LECTURE NOTE 2

INTERNATIONAL MEDIUM OF EXCHANGE

Money as a common denominator, measure of value, store of wealth and unit of account
promote both domestic and international trade. A nation can finance her import through
export proceed, grants or loans from other nations which must be denominated in
internationally recognized currency maintain in foreign reserve. The quantity of domestic
currency that will be required to meet payment for goods and services will be determine by
the exchange rate.

FOREIGN EXCHANGE
Foreign exchange is the international currency that is widely accepted in settlement for goods
and services. This is the means of payment for international transactions. This simply means
currency other than the local currency and in the case of Nigeria, any currency other than
Naira that is convertible. A convertible currency is the currency that is, freely exchange for
other countries’ currency without prior permission from the government of the country that
issues that currency. Therefore, convertibility is the capability to exchange, transfer, purchase
with, acquire with or dispose for other foreign currencies for legal purposes. The acceptable
international medium of exchange that serves as the basis for exchange rates are those
currencies of groups of seven industrialized countries and these are as follows:
i. America U S. Dollar (US$)
ii. British Pound Sterling (€)
iii. German Deutsche Mark (DM)
iv. French Franc (Ffr)
v. Canadian Dollar (Can $)
vi. Italian Lira
vii. Japanese Yen

PRE-REQUISITE FOR CURRENCY CONVERTIBILITY

There are prerequisites for a country’s currency to achieve its convertibility and these are but
not limited to as follows:
i. Possession of huge external reserves in the form of foreign exchange, gold, special
drawing rights (SDR) and other reserve balances sufficient to cover several months of
imports.
ii. Reduction in budget deficits to an acceptable level
iii. Cooperation with World Bank and IMF
iv. Debt level, particularly external debt level should be low.
v. Absence of trade controls and exchange restrictions
vi. Maintenance of comfortable reserve with the International Monetary Fund
vii. Growth in domestic output and employment as reflected by low inflation and balance of
payments equilibrium
viii. A sound export base as depicted by foreign exchange earning capacity and good
historical trend in payment for import.
ix. Privatization and commercialization of government enterprises

1
x. A free economy
xi. Liberation of domestic prices to engender competition and incentive for producers such
that production can react appropriately to market conditions.

POSITIVE EFFECT OF FULL CONVERTIBILITY

i. It helps to popularize a country’s currency
ii. It reduces speculative and arbitrage tendencies
iii. It helps to wipe out the activities of black market
iv. It opens up avenues for foreign direct investment
v. It is consistent with the concept of globalization
vi. It helps to improve the quality of dialogue with external creditors especially with respect
to debt rescheduling.
vii. It helps a country to achieve a realistic exchange rate for its currency
viii. It provides opportunities for trade expansion among countries as they trade with each
other in known currencies

NEGATIVE EFFECT OF FULL CONVERTIBILITY

i. Domestic currency will be vulnerable to exogenous factors
ii. Market failure due to externalities could have negative effect on a fully convertible
currency
iii. No country of the world can afford to give absolute freedom to market force as doing so
could make the currency vulnerable to sudden crash
iv. Once a currency is fully convertible, the conduct of economic policy of that country will
be subject to input from World Bank and IMF

FACTORS INFLUENCING DEMAND FOR FOREIGN EXCHANGE

i. Speculation and Hedging
The demand for foreign exchange can be motivate by speculation based on anticipated
movement in exchange rate or depreciation of a particular currency against another currency.
ii. Personal Uses
People also demand for foreign exchange for personal uses. People uses foreign exchange for
settlement of school bills, examination bills, subscriptions and remittance.
iii. Reserve
Foreign exchange is also required by a country that wishes to maintain reserves in a foreign
bank or to increase her reserve with international financial institutions like IMF.
iv. Discharge of Foreign Obligation
Foreign exchange is needed to pay subscription by each and every member of one foreign
organization or the other e.g UNO
v. Trading Activities
Nigeria is import dependent and as foreign exchange is required for importation of goods and
services particularly for foreign capital goods, raw materials or immediate products and
consumer goods in general. Therefore, importer in this trade must settle such purchases with
foreign currencies that are source through banks or foreign exchange authorized dealers

