Nigeria’s multiple exchange rate windows: How do the markets operate, and who can access them?

Overview of the Three Markets

The Official Market

This window is operated by the Central Bank of Nigeria (CBN) – the apex bank. It is used by the CBN to supply foreign currency to authorized dealers. Due to its role as the nation’s custodian of external reserves, it is the market’s largest supplier of foreign currency. The Central Bank of Nigeria (CBN) establishes an official market rate for foreign currencies, guiding the supply process.

How does the official market rate operate?

The official market rate acts as a reference for foreign exchange transactions. The CBN utilizes a managed float system, allowing market forces to influence the rate while curbing excess volatility. This official rate reflects CBN’s efforts to maintain stability and prevent the depreciation of the Nigerian currency.

Who can access it?

The official market rate is accessible to organizations like banks, foreign exchange bureaus, and other financial institutions that have been granted a CBN license to engage in the foreign currency market.

The Parallel Market

The parallel market, also referred to as the black market, diverges from the government’s official rate. It is a willing buyer, willing seller market and is susceptible to high volatility influenced by factors like political instability and speculation. Regional banks set their rates alongside the official CBN rate, while the parallel market rate, which often offers the highest rates and is most accessible, fluctuates based on prevailing market conditions.

How does the parallel market rate operate?

The parallel market rate is typically influenced by supply and demand dynamics, as retail buyers and sellers negotiate rates based on their assessments of the currency’s value. Often, the parallel market rate trades at a premium to the official exchange rate, and it is often a more accurate reflection of the true value of the naira given it’s the least regulated market.

Who can access it?

The parallel market is accessible to all, and Bureau de Change (BDC) entities play a role in providing foreign currencies in this market. BDCs have authorized access to foreign currencies as approved retailers, and despite misconceptions regarding their legality, these operators source currencies through official channels, mainly from banks.

In Nigeria, the black market thrives due to challenges in accessing foreign exchange from the official channel. The notable difference between the official rate and the parallel market rate has prompted the CBN to implement stricter measures to oversee BDC operators. This rigorous approach is exemplified by the recent apex bank policy, consolidating all three windows into one and adopting the rate at the Investors and Exporters (I&E) window, determined by market forces of demand and supply (willing buyers and sellers), as the sole rate.

The Investors and Exporters (I&E) Market

The Investors & Exporters (I&E) window serves as the market trading segment primarily for investors, exporters, and other wholesale end users. This platform facilitates foreign exchange trades at a market-determined exchange rate on a wholesale level.

Introduced in April 2017, the I&E Window aims to enhance liquidity in the foreign exchange market and ensure prompt execution and settlement for qualified transactions, as specified by the CBN. Exchange rates for transactions within this window are agreed upon between authorized dealers and their counterparties, promoting transparency and liquidity. Before the creation of this window, the economy had cooled and entered a recession in August 2016, when the National Bureau of Statistics revealed that GDP had decreased by 2.06% for the second quarter of that year. The government introduced this window in a bid to revive the real sector of the economy and improve international trade, although the jury is still out on the effectiveness of the policy.

How does the I&E market operate:

According to the CBN, this window was established to increase market liquidity for foreign exchange and guarantee prompt execution, for eligible international trade transactions.

Who can access it?

According to the CBN, suppliers for this market include exporters, authorized dealers, and portfolio investors. Given this, participants in this market can be any “wholesaler” with foreign currency seeking to swap for naira at a market-determined rate rather than the CBN’s official rate.

However, this process has been unsuccessful as market participants try to take advantage of the premium between the parallel market and the official market. Given the technicalities and bureaucratic tendencies of this window, it has largely proven ineffective as bottlenecks exist in accessing the window.

Evolution of the naira/dollar exchange rate

From 2011 to 2014, Nigeria experienced an economic boom fueled by a thriving oil industry. Oil prices soared to an average of US$109.75 per barrel, which helped the CBN maintain a largely stable currency, as the naira traded within a range of NGN155-156/USD between 2012 to 2014. Despite apparent stability, the depletion of foreign reserves and the Excess Crude Account (ECA) left the central bank with minimal fiscal buffers to uphold naira stability and overall economic health.

In 2015, amidst a sharp decline in oil prices, the naira weakened to an average of NGN193 against the US dollar. Despite dwindling reserves, the government maintained a fixed exchange rate of NGN197, rejecting expert recommendations for devaluation. Emphasizing agricultural and solid mineral development, the government aimed to counter the impact of the global oil market downturn.

