(Think like an Economist) in order to enlighten my fellow Nigerians
already panicking regarding the above mentioned subject matter so far
making headline on some of our national dailies.
Few years ago a research economist at the Federal Reserve Bank of San
Francisco wrote the following line:
If you ask the random sample of economist to name the three most
difficult questions confronting mankind, the possible answers will
probably be: What is the meaning of life? What is the relationship
between quantise mechanics and general relativity? What is going on in
the foreign exchange market? Not necessarily in that order.
Anyone who travels outside Nigeria have some good intuitive sense of
what an exchange rate is. But why exchange rate are at the level they
are?, Why their value changes?, and What if anything should be done
about it? are different questions.
Let's try out by cleaning away some of the rhetorical underbrush who
can gets in the way. The subject of exchange rate is typically
discussed with some terminologies that can be deeply misleading.
Let's start with this idea, everyone knows that strong is good and
weak is bad. Everyone knows that in financial matters appreciate is
good, I.e when your house or stock that you hold are worth more.
Similarly, depreciate is bad, like when your house or stock losses
Well, exchange rate are a case where what everyone knows about
stronger and weaker is wrong when it comes to prices. After all, it's
never clear from an economic point of view whether a higher price is
good or bad, whether you favour strong or weak fuel prices for example
depends on whether you are a share holder in an oil company or whether
you are a consumer pumping fuel to put in your car. Producers always
like high prices for what they produced. Consumers always like low
prices for what they buy. Societies have both consumers and producers,
indeed most of us play both roles at various times.
Now an exchange rate is just a price and we are going to define the
term as: Exchange rate is the rate at which one currency can be traded
So when you say a strong Naira, all that means is that Naira can buy
more of other currencies. A weak Naira just means Nigerian currency
buy less of other currencies.
Now, whether you prefer that a price is high or low, remember always
depend on whether you are buying or selling. If you are buying
imported product you would like a strong Naira that can afford lots of
other currencies. If you are working in an export industry which is
selling somewhere in the world, you might prefer weak Naira.
We will get into that sort of logic more as this write up goes along.
But the point is, the foreign exchange rate is just a price like any
other price, high prices and low prices just depend on where you are
In the foreign exchange markets for currencies, everything is as you
would expect, a market of demand and supply.
Let's look carefully at the Supply side of Foreign Exchange:
1. If you are a Nigerian tourist travelling abroad you are supplying
Naira, that is you want to give Naira to the foreign exchange market
to receive foreign currencies in exchange.
2. Foreign firms that sales in Nigerian Market earn Nigerian Naira,
like Toyota selling a car in Nigeria selling a car in Nigeria but back
home where they produce the goods they need to have their own
currency. They want to have in the case of Toyota Japanese Yen. So
they will supply the Naira that they earn by selling in Nigeria into
the foreign exchange market and they will exchange them for whatever
their home currency is.
3. Nigerian who want to invest in other countries. Nigerian investors
start up with Naira, they have those Naira but if they want to invest
in let's say Germany, then they need Euros. These Nigerians will have
to supply the Naira into the Foreign exchange market and collect Euros
so that they can invest in Germany.
The Demand side of Foreign Exchange Market.
Now on the flip side who is demanding Naira?
1. Foreign tourist to Nigeria, they are arriving with their own home
currencies. They are going to demand Naira because that's what they
need to spend in Nigeria.
2. Nigerian exporters who sold in other countries has owned foreign
currencies but they want to trade back into Nigerian Naira to pay
their workers and suppliers in Nigeria. So they're going to demand
Naira in the Foreign exchange Market.
3. Foreign investors who want to invest in Nigerian assets, Nigerian
stocks, bonds and real estate. They start up with whatever their home
currency is and they demand Naira because they need Nigerian Naira to
buy the Nigerian assets.
Therefore, you can imagine the foreign exchange market as involving
groups of people involved in the supply and demand of foreign
currencies. Of course when we think about the supply and demand in the
foreign exchange market it typically happens through financial
intermediaries like banks. Then if you're a tourist in America you
don't have to literarily find an American who wants to tour in Nigeria
and swap money with him. Instead everyone goes to the bank, the bank
act as an intermediary marching up these folks who want to trade their
currencies. Therefore, an average person doesn't actually observe a
foreign exchange market in operation.
