CBN Edges Towards Free Float Of Naira With Discontinuation Of Cap On Forex

The Central Bank of Nigeria (CBN) has announced significant reforms in the foreign exchange market, signaling a stride towards a market-driven exchange rate mechanism, potentially paving the way for a free float of the Naira.

This follows last week’s circular removing caps on international money transfer operations. The CBN’s recent circular outlines pivotal changes, including the discontinuation of a cap on the spread in interbank foreign exchange transactions and the lifting of restrictions on the sale of interbank proceeds.

“A key objective of the ongoing foreign exchange market reforms by the Central Bank of Nigeria is to promote a market-based price discovery system,” the circular states, marking a shift towards a more liberalized forex regime.

“Under the new guidelines, forex transactions will operate on a “Willing Buyer and Willing Seller” basis, ensuring more flexibility in the exchange rates determined by market forces. The CBN emphasizes the importance of transparency and ethical standards, mandating that “Authorized Dealers are to continue to conduct their foreign exchange transactions…and to strictly adhere to high ethical standards.”

Lifting Caps and Restrictions

The circular explicitly states the removal of any cap on the spread between buying and selling prices in the interbank foreign exchange market.

This move is expected to enhance the liquidity and efficiency of the market by allowing more room for price negotiation.

Furthermore, the lifting of restrictions on the sale of interbank proceeds is anticipated to increase the availability of foreign currency in the market.

Willing Buyer, Willing Seller Basis

The CBN has mandated that authorized dealers conduct their foreign exchange transactions on a “Willing Buyer and Willing Seller” basis.

This directive aims to foster a more transparent, competitive, and efficient market, where exchange rates are determined by the market participants themselves, without fixed rates imposed by the regulator.

In addition to promoting market-based pricing, the CBN’s circular stresses the importance of maintaining high ethical standards and transparency in foreign exchange dealings.
Authorized dealers are expected to adopt appropriate price disclosures and ensure transparency in transactions, which is crucial for building confidence in the new system.

What this means

The move could be interpreted as a step closer to a free-floating Naira, where the currency’s value would be determined by supply and demand dynamics without direct intervention from the central bank.

While the circular does not explicitly announce a full transition to a free float, the reforms indicate a significant shift in policy direction.

Analysts view this development as a positive step towards aligning Nigeria’s foreign exchange market with global best practices. A market-driven exchange rate mechanism can enhance competitiveness, attract foreign investment, and potentially reduce the volatility associated with forex scarcity and speculation.

However, the transition to a fully free-floating currency requires careful monitoring and supportive fiscal policies to mitigate potential risks, such as excessive currency volatility and inflationary pressures. The success of these reforms will depend on the implementation fidelity and the overall economic policy framework of the Nigerian government.

Other implications

The implementation of the CBN’s foreign exchange market reforms, moving towards a more market-driven exchange rate system, necessitates complementary fiscal policy reforms to ensure the stability and growth of the Nigerian economy.

Specifically, reducing fiscal deficits and increasing government revenues are critical steps that need to be taken alongside these forex reforms. A reduction in fiscal deficits can help curb inflationary pressures by limiting the need for government borrowing, which often leads to an increase in money supply.

Increasing government revenues, through measures such as improving tax collection and diversifying the economy away from oil dependency, can provide the government with more resources to invest in critical infrastructure and social services without resorting to excessive borrowing.

In addition, the shift towards a market-driven exchange rate, as indicated by the CBN’s recent policy changes, has significant implications for inflation and the cost of imports in the short term.

By allowing the Naira’s value to be determined by market forces, prices for imported goods, which are often indexed to the exchange rate, could experience volatility as the market adjusts to the new regime.

This could lead to short-term inflationary pressures as the cost of imports rises, affecting consumers and businesses that rely on foreign goods and services.

However, this policy also has the potential to restore foreign investor confidence and attract much-needed foreign investment into Nigeria.
Additionally, by making imports more expensive, the policy could naturally curb excessive reliance on foreign goods, encouraging the development of local industries and reducing the trade deficit over the long term.