A little over two months after the Central Bank of Nigeria (CBN) consolidated the various segments of its multiple exchange rate structure into a unified floating exchange regime, foreign exchange (FX) shortages have worsened, with the naira plunging to new lows in both the official (Investors and Exporters (IEFX) window) and the parallel market – seemingly on a daily basis.

The initial wave of optimism, triggered by the raft and accelerated pace of reforms enacted by the new administration, has now given way to uncertainty as the FX supply question continues to puzzle market participants and policymakers. Foreign investors, many of whom have been badly burnt in the past, are largely in “wait and see” mode, watching with keen interest the level of transparency, efficiency and credibility of the new FX regime. This is in addition to keeping one eye on the strategic sequencing of the next set of reforms, and how they are expected to dismantle long-standing structural bottlenecks that have constrained Nigeria’s business climate for decades.

Reverse Convergence

The ensuing volatility and the steep slump in the value of the naira at the Investors and Exporters window in the immediate aftermath of the policy announcement was largely expected given the significant backlog of unmet FX demand, estimated at circa $12 billion. As at 21 June, a week after the effective liberalisation of the FX market, the naira had lost 38.7% to trade at ₦763/$ at the IEFX window – at par with the parallel market rate. However, in the seven weeks that have followed, banks have largely been unable to come up with the dollars to meet FX demand, and buyers have increasingly turned to the parallel market, widening the gap between the official exchange rate and the alternative markets. As at 15 August, the naira closed trading at the IEFX at ₦774/$ while the parallel market rate traded at ₦940/$, pushing the premium to ₦166/$ (21.4%) and creating the incentive for round-tripping, which was pervasive under the previous multiple exchange rate system.

Figure 1: Exchange Rate (₦/$)

Source: The CBN

The gross external reserves level had lost 8.6% year-to-date as at 13 August 2023 to $33.8 billion. While the CBN has categorically stated that it would conduct periodic interventions in the FX market, a review of its recently released audited accounts reveal a $13.8bn exposure to JP Morgan, Goldman Sachs and FX Forwards, leaving the Apex bank with significantly less ammunition (40% less) than initially thought to embark on its planned FX interventions. The net reserves are now estimated at $18.6 billion, which is sufficient to cover an estimated 3.5 months of imports of goods and services compared to the 6.46 months that was previously brandished as at April 2023.

Figure 2: Gross External Reserves ($’ Billion)

Source: The CBN

At the same time, FX turnover on the Spot market fell substantially (by 39.71%) in July to $4.66 billion after a 22.48% increase in June to $7.73 billion as the initial market euphoria faded and the supply question became increasingly louder.

Figure 3: FX Turn Over ($’ Billion)

Source: FMDQ

In addition, Nigeria has what many might call an excess liquidity problem. Money supply (M3) has surged to an all-time high of ₦64.9 trillion while the real return on 364-day Treasury Bills remains firmly in negative territory (averaging -13.6% so far in 2023), which is fueling the demand for FX as well as equites.

A Silver Lining?

Nigerian companies with significant dollar debts have suffered significant currency-related losses, and many more, reeling from the double whammy of heightened FX costs and inflationary pressures, are now seeking to import goods ahead of Christmas season sales and, as a result, we expect currency pressures to intensify in the coming weeks. This is in addition to the impact of increased FX demand stemming from overseas school fees payments. Nonetheless, the silver lining is that many companies, unable to access FX to import raw materials, are now substituting imported raw materials with locally produced items and also expanding exports to boost FX earnings, in a bid to curb dependence on external sources for foreign currency.

Who needs a Parallel Market?

The CBN is putting the blame for the downward spiral in the parallel market partly on the diversion of diaspora remittance inflows to unofficial channels, which is starving the official FX market of inflows. The CBN has stated the ‘what’ and the ‘where’ without crucially addressing the ‘why’. Remittances from the diaspora, estimated at $20.13 billion in 2022, have risen substantially in the past decade, playing an increasingly essential role in Nigeria’s economy, serving as an important source of FX earnings and a catalyst for economic growth and development. While the slow economic recovery and cost of living crises that confronted many developed economies in 2022 constrained remittance flows into Nigeria, the implementation of capital controls and other unpopular policies by the CBN also restricted inflows through official channels. As the parallel market premium widens, we expect diaspora inflows through the unofficial channels to increase further.

The liberalisation of the FX market was supposed to allow the naira trade freely, so why does the parallel market still exist? On one hand, businesses and individuals are looking for any means to access FX in the face of worsening scarcity. On the other hand, the restrictions on access to FX via the official market for the import of 43 items remain in place as part of the CBN’s import substitution objective within its development strategy. This, in itself, is a form of capital control and implies that importers of these ‘restricted’ items will simply access FX via alternative channels. We believe that these restrictions continue to send a negative signal, particularly to foreign investors, and that the CBN should now adjust its approach to achieving its import substitution goal by abandoning these restrictions in favor of fiscal tools (tariffs), which reflect the Common External Tariff of the Economic Community of West African States (ECOWAS), and are aimed at making domestic production relatively more competitive than imports. This will be critical in minimising the current distortion in the FX market.

The absence of red tape in the parallel market and the growing adoption of digital channels, particularly by FinTech Money Transfer Operators (MTO) and blockchain-based digital currencies due to their speed, convenience, seamlessness and cost-effectiveness continue to make the alternative FX market more preferred. Banks, bogged down by regulatory bottlenecks and institutional requirements, are struggling to play catch up in this regard.  For instance, a recently instituted regulation requires customers to present their tax clearance certificates (TCC) before they can access FX from banks, pushing even more buyers to the alternative FX markets. This is a particularly worrisome constraint in a country where the informal sector is estimated to account for as high as 80% of GDP with many not having the tax certificates.

Low Hanging Fruit

At the crux of the matter remains Nigeria’s external imbalance problem and the CBN still obsessively seeking to manage FX demand. In the medium- to long-term, we expect greater fiscal and monetary policy coordination as well as the elimination of structural rigidities to build investor confidence and invisible flows. However, a short-term solution to FX scarcity requires the ‘de-bottlenecking’ the official FX market to incentivise supply, in addition to enacting reforms targeted at squarely addressing insecurity in the Niger Delta region to restore oil production to at least OPEC-sanctioned levels of 1.38 million barrels per day and benefit from relatively higher oil prices (average of $80 in 2023).