Wednesday, April 29, 2015

Arbitrage 2 : Black market and official patronage nullifies arbitrage in Nigerian foreign exchange market

Price inefficiency or mispricing in the foreign exchange market in Nigeria is fueled by the existence of two markets for the same product: the official rates market and the black market. This is taking a toll on Nigerian economy.

The reasons for its continued existence include one or more of the following:Price inefficiency or mispricing in the foreign exchange market in Nigeria is fueled by the existence of two markets for the same product: the official rates market and the black market. This is taking a toll on Nigerian economy.

The reasons for its continued existence include one or more of the following:

  1. It is being supported by stakeholders in the financial industry and politicians. As was mentioned in the first article, mispricing is a form of price discrimination and creates opportunities for monopolies or oligopolies to exist. Nigerian banks are attracted to such market opportunities and would rather make maximum profits unless the government steps in to curb the markets. The government does have the necessary powers because politicians who buy and sell foreign exchange in high volume use the mispricing premium to make huge amounts of money for their personal gain. So, a powerful lobby makes it possible for such an inefficient setup to exist. If arbitrageurs were allowed in the market, the price difference in the two markets for foreign exchange would disappear, thereby converging prices.
  2. Arbitrage cannot exist alongside black markets.

  3. There is no risk involved in selling in the foreign exchange market. Both educated and non-educated people participate in the foreign exchange markets. Sources of foreign exchange are cheaply gotten from tourists and people coming from abroad. Nigerian import regulations state that non-residents can bring in the local currency, the Naira, up to the amount of N5,000 and foreign currencies of an unlimited amount, provided both are declared on arrival.
  4. The black market premium is high. It is about 20 naira above the official rates when exchanging dollars for naira. When transactions run into the millions of dollars or pounds, the black markets are more attractive than the official rates market. Speculative losses that could be incurred by buyers and sellers in the market are made up for by the high market premium. That makes the market more riskless.
  5. There is economies of scale. The value of transactions are very large and huge. When the quantity of transactions run into the millions and the premium or mispricing gap is high, then the market is tempting for banks and politicians not to participate.

Hence, no one expects the price differential in such a market to disappear because corruption and entrenched lobbies would fight with all they have to squash any legislature that is raised. Now, back to the question that is the thrust of this blog article: would allowing ATM Naira-denominated debit cardholders to withdraw in foreign currencies from abroad and bring the amount into the currency encourage arbitrage and is it harmful to the economy?

Before the recent slash of the annual amount ATM Naira-denominated cardholders can withdraw from $150,000 to $50,000, it was business as usual. Foreign currency from abroad fueled the black market and was welcome in unrestricted amounts. But, Nigeria has been bedeviled by two evils: falling oil prices and a reduction in its output or income. The projected growth rate for Nigeria has been reduced by the IMF from 6.3% in 2014 to 4.75%. The economic front is not too sound. Foreign exchange reserves is a major concern of the Finance Ministry and the Central Bank of Nigeria in stabilizing the local currency, the Naira. Debt servicing is also another problem they have to deal with.

The naira is depreciating daily. Hence, foreign currency withdrawn from abroad is cheaper especially since there is a time lag between the withdrawal and when the banks settle card companies like MasterCard and Visa. Banks end up paying higher. The country is then losing important foreign reserves due to speculation.

Arbitrage is supposed to exist in this practice but the existence of a black market nullifies arbitrage. Foreign currency bought cheaper from abroad are sold at a higher premium than even the banks that buy at the official rate. This is then a slowly developing lucrative business. If this trend is not curtailed, it will create a market. It is very easy for a black market trader to make use of a network of nuclear and extended family members to procure maximal gains from the deficiencies of the market using a Naira-denominated card.

So, Nigeria is losing foreign exchange reserves at a sensitive point in its monetary history.

Curtailing these cardholders though is repressive. They are reacting to market forces created since the Naira was devalued in 2014 and has continued to depreciate as oil prices remain low.

The problem lies at the hands of the Ministry of Finance and the Central Bank of Nigeria. As I wrote earlier, arbitrageurs react to price differences like high pressure flows to areas of low pressure. The high premium created by mispricing in the foreign exchange market in Nigeria has created this trend and it cannot be stopped. It could only become more treacherous by official fiat by existing in the underground economy. Where conscious barriers to efficient functioning of the markets are created by government agencies that are supposed to ensure market inefficiencies are curtailed, there is nothing any stakeholder in the industry can do.

The black market has been a tool of the system to make quick money on the side while the books are made to look good. This practice has been going on for years. It cannot be stopped. Reducing the yearly amounts Naira-denominated cardholders are allowed to withdraw overseas will push the market into the underground.

By cutting usage, the CBN will have the opportunity to track regular users of these cards; maybe even label them saboteurs of the Nigerian economy. The effectiveness is what one is doubtful of. The banks are complaining because these cardholders are making much premium than they are; which should be worrisome. One expects that they also play to the market and make use of the opportunity proffered.

It seems that when pushed to the wall, the Ministry of Finance and the Central Bank of Nigeria set up barriers to trade that could create more problems in the future especially in the banking industry.

Previous post on arbitrage: An opportunity for price differentials to converge in financial markets

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