2
vi. Investment in Overseas Countries
Where an investor discover that the returns on investment is more in a foreign country than is
available in domestic environment, he will demand for foreign exchange to enable him invest
in such market.
vii Repayment of Foreign Loans and Interests
Repayment of foreign loans and interest are contractual and country needs foreign exchange
to discharge this obligation

FOREIGN EXCHANGE MARKET (FEM)

This is the medium of interaction between the sellers and buyers of foreign exchange in a bid
to negotiate a mutually acceptable price for the settlement of international transaction.
Foreign exchange market provides an avenue for the exchange of nation’s currencies and
creation of a effective mechanism for the allocation of foreign exchange. The foreign market
have the following as the participants, individual, importers, exporters, tourist, oil companies,
Bureau de exchange, universal and other banks, Nigeria Export-Import Banks, Chamber of
Commerce and the Central Bank of Nigeria as the apex financial institutions that regulates
the markets in line with the government policy.

THE PARALLEL OR BLACK MARKET

This is an illegal or unofficial foreign exchange market scattered in commercial centre and
towns in country. Rates in these markets are determined by the residents, either corporate or
individuals of a country, who in a unique position to maintain a steady pulse on the daily
economic and political developments as well as the supply and demand for foreign currency.
Black market provides alternative source for foreign currencies, through non-banking
channels valuing currencies at a negotiable exchange rate which are bench marked against the
official exchange rate. The buyers and sellers meet and deal in foreign exchange at a rate
different from the official rates. Thus, when the official rate is high, the black market rat goes
up and when the official rate is low, the black market rate goes down. Funds are being
sourced to this market through money laundering, diversion of approved remittance, citizen
returning from abroad, smuggled ,exports, under-invoicing of exports, over-invoicing of
imports.

MAJOR PLAYERS IN THE FOREIGN EXCHANGE MARKET

The key participants in the foreign exchange market consist of the Central Banks, Universal
and other Banks, Foreign exchange brokers, investing funds managers, major companies and
multinationals comprising of petroleum based companies, liquid natural gas companies, oil
companies, Bureau De change and the black market dealers.
i. The Central Banks
The Central Banks as the monetary authority in the market manages the foreign reserves and
bridges the fluctuation gap in the value of its country’s currency. The bank has a duty to
supply foreign currency to the market on daily basis and formulates the operating rules and
procedures the participants in the market must follow.

3
ii. Universal Banks and Others
These are bank and non-bank financial institutions play a leading and major role in the
foreign exchange market. As authorized dealers in foreign exchange, they serve as
intermediaries between the users and other operators in the market therefore, buy and sell
foreign exchange on behalf of their customers. They also provide a medium for exchange in
international trade transactions through the granting of foreign currency loans to their
customers and educating their importer and exporter customers on foreign exchange
customers on foreign exchange matters.
iii. Foreign Exchange Brokers
This class of participants act as intermediaries between the sellers and the users of foreign
exchange. They buy and sell on behalf of their customers in the market and make their
returns through the margin between the buying and selling rates.
iv. Bureau De Change
They were not allow to participate in the foreign exchange, but the law permit the operator to
buy and sell foreign currencies to the public who patronise them and to keep adequate record
of their transactions that should be forwarded to the Central Bank from time to time.
v. Investment Managers
These are fund managers which apply various investment vehicles or products in the
management of funds and investment in the foreign exchange market.
vi. Major Companies and Multinational Corporations
These participants move funds within and outside different countries for trade related
transactions, hedging against exchange risks and for speculative purposes.
========================================================
HISTORY OF FOREIGN EXHANGE SYSTEM IN NIGERIA
Regulating the foreign exchange system in Nigeria after independence was the passing of the
exchange Control Act in 1962. This act vested in the Central Bank of Nigeria the authority to
approve all applications for visible imports and certain invisible items apart from repatriation
of capital, profits and dividend were the exclusive functions of the Federal Ministry of
Finance.
regulation to de-regulation era – 1959 to 1986
de-regulation era – 1986 to 1994
guided de-regulation era – 1995 till date
HISTORY OF FOREIGN EXCHANGE MANAGEMENT IN NIGERIA
Foreign Exchange Management in Nigeria has undergone a lot of reformation from inception
to date. Nigerian currency was tie to the British Pound Sterling being the colonial master and
fixed exchange rate regime was the system in operation. The exchange rate in Nigeria was fix
and managed accordingly by Central Bank of Nigeria. Structural Foreign Exchange Market
(SFEM) was promulgate in 1985 and since then the Naira has floated in a bid to find its
appropriate market value. CBN had managed the naira value by adopting the following
instruments of intervention:

