Nigeria’s central bank floats the naira

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In mid-June the Central Bank of Nigeria (CBN) introduced a flexible interbank exchange rate market, effectively floating the naira in a major departure from historical policy.

In the months since, the currency’s value has dropped by more than 35%, trading at approximately N400:$1 in mid-August, but the recent policy shift is expected to restore investor confidence in the country.

“The liberalisation is going to make the economy buoyant, and since the capital market is the engine room of the economy, it will also help to revive the market, as foreigners will like to mop-up stocks that have good fundamentals,” Mike Eze, managing director of Nigeria-based Crane Securities Limited, told local media in June.

Implications of previous policy

The CBN had previously kept the naira pegged at between N197:$1 and N199:$1 in the 15 months through to June. However, as a result of falling reserves and lower revenues, the gap between the official rate and parallel rate widened, where the naira traded nearly 60% lower.

Lower energy prices and decreased oil production, partly due to sabotage of infrastructure, has constrained Nigeria’s public finances. The country had previously relied on oil for two-thirds of its budget and 90% of export earnings.

As other major oil-producing countries – such as Russia, Kazakhstan and Angola – allowed their currency to devalue, the CBN deployed capital controls to stem the outflow of hard currency and stabilise the naira.

Under the previous regime, while the CBN allocated US dollars at the pegged rate to companies deemed strategic for the economy, the majority of importers and manufacturers could not obtain the foreign exchange needed to run their businesses. Importers were also banned from using foreign currency to purchase certain categories of goods, ranging from cement to toothpicks.

Factories that relied on imported raw materials and equipment were particularly affected and had to close operations or source currency on the more expensive parallel market, which was trading at N350:$1 in early June.

In defence of the currency, the CBN spent $4.7bn in the first three months of the year, with reserves falling from $34.2bn in December 2014 to $25.8bn by mid-August. At the same time, Nigeria’s GDP shrunk by 0.4% year-on-year in the first quarter of 2016, the economy’s first contraction in over a decade.

Effects of the FX regime mechanisms

In addition to introducing an interbank market for foreign exchange trading, the CBN has created a system of primary dealers, whereby a group of eight to 10 large banks will buy hard currency from the central bank in batches of $10m.

“To improve the dynamics of the market, we will introduce foreign exchange primary dealers, who would be registered by the CBN to deal directly with the bank for large trade sizes on a two-way quote basis,” Emefiele told international media.

While inflation could rise in the short term as a result of the policy change – FSDH Merchant Bank predicted inflation could rise from a 10-year high of 16.5% in June to 17.35% in July – this was in part limited by the fact that the majority of importers were previously unable to access hard currency at the official rate, so most imported goods already reflect the higher parallel market exchange rate.

For its part, the energy industry may face some near-term financing challenges as a result of the float.

According to Fitch Ratings, 45% of all Nigerian bank loans – many of which are for oil and gas companies – are denominated in foreign currency. Even after oil prices dropped by roughly 50%, many firms still had access to dollars at the cheaper, official rate to service their debts. These same companies will now be buying dollars at the higher market rate, which could impact their ability to repay loans.

Investor confidence

Despite these obstacles, the CBN’s move to float the naira has been broadly welcomed by the business community and is expected to facilitate long-term economic benefits as foreign investors return to the country.

The Nigerian Stock Exchange posted a 5.38% gain on the first two days of trading after the new foreign exchange regime launched, indicating positive investor sentiment.

However, the full benefits of the reform may take some time to materialise. According to Mustapha Suberu, lead of research and strategy at Eczellon Capital, a Nigeria-based investment bank, some foreign investors may still be cautious in the near term.

“They want to see how effective, efficient and transparent foreign exchange transactions will be at the interbank market. They want the initial volatility to play out and have a proper guide on what the true value of the naira may be,” Suberu told local media in June.

The process of shifting to a free float in Africa’s largest economy will likely take some time as well. Shortly after devaluation, the currency stabilised for just under a month, suggesting that the float is not yet fully liberalised. Furthermore, as of August, the official rate continues to diverge noticeably from the parallel market, indicating that the currency may still be overvalued.

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