Jul 14, 2010 By Babajide Komolafe

 

Continuous defense of the naira by the Central Bank of Nigeria (CBN) could lead to faster depletion of the nation’s foreign reserves, say analysts at the Financial Derivative Company Limited.“CBN’s commitment of supporting the Naira at any cost is having the undesired effect of depleting external reserves.

 

Reserves have dipped by over 13 per cent year-to-date despite foreign exchange income from oil production (well over 10,000mbpd) and a year-to-date average oil price of about $79pb,” they said in July monthly economic report of the company.The naira, they maintained, is presently overvalued against the dollar based on the Purchasing Power Parity (PPP) concept.

 

The report stated, “The PPP is a concept founded on the law of one price; the idea that in absence of transaction costs, identical goods will have the same price in different markets (countries).“The theory states that exchange rate adjusts so that an identical good in two different countries have the same price when expressed in the same currency. When a country’s domestic price level is increasing (inflation), that country’s exchange rate must depreciate in order to return to PPP.

 

“Using the same methodology as the Big Mac Index (which looks at the prices of a Big Mac burger in McDonald’s restaurants in different countries), we test the PPP theory for urban Nigeria. A basket of goods has been selected and priced (market price) in their domestic currency.“The result shows that the Naira is grossly over-valued by 15 per cent while against the Pound Sterling, it is under-valued. The differential, according to the PPP theory, is attributed to price (inflation) differences between the countries.

 

“With inflation rate of about 2 per cent and 3.7 per cent in the US and UK respectively, actual inflation rate for Nigeria should range between 17.84 per cent (15.84+2) and 18.17% (-14.47-3.7). There are, however, constraints to the use of this concept such as rounding errors, carrying cost, composition and size of the basket.“Correcting for these shortfalls will help for better accuracy. Inspite of the obvious setbacks the PPP framework for deriving a country‘s real equilibrium exchange rate has, it is usually not far from reality as shown by the Big Mac Index.

 

“The Naira should therefore move towards its long run equilibrium level according to the PPP. In other words, the Naira is expected to depreciate against the dollar or face serious speculative pressures and further depletion of reserves. The Naira is also expected to appreciate against the Pound Sterling in the long run.“The simultaneous pressure emanating from escalating inflation risks, real exchange rate disequilibrium, and negative real interest rates can be viewed as a perplexing dilemma for which the CBN must find a solution.

 

“In the recently concluded 10th International Economic Forum on Africa held in Paris, Governor Sanusi highlighted what could be the monetary policy priority of the apex bank in the near term. In an interview with Reuters, the governor disclosed that maintaining exchange rate stability in a time of growing global economic uncertainty was imperative.“Maintaining currency stability at all cost implies more frequent intervention in the foreign exchange (forex) market by the CBN in a bid to defend the Naira and at the expense of building the foreign reserves.”

 

Nigeria‘s foreign reserve was approximately $37 billion at the end of June. Over 80 per cent of this was dollar denominated 10 per cent in Euros and the rest in other investments such as gold.The CBN is also contemplating diversifying its forex reserves to include other currencies, in particular the Chinese Yuan. This is a strategic move that could benefit the country in the long term; however, like most investment decisions, the diversification of re-serves to the Yuan is not risk free. Year-to-date, about 9 per cent of the country’s reserve has been lost – partly due to the loss in the value of the euro but mainly because of increased speculative activities.

 

In the same period last year, over 20 per cent of foreign reserves were eroded due to high speculative activities.“In recent weeks, demand pressure in the forex market has amplified. A look at activities at the WDAS auction in May show that forex demand grew by 66 per cent to $3.2bn, compared to the preceding month. Most of the growth in demand for forex was speculative as the Naira continues to come under huge pressure in the parallel market.

 

“The spread between parallel and official rates is widening to levels last seen in December 2009 and early January 2010. If this pressure persists, and we expect it to, then the nation’s forex reserves could deplete faster than the CBN anticipates.“The market will see this as a sign of weakness and an un-sustainable defense of the Naira. This will lead to a further increase in currency speculation.”

 

(Source:Vanguard)