This paper contains two parts, with the first part being a continuation of the paper “FLOATING EXCHANGE RATE MODEL AND ITS DISCONTENT FOR EMERGING ECONOMIES”, published recently by this author and the second part being on the current critical forex liquidity situation in Nigeria.
For those who may not know, floating exchange rate model, simply put “The value of a currency fluctuates with the global supply and demand for the specific currency” was introduced only recently, to be precise, in 1976, during the so-called Jamaica agreement after the Bretton Woods system was abolished.
The model is hinged on the theory of demand and supply, under the assumption that there is equilibrium and that all transactions are done in a perfect market environment, a market environment without oligopoly or monopolistic patterns between nations.
Thus, the model was designed for countries that could compete with one another on more or less equal/similar terms, with equal access to similar production factors and market relevant tools.
During its conception, probable negative impacts on developing economies were overlooked.
All economies whether industrialized or tertiary (agricultural and raw materials) were considered equal to trade by the same rule.
Meanwhile, the dynamics of the inequality and resulting negative impacts are increasingly creating vulnerability of societies around the world that were once buoyant or doing fine.
The complexity and far reaching impacts of the model are so glaring that they can no longer be ignored.
The abolition of the Bretton Woods system led to the development of three parallel systems:
They are dollarization, pegging and managed floating rates. I do not think I need to go into details as to how they function in this paper.
However, it is important to note that although floating seems more popular with economists from such institutions as the world bank and the IMF, under the assumption that the famous invisible hand would always create an ideal equilibrium that is beneficial to all participants.
That these institutions do not differentiate between economic superpowers and dwarf economies does not make them equal or the arrangement right.
It is also important to note that there is nothing like free-floating exchange rate as sometimes implied by some African economists.
Actually, depending on economic goals, the value of the floating is also managed and is usually allowed within a predetermined bandwidth only, making the instrument very political around the world.
Central banks around the world have a number of tools they employ to manage the value of their currencies, this sometimes include direct intervention by buying and selling forex, or raising or lowering short-term interest rates, amongst others.
These interventions are to influence the value of the currency in any desired direction to promote economic growth but also to support predictability and reliability.
In fact, the perception and impacts of exchange rate policy for a developed economy and a developing economy may be at variance.
For many emerging economies, it should include to prevent a development that could eventually lead to a junk currency, with all its inflationary consequences.
It is incorrect in economics theory and there are no proven empirical data to support any assertion that devaluation leads to the preservation of any foreign reserve, if the Marshall – Lerner condition is not fulfilled.
The assertion that floating exchange rate automatically balances out deficits in trade balance is built around the general assumption that devaluation automatically leads to a surge in export and reduction in imports.
But empirical observations from numerous emerging economies have shown that this is often not the case, because trade between emerging and developed economies tends to be inelastic in the short term, often, with no immediately available equivalent local substitutions and in many cases, substitutions do not exist at all.
The assertion also ignores such core issues as productivity, quality and trading standards as well as market access and structures.
For emerging economies, floating exchange rate could be a sure path to worsening their terms of trade and lowering their living standards, without trade deficits balancing out.
In fact, it can lead to the trade deficits growing faster, with a negative correlation between exchange rate and economic growth.
The inflationary impacts on domestic prices of non-traded goods in emerging economies often surpass any supposed benefits of the devaluation.
Now, to put things in their rightful perspective, let us take the whole of Africa’s economy as example for our discourse.
Africa is a continent with a land mass of about 33 million square meters that could contain China, India, the USA and most of Europe, with a population of about 1,171 billion inhabitants (about 16% of current world population) but produces about only 2% of world trade.