Africa’s largest economy has finally floated its fixed currency exchange rate for the first time in history. The freeing of the Nigerian naira after months of policy debates saw the currency immediately plummet by 40%.
One would have to go back two decades to find parallels. South Africa – then Africa’s largest economy – also went through an agonising shift from a fixed exchange rate to a free-floating exchange rate after many permutations.
There are important lessons to be learnt from these two major African economies.
The management of exchange rates is one of the instruments used by a state in pursuit of economic development. How it manages its finances – fiscal policy – as well as trade policies are also key.
But in a globalised world the management of exchange rates has taken on added importance. This is because most countries have opened their economies by adopting export-led development, which is underpinned by a low cost of production and an undervalued exchange rate. The exchange rate value of their currencies therefore plays a vital role.
An exchange rate is a nominal value of one currency against another of a trading partner. For example the South African rand or Nigerian naira against the US dollar, pound or the euro. And citizens of a country buy, sell and get paid a wage by a currency.
But how do countries manage their exchange rates? In particular, how do they go about making sure the value of their currencies is working for rather than against them?
Options for managing currencies
Historically, most currencies were backed by gold as the standard for trade. This ended in the 1970s when the gold standard collapsed due to debt default and high oil prices.
Currencies backed by gold were accompanied by economic policies that put the state at the centre of economic policy. Known as Keynesianism, the logic was that increased government spending would lead to higher output and, ultimately, full employment. The collapse of the gold standard therefore also had an impact on how economies were managed. Countries were encouraged to put the market mechanism at the centre and privatise state assets. This was the foundation of what is now called neoliberal economic policies, characterised by a small government, privatisation of key institutions including health and education, and free-floating exchange rates.
Countries responded differently to the 1970s crisis, devising new ways to manage their currencies. Some adopted fixed currencies pegged against the currency of their major trading partner. A fixed exchange rate is sometimes called a crawling peg because of the movement of the currency within a band. Others allowed their currencies to float. Variations in between have also been tried. For example, within the floating model approach where the market is left to decide the value of the currency, countries have chosen to “manage” the rate by intervening in the market. And then there is the hybrid model under which the currency is allowed to float, but within a specified band.
The job of managing exchange rates falls under a country’s central bank, which controls monetary policy. Which regime it chooses has a direct impact on every aspect of an economy.
There are those very much in favour of fixed exchange rates, and just as many vehemently opposed to them. Some view a fixed exchange rate regime as too inflexible. Others point out that it reduces uncertainty in the face of international capital flows.
In the 1970s, after the collapse of the gold standard, South Africa fixed its exchange rate against the US dollar within a band. Similarly, between February 2015 and June 2016 Nigeria pegged the naira against the US dollar. It did this because of concerns about the currency depreciating against the dollar, making imports expensive.
The biggest weakness of a fixed exchange rate is that interest rate hikes in the pegged country currency may also strengthen the domestic currency. This inevitably leads to an excess demand of foreign goods and unsustainable external borrowing by government.
For example if the US increased interest rates and the dollar strengthened, the naira would also strengthen. Nigerians, experiencing a wealth effect, would respond by importing more. This phenomenon would not have been caused by factors in Nigeria, such as higher economic growth or higher oil prices, but because of actions by the US Federal Reserve. It is this artificial wealth effect that is of concern.
Both South Africa and Nigeria have abandoned this approach – South Africa in 2000 and Nigeria in 2016 – and replaced it with floating exchange rates. In the case of South Africa, various frameworks were adopted between 1960 and 1998, including exchange-rate targeting and an eclectic approach within a crawling peg.
Their decisions follow a global pattern where the policy choice in exchange rate management has shifted in favour of floating exchange rates.
Why South Africa changed course
In the 1990s the South African Reserve Bank paid a heavy price when trying to control the value of the country’s currency. In an effort to counter speculative activity in 1996 the bank sold about US$14bn into the market. In taking such action, it temporarily put a bit of a brake on the depreciation of the currency. But in the end the intervention only contained the depreciation from R3.50 to the dollar to R4.50 to the dollar.
In 1997 the bank intervened again, this time in two ways. First, it sold slightly more rand than it had bought, to the tune of about an extra $1bn. Second, it raised interest rates to 7% in real terms. Higher interest rates attract capital inflow thereby strengthening a country’s currency. The South African Reserve Bank relied heavily on this knowledge.
Once again these actions resulted in only marginally containing the depreciation of the currency.
Subsequent to this episode, there was a shift in the South African Reserve Bank’s policy. The bank adopted an eclectic approach that meant that not only the exchange rate mattered in monetary policy but also money supply.
Why Nigeria changed course
At the height of the oil price boom, Nigeria’s economy grew rapidly and overtook South Africa’s as the continent’s biggest economy. Inward investment in Nigeria grew and the country looked at investment opportunities elsewhere. Companies such as Oando listed on the Johannesburg Stock Exchange in South Africa. The Nigerian government also raised capital in international markets.
But when oil prices plummeted the country’s economic weaknesses were exposed. As the Nigerian dollar receipts dropped due to lower oil prices, the naira also weakened, prompting government to fix the currency in February 2015.
However, dollar receipts from the sale of oil continued to fall, making it difficult for importers. It also led to a scarcity of dollars. That in turn led to the development of a parallel dollar market that worsened the shortage in the formal sector. When there is scarcity of dollars, the dollar exchange rate market is illiquid making it difficult to pay dollar commitments.
The illiquidity and the difficulty to service foreign debt prompted the state to respond by floating the currency’s exchange rate. The aim was to discourage imports emanating from the parallel market and devaluing the naira.
It is not surprising that the naira responded by depreciating against the dollar to find its true value.
But Nigeria’s decision is no panacea for country’s ailing economy. This is true too of South Africa. Nigeria has to diversify its export basket away from oil. And South Africa has a host of structural problems it needs to address, such as high levels of unemployment, poverty and inequality.