Naira Struggles Part 3: The Impossible Trinity, Capital Controls and Multiple Markets

I should start off with an apology. I usually try to write my blog posts in a manner that allows casual readers to get the gist without too much economics jargon. It will be difficult with the topics I am about to discuss but I will try my best. If you have any difficulties understanding some of the concepts you can drop a line in the comments and I will try to explain it better.

This post is primarily about the Naira and its struggles and to help you get a better understanding of some of the actions the CBN has taken to halt the implied devaluation. First a few concepts to understand.

  1. The Impossible Trinity

    you have probably heard the phrase; “You can’t eat your cake and have it”. The impossible trinity in economics is the closest thing to that statement. The basic idea is that a country has three options of which it can only pick two. A country has to choose between having independent monetary policy (aka the ability to set interest rates), having fixed exchange rates, and having free capital flows (i.e. free movement of money into or out of a country for trade, investment, or other business purposes).

    If a country chooses to have independent monetary policy and free capital flows then it must have floating exchange rates. If a country chooses to have fixed exchange rates and free capital flows then it must give up monetary policy. Finally if a country chooses to have fixed exchange rates and independent monetary policy then it must implement capital controls.

    The reason for this phenomenon is what is commonly referred to as uncovered interest rate parity. This is the idea that, all things being equal, money will always flow to destinations where it can get better returns. For example, if investors have to choose between two countries both with free capital flows and fixed exchange rates, and identical in all other ways but the interest rate offered, they will always choose the country offering higher interest rates.

    Another example is if you had two countries also with fixed exchange rates, free capital controls and identical interest rates. If one decided to lower interest rates but the other doesn’t, then capital should flow out of the country that lowered interest rates to the country with higher interest rates.

    A final example is if a country fixes exchange rates and has free capital flows but the fundamentals change requiring it to raise interest rates or lower the exchange rate but it doesn’t. The implication is the same as in the previous example, capital should flow out of the economy.

    Now you are probably asking, so what? This is what. If capital is flowing out of your country then your currency should be weakening. Remember for free floating exchange rates, demand and supply of foreign currency determines the exchange rate. However if capital is flowing out of your country (implying higher demand for foreign currency) then to keep exchange rates fixed your central bank has to increase the supply of foreign currency in the currency market (aka selling foreign reserves). If you don’t operate a fixed foreign exchange regime then your currency will simply devalue to the point where your current interest rate make sense. However if you have a fixed currency regime, fixed by your central bank selling foreign currency, then capital will keep flowing out as long as the interest rate mismatch is present, all other things remaining equal of course.

    The kicker is that your central bank does not print foreign currency and therefore has a limited supply of foreign currency to sell on the foreign exchange markets. Therefore if the mismatch persists long enough, i.e. capital keeps flowing out, your central bank will eventually run out of dollars. When that happens your country will have no choice but to abandon its fixed exchange rate policy resulting in a sharp devaluation of the local currency. A devaluation to catch up with the true value. Of course by this time you central bank would have blown its reserves and still end up with a devalued currency. Most times this kind of sharp devaluation also leads to a financial crisis.

    In some cases this phenomenon occurs slowly. However in some cases speculators, sensing the mismatch and the opportunity to drain foreign currency from a central bank, can make this happen very quickly. Note that the speculators are not necessarily the cause. They just sense the opportunity. This principle explains the mechanics behind some of the most serious financial crises on record, such as the famous black Wednesday in England, and the Asian financial crisis in 1997. This is why most countries try to obey the rules set by the impossible trinity. The United States for instances allows free capital flows and sets independent monetary policy, allowing its currency to float freely. Singapore has fixed interest rate, free capital flows and therefore does not have monetary policy.

    Side note: In reality no countries are identical. Various other factors such as risk, or capital market integration, or currency substitutability, influence the equilibrium interest rates and exchange rates. You can therefore have interest rates at 12% in one country and interest rates at 1% in another without having capital flow out of the 1% country to the 12% country. However the basic rules still apply.