When Nigerian Naira is stronger and can buy more foreign currencies,
those who supply Naira benefit and those who demand Naira suffer.
Similarly when Naira is weak and can buy less of foreign currencies,
then those who supply Naira suffer and those who demand Naira benefit.
Furthermore, to try and make this distinction a little more concrete,
let's think again and walk through each of our three groups. Tourist
who either from Nigeria or coming to Nigeria, those who trade goods
exporters or importers and those who want to invest in other countries
whether they are from Nigeria and investing abroad or from abroad
investing in Nigeria.
* Tourist first: imagine you are tourist in other country, you are
trading Naira for other currencies, in that situation a strong Naira
is great because is buying more of the foreign currency. It simply
means you can buy more stuff if you are abroad.
But if you are a foreign tourist coming to Nigeria, you will prefer
your home currency to buy a lot of Naira, so you will prefer that the
Naira be weak. In this regard businesses that cater for foreign
tourist, for example running a restaurant or a hotel at Yankar
Amusement park where there are lots of tourist that come in to stay
you will like a weak Naira, because that encourages more tourist from
abroad to come and patronise your hotel and restaurant business.
* Firms that import and export: firms that produce Nigerian imports
prefer a strong Naira because they are earning Naira. You should
remember our example of Toyota when they come to Nigeria an earn Naira
they will like to have a really strong Naira, because when they trade
back to Yen they get a lot more Yen.
Indirectly Nigerian consumers should also like a strong Naira because
they are the ones buying the imported product. In effect a stronger
Naira means Nigerian consumers can buy more goods from all around the
On the flip side, Nigerian firms that export abroad are going to
prefer a weak Naira and stronger foreign currencies because they are
earning foreign currencies. After all a Nigerian exporting firm pay
its expenses in Naira. It earn the foreign currency and then it wanted
to trade back to Naira. In effect for an exporting firm, a weak Naira
hold down the firm's expenses which are incurred in Naira, while a
strong foreign currencies keeps the earning up since they are earning
the foreign currency.
Now as a result of the above mentioned explanation, a strong Naira
turns to hurt export, tend to help import and either reduce a trade
surplus or occur a trade deficit. A weaker Naira on the other hand
tends to encourage exports, makes it easier to produce and sale abroad
or more profitable to do so. A weaker Naira hurt imports and makes
your Naira buy less in world markets, and it reduces a trade deficit
or causes a trade surplus.
* Foreign investors in Nigerian economy like a strong Naira because
the Naira they earned with their investment are now worth more, so
they are earning Naira, they like getting more so that when they trade
back to their home currencies they got more money than they expected.
However a strong Naira can hurt Nigerian investors abroad, because
they are earning foreign currencies and a strong Naira means when they
convert back into Naira they will get less than otherwise expected.
That is to say a strong currency encourages a net inflow in financial
capital and encourages most of the people to come to Nigeria and get
Naira. While a weaker currency discourages such inflow.
Now this also to put together, I mentioned a moment ago that a strong
currency tend to discourage export and raise import that lead to a
trade deficit. Here I am saying that in terms of investment strong
Naira encourage capital inflow and these are essentially the same
statements because trade deficit mean the inflow of capital.
To put this point in another way, a strong Naira encourages foreigners
to invest in Nigerian assets instead of buying Nigerian goods, so it
encourages that inflow of capital. Conversely, a weaker Naira
encourages foreigners to buy Nigerian exports instead of investing in
Nigerian assets and that leads to smaller trade deficit and a lesser
inflow of capital.
In conclusion on today's piece of post about foreign exchange, I will
like to close this by saying that there isn't too much cause for alarm
with regards to the present weakness of Nigerian Naira against other
currencies. Also note that when we think about a stronger and weaker
Naira, appreciate and depreciate, remember it all depends whether you
are a buyer or a seller.
(c) Abdullazeez Badaru Jikamshi