Figure 1: US Dollar/Nigerian Naira Exchange Rate Trend (2014 – 2024)

In June 2016, the Central Bank of Nigeria ended the fixed exchange rate between the Nigerian naira and the US dollar, causing a substantial devaluation exceeding 40%. The decision aimed to alleviate mounting pressure on the nation’s foreign reserves due to falling oil prices. As a result, the naira weakened to NGN280/US$, and by year-end, it declined further to an average of NGN315/US$, marking a significant 64.5% drop from the previous year.

With oil prices averaging US$43.58 per barrel and hitting a low of US$26.21 per barrel, the Nigerian economy faced formidable challenges. To manage the devaluation, the Nigerian central bank introduced multiple exchange rates, including the Nigerian Autonomous Foreign Exchange Rate Fixing (NAFEX), which established a market-driven rate for investors and exporters (I&E).

Since 2018, the central bank has implemented numerous devaluations in pursuit of financial stability, yet by December 2022, the exchange rate had reached NGN488/US$. On Wednesday, June 14, 2023, the Nigerian government, in a bid to mitigate the effects of currency rate volatility, announced the consolidation of the foreign exchange market, allowing market forces (I&E) to determine prices. The Naira traded between N750 to N755 but closed at N632. The naira has since significantly lost value, currently trading at N1,490/$1 as of Monday, May 20, 2024. However, time will play a role in stabilizing the exchange rate as the market adjusts from the artificial premiums of the parallel market.

The impact on investor appetite and adverse growth in sectors such as energy

The naira’s depreciation has affected foreign investors and local businesses in Nigeria. For investors, it impacts portfolios denominated in Naira, while businesses face increased production costs. Naira devaluation also fuels inflation, particularly in an import-dependent economy like ours. Pricing risks emerge from varied exchange rates, complicating price adjustments and potentially impacting sales. Liquidity risks stem from uncertain foreign currency availability, undermining investor confidence in the convertibility and repatriation of their investments at a preferred time.

In my role as an investment advisor at CrossBoundary Advisory, I collaborate closely with numerous off-grid renewable energy companies. Just like businesses in other sectors, they grapple with exchange rate challenges. In Nigeria, the fluctuating exchange rates of local and foreign currencies have complicated investor planning and added to market uncertainty. This uncertainty can drive investors to hesitate or explore alternative markets due to unclear asset valuations.

Despite robust demand for crude oil, Nigeria’s foreign currency production capacity was hampered by the sharp decline in global oil prices during 2015 and 2016. The stark depreciation of the naira against the dollar has discouraged investors, resulting in diminished foreign cash inflows into the country. Consequently, a weaker exchange rate may inflate import costs for goods and services, adversely affecting businesses reliant on imported materials. In the off-grid sector, companies may face challenges affording equipment and materials for sustainable power solutions in remote areas. The process of accessing foreign currencies for imported machinery can escalate operational expenses and pose logistical hurdles, leading to frequent price adjustments for consumers.

According to a USAID Power Africa report by Deloitte, hard currency financing accounts for 93% of capital deployed into the off-grid sector since 2018. This reliance exposes most off-grid companies to the fluctuations of the foreign exchange market, significantly impacting their profitability. Nigeria’s off-grid companies predominantly generate revenues in naira. However, capital expenses (generation and distribution components) are mostly imported and incurred in foreign currency, which exposes them to foreign exchange risk due to currency creating a mismatch. The reluctance of local financial investors, primarily commercial banks, to fund solar off-grid initiatives exacerbates challenges for the sector. Typically, funding is sourced from entities experienced in off-grid processes, such as the US$550 million Nigeria Electrification project, supported by the World Bank (US$350m) and African Development Bank (US$200m), which was initiated in 2018 when the exchange rate averaged NGN361/$. This project is slated for completion by 2025; however, the rate as of May 2024 stood at NGN1,490/$1, greatly influencing repayment considerations.

Conclusion

Given these considerations, I argue that the government should implement transparency and accountability measures, such as regularly publishing economic data, developing regulatory frameworks, and upholding the rule of law, to build market trust. Additionally, I see the recent unification policy of the new administration as a significant step in restoring confidence in the market, although it is not without its flaws. J.P. Morgan has expressed optimism about the exchange rate unification, believing it will offer long-term stability for the naira, especially when combined with anticipated economic reforms from the government.

I believe this policy will improve transparency, level the playing field for Nigerian businesses, eliminate arbitrage from multiple exchange rates, and attract more foreign direct investment. Successful exchange rate unification hinges on careful planning and coordination among the government, the Central Bank of Nigeria, and private sector stakeholders. We’ll continue to watch the market to see how things evolve.