    If you are still reading then congratulations. You must really love economics.

  2. Multiple Markets.

    The second principle to understand is the idea of multiple markets and multiple prices for the same good in different markets. Consider a simple example with four different markets for yams, A, B, C, and D. In all the markets the sellers of yam can go to any market they want. However in market A only buyers approved by the president can enter the market. In market B only buyers who can prove they are bonafide yam consumers can enter the market. In market C you have to show your national ID card, PVC, or passport to enter the market. Finally in market D there are no rules. Anyone can go and buy yams. If the supply to all four markets is the same then you can guess that prices would be different in all four markets. In the market where presidential approval is needed you would expect prices to be lowest. Very few would be able to get presidential approval so there will be fewer buyers for the same supply of yams leading to lowest prices. More people would be able to enter market B so the prices would be a bit higher than market A. In market C even more people would be able to participate and so prices would be higher in market C. Finally in market D everyone would be able to participate and so demand should be highest and prices highest.

    In general given supply constraints, different levels of market restrictions can lead to different prices of the same commodity. Prices will be highest in the most open markets and lowest in markets with the most restrictions on who can buy.

    The same principle applies in foreign exchange markets. Given restricted supply, the markets with the most open access, the black market, should have the highest prices, aka the highest exchange rates. The BDC with some restrictions should have lower prices than the black market. The Interbank market with even more restrictions than the BDC should have the lowest prices.

    What happens if you increase the restrictions on any particular market? The demand in that market should reduce while the demand in the next less restricted market should increase. People should move from the new more restrictions market to the less restricted market. The result of course is that the price difference between the two markets should increase.

And now we are ready to talk about the Naira.

In terms of the impossible trinity, Nigeria like many other oil producing countries, tries to violate the rules. We implement a pseudo fixed exchange regime, we implement independent monetary policy, and we allow free capital flows. We can do this because we have oil aka a source of free foreign currency that counts as capital inflows. We do this for good reason too. The negative side effects of allowing a currency appreciate due to massive oil money inflows can be disastrous. So even if there is an interest rate and exchange rate mismatch that results in capital wanting to flow out, we can negate this with oil money.

What happens when the oil price crashes and oil money dries up? A double whammy. On the one hand the oil price crash implies the currency should devalue. On the other hand the oil money capital inflows that we would have had to keep the currency stable dries up. All that’s left to keep the currency stable is the foreign reserves. And that is limited.

Nigeria sold foreign exchange for months to defend its currency in the face of capital outflows. It initially sold currency at the DAS auction at its desired rates. Access to the DAS auction was of course highly restricted. The interbank market and BDC markets were much more open and as expected the exchanged rates there were higher and more reflective of the fundamentals. The black market, the most open market, even higher.

Given the fundamentals and depleting foreign reserves it came as no surprise that the exchange rate desired by the central bank (N150 plus or minus a few, and then N168 plus or minus a few) was unsustainable. The central bank then accepted a devaluation again scrapping the WDAS auction completely and accepting an exchange rate of around N200.

Recall the interbank market was allowed to float freely with the CBN targeting its desired exchange rate by selling foreign currency at its DAS auction. The CBN however changed strategy and began selling foreign currency directly on the interbank market. This resulted in the interbank market kind of becoming the new DAS market with the exchange rate virtually fixed. The BDC started to play the role the interbank market had formerly played, acting as a guide to what the true exchange rate was. And the black market still being the black market.

As expected the CBNs target exchange rate of N200 was still not enough to stem the tide of net capital outflows. The CBN was still stuck in a situation where it had to keep draining its reserves to keep the currency at its desired rate. The foreign reserves were however not looking pretty, dropping to under $30bn for the first time since a long time.

Now given our discussion about the impossible trinity, what options do you have if you face capital outflows, want to keep independent monetary policy and still want to keep your fixed exchange rate? Capital controls.