4
i. Average Pricing Method at inception of SFEM in September 1986 while Marginal Rate
was adopt one month later and bidding was forth nightly.
ii. Autonomous Foreign Exchange Market (AFEM) came up in March, 1987 and the bidding
period became daily
iii. The Dutch Auction System (DAS) came up on 2 nd April 1987 and the bidding sessions
were forth nightly and this development facilitated the merging of the first and second tiers
foreign exchange markets.
iv. Inter Bank Foreign Exchange Market (IFEM) was introduce along with Bureau de Change
in January 1989 and the bidding session was daily.
v. Foreign Exchange Market (FEM) replaced IFEM in January 1990 with weekly bidding
sessions
vi. DAS re-emerged in December, 1990 on a weekly bidding system
vii. DAS was tinkered with and given a new name of Modified Dutch Auction System in
August 1991.
viii. AFEM was returned in 1995 as a daily session
ix. AFEM gave way to IFEM in 1999 as a daily session. The amount for the auction was
determine by the bids received.
x. DAS returned with fanfare on 15th July 2002 and has been on ever since as at press time.
CBN determines in the session held twice a week, what amount of currency it wants to sell.

IMPORTANCE OF FOREIGN EXCHANGE CONTROL REGULATIONS

Central Bank of Nigeria (CBN) by the Foreign Exchange (Monitoring and Miscellaneous
Provisions) Act no 17 of 1995 is the main authority for exchange control regulations in
Nigeria. Foreign exchange in whatever currency is a scarce commodity and as such must be
conserved strictly for the procurement of essential commodities. Therefore, the following
reasons are important for restricting public access to foreign exchange reserves in a country:
i. To attract and conserve earned foreign exchange for balance of payment purposes.
ii. To make possible efficient allocation of available foreign exchange reserves in
accordance with the need areas of the economy.
iii. To discourage the warehouse syndrome whereby virtually everything including tooth pick
is imported.
iv. To encourage inventiveness so that Nigerian entrepreneurs can produce and be protected
in the Nigerian market which frankly is enormous.
v. To enable the CBN to keep record of aggregate inflows and outflows and the justification
of the outflows.
vi. To stimulate economic growth by producing what we need and even selling such abroad to
earn foreign exchange and this will support and strengthen local industries.
vii. To support the naira by restricting its conversion to foreign currencies. When the naira is
frequently on the parting end in large quantities, the value will fall while foreign currencies
will appreciate.
viii. It is a good thing to control the usage of foreign exchange because the fast developing
countries o the Far East including Malaysia, Singapore and India started by clamping down

5
on imports while experimenting with local manufactures which their own people had to live
with until perfection naturally followed.

6
TYPES OF FLOATING EXCHANGE RATE
Nigerian maintains a floating exchange rate regime that allows it to quote the naira in pence
rate. A country could allow its floating rate to be free or managed.

i. Free Floating Exchange Rate

This is a system whereby the monetary authorities sit back and allow the currency to finds its
competitive rate through the interactive forces of demand and supply in the international
market. The limitation of free float is that, there are, other factors that affects the rate of
exchange such as politics, speculation, counterfeiting and hot money among other things that
affect the level of exchange rate.

ii. Managed Float / Dirty Float

This is a system where the monetary authorities merely put the currency on a floating roller
with the understanding that the monetary authorities want it to achieve its true market rate.

