9 Reasons for Multiple Exchange Rate Systems and Its Problems

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Meaning of multiple exchange rate systems

Multiple exchange rate systems refer to systems where a country maintains more than one official exchange rate for its currency.

How it works

In a multiple exchange rate setup, the apex bank may set different rates for different types of transactions or for different types of goods and services.

For instance, when Nigeria was fully operating a multiple exchange rate sytem.

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During that period, there was CBN rate which was usually updated on its site; there was different rate on Importers’ and Exporters’ Window, while at the parallel market, traders had a field day quoting different prices until recently it tried to implement a unified rate, beginning from June 14, 2023.

Specifically, Nigeria has been inconsistent with its foreign exchange policy. And has been switching from one FX system to the other.

Examples of countries that use multiple exchange rates are:

Reasons for Multiple Exchange Rate Systems

Countries don’t simply adopt such systems for the sake of it; there are core economic and political reasons that underpin their decisions, some of them include:

Also Read:  Nigeria May Impose 'Heavy' Tax On Foreign Exchange Transactions At Parallel Market

Economic Justifications

Protection of Vulnerable Sectors: By using favorable exchange rates for essential imports like medicines and basic food items, governments can ensure their affordability.

Combatting Capital Flight: When countries face economic instability, capital tends to flow out. Different exchange rates can deter such movements by making it less lucrative for capital flight.

Reserve Management: Multiple rates can help authorities control and manage their foreign currency reserves more effectively, ensuring they have enough for critical imports or debt servicing.

Control of Import and Export: With distinct rates for different sectors, governments can encourage or discourage specific imports or exports to protect domestic industries.

The CBN under former governor Godwin Emefiele did this, by making sure that some products do not have access to the official FX rate

Political Implications

Pleasing Different Constituencies: By offering favorable rates to certain industries or sectors, governments can gain political goodwill, particularly from influential stakeholders.

Maintaining Economic Sovereignty: Multiple rates can be a tool to counteract external economic pressures or influences, allowing nations to maintain more control over their economic fate.

Global Pressures: In some scenarios, countries facing international sanctions or other forms of economic pressures might resort to multiple rates as a strategy to navigate these challenges.

Temporal Advantages

It’s worth noting that, in some cases, countries adopt multiple exchange rate systems as a temporary measure. For instance:

Transition Periods: Post-economic crises or major policy shifts, nations might use multiple rates as a transitional mechanism before moving to a unified or different system.

Stabilization Measures: In times of hyperinflation or other economic shocks, multiple rates can serve as a temporary stabilization tool.

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Problems with Multiple Exchange Rate Systems

While multiple exchange rate systems might be adopted with the best of intentions, they invariably come with their set of complications and challenges.

Economic Inefficiencies

Resource Misallocation: Different rates can distort price signals, leading to resources being allocated to less productive sectors over potentially more profitable ones.

Distorted Pricing: The existence of various rates can complicate price setting for goods and services, leading to inefficiencies in the market.

Reduced Incentive for Production: Favorable rates for certain imports might reduce the motivation for domestic production of those goods, impacting local industries.

Financial Market Disturbances

Black Markets and Unofficial Rates: Often, when official rates don’t reflect market realities, black markets emerge, offering unofficial rates that might be more attractive for certain transactions.

Again, Nigeria is typical example of a country where multiple exchange rate systems have failed. It has led to the prevalence of black market rates across major cities across the country.

At some points, the difference between the official rate and the black market rate was over N200.

The popularity of the unofficial rates has led to many Nigerians and investors believing that the rate at the parallel market is more realistic than the official rate or the rate recognised by the CBN.

This is a reflection of I&E exchange rate which closed at $/N772.59  on Wednesday, September 6, 2023, while the black market rate closed at USD/NGN930.

Arbitrage Opportunities: Differences in rates can lead to arbitrage, where individuals or entities take advantage of the price differences for the same asset in different markets.

In most cases, the arbitrage system favours cronies of the government. A few days ago, a former CBN Governor and the former Emir of Kano Muhammadu Sanusi II revealed how an inexperienced persons took advantage of of Nigeria’s weak FX system to make billions of naira from the difference.

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According to him, sycophants of government buy US dollar at the official rate and take it to the black market, where they make huge profits.

Difficulty in Investment Decisions: For foreign investors, the existence of multiple rates adds another layer of uncertainty, potentially making the country a less attractive destination for investment.

When the government of President Bola Tinubu announced the abolition of multi exchange systems, investors, financial analysts, and global financial bodies such as IMF, World Bank praised his decision.

Complications for International Trade

Trade Imbalances: By artificially making imports cheaper or exports more lucrative, multiple rates can lead to trade imbalances.

Strained Diplomatic Relations: Disputes over which exchange rate to use can lead to tensions with trading partners.

Challenges in Monetary Policy Implementation

Lack of Clarity: Multiple rates can obscure the true value of a currency, making it challenging for central banks to gauge the effectiveness of their monetary policies.

Limitations in Policy Tools: The presence of multiple rates can tie the hands of policymakers, limiting the tools they can use to address economic challenges.

Conclusion

Multiple exchange rate systems is more detrimental to a country’s economy than the benefits inherent from such systems. It must be carefully operated.

Author

  • Opeyemi Quadri

    Ope is a finance writer and researcher with 10+ years of experience in content creation. His interests cut across decentralized finance, investment, foreign exchange, government policies and politics.

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