CBN’s FX policies spurred popularity of the parallel market

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The parallel market in Nigeria is out of favour with policy makers again, but it is still wildly popular among economic agents. Godwin Emefiele, the Governor of the Central Bank of Nigeria (CBN), described the parallel market as “a tainted market in Nigeria, where people who desire to deal in illegal foreign exchange transactions including sourcing of FX cash for purposes of offering bribes, corruption. That is where they deal.” This was during the press briefing following the Monetary Policy Committee (MPC) meeting of November 24, 2020.

The Governor warned participants in the market and wondered why it has become the reference rate for many rather than its administered rate. What that speech was meant to achieve is unclear because the CBN is the single largest supplier to BDCs, a huge player in the parallel market. In this regard, it is hard to overlook the CBN’s missing sense for irony: between 2018 and 2019, the CBN sold $22.1bn in FX to the BDCs. The CBN only shuts out the parallel market when it faces an FX supply crunch, like in 2016 when it stopped sales to BDCs.

That accusation is only a part of the Governor’s assault. To further discredit the market, he claimed that “the parallel market as far as we know it and the data that we have, is a shallow market in Nigeria with no more than 5 percent of market share.” But the parallel market outside the BDCs is largely informal, including the traders under trees, in hotels, on the streets, in local markets, and peer to peer transactions, among others.

This makes the reliability of CBN’s estimate of its size very suspect. One could further argue that size is of no significance if the supposed robust market under the CBN’s watch and with 95 percent control can barely fulfill its functions. Although the parallel market is described as shallow, the CBN’s many FX restrictions for over 40 products and capital controls continue to deepen the segment.

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The international community as well as the businesses and people operating in the Nigerian FX market take the parallel market seriously and reference the rate. They would pay little attention to CBN’s claims because there is illiquidity in the CBN’s favoured segment of the market. Where official channels have struggled, the parallel market segment has been helpful in meeting FX demand and in ensuring that holders of FX receive better value for money. This is why exporters and investors have chosen the sidelines rather than do business with the CBN, ignoring the investors and exporters’ window that was created for, and named after them. Based on this, it would seem obvious that the CBN is fighting a lost battle.

One might wonder why the CBN has turned on the market for which it is the single largest supplier and the main driver of its popularity. A look at recent and past history would indicate that the tirade was not unexpected; it has become frequent with each episode of FX supply challenges.

Historically, the parallel market’s popularity has been tied to the poor approach of policy makers to exchange rate management during a crisis. In periods of stability brought by oil booms, the parallel market plays its role without much regulatory attention. In a crisis, the Nigerian approach has always been to delay adjustments to the currency even when there is a considerable export shock that affects FX supply. Meanwhile, the parallel market is quick to adjust to changing FX dynamics, ensuring better liquidity than the official market.

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In the official market, an overvalued exchange rate is maintained even if it serves no value to the general public. The official market then loses credibility because the CBN cannot meet FX demand at its quoted rate, pushing users of FX to alternative channels. As a result, prior to the exchange rate reforms in the 1980s and afterward, the parallel market had always been relied on to provide a more efficient, even if imperfect, pricing of the naira.

The premium in the parallel market becomes a source of arbitrage for those who can access discounted rates at the official segment. The premium can be so significant to the extent that it signals to businesses that FX round tripping is a more profitable adventure, with huge implications for the economy. For the BDCs, which receive supply from the CBN at less than parallel market rate, this is usually a sweet deal. These suggest that the CBN plays a large part in the corruption happening in Nigeria’s FX markets.

What is responsible for this situation is how the CBN manages the currency during periods of stability and oil booms – high oil prices and external reserves. There is usually a convergence in the parallel and official market rates as the CBN has enough firepower to meet FX demand. The CBN maintains a strong currency, with little regard for changing fundamentals between Nigeria and its trade partners, which would suggest a devaluation. This comes at a cost to competitiveness as the Naira becomes overvalued and uncompetitive for non-oil exports. This also does not prepare the economy to accommodate shocks that come with commodity cycles. This was the case during the oil boom of the 1970s and even in the 2010s.

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Meanwhile, regular and predictable adjustments to the currency even in times of oil boom would be a better approach to exchange rate management according to empirical economic literature. It would help to ease the adjustment required during FX shocks, provide more resources to governments relying on oil revenues, properly guide economic agents and prevent the resulting economic slump that is a constant feature.

With this in mind, it is clear that the parallel market is here to stay, with its credibility in guiding rates intact. It is of little surprise that even the CBN does not ignore the market for too long. The popularity of the segment would depend on how the CBN continues to manage the exchange rate. The FX demand management of the CBN, capital controls and overvalued exchange rates would only further deepen the parallel market. The slow pace of financial inclusion also means it would remain a popular channel for many Nigerians.

The CBN is better served focusing on loosening its tight hold over the official segments rather than engaging in a fight with two forces it cannot control – oil prices which dictate FX liquidity and the parallel market which ensures a more efficient pricing of the exchange rate.

Ben Idowu, a financial analyst writes from Lagos.

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