Foreign exchange reserve held in the Central Bank of all countries is the lifeline of any country: big or small economy. The adequacy of foreign exchange reserve is particularly important because of the inconvertibility of many national currencies and the absence of some currencies as international reserve currencies which makes it impossible for such countries to borrow or consummate international transactions in their own currencies. The implication of this is that low foreign exchange balance can cause currency crisis which ultimately can lead to social unrest in a country.
History is replete with such cases. From the 1997 Asian Financial Crisis, to Latin America economic crisis, Russian financial crisis and the economic downturn of Nigeria upon the collapse of commodity prices in 2014; the common variable is that all economies involved did not have sufficient foreign currencies to defend their local currency which led to capital flight and loss of investor confidence and the unavoidable attendant challenge of currency crisis or banking crisis or both.
In view of this, Nigeria, a country dependent on crude oil revenue as a principal source of foreign exchange must learn to treat oil boom as temporary and oil bust as permanent while adopting other engines of growth like manufacturing and export promotion to insulate it from what many analysts have arguably described as the original sin.
So how does exchange rate works and how can an optimal exchange rate be predicted. This questions are very important because a country must choose between what is political popular or desirable and what is economically feasible. At this stage, we can compare international reserve currency, for instance dollars to Apple and Nigeria’s Naira to Orange. If the exchange rate of Nigeria is $1 to N1, then we can safely assume we need to 31billion naira to consume the $31bn foreign exchange balance of Nigeria. This makes no economic sense. The consequence is that we have equalized apple to orange. But if exchange is set at $1 to N10 for instance, it then follows that we have been realistic enough to appreciate that Naira is of less value to US dollars and in this case N320bn will be required for complete exhaustion of $32bn which then means that the rate of depleting US dollars has been reduced. To expand the argument, Nigeria’s foreign exchange can last more months of imports and it will take sufficient time for balance of payment problems to ever occur.
But a lot of people would be quick to mention that many years ago, Dollars and Naira were almost at par. The answer is that, indeed, that was many years ago. Many years ago, Nigeria exported cash crops like Cocoa and Rubber before the easy money from oil accrued to government coffers and attendant Dutch Disease. Additionally, few Nigerians travelled abroad for all kinds of tourism, education and the proclivity for imported goods (GUCCI, other designers and private jets) were at the lowest ebb. But things have changed so dramatically, we all want to be educated at Harvard, MIT and Oxford so we need dollars to settle tuition fees and other allowances.
Although there are not one size fits all to economic management, nevertheless, anyone who cares about the recipe for economic development today will be willing to understand what some East Asian dragons, notably South Korea and Japan have done right. I sight this example because in 1960, the per capital GDP of Nigeria and South Korea were $1,442 and $1,610 respectively. South Korea had since grown dynamically and its GDP per capital stood at $28,702 as at 2010. If there is one thing some Asian countries have done right, it is sound macro-economic management and predictable exchange rate over a long period of time. I will now bore my readers a little bit by technically highlighting foreign exchange reserve and exchange rate of some major economies.
Japan, South Korea, China, Russia, Indonesia and Vietnam have foreign reserves of $1.2tr, $377bn, $3.02tr, $400bn, $123bn and $28bn with an exchange rate of 113 Yen, 1,123 Won, 6.9RMB, 57 Rubble, 13,332 Rupiah and 22,705 Dong to a US Dollar respectively. Nigeria has foreign reserve of $32bn and an official exchange rate of N305. You will notice that none of the countries mentioned above set their exchange rates at par with the United States Dollars because an attempt to do so will make their export expensive and less competitive in the international market which will also lead to fast draining of foreign reserve. This, perhaps is the reason why they have been able to save large amount of foreign reserve which insured them against possible currency crises.
In view of the complexities around foreign exchange as I have explained, an economically feasible exchange rate and not politically popular exchange rate is required. We must now bear in mind that an overvalued Naira will make imports cheaper and Nigerian exports expensive and vice versa. Nigeria has to establish competitive exchange rate that will promote exports, create badly needed jobs and attract much needed FDI with associated technologies. At this point, it is important to note that what really matter is consistent and predictable exchange rates to boost investors’ confidence. For instance, China operated an exchange rate regime that was predictable and consistent over many years and this enhanced the rate of inward Foreign Direct Investment to China.
The periodic intervention of CBN in the FX market suggests that CBN sells dollars to maintain a strong Naira. This regular intervention shows that the demand for greenback outweighs its supply in the market. The implication of this come in many folds. First, depletion of foreign reserve means bad economic positioning for the raining day. Second, high interest rest in an attempt to prevent capital flight which will definitely take its toll on the real economy by increasing cost of credit. With the sustained increase in the price of oil, then intervention may continue but might not be sustainable should production drop or slash in the price of oil caused by glut in international market. Our exchange rate must reflect the reality of Nigeria’s economic structure in such a manner that the currency is neither overvalued nor undervalued but set at almost equilibrium to help achieve the country’s short and long term economic objectives.
Therefore, what really matter is a predictable and consistent exchange rate regime. It is politically desirable to set Naira at par with Dollars but this can only remain a wishful thinking in view of prevailing circumstances. Setting the right exchange rate will also eliminate the difference between official and black market rates. This can be achieved by bearing in mind the elasticity of Nigeria’s imports to exchange rate.
As Nigeria, now takes economic diversification more seriously, focusing on labor intensive industries and economy of scale, the word of the great political-economy philosopher- Adams Smith, suffice: “The wealth of nations comes not from the exploitation of precious metals but from deepening division of labor that enhances productivity.”
Kolawole Omole, Masters Student, Public Administration/Development Policy, ISSCAD, Peking University, Beijing.
