Naira Struggles: The Thing With Expectations

This is how exchange rates and peoples’ expectations about the value of a currency interact;

Your domestic currency is the Naira. You have some business to transact in the near future which requires the use of foreign currency, for simplification we will assume US dollars. You cannot see into the future though, so you have to guess what you believe the exchange rate would be in the future. If you have no reason to believe there will be any changes in the near future then you act based on the current exchange rate. But if for whatever reason you believe the Naira will be devalued in the near future then you act TODAY as if the naira is already devalued.  If you consider a foreign exchange market where, for whatever reason, the participants believe the Naira would be devalued soon, they act immediately. But if they all act immediately then the currency actually gets devalued immediately even though the fundamentals might not really have changed.

To see how this works consider two examples. Assume you just got back and you have $500 that you want to sell for Naira. But you now believe that instead of the N155  per dollar you get today, if you waited a few days you might get more naira for each dollar, maybe N180. The normal reaction is to wait a few days and see what happens. In essence if you are a dollar supplier and you believe the currency is about to be devalued, your rational response is to restrict your supply and wait for the future better deal. Restricting your supply today however reduces supply of dollars today. Your expectations about a future devaluation causes a devaluation today.

The story on the demand side is the same. Say, for example, you need to buy dollars for school fees next month. You however now believe that the Naira would be devalued soon. The rational response is to do what you can to buy the dollars today. Your actions increase the demand for dollars today and help devalue the currency today. Unpopularly called “frivolous demand”. Overall the reactions by players, both on the dollar demand and dollar supply side, to a change in expectations about a future devaluation causes the devaluation to happen immediately. In economics it’s called a self-fulfilling prophecy.

As a regulator the action to take is simple. Either you step in and defend the currency by making up for supply shortfalls. If the market believes you can continue defending the currency indefinitely then the expectations are squashed. Of course this is dependent on the market believing you can keep on defending the currency. If the market sees that you have the reserves to keep defending the currency indefinitely then expectations are squashed. But if the market sees that you do not have enough reserves to defend the currency indefinitely, or at least for a long time, then the market can wait, draining your reserves in the process. If the regulator doesn’t have the capacity to defend the currency then accepting a devaluation that squashes expectations is necessary.

Which brings us to the actions of the CBN last week. The Naira has been under pressure since the international community accepted that the oil price movement wasn’t a temporary shock. The expectation, given the CBN’s reserves and the already high MPR and CRR rates made it almost certain that the Naira would be devalued. The Naira was officially devalued to 168 per dollar with a band between 160 and 176. Given that the Naira was already trading at 177 per dollar on that date then you must wonder if the CBN really thought its action would stabilize the Naira. Of course hindsight is always 20/20 but it does seem like we are not done with the official devaluations. As it stands there is only one way the Naira is going. Here’s hoping they act to squash expectations next time.

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