The CBN has implemented capital controls but in a rather odd way. It didn’t implement economy wide capital controls which is what it should have done in the face of a lack of options. Instead it implemented de-facto capital controls on specific markets and in a seemingly ad-hoc manner.

First it implemented restrictions on trading in the interbank market. As we learned from our discussion on multiple markets this simply implies demand moving from the new restricted market to the next less restricted market with the result divergence in prices. As expected activity on the interbank market dropped and the spread between the interbank and the BDC segment widened.

Still capital outflows.

Then the CBN implemented even more restrictions on the interbank market with the now infamous toothpick memo, banning even more participants from the interbank market. As expected this implies more movement from the interbank to the BDC segment and an even wider spread. A spread of the type we haven’t seen since the Abacha days.

What next? The CBN has implemented restrictions on the BDC segment. In the last couple of days the CBN has demanded that the BDCs submit BVN numbers for every transaction. I suspect there have been extra restrictions on the banks too but I can’t say for sure. The result however is the same. A movement of the market away from the BDC segment to the black market. In the past few day’s banks (who also act as bankers to the BDCs) have started rejecting foreign exchange. The FX market is so clearly moving away from the BDC segment to the black market. As expected the price at the now restricted BDC segment has moved closer to the very restricted interbank market. But what is happening to the black market?

Word from the streets is that the Naira has strengthened there too. I suspect this is just a temporary phenomenon as the black market probably couldn’t handle those kinds of volumes. I suspect this is the case because the fundamentals that led to capital outflows a week ago have not changed. The oil price is still low and projected to stay low. The FG also still has no cabinet (not that it matters). The only thing that has changed is the restrictions on the BDC.

What is my prediction? It will take a few days for the black market to settle and for it to figure out how to handle capital outflows. The CBN had worked really hard to move the market into the formal financial system to the detriment of the informal markets so the informal markets probably were not prepared. We have witnessed all this cash flow out of the formal system and given the pricing mismatch the arbitrage opportunities are immense. Nigerians are the most entrepreneurial people though and I bet someone somewhere near a border is solving the logistics of handling capital outflows in cash. Once they figure it out then we will see the slide continue. Although this time there will be a lot less information about anything.

What the CBN will do when that happens is unclear. Implementing capital controls for the formal financial system is easy. Implementing capital controls for the black market is hard. Hard because it involves physically stopping cash from going across the border. Do I think the CBN can successfully stop cash flowing across the border? No I don’t think so. I would be happy to be proved wrong though. What options does the CBN have when it can’t implement capital controls anymore? We know the answer to that.

The Naira struggles continue. Stay tuned for the next installment in this seemingly never ending saga.


3 thoughts on “Naira Struggles Part 3: The Impossible Trinity, Capital Controls and Multiple Markets

  1. “It didn’t implement economy wide capital controls which is what it should have done in the face of a lack of options.”
    What would an economy wide capital control look like

    2. You said the presence of a cabinet wouldn’t have made a difference, why? I would have thought that fighting a battle on two fronts might lead to a victory than at one. What’s Ur opinion

    1. The general rule with monetary (and fx targeting) policies is to act strongly, swiftly and quickly. To overact if you will and then cool off later. Overacting produces better outcomes by convincing people that whatever it is that is wrong is dealt with completely. So it is not that the actions taken by the CBN to stem the capital outflow are wrong but that they have implemented them in a slow drip kind of way. Each action is marginal and doesn’t do enough to convince players that the struggles are over. A comprehensive and large nationwide crackdown on all markets might have been more effective even though I don’t really think we have the capacity to properly implement capital controls especially with regards to the black cash market.

      As per the cabinet, the problems as I have explained above are structural brought about by the CBN wanting violate the trinity in the face of capital outflows. A new cabinet does not change that especially since we know they will also be constrained by low oil prices. To be clear a new cabinet will have an effect in improving confidence and giving investors a sense of the direction. But it probably won’t convince people that the a $ is suddenly worth N200 and not the N240 they currently think its worth.

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