OBJECTIVE OF EXCHANGE RATE POLICY

The exchange rate policy pursued by each country at any particular point in time depends on
the objectives intend to be achieve by the authorities. The main objectives of exchange rate
policy in any country are:
i. To preserve the international value of the domestic currency
ii. To maintain a favorable external reserves position
iii. To ensure external balance and overall goal of macro-economic stability such as price
stability, moderate inflation rate, full employment

OVER-VALUED CURRENCY
A currency is over-valued if the exchange rate does not reflect accurately the cost price
structure of the domestic economy related to other countries. The foreign exchange value of
the currency is fixed at a higher level than allowed by market forces and as such prices of
imported goods tend to be cheaper than comparative goods at home country. This situation
always arise where the exchange rate is subject to controls by the monetary authority of a
country rather than allow forces of demand and supply to determine the exchange rate. The
currencies of other countries tend to be cheaper relative to the home currency, hence, it is
cheaper to import but less incentive to export.

On the other hand, a country may intentionally overvalue its currency for the following three
reasons to the country advantage:
i. The country is persecuting a war and needs large quantities of import such as goods, arms
etc.
ii. The country is under heavy external debt burden.
iii. The country is at the developmental stage and needs large volume of essential raw
materials and capital equipment from abroad.
Consequentially, the country pays less to other countries in terms of its currency both for
imported goods and for repayment of foreign debt.

7
EFFECTS OF OVER-VALUED CURRENCY
i. It makes imported goods cheap and increases the country’s propensity to consume
imported goods.
ii. It discourages export with concomitant negative impact on the balance of payments of a
country.
iii. It encourages smuggling of goods, as smugglers tend to make huge gains from their illicit
activities.
iv. It encourages black/parallel market of operations
v. It leads to capital flight in the form of over-invoicing of import or under-invoicing of
exports.
vi. It discourages direct foreign investments in the sense that it will not be profitable for
potential investors
vii. It leads to distortions in resource allocation as the strength of the currency does not
rationally reflect the inflow and outflow of foreign exchange.
viii. Where the country is highly indebted to external creditors, it could frustrate the process
of debt rescheduling.
ix. It makes it difficult for a country to attract foreign financial assistance either in the form of
aid or loan
x. It could result to poor relationship with international financial organizations wuch as
World Bank and IMF

EXCHANGE RATE ADJUSTMENT

If a country’s currency is actually over-valued, the symptom is that the value of imports will
increase generally while exports reduces but the reverse is the case if the currency is under-
value. The country may therefore re-value her currency either downward or upward through
any of the following adjustment:

i. Crawling
This is a process where the value of the currency is officially adjusted downward of upward
at a very gradual basis. The exchange rate adjustment is gradual and there is no
announcement effect. It is a system of exchange rate where the rate is adjusted at short
intervals with a view to reflecting the prevailing rate of inflation and between the
adjustments, affixed exchange rate system prevail. It also takes longer time than can be
tolerated for the envisaged rate to be achived.
ii. Adjustable Peg
This involves the pegging or fixing of a country’s currency with reference to an international
reserve asset such as gold and undertakes to maintain the values of the currency at this level
of the currency at this level by buying or selling with or for gold if it gyrate bellow or above
its par value.
iii. Target Zone / Crawling Bands
This is a system of exchange rate where countries in a special relationship of which member
must include those countries with major convertible currencies of the world, agree and
committee themselves to maintaining exchange rates within a predetermined ranges.

8
iv. Direct Devaluation
This is the reduction in the value of a country’s currency in terms of the value of the
currencies of other countries. It is a deliberate government action whereby the official rate of
exchange between its currency and those of other countries is amend so that the exchange
rate becomes less favourable to the home currency. It is aim to increase exports and reduce
imports thereby creating excess foreign exchange earning of a country.
v. Revaluation of Currency
This is a method where the value of a country’s currency is allow to appreciate against other
currencies of the world. It is a phenomenon that allows less quantity of a nation’s currency to
be exchange for a unit of currency of other countries. It is aim at enhancing the purchasing
power of a nation’s currency thereby improve the living condition of a citizen.

The following measures can be taking to re-valuate a currency:

a. Reduction of imports
b. Enhancement of exports
c. Monetary policies such as:
a. Indirect policy like open market operation
b. Direct measure like uses of stabilization security
c. Increase in Minimum Re-discounting Rata (MRR)
d. Increase in Cash Reserve Ration (CRR)
iv Fiscal policies such as:
a. Increase in tariff
b. Increase in import duties
c. Total ban of some products
d. Monitoring of foreign exchange market operator’s by the CBN
v CBN imposition of sanctions and penalty such as:
a. Review of Exchange control Act in line with the aim of the government
b. Moral suasion
Vi Market Controlled Adjustment
This is a process whereby rate of exchange is allowed to be determined by market forces. For
example to remove all official control and guidance and to allow full market flexibility in the
determination of the exchange rate.

