Flexible Exchange Regime: Meaning and Effects
“The Central Bank of Nigeria, CBN, yesterday, announced a flexible exchange rate regime aimed at making foreign currencies more accessible. With this action, the CBN has nullified the official exchange rate regime of N197/dollar. The CBN took the measure following severe pressures on external reserve and foreign exchange supply crisis. Governor of the CBN, Mr. Godwin Emefiele announced this at the end of the Monetary Policy Meeting.” – Vanguard
Flexible Exchange Rate: What Does it Mean?
The other day, I warned that we are in a recession. I am happy to note that the CBN just confirmed it. Anyway, let us discuss this new policy of CBN. A floating (flexible) exchange rate is a country’s exchange rate regime where its currency is set by the foreign-exchange market through supply and demand for that particular currency relative to other currencies. Thus, floating exchange rates change freely and are determined by trading in the Forex market. This is in contrast to a “fixed exchange rate” regime, which was in practice prior to yesterday.
An exchange rate is simply the price of one currency in terms of another. The process by which that price is determined depends on the particular exchange rate mechanism adopted. In a floating rate system, the exchange rate is determined directly by market forces and is liable to fluctuate continually, as dictated by changing market conditions. In a ‘fixed,’ or managed rate system, the authorities attempt to regulate the exchange rate at some level that they consider appropriate. Such a system often seems appealing to those who are troubled by the uncertainties of the present, highly volatile, floating rate environment.
But the choice of exchange rate regime involves considerations that extend beyond the stability or otherwise of currency prices. This will become clearer after an examination of some fundamentals of the foreign exchange market.
In a floating exchange rate regime the price of the US dollar, like any other market-determined price, depends on the relevant forces of supply and demand. But what are the relevant forces of supply and demand in the foreign exchange market? To try to answer this question, let us consider, for illustration, the factors that determine the relationship between the American dollar and the Naira.
Nigeria requires dollars to pay for their imports of goods and services and to fund any investment they may wish to undertake in this country. Assume that they obtain these dollars on the foreign exchange market by supplying (selling) Naira in return. So our demand for dollars is determined by our exports and our capital inflow from other countries. On the other side of the market, the demand for dollar is determined by our need to pay for imports from other countries, and for any capital investment that we undertake there. We buy those dollars by supplying the Naira in return.
In summary, then, the demand for dollars reflects the behaviour of our exports and capital inflow, while the supply of dollars reflects the behaviour of our imports and capital outflow. In other words, transactions on the foreign exchange market echo the international trade and financial transactions that are summarised in the balance of payments. Within the balance of payments, the relationship between our exports and imports of goods and services is captured by the balance of current account, while the relationship between capital inflow and capital outflow is captured by the balance of capital account.
The distinguishing characteristic of a floating exchange rate system is that the price of a currency adjusts automatically to whatever level is required to equate the supply of and demand for that currency, thereby clearing the market. The logic of the relationship between our international transactions and the supply and demand for currencies implies that this market-clearing, or ‘equilibrium’, price also produces automatic equilibrium in the balance of payments. That is, the balance of current account (whether positive, negative, or zero) must be precisely offset by the balance (negative, positive or zero) of the capital account. Under floating exchange rates, these outcomes are achieved automatically without the need for government intervention. By contrast, under fixed exchange rates, balance of payments equilibrium is not the normal condition.
These characteristics of the floating exchange rate mechanism have important implications both for the nature of our relationship with the global environment and for the policy options available to the authorities in managing the economy. Let us now consider some of these implications:
(a) Shock Absorber
A flexible exchange rate acts as a kind of shock absorber that helps to insulate us against overseas disturbances. This is because the relationship between our international transactions and the foreign exchange market runs in both directions. Simply put, a recession in any country we import items from will insulate our economy, to some degree, against international economic instability. By the same reasoning, floating exchange rates also help to diminish the international transmission of our own domestic economic instability.
(b) Balance of Payment
In a fixed exchange rate regime, the need to manage the balance of payments often creates difficult conflicts with the government’s domestic policy objectives. By ensuring automatic balance of payments equilibrium, floating exchange rates can liberate economic policy from this constraint, allowing the government to concentrate more easily on such internal issues as full employment and price stability. But note that balance of payments equilibrium means nothing more than that the current account and the capital account sum to zero.
(c) Monetary/Fiscal Policies
Exchange rate flexibility increases the effectiveness of monetary policy, and diminishes the effectiveness of fiscal policy in regulating the economy. Suppose, for example, that there is a perceived need to stimulate the economy with a view to reducing unemployment. The appropriate monetary policy action is for the Central Bank to reduce interest rates. This causes a depreciation of the Naira, which in turn encourages exports, discourages imports, and increases net capital inflow.
