Explaining The CBN Floating To A 5 year Old

Teni, Mark, and Aki approached their professor to inquire about the new financial policy, and this was the professor’s explanation:

“Sometimes, to understand the present, we must first revisit the past.”

It’s essential to comprehend the situation in the FOREX market prior to this policy change.

Then, let’s delve into understanding this new development and its implications.

“Alright, enlighten us,” the students responded eagerly.

The professor continued…

What was happening before?

Previously, the Central Bank of Nigeria (CBN) used to regulate the price of the dollar (exchange rate). Each morning, the CBN would instruct the banks:

“Mr. Banky, regardless of the circumstances, today you must sell your dollar at N550.”

As the authority, the CBN’s instructions were mandatory for the banks to follow. They had no choice.

Every day, the CBN would attempt to set the exchange rate. However, due to high demand for dollars, there came a point when the banks would inform the CBN:

“Sir, all my dollar reserves have been depleted. I have nothing left to sell.”

But Nigerians rely heavily on imported goods and services, which require dollars. So they would seek out alternative sources:

“Who can provide me with dollars since the banks have run out?”

“Go to the aboki, he should have some.”

(“Aboki” refers to the black market or parallel market.)

The aboki would say, “My friend, I know the banks are selling dollars at N550, but my rate is N750. Will you buy it before it runs out?”

(This is known as multiple rates, where the bank’s rate differs from other markets.)

With nowhere else to obtain dollars, people would reluctantly buy them at N750 from the aboki.

(Whenever Nigerians import goods, they must pay with dollars because foreign producers cannot accept the Nigerian currency. As Nigeria demands more dollars, the value of the dollar strengthens while the naira weakens.)

What the CBN is saying now:

The CBN has announced that they will no longer dictate the selling rate to the banks. Instead, let the market determine the price of dollars through willing buyers and sellers. In other words, the dollar is no longer fixed but is now floating.

Previously, the naira was relatively strong because the CBN artificially propped it up by regulating the exchange rate. Now that the CBN is relinquishing control, the naira will depreciate, resulting in devaluation.

What does it mean?

Initially, the price of dollars (exchange rate) will increase.

In simpler terms, the value of the dollar will rise.

From an economic standpoint, this policy is generally considered favorable under normal circumstances.

(However, this policy must be accompanied by other measures for optimal effectiveness.)

Expensive dollars mean that importing goods will become costly, encouraging people to purchase Nigerian alternatives.

It promotes buying the naira, growing the naira. It encourages import substitution and devaluation, which can benefit the Nigerian economy if all goes as planned.

Additionally, as the naira weakens against the dollar, it becomes easier to export Nigerian products as they become cheaper for international buyers.

If exports are encouraged, there will be increased demand for the naira, ultimately strengthening the Nigerian economy.

Furthermore, Nigerian banks may reintroduce support for naira cards in international transactions. This means that individuals who wish to do so can easily pay for services like Netflix and Apple Music again.

Please note: The FOREX market is complex, and this policy has wide-ranging effects on various stakeholders in the economy. The analysis provided here is a summarized perspective.

Also, it’s important to remember that the above analysis represents my personal opinion, and the economy may respond differently in the future.