Exchange Rate Policy for Naira Stability: A Case for a Crawling Peg.

By Chinedu Okoye 

Naira Weaken on Bleak Macro Outlook:

The Naira continues to experience pressure on the NAFEM even as the Central Bank intervened using the retail dutch auction system to supply FX directly to verified customers. There has continued to be low FX turnover suggesting that investors are still wary about Naira Fundamentals.

The Oil and Gas sector is marred by challenges and the country periodic debt obligations to settle. With T-Bills repayments due as early as the first quarter of 2025. The National Oil Company (NNPCL) is also faced financial distress, with debts up to $6 billion.

The Naira pressure is expected to continue as long as the above issues linger, especially in its Oil and Gas sector as fuel prices (largely imported at the moment) and exchange rate pressures are interconnected.

Prior Zero Equilibrium Position:

As posited in our prior paper referenced below, to stabilize the Naira the monetary authorities might have to tweak its exchange rate policy. We suggested that a "tighter version of the current exchange rate policy is imperative to enforce stability".¹ By this we meant creating a floor for the Naira.

The Naira needs stability and "the CBN demonstrated this understanding with its various tranches of $10,000 and $20,000 to registered BDCs".¹ As such we make a case for a market reflective peg that ensures a floor at a minimal cost to the Central Bank. A managed float with a soft peg, or a crawling peg. 

A Case for a Crawling Peg:

Absent adequate reserves to fix at a lower rate, the Central Bank might need to review it's managed float policy to reach a middle point as the Naira's fundamentals seem shaky. A crawling peg provides a middle ground that sustains the market reflective nature of the Naira but creates a floor beyond which the Bank would intervene.

Here the exchange rate is primarily determined by market forces through a willing buyer-willing seller model, but the central bank or monetary authority intervenes when the currency crosses a pre-defined threshold. This provides a floor and provides stability.

Under this system, the Central Bank sets a lower band at the resistance level of N1500/$1. This allows the Naira to appreciate freely or fluctuate above this floor according to market forces, as the Bank intervenes only when the currency depreciates below N1500/$1 on the NAFEM.

The aim of this is to prevent excessive depreciation whilst still allowing for an appreciation of the Naira and some degree of market-driven flexibility. 

Mechanics of the Crawling Peg:

Setting the Floor (Lower Band)Determination of the Floor:

The CBN would identify a threshold level of N1500/$1, which is deemed a critical resistance level. Below this rate, the CBN considers the Naira's value too weak. This communicates the floor to market participants, signaling that the Naira won’t be allowed to fall below this level without central bank intervention.

Market Operations and Exchange Rate Determination:

The exchange rate would still be determined by market forces, with buyers and sellers of foreign currency setting prices through supply and demand. This allows for market-driven flexibility, so the Naira can strengthen if demand for it increases or depreciate if demand for dollars rises.

So the Naira’s exchange rate would reflect market conditions, such as trade balances, capital flows, and investor sentiment, within the band above the floor.

Trigger for Intervention:

If the exchange rate approaches or crosses the N1500/$1 floor, the CBN would step in to support the Naira by selling from its reserves to increase the supply of the Greenback.

Adjustments: 

If economic fundamentals shift or if sustained pressure on the Naira continues, the CBN might adjust the floor over time.

For example, the floor could be allowed to "crawl" at a pre-determined rate (e.g., N50/month) to reflect changes in inflation differentials, terms of trade, or other macroeconomic factors. If Macro conditions improve there might be a revision upward.

Potential Impacts:

By setting a clear floor, the CBN can prevent panic-driven sell-offs or speculative attacks that could push the Naira into a freefall. This creates a more stable FX environment, which is essential for businesses, investors, and traders/trade partners.

The clarity provided by this system could boost confidence among market participants, as they would have a better understanding of the boundaries within which the exchange rate would operate. This stability of sorts is also expected to pass through to price stability. 

Long Term Considerations:

Over time, the success of this system will heavily depend on Nigeria's economic fundamentals—such as price stability, policy credibility and economic diversification from industrial development. If these fundamentals improve, the Naira could appreciate, reducing the need for frequent interventions.

The CBN would need to periodically review and adjust the floor in response to changing economic conditions, in as much as the crawling peg remains relevant and effective in achieving its goals.

This could also be a temporary measure as the Bank could revert back to the current system or even a free float should fundamentals demand. However a proactive approach is preferred over a reactionary approach to the Naira weakness and volatility.

We believe this would work because there is already a tight grip on the FX market with little wiggle room for arbitrary gains from hoarding. Monetary Policy for African countries needs to be tied to the needs and unique nature of the economy.

Zero Equilibrium Paper on Reference:

¹ "Stabilizing the Naira using Effective Strategies for FX Management".

(http://zeroequilibrium.blogspot.com/2024/07/stabilizing-naira-using-effective.html)