(by B.O Orama (The Guardian; 10.05.06))

During my recent visit to Nigeria, I read with great interest and concern an article in The Guardian Outlook column of April 23, 2006 titled "CBN: Innocent Shadow Chasing or Foreign Tool?", authored by Mr. Henry Boyo. I considered it a duty to young economics students as well as our dear country that I correct certain misleading information and theoretical flaws in that article so that further debate on the important subject matter addressed by that article can be concluded under the right framework.

The main arguments of Mr. Boyo are that:

• the Naira ought to appreciate significantly against the US dollar: considering the rapid increase in Nigeria's foreign exchange reserves in the past few years. He drew support for his argument from his claim that under the Abacha regime when reserves were at USD5 billion, the price of USD1 in Nigeria was N80. He then blamed the Central Bank of Nigeria (CBN) for administratively fixing the exchange rate of the Naira by resisting its appreciation.
• that allowing Bureau de Change firms to formally participate in the foreign exchange market would encourage smuggling and hurt local manufacturers; and
• that the policy of sterilising excess crude oil revenues is a "folly of the highest order"

My primary point of departure in this rejoinder is that the main goal of any central bank is to use monetary and exchange rate policies to ensure internal and external macroeconomic balance. Imbalances occur when there is disequilibrium between domestic demand and domestic supply. In many developing countries suffering from economic difficulties, excess demand is usually the source of the imbalance. To restore balance under such a situation, you can either increase output or decrease demand. You may also pursue the two goals to varying degrees simultaneously.

However, since it is easier and faster to reduce demand than to increase output, pursuit of external balance in the early part of macroeconomic reforms normally focuses on demand management using both expenditure reducing and expenditure-switching policies. Expenditure-reducing policies are those that are directed at reducing domestic demand through increased taxation and reduction in government spending. Expenditure-switching policies are directed at affecting the Real Exchange Rate thereby influencing domestic resource allocation between Tradable and Non-Tradable sectors of the economy. Tradables (importables and exportables) are the activities (goods and services) that enter or can enter international trade. Non-tradables or home-goods are the goods and services that due to their nature, for example, transport costs, commercial policies, etc. do not or cannot enter international trade.

Real exchange rate is the ratio of tradable goods to non-tradable goods prices multiplied by the nominal exchange rate. Tradable goods prices are directly linked to international prices while non-tradables prices are usually proxied by the Consumer Price Index (measure of domestic inflation). When non-tradables prices rise (an increase in domestic inflation) relative to tradable goods prices, the real exchange rate appreciates making it more profitable to produce home goods than tradables. This development then directs resources to the production of home-goods at the expense of importables and exportables.

At the same time, it becomes cheaper to import as a result of exchange rate appreciation, so imports rise to fill the supply gap in the importable goods sector. Export on the other hand decline widening the imbalance in the external account. From the foregoing, it is fairly obvious that Real Exchange Rate appreciation caused by rising domestic inflation can trigger a depreciation of the nominal exchange rate as a result of the increased import demand and reduced exports.

With the above framework in our mind, let us now return to Mr. Boyo's criticism. It is a well known fact that the purpose of sterilising oil windfalls is to ensure money supply levels that are consistent with the government's macroeconomic objectives, in terms of inflation targets, interest rate levels and ultimately economic growth targets. If the windfall is not sterilised, domestic money growth will quicken and raise domestic price levels. Such a scenario as we have seen in our simplified theoretical construct above, may constrain exports, increase import demand and possibly cause further nominal exchange rate depreciations. Thus, it appears that Mr. Boyo is criticising the CBN for protecting the value of the Naira - something that Mr. Boyo, in another breath, criticises the CBN of not doing.

I will not want to go into the comparison made with the exchange rate during the Abacha regime because the criticism assumes that time stood still between 1997/98 and today. That is there was no growth in economic activity and demand for foreign exchange. Some of us who were around also know how exchange rate was determined at that time. However, it is clear to me that integrating the Bureaux de Change (BDCs) into the formal foreign exchange market is the right thing to do to bring more transparency to the market and more rapidly eliminate the parallel market and unify the exchange rate of the Naira in all markets. I can assure Mr. Boyo that this is what obtains in Egypt, Ghana, UK, most of Europe, etc. In all these countries smuggling did not expand neither were local manufacturers unduly hurt. When the BDCs expand their outlets, it will make it easier to mop-up supply that goes to the informal (parallel) sector and also reduce speculative demand for foreign exchange. Mr. Boyo may wish to know that excessive documentation drives significant levels of foreign exchange transaction (demand and supply) to the parallel market where premia (demand) or discounts (supply) are paid or suffered to compensate for lack of documentation.

In sum, I think that the CBN is doing the right thing and all of us should support them. Further, for the sake of up and coming economists and to ensure that our economic policies are founded on a sound theoretical foundation, those who challenge them should do so based on theory and proven empirical evidence.

*Dr. Oramah is Director (Planning and Development Dept.) with the African Export-Import Bank Cairo, Egypt.