You have probably already heard about the suspension of Sanusi Lamido Sanusi as the governor of the Central Bank of Nigeria. Officially Sanusi was suspended because of concerns raised by the Financial Reporting Council of Nigeria over “financial recklessness and also violation of due process and the mandate of the CBN”. Most observers however argue that his suspension was not unconnected to Sanusi’s allegations against the NNPC. Sanusi had earlier claimed that $50bn (later revised to $20bn) in crude oil sales was not remitted by the NNPC and was unaccounted for. In this article I hope to show why it was within the CBN’s mandate to raise questions about actions within the NNPC and why it is still important that the CBN continues to question the dealings of the NNPC.

First a little background. One of the core mandates of the CBN is to ensure price stability. Basically it is one of the CBN’s responsibilities to ensure that prices don’t change very quickly. For most countries price stability and exchange rate stability are inextricably linked. The same goes for Nigeria too. The CBN lists exchange rate stability as one of its core mandates as well. But where do exchange rates come from?

To understand how exchange rates are determined it is useful to simplify things. Assume there are only two countries in the world, Nigeria and the US. Nigeria produces only crude oil and the US produces only iPhones. However Nigerians want iPhones even though they don’t produce any. Americans also want crude oil even though they don’t produce any. Say for example Nigerians want to buy 100 iPhones from the US and in turn Americans want to buy 100 barrels of crude oil from Nigeria then both countries would have to agree to exchange 100 iPhones for 100 barrels of crude oil. Or one iPhone to one barrel of crude oil. Now of course it is 2014 and people rarely barter for goods and services. The foundations are however still the same. If the value of an iPhone in the US is $100 and the value of a barrel of oil in Nigeria is N1000 then one iPhone for one barrel of crude oil results in an exchange rate of $1 to N10. In general the exchange rates are determined by the supply of dollars (driven by foreigners who want to buy your stuff) and the demand for dollars (driven by the stuff you want to buy from foreigners). Stuff here could mean anything from actual goods to services, investments, even travellers. This constant demand and supply determines exchange rates.

The changes in demand and supply consequently determine the changes in the exchange rate. For example, if the fundamentals changed, and the US was willing to exchange 200 iPhones for the same 100 barrels of crude oil, then the exchange would be 2 iPhones to 1 barrel of crude oil. Given the same relative prices, that would imply an exchange rate of $1 to N5. In essence the value of our exports (crude oil) has risen relative to the value of our imports (iPhones) and that has manifested in the strengthening of the local currency. The same dynamics apply in a broad market sense. For instance if the rest of the world wants more of what we export (bringing their dollars) but our imports do not change, then we have more foreign dollars bargaining for the same amount of naira. This means the naira should strengthen. On the flip side if we want to import more from the rest of the world, but our exports remain the same, then it implies there is more demand for the same amount of dollars to buy those imports. We will have to offer more naira for every dollar. The naira should weaken.

As you can probably guess, this is an inherently unstable process. The implication is that exchange rates could fluctuate daily depending what is being exported and imported. This volatility is particularly true in small countries with just a few export commodities. Although foreign exchange traders and speculators tend to smooth out the process, Central Banks occasionally intervene to stabilize exchange rates. [I should point out that Central Banks sometimes have other reasons for intervening in foreign exchange markets but the mechanism for intervention is still the same.] Central banks intervene by buying and selling foreign currency with the goal of manipulating the supply of foreign currency to hit a target exchange rate. Revisiting our previous example, if for whatever reason the US was willing to exchange 200 iPhones for 100 barrels of crude oil, the exchange rate should turn out to $1 to N5. But what if the CBN decided this change in US demand for crude oil is only temporary. They can ensure that the exchange rate remains at $1 to N10 by buying up half the dollars from the sale of crude oil. If the Americans come with their $20000 ( the value of 200 iPhones in America) to buy the 100 barrels of crude oil, the CBN could buy up $10000, leaving only $10000 to exchange for the 100 barrels of crude oil. In essence the CBN has reduced the supply of dollars in the foreign exchange market and as a result has prevented the naira from strengthening to $1 for N5. The impact of the CBNs intervention is that the exchange rate remains $1 to N10. What does the CBN do with the $10000 it bought? It stashes it somewhere, popularly called external reserves.
The same happens in reverse. If for whatever reason Nigerians want to import a lot more stuff, but our exports remain the same, then it implies more naira chasing the same amount of dollars from the same exports. This should imply that the naira should weaken. If the CBN wants to prevent this from happening then it would have to sell dollars in the market. Selling dollars in the market increases the supply of dollars which prevents the naira from losing value. This is what is popularly known as “defending the naira”. Where does the CBN get dollars to sell to the market? From the same external reserves.

The mechanics of exchange rates are the same all over the world. A country’s exports and imports of goods, services, investment goods etc. determine the exchange rate. The central bank can however intervene by buying or selling foreign currency on its domestic market to influence the rates. The central bank’s ability to stop its local currency from strengthening is virtually unlimited. The central bank can usually buy up as much dollars as it wants. There is no technical limit to how much dollars it can buy since it can always print domestic currency to buy it. There is however a limit to how long a central bank can continue defending its currency. Recall a central bank defending its currency implies selling dollars on the foreign exchange market. If the central bank runs out of dollars then it cannot defend the local currency since the central bank cannot print dollars.