Vii Flexible or Floating Rate Regime

Flexible or floating rate regime implies that the forces of demand and supply will determine
the exchange rate in the market. This regime assumes the absence of any visible hand in the
foreign exchange market and that the exchange rate adjusts automatically to clear any deficit
or surplus in the market
FACTORS INFLUENCING EXCHANGE RATES
i. Interest Rates Differential: The level of interest rates on investment either in one
country or in another affects the supply and demand of their currencies. Interest rate is the

9
rate of return on capital invested either at home or abroad and such investment may take the
form of deposit account stocks, shares, treasury bill and treasury certificates etc.
ii. The Rate of Inflation and Level of Price: A persistent increase in the price of goods and
services which result to inflation has a significant role to play in determining the value of a
country’s currency in term of other currencies. The rate of inflation and levels of price in an
economy create a market demand for one currency as opposed to another currency. The
consistent high inflation rate will continually depreciate the value of Nigeria relatively to US
Dollar.
iii. Level of Money Supply in the Market: The factors of demand and supply determine the
price of commodities in the market. Exchange rate is subject to forces of market interplay,
hence, the level of money supply at any time must equate the level of economic growth with
production.
iv. Capital Flight: This may be in form of over-invoicing or imports or under-invoicing of
exports which normally have the effect of diminishing volume of a country’s foreign
reserves, thus, impacting negatively on the exchange rate.
v. Economic News: This usually have immediate effect on exchange rate. For instance, the
impact of oil prices usually affect the exchange rate of Naira.
vi. Balance of Payment Position: Balance of payment may be either favourable,
unfavourable or at equilibrium. Any country with favourable or surplus balance of payment
will have more foreign exchange and its own currency will be quoted at a premium on the
forward market. But in a situation where a country has a deficit balance of payment which
leads to excess supply of its currency over demand for it, there is tendency for the currency to
depreciate in value which is only possible in a country where the domestic currency is
convertible.
vii. Leakage Economy: If the economy is characterised by leakages such as smuggling of
imports and exports, the cumulative effect will be depreciation in the exchange rate of
domestic currency. If the economy is performing poorly, it will reflect in the exchange rate of
that country’s currency.
viii. Confidence and Speculation: The political economy of a country affects the dealer’s
confidence in dealing with currency of that particular country. Also, lack of confidence and
uncertainty in the money market can lead to speculation in a currency.
ix. Lead and Lags: This means when an investor made a decision in buying and selling
foreign exchange based on his expectation in the nearest future about the effect of movements
in exchange rates and how this will impact on his selling or buying decision. Lead means
instant action or immediate action on buying and selling decision while lags means to delay
an action or post pone decision taking.
x. Hot Money: This is a substantial quantity of international money or capital flow which
are available for investment. This money moves from one country to another in order to
obtain the benefit of higher interest rate. It flows from a weak currency into stronger currency
in anticipation that the stronger currency will increase its value and leads to capital profit.
xi. Hedging: This is a process of converting the foreign currency equivalent of foreign assets
into more suitable and profitable currency in order to reduce or eliminate any future losses
arising due to exchange rate fluctuation.

10
xii. Swap: This is a transaction where a currency is sold and repurchase simultaneously but
the delivery dates for sale and purchase are different. The swap rate is the cost of entering
into the swap arrangement.
xiii. Arbitrage: This is a high risk but sweet business of buying a currency or any other asset
in a financial centre where it is cheap and selling it at another centre where it is expensive
with a view of making profit.
xiv. Stock Exchange Influence: Stock exchange operations in foreign securities exert
significant influence on the exchange rate.
xv. Exchange Control Regulation: This is a means by which government restrict the
outflow of capital and protect the value of the country’s currency.
xvi. Central Bank Intervention: The Central Bank acts as balance forces in the foreign
exchange market through interventions. The intervention would be to prevent a devaluation
of the currency beyond certain acceptable limit or a revaluation of the currency in exchange
for foreign currencies.

11