counter (OTC) single currency interest rates derivatives was almost $553 trillion. The gross market value of outstanding derivatives contracts – which provides a more meaningful measure of amounts at risk than notional amounts –stood at $15.5 trillion as of the end of June 2015.

Over-the-counter is a transaction done directly between two parties, without any supervision of an exchange. It is contrasted with exchange trading, which occurs via exchanges. In an OTC trade the prices is not necessarily for public consumption unlike the stock exchange trading market. In forex swapping, no parallel market agent is needed. OTC could provide more liquidity as the new exchange regime evolves. 

As result of the new flexible exchange rate regime, it is expected that the derivative sector in Nigeria will become deeper through exchange of swap contracts thereby providing additional liquidity into the foreign exchange market. 

For instance, investors should normally be able to predict the deposit and inflation rates over a reasonable period of time if they are to be attracted to invest in the real sector of the Nigerian economy. This is because investors want a marginal return above their deposit plus inflation rates before decision to invest in Nigeria as opportunity costs to their alternative investment opportunities in another country.

A good, transparent, predictable, measurable and well functional exchange rate regime will attract investors to Nigeria. It is reasonably pragmatic to quantify and mitigate systemic risks in a transparent and flexible currency market, however, an uncertain market conditions apparently discourages investments. 

Lastly, the deposit and inflation rates are also important to the new flexible exchange rate regime. The Central Bank of Nigeria (CBN) should implement policies that mitigate liquidity and interest rate risks. The CBN should come up with fiscal programmes that aim to drastically reduce interest rates to single digit. This could have direct impact the inflation rate currently around 15.6%. The CBN could reduce the liquidity problem in the system through issuance of attractive bonds to local and international investors.

Commercial banks are expected to display their daily exchange prices and sell forex directly to customers. This will subsequently boost infrastructural finance required for revamping the ailing industries in key sectors of the economy. 

I expect the new exchange rate regime to facilitate international trade and investments into Nigeria. It will also enable transparency and stability in local pricing for goods and services.

Ayodele Ojo BSc (UNILAG), MSc Real Estate (KTH,Sweden), AIRPM(UK) a public affairs & business analyst writes in from London, UK.