The Nigerian foreign exchange market works in almost the same way with one major exception. Crude oil makes up the bulk of Nigeria’s exports, somewhere around 90% officially. The bulk of earnings from the sale of crude oil should flow to the federal, state and local governments to the Federation Accounts Allocation Committee (FAAC). However the CBN, as banker to the government, receives these dollars from the export of crude oil, and credits the FAAC the naira equivalent. In essence the government’s share of dollars from crude oil exports doesn’t go directly to the foreign exchange market. Instead the CBN sells these dollars in batches depending on its target for the exchange rate. The reason for doing this is probably to safe guard the credibility of the naira. Imagine what would happen if the FAAC actually paid out dollar allocations to state governors and local government chairmen for instance. However the implication for exchange rates is technically unchanged. Instead of the CBN buying dollars from the market to prevent the naira from strengthening, it simply chooses not to sell all the dollars it receives from the government’s share of oil exports. On the flip side it defends the currency by selling more than its receipts from the government’s share of crude oil sales. The way to judge if the CBN is intervening in the foreign exchange market is not by looking at its sale of dollars but by monitoring the change in its external reserves. If the external reserves are falling then it means the CBN is probably defending the naira, and if the reserves are rising then it means the CBN is probably preventing the naira from strengthening.

If you are still reading then it means you were not bored to death by the explanation of how foreign exchange markets work. Now we can get back to the Sanusi matter. In the midst of the 2009 financial crisis the Federal Reserve Bank (the US central bank) launched its quantitative easing exercise. In essence the plan was to buy up a lot of assets every week as a way stimulating demand. The short term implication of this was a relatively weaker dollar. By implication this implies a stronger naira, or a build-up in the CBN’s external reserves since it should have been trying to stabilize the naira. From the Nigerian perspective, the crude oil price also recovered to about $90 a barrel. Again this means the value of our exports should have returned close to pre-crisis levels. The naira should be strengthening or the CBN’s external reserves should be rising.

To put things in perspective, the CBN’s external reserves dropped from about $60bn in 2008 to about $43bn in June of 2009, during the peak of the crisis. The price of crude oil (the major export) crashed from about $100 to about $40 per barrel during the same period. As expected the CBN in its attempt to defend the naira sold a lot of dollars on the market although it eventually accepted a devaluation. However, as the crude oil price recovered to about $100 per barrel and the financial system stabilized, the expectation was that the naira should have strengthened as well. A rising value of exports combined with a weaker dollar should have resulted in the naira strengthening or the CBN’s external reserves building up again but that did not happen. The external reserves rose to a peak of about $47bn in 2013 but nowhere near its pre-crisis levels even with a weaker naira. If you assume that the US Federal Reserve’s QE has to end at some point then the failure in building up the reserves posed a significant risk to the naira. Remember the CBN’s ability to defend the naira depends on the size of reserves it has available. The failure had probably been apparent for a while but as long as the dollar was weakening it wasn’t a big problem. The umbrella was leaking but it was not raining yet.

So what explains the failure of the CBN to build its reserves? There are three possible explanations for this. The first is that dollars are leaving the system at a faster pace than before the crisis. This could be because imports are rising at a faster pace or because dollars are leaving through undocumented means, such as through money laundering. The CBN tried to tackle this with its KYC requirements for banks and its various actions against Bureaux de Change forcing them to account for sales of dollars purchased from the CBN and interbank markets. I assume this was an attempt by the CBN to tackle potential leakages from dollars illegally leaving the system.

The second explanation is that dollars are coming in but Nigerians are simply holding on to those dollars. In essence Nigerians are holding their own reserves which mean less supply of dollars in the foreign exchange market. The CBN moved against this too. Remember the whole brouhaha about forcing Western Union and MoneyGram to pay remittances in naira? And the threats to fine business who quote prices in dollars? I assume that was an attempt to limit the amount of dollars Nigerians hold. Less dollars in hand means more in the market.

The final possibility is that the dollars simply are not coming into the system. Given that about 90% of Nigeria’s exports are from crude oil and the agency directly in charge of crude oil exports and remittances to the CBN is the NNPC then there you have it. My guess is that the CBN tried to figure out just how much dollars should have been remitted from the NNPC and got no information. The $50bn figure quoted by Sanusi was probably an estimate because the NNPC did not release any information. Of course it has now been revised to $20bn but at least it is clear where the problem is. It appears all the dollars aren’t flowing into the system.

It is important that the NNPC, CBN and all the parties involved clear up any outstanding issues as the threat to the stability of the naira is now very real. The rumoured end of the Federal Reserve’s QE was already putting pressure on the naira. The sacking (or suspension) has put even more pressure. The external reserves have dropped by about $4bn since December of 2013 and things are not looking good. The umbrella is leaking and it is about to start raining.





Nonso Obikili is an economist at Economic Research Southern Africa with research interests in African economic history, economic development and macroeconomics. Current research includes the long term effects of the trans-Atlantic slave trades on political economic development in Africa. He was formerly a Lecturer at the State University of New York at Binghamton and is a regular contributor to various policy oriented think tanks in Nigeria. He tweets @Nonso2