How Do Exchange Rates Work?

How do I explain how exchange rates typically work, simply and in a way that is easy to understand? Let’s try an illustration.

Suppose there are just two countries in the world, USA and Nigeria. In this ideal world, $1= N1. Now, Both of these countries’ populations love to eat burgers. A burger is made of the same stuff whether it is American, or Nigerian: buns, meat, vegetables and some cheese. The price of a burger in each country represents the cost of all those materials, plus profits. All things being equal, a burger should cost about the same in each country, given that their exchange rates are 1:1 and a burger is a burger. But as we know, all things are rarely ever equal. Because America has abundant meat, wheat industries, good roads, skilled chefs, refrigerated trucks and cheese producing farms, in other words, a huge supply of all the raw materials for a burger, and distribution infrastructure to get them everywhere, and the labor force that is good at making them, a burger is easier to put together there and thus costs way less to produce. And so it sells for $5.00.

Nigeria on the other hand does not have as much wheat production, has too little meat production, many of which are damaged during travel because of bad roads and no refrigeration, has very few people who know how to make the burger properly, and cheese is very rare in the country. Therefore, a burger is wayyyy harder to put together in Nigeria, and so it ends up costing almost 4x more, or N20.00 (which is equivalent of $20.00) produced domestically. Under these circumstances, demand for burgers will be lower in Nigeria, just because of how expensive it is.

This situation doesn’t persist for long though, because one enterprising chap, Tochukwu of Nnewi has run the numbers and realized that if he bought American burgers for $5.00 and shipped them across the ocean for $2.00 each, he could sell burgers in Lagos for N12.00 and make a great profit despite being cheaper than everyone. Now, to buy  burger in America, you have to buy dollars with your naira since that’s all they accept in the international market. So he buys $1,000 with his N1,000.00 But since the seller only has $1,000 and has to charge a fee for his services as well as the cost of transporting the dollars , they sell it to him at N1.02 to $1.00. Your equal exchange rate just ticked up. If there was an equal demand for naira from a dollar holder, the seller also trades $1.02 for N1.00 and the rate is restored (i.e. N1.02 received matches the $1.02 paid which restores the 1:1 relationship). But if there isn’t, the Naira becomes slightly devalued. This is why balance of trades (imports-export) helps move the exchange rate up or down..since it decides which currency is being sold or bought more than the other.

So once Tochukwu of Nnewi does his import and makes a killing, everyone realizes that it is better to import burgers than to try to make it at home. They all start buying dollars, which in turn causes the price of dollar to keep climbing, without a corresponding export to bring it down. By the time the currency settles, it usually lands at a natural value of that good and service in the importing country, or using our example, the demand for American burgers, and thus US dollars will stabilize when the price of buying the burger abroad approaches that N20.00 cost of making it at home. That’s when it no longer makes sense to keep importing, and thus demand stops. And so the natural expectation for the exchange rate between those two countries is N4:$1 which is at the price where a $5.00 burger, sells for N20.00 at home.

This is typically what determines exchange rates in most countries where the governments let market forces determine the rates. Simple supply and demand. Now, back to Nigeria of 2016.

Now, suppose the government feels N4:$1 is too high a price to pay for dollars, and they want naira to instead trade at N2:$1 helping to keep burger prices at N10.00? They will sell whatever dollars is at their disposal (in our case from selling oil), and buy up the naira creating artificial demand for the naira (it’s artificial because no one is actually selling the dollars to buy goods in naira). This means that naira is still N4 to a dollar, but the government pays N2.00 out of it in order to keep its citizens happy. This is what Emefiele is doing now. However, they have to keep selling oil to get more dollars to keep that going. If they run out, we know where naira should head. Since our revenues from oil has dwindled, we won’t have the dollar reserves to keep buying up naira, so it’s only a matter of time before the naira falls anyway.

The question here is: what is the best use of the dollar reserves we have between now and when we eventually run out? Should we use the $30 Billion or so to keep buying up naira to keep exchange rates up, essentially subsidizing consumption in the country? Or should we let the exchange rates fall to the point where people stop ordering burgers abroad and use that $30 billion for more productive uses like capital investment?

Remember why the burger was more expensive in Nigeria to begin with, it was harder to produce in the country. Now, if the government used that $30 billion to invest in agricultural subsidies, machinery, business loans and training for chefs who can make burgers, the price of a burger will eventually fall since it becomes easier to make. It’s not a mistake that American government runs some of the biggest agric subsidies in the world. Subsidizing production is always more long term beneficial than subsidizing consumption, yet Nigeria subsidizes exchange rate and thus imported goods (in effect, Emefiele is the one building up the same demand he is trying to stifle with all sorts of draconian policies, like someone driving their car in top gear while simultaneously slamming the brakes) , and also subsidizes petrol products consumption.  Since we have 180m people, if we actually spent the money we’re burning on the naira to instead invest in our own productivity, we might even get so many people investing their money into growing wheat, cheese, meat and making burgers that it becomes cheaper than America and they have to then buy from us. America did it to take over trade from Britain. And then China did it to take over trade from America. It’s not an impossible thing. It just takes smarts. It might hurt in the short term, but in the long term, it’s sound policy.

But with a president who thinks ‘if we devalue against dollar, we will devalue against franc, and deutschmark’ and a CBN governor who has chosen political expediency over sound finance, I don’t think Nigeria is going to see sound fiscal policy anytime soon.

Anyway, I hope you gained something from this regarding the current issues in the country. Being informed is the least we can do.

Advertisements

8 Comments

  1. Simple. Clear.
    Thank you.
    Now next question, how do we get a new CBN governor out of office? Without your read, and even to the economically naïve evidently, he is absolutely clueless.

    Like

    1. I’ve always been sure that a new CBN governor is what we need. But these days I’m not too sure. It seems we need a new President, and for that we’ll have to wait for 2019. It is what it is.

      Like

  2. This was very insightful. it took some concentration but this is still the simplest explanation of exchange rates I’ve come across which still touches all bases. Sad about our fiscal policy, like u pointed out in the last paragraph. Good work!

    Like

What do you think?

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s