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THE DYNAMICS OF NAIRA DEVALUATION

Maybe because it affects almost every facet of our domestic lifestyle, one major issue that has been the subject of persistent and passionate public discourse on a national scale in recent times (apart from the forthcoming General Elections), is the exchange rate of the national currency (the Naira), to other foreign currencies, especially, the United States of America’s Dollar.

The exponential increase in the exchange rate of the Naira to the American Dollar, with attendant inflationary fall-out, has led to misgivings by a vast generality of Nigerians, who perceive the devaluation policy of the Central Bank of Nigeria (CBN), as being rather insensitive and ill-timed. In view of the public perception, and seeming lack of adequate information about what necessitated, the devaluation, and aligning to the theme of this edition of Harmony News, which is Finance and Economy, we have brought to you in this edition, an expose on the policy of currency intervention, its types, and effects among others. We hope you find it educative and informative.

Please note that we welcome feedback on the topic of discuss as espoused in this piece

 

Currency intervention, also known as currency manipulation, exchange rate intervention or foreign exchange market intervention is the purchase or the sale of the currency on the exchange market by the fiscal authority or the monetary authority, (i.e. Central Bank of Nigeria), in order to influence the value of the domestic currency.

 

Purposes

There are many reasons for the authority to intervene in the foreign exchange market.

Some general consensuses are related to adjusting the volatility or changing the level of the exchange rate. First, governments always prefer to stabilize the exchange rate because excessive short-term volatility erodes market confidence and affects both the financial market and the real goods market. When there is an inordinate instability, exchange rate uncertainty generates extra costs and reduces profits for firms. As a result, investors are unwilling to make investment in foreign financial assets. Firms are reluctant to engage in the international trade. Moreover, the exchange rate fluctuation would spill over into the financial markets. If the exchange rate volatility increases the risk of holding domestic assets, then prices of these assets would also become more volatile. The increased volatility of financial markets would threaten the stability of the financial system and make monetary policy goals more difficult to attain. Therefore, authorities conduct currency intervention. In addition, when economic conditions changes or when the market misinterprets economic signals, authorities use the foreign exchange intervention to correct exchange rates, in order to avoid overshooting of either direction.

Moreover, in recent years, another possible reason for intervention, profitability, has been brought forward. Some literature has presented significant profits from intervention. Although few governments confess that profitability is a motivation for intervention, some monetary authorities admit that it is a useful gauge of their success in convincing the public for currency intervention.

 

 

Types

Currency intervention could be classified into different categories according to its characteristics.

Sterilization

Depending on whether it changes the monetary base or not, currency intervention could be distinguished between sterilized intervention and nonsterilized intervention.

Nonsterilized intervention

Nonsterilized intervention is a policy that alters the monetary base. Specifically, authorities affect the exchange rate through purchasing or selling foreign money or bonds with domestic currency.

For example, aim at decreasing the exchange rate/price of the domestic currency, authorities could purchase foreign currency bonds. During this transaction, extra supply of domestic currency will drag down domestic currency price, and extra demand of foreign currency will push up foreign currency price. As a result, the exchange rate drops.

Central bank purchase of foreign-currency bonds

Central bank balance sheet

Assets

Liabilities

   

Foreign-currency bonds (+1)

Monetary Base (+1)

   

Sterilized intervention

Sterilized intervention is a policy that attempts to influence the exchange rate without changing the monetary base. The procedure is a combination of two transactions. First, the central bank conducts a nonsterilized intervention by buying (selling) foreign currency bonds using domestic currency that it issues. Then the central bank “sterilizes” the effects on the monetary base by selling (buying) a corresponding quantity of domestic-currency-denominated bonds to soak up the initial increase (decrease) of the domestic currency. The net effect of the two operations is the same as a swap of domestic-currency bonds for foreign-currency bonds with no change in the money supply. With sterilization, any purchase of foreign exchange is accompanied by an equal-valued sale of domestic bonds, and vice versa.

For example, desiring to decrease the exchange rate/price of domestic currency without changing the monetary base, authorities purchase foreign-currency bonds, the same action as in the last section. After this action, in order to keep the monetary base, governments conduct a new transaction, selling an equal amount of domestic-currency bonds, so that the total money supply is back to the original level.

Central bank purchase of foreign-currency bonds

 

Central bank balance sheet

Assets

Liabilities

   

Foreign-currency bonds (+1)

Monetary base (+1)

   

 

Central bank sale of home-currency bonds

Central bank balance sheet

Assets

Liabilities

   

Domestic-currency bonds (-1)

Monetary base (-1)

   

 

Net effect of a sterilized foreign-exchange purchase

Central bank balance sheet

Assets

Liabilities

   

Foreign-currency bonds (+1)
Domestic-currency bonds (-1)

Monetary base (—)

   

Direct and indirect intervention

Direct intervention

Direct currency intervention is generally defined as foreign exchange transactions that are conducted by the monetary authority and aimed at influencing exchange rate.

Indirect intervention

Indirect currency intervention is a policy that influences the exchange rate indirectly. Some examples are capital controls (taxes or restrictions on international transactions in assets), and exchange controls (the restriction of trade in currencies, Neely 1999).[3] Those policies may lead to inefficiencies or reduce market confidence, but can be used as an emergency damage control.

 

Effectiveness

Nonsterilization Intervention. In general, there is a consensus in the profession that non-sterilized intervention is effective. Similarly to the monetary policy, nonsterilized intervention influences the exchange rate by inducing changes in the stock of the monetary base, which, in turn, induces changes in broader monetary aggregates, interest rates, market expectations and ultimately the exchange rate.[4] As we have shown in the previous example, the purchase of foreign-currency bonds leads to the increase of home-currency money supply and thus a decrease of the exchange rate.