It appears we may be heading back into the demand management era at least if I am reading the signals correctly. First there was milk and then the order to restrict foreign exchange for food imports. An “order” that the CBN doesn’t really have to obey to be honest. Anyway, given that we have been here before and written about all this already I thought it would be useful to share a short story I wrote originally published in the Guardian in 2016. Also added a bit of a follow up explanation. Enjoy.
In the town of Bali there is a market, Yelwa, where yams are sold. The chief in Bali decides who can enter the market to buy or sell. In the beginning, the chief did not really care who came or went. Across the river in Bali is another yam market, Ebba, where the chief has no authority. In Ebba anyone can come to buy or sell. Since anyone in Bali can go to whichever market they like with ease, the price of yams in the two markets is about the same.
One Tuesday the chief in Bali decides, for reasons unknown, that all the descendants of Suntai can no longer come to Yelwa market to buy yams. The Suntai family is big in Bali making up about 20 percent of the population. The Suntais vent their anger at the rules but eventually decide that it is not worth the fight. They also have the option of crossing the river to Ebba market where the chief has no authority. And so they cross in their droves.
The people selling yams in Ebba market see the new crowd coming and say to themselves, “See crowd oooo. This yam we are selling no dey enough. We must increase price now and make money from these people.” At the same time the yam sellers in Yelwa look around their market and see a crowd that is not as big as it used to be. The Suntais have been banned and they used to be big customers. They say to themselves, “If we want this yam to sell today, we have to reduce the price. If not, nobody go buy am.” Suddenly yams in Yelwa are cheaper than in Ebba. The yam sellers in Yelwa are still loyal to their chief so they stick around and continue selling.
The next Thursday the chief in Bali again decides to ban the Wakils from Yelwa market. The Wakils, also a big family, complain but have already heard what happened to the Suntais. They decide not to bother about the ban and just go to Ebba market across the river. The people selling yam in Ebba market see an even bigger crowd coming to buy their yams. They rejoice again and increase the price again. “If all of you want this yam you must pay o. If you no wan pay give chance, another person dey your back wey go pay”.
Meanwhile, at Yelwa market the crowd is even thinner. One of the yam sellers in Yelwa gets a call from his friend across the river. Yams are selling in Ebba for double the price. The seller decides that loyalty to the chief is not that important. “Na loyalty we go chop?” The seller packs up and carries his yams. “Where are you going?” other yam sellers ask. The seller says he is taking his yams to Ebba where people are paying double. Many other sellers follow suit.
On Sunday the chief of Bali is at it again. The chief decides to ban all the Lugujas from Yelwa market. The Lugujas do not bother debating. They just go across the river to Ebba. At this point the few yam sellers in Yelwa who were loyal to the chief get fed up. Almost all of them decide to carry their yams and go to Ebba to sell there. Even the few yam sellers who are afraid to cross the river instead decide to stay at home. The Yelwa market has become a barren wasteland. The only person left selling yams is the chief’s cousin who is selling yams from the chief’s own farm. The chief finally notices that the Yelwa market is dead and calls his adviser to explain what happened. The adviser says “But chief, you are the one that stopped the Suntais, Wakils and Lugujas from coming to the market. You drove them across the river and all the sellers have gone there too.” The chief replies, “But I had very valid reasons for sending them away. Honestly, the reasons were valid”. “Chief”, says the adviser, “the reason you sent them away does not matter. All that matters is that where the buyers go, the sellers will go as well. If you want the market to come back to Yelwa then you must let the buyers come back as well.”
This story is an allegory of the Nigerian foreign exchange market. The Central Bank of Nigeria, in its quest to fix the exchange rate implemented rule after rule restricting who could buy forex officially. The rules pushed buyers to the black market and resulted in the black market rate moving far away from the “official” rate. The more rules the CBN implemented, the further away the black market moved. The reasons behind the rules are irrelevant. All that matters is more rules lead to a bigger gap between the official and black market, and the gap is a major factor behind the economic instability the country is currently going through.
The simple principle to understand is the idea of multiple markets and multiple prices for the same good in different markets. Consider a simple example with four different markets for yams, A, B, C, and D. In all the markets the sellers of yam can go to any market they want. However in market A only buyers approved by the president can enter the market. In market B only buyers who can prove they are bonafide yam consumers can enter the market. In market C you have to show your national ID card, PVC, or passport to enter the market. Finally in market D there are no rules. Anyone can go and buy yams. If the supply to all four markets is the same then you can guess that prices would be different in all four markets. In the market where presidential approval is needed you would expect prices to be lowest. Very few would be able to get presidential approval so there will be fewer buyers for the same supply of yams leading to lowest prices. More people would be able to enter market B so the prices would be a bit higher than market A. In market C even more people would be able to participate and so prices would be higher in market C. Finally in market D everyone would be able to participate and so demand should be highest and prices highest.
In general given supply constraints, different levels of market restrictions can lead to different prices of the same commodity. Prices will be highest in the most open markets and lowest in markets with the most restrictions on who can buy.
The same principle applies in foreign exchange markets. Given restricted supply, the markets with the most open access, the black market, should have the highest prices, aka the highest exchange rates. The BDC with some restrictions should have lower prices than the black market. The Interbank market with even more restrictions than the BDC should have the lowest prices.
What happens if you increase the restrictions on any particular market? The demand in that market should reduce while the demand in the next less restricted market should increase. People should move from the new more restrictioned market to the less restricted market. The result of course is that the price difference between the two markets should increase.
Since the introduction of the NIFEX window the CBN has pushed for convergence in all markets by essentially selling as much FX to each market as it can. Rice importers are banned from official markets and move to the black market, but at the same time the CBN sells FX to BDCs or other connected fellows who then indirectly sell it on the black market, keeping the prices in both markets close. But what happens when the CBN starts to run out of FX and can’t sell as much to the BDCs, and still insists on keeping its market access restrictions?