These exchange rate effects tend to reinforce any initial expansionary impulse resulting from the change in monetary policy. By contrast, where the exchange rate is fixed, monetary policy is quite ineffective. Indeed, the logic of a fixed exchange rate system essentially precludes the conduct of an independent monetary policy.
The above helps to explain why fiscal policy has come to be overshadowed by an increased reliance on monetary policy as the primary instrument of macroeconomic stabilisation.
Effects of a Flexible Exchange Rate on an Economy
While the impact of a currency’s gyrations on an economy is far-reaching, most people do not pay close attention to exchange rates because most of their business and transactions are conducted in their domestic currency. For the typical consumer, exchange rates only come into focus for occasional activities or transactions such as foreign travel, import payments or overseas remittances.
A common fallacy that most people harbour is that a strong domestic currency is a good thing because it makes it cheaper to travel to Europe, for example, or to pay for an imported product. In reality, though, an unduly strong currency can exert a significant drag on the underlying economy over the long term, as entire industries are rendered uncompetitive and thousands of jobs are lost. And while consumers may disdain a weaker domestic currency because it makes cross-border shopping and overseas travel more expensive, a weak currency can actually result in more economic benefits.
The value of the domestic currency in the foreign exchange market is an important instrument in a Central Bank’s toolkit, as well as a key consideration when it sets monetary policy. Directly or indirectly, therefore, currency levels affect a number of key economic variables. They may play a role in the interest rate you pay, the returns on your investment portfolio, the price of food items in your local market, and even your job prospects.
Currency Impact on the Economy
A currency’s level has a direct impact on the following aspects of the economy:
Merchandise trade: This refers to a nation’s international trade, or its exports and imports. In general terms, a weaker currency will stimulate exports and make imports more expensive, thereby decreasing a nation’s trade deficit (or increasing surplus) over time.
A simple example will illustrate this concept. Assume you were an exporter who sold a million pieces of Aba made shoe at $10 each to a buyer in Europe two years ago, when the exchange rate was USD1=197 NAIRA, the depreciation in our domestic currency would still make your shoe business competitive in international markets.
Conversely, a significantly stronger currency can reduce export competitiveness and make imports cheaper, which can cause the trade deficit to widen further, eventually weakening the currency in a self-adjusting mechanism. But before this happens, industry sectors that are highly export-oriented can be decimated by an unduly strong currency.
Foreign capital will tend to flow into countries that have strong governments, dynamic economies and stable currencies. A nation needs to have a relatively stable currency to attract investment capital from foreign investors. Otherwise, the prospect of exchange losses inflicted by currency depreciation may deter overseas investors.
Capital flows can be classified into two main types – foreign direct investment (FDI), in which foreign investors take stakes in existing companies or build new facilities overseas; and foreign portfolio investment, where foreign investors invest in overseas securities. FDI is a critical source of funding for growing economies such as Nigeria, whose growth would be constrained if capital was unavailable.
Governments greatly prefer FDI to foreign portfolio investments, since the latter are often akin to “hot money” that can leave the country when the going gets tough. This phenomenon, referred to as “capital flight”, can be sparked by any negative event, including an expected or anticipated devaluation of the currency.
It must be stressed however that a devalued currency can result in “imported” inflation for countries that are substantial importers. A sudden decline of 20% in the domestic currency may result in imported products costing 25% more since a 20% decline means a 25% increase to get back to the original starting point.
And for us in Nigeria, what this means is that with this policy of CBN, the prices of imported items will rise. And since we depend mostly on imports, we are all going to find it very rough, until and unless we deliberately cut down on our imports and patronise locally produced items.
Conversely, the policy will stimulate entrepreneurship. When faced with rising prices of imported items, we will be forced to look inwards!
At the end of the day, no single economic policy is bad, and no single one is good either. Much depends on what the government wishes to achieve. Economic policies are tools of achieving a set of economic objectives. A particular policy can be effective in South Africa whereas it can be damaging in Nigeria. A tool that a mechanic uses to fix plugs will not be what he will use to fix tyres.
Devaluation of currency and a floating exchange rate are good tools for an export oriented economy because, ultimately, imports are costlier while exports attract more money into the pocket. Unfortunately, we are import dependent. The policy therefore will force us to look inwards, patronise our locally produced goods and services. And even export. It will engineer entrepreneurship. I do hope that that is what the government is thinking of. If it is a short term policy of getting more funds from oil export, then it will not be in the interest of the masses.
Another sore point is the inconsistency of the government – there is so much policy reversal and this makes the environment unpredictable. And an unpredictable economy is a high risk that will deter investors.
I have my fears that this economic policy of a floating foreign exchange is aimed at shoring up revenue accruals from the exportation of oil. We basically do not have any other thing to export. I recommend a holistic surgery of the entire economy and not this quick fix approach to solving issues.
Anyway, time will tell!
Pat Mozea is an Economist & a Public Affairs Commentator
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