The reduction in oil price has brought exchange-rate risk back to the forefront in Nigeria; creating foreign exchange instability which has seen the nation, an import-dependent economy continually spending more while generating little foreign exchange income. This has left the economy in a vulnerable state. More often than not, nominal exchange rates tend to draw the most attention to the less volatile factors which when touched, has the potential to create major vulnerability in an economy.
In theory, when commodity prices are falling as local currency values were rising, purchasing power would stabilise due to cash inflows, and there would be no real foreign exchange risk. However, in Nigeria’s case, the crash in oil price and the little generation of earnings in foreign currency has created a huge imbalance. Nigeria spending more foreign currency on importations and earning less foreign currency; creating a deficit. Along with this deficits are obvious risk but tend to be misleading factors, demanding immediate interventions, which creates a chain reaction of more erratic risks.
Many developing nations, when faced with this challenges tend to rush to managing the visible risks immediately. For example, micro-managing FX transactions, pegging the Naira, currency swaps, trying to control currency futures and options. Such tactics often negate longer term views as they act as temporary solutions to underlining severe and more permanent issues . These kinds of risk mitigation would down the line see Nigeria face greater exposure to the less obvious risk that is more challenging to manage and these risk may in the nearest future become unmanageable. For example, trying to manage a risk which stems from a mismatch between cost and investments in one currency and revenues in another will create risks which are initially difficult to forecast.
Understanding where and how foreign exchange fluctuations affect the nation’s cash flow is not a straightforward case and no amount of research can accurately prevent risk likely to arise. Various factors from macroeconomic trends to internal competition within market segments determines how foreign exchange rates affects the economy. While economist use mathematical risk-management tools in analyzing risk, development economists lean more towards understanding where and how exchange rates can drive or derail the economy. Each of these arising risks will influence cash flows and value in various ways, thus, requires context-specific approach in risk mitigation.
Presently, Nigeria has already made some economically unintelligent decisions by rushing to manage immediate risks that were apparent as soon as the shift in commodity pricing occurred. There are no easy ways to undo these decisions, so the only viable option is to ensure that things don’t get out of hand. Here is how;
Take a holistic perspective
Foreign exchange risk should not be managed in isolation of intense policy research, as doing so could trigger more hazardous risk. For example, if Nigeria is borrowing and signing a loan $6bn deal with the IMF today for 2017, it should consider buying the loan required today and enter a forward contract for a fixed rate whereby, changes in exchange rates does not affect repayment rate. Understanding where and how foreign exchange risk triggers one another in a vulnerable economy is crucial for effective mitigation of these risk.
Focus on cash flow, not earnings
Often times, the country’s accounting report fails to draw attention to the most important aspect of currency risk; cash flow. For example, the nation’s reserve contains information on FX gains and cumulative adjustments from translating foreign currency- designated assets and liabilities without separating assets from liability in the final analysis; when the focus is placed on earnings it negates cash flow activities, and cash flow is the truest reflection of reality.
Additionally, it is common for economist to look at just numbers in financial report, the most vital effects of changes in currency rate comes from structural risk analysis. As a matter of fact, standard financial reports often lead analysis to misleading conclusions about a nation’s reserves by overstating the accounting impact on incomes earned as opposed to the real effect of cash flows. The finance ministry should focus on the potential risk created by spending more than what is going into the reserves.
Secondly, it is common for commodity-dependent nations to struggle whenever there is a negative shift in commodity price, however, it is wise for a government in such scenarios to avoid the temptation of try mitigating all of the risks that are induced by shocks in commodity prices.
Furthermore, the main reason why mitigating obvious risk in this scenarios is a given is such risks are initially very obvious creating a panic that requires immediate actions. However, mitigating the risk more often than not create a chain reaction of more harmful risks that were initially less obvious. For instance, price fixing, currency pegging and control are ideal when oil price makes a free fall from $89 to $37 per barrel, what is not considered in such decisions making process is the chain reactions it is likely to create in the macro economy that will overflow negatively into the entire economy.
Fourthly, the current economic condition of price fixing and FX irregularities shows that the Central Bank of Nigeria(CBN) is the main driving force in economic policy making and this should not be so. Central banks are banks regulatory body and because they are market driven, being that a market-driven approach to managing an economy is more often that not shallow and is hardly based on real research on longer-term development goals, a Central Bank should under normal circumstances only act as a support to the finance ministry and not the other way round.
In conclusion, Nigeria should be able to stabilize and possibly grow the economy if the finance ministry with the appropriate support of the CBN takes a holistic approach that focuses on the effects of cash flows than on earnings and be fully adverse with the limitations of financial instruments and how to use them to the nation’s advantage. Both the finance ministry and the Central Bank of Nigeria should be transparent with each other about the risk they face and strategies developed to hedge these risk.