By SBM Intelligence

Two days ago, the Central Bank of Nigeria announced that it would be adopting a flexible exchange rate policy in the management of foreign exchange (FX).

The guidelines to the new policy, dated 15th June, 2016, spelled out how the new policy would operate.

The key highlights of the policy are listed below:

● The CBN shall operate a single market structure through the autonomous/ inter-bank market i.e. the Inter-Bank Foreign Exchange Market with the CBN participating in the FX market through interventions.

● The FX Rate will be purely market-driven and for 2-way quotes, the spreads will be determined by FMDQ OTC Securities Exchange (FMDQ) via its market organisation activities with the Financial Market Dealers Association (FMDA). Also 1-way quotes will be accepted.

● The CBN shall introduce FX Primary Dealers (FXPDs)who are Authorised Dealers (ADs) designated to deal with the CBN on large trade sizes ($10.00 million) on a two-way quote basis.

● ADs shall be authorised to offer FX Forwards and non-standardised FX Futures to end users be backed by trade transactions. FX forwards purchased by ADs are transferrable in the Inter-bank FX market.

● Proceeds of Foreign Investment Inflows and International Money Transfers shall be purchased by Authorised Dealers at the interbank rate.

● Inter-bank funds shall NOT be sold to Bureaux-de-Change.

Perhaps the most important information that was not spelled out in the guidelines is that henceforth the exchange rate would be purely market driven. Hitherto the official FX market consisted of a primary and secondary market.

The primary market involved the auction of FX by the CBN using various mechanisms – the Retail Dutch Auction System (RDAS) or Wholesale Dutch Auction System (WDAS). The secondary market was driven by the banks who transacted within themselves in the “interbank market”.

Now primary market is being discontinued and the CBN will instead bolster the secondary market through periodic interventions, i.e. the CBN will enter into transactions with the FXPDs when it sees the need to eliminate wild fluctuations in the exchange rates.

In addition, FX Forwards and Futures will allow end users to lock in the price at which they will purchase/sell FX from/to ADs a future date – thus eliminating some price risks.

What will be the effects of these measures?

For one, the Naira is likely to weaken further in the short term since it will no longer be shored up by the CBN.

The inflation rate will likely spike as the value of money reduces. Should this occur, the Monetary Policy Committee may see the need to increase the monetary policy rate (the rate at which the CBN transacts with banks), leading to an increase in the cost of borrowing money in the economy and resulting in a drop in credit.

Such an action will have an adverse effect on the real sector as businesses will suffer a drop in profit margins and individual borrowers will see more money taken out of their pockets.

In the medium to long term however, we expect that as people get used to the new FX market, inflation rates will start to drop and the real benefits of the policy will take effect.

Just as reduction of petrol subsidies eliminated diversion of products and savings for government, so will this policy eliminate many sharp practices. If all goes well, the days where the majority of Nigerians suffer for the benefit of a few as a result of monetary policy mishaps are nearing their end.

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Op–ed pieces and contributions are the opinions of the writers only and do not represent the opinions of Y!/YNaija