Lagos — Not too many people with an understanding of the Nigerian economy were surprised when the naira started its slide against the US dollar sometime in November last year. Indeed, I recollect sending a text message to an official of the Central Bank, late in October wondering for how much longer the Bank will keep propping up the naira in the face of Nigeria's vulnerability to the global economic contraction. The country's over-dependence on oil as its main source of foreign currency earnings means that when the price of crude declines, there will be a corresponding drop in foreign reserves accretion. Essentially, Nigeria's terms of trade deteriorated sharply in 2008, such that its payment position came under considerable pressure and confidence erosion.

Added to this, given that alternative sources of foreign exchange inflows comprising portfolio foreign investment and international credit lines once open to Nigerian banks had dried up, meant that CBN became the primary source of foreign exchange in the economy as 2008 drew to a close. Being the chief provider of foreign exchange, CBN, naturally, would have had to dip into the country's foreign reserves to prevent a depreciation of the naira.

The Central Bank was caught between the devil and the deep blue sea. It had to find a balance between depleting the country's foreign reserves to keep the naira at N117 against the US dollar, or allowing it to depreciate. It wisely chose the latter alternative. Unlike in 2006 when the Central Bank Governor, Chukwuma Soludo, boasted that the naira was the currency to hold and moved to close the premium between the official and parallel market rates with the introduction of the weekly Dutch Auction System, the economic climate late last year had changed drastically, compelling the Bank to change course.

But a danger lurked - speculators started taking positions in the foreign exchange market and were betting against the naira - thus precipitating a sharper decline of the local currency against the US dollar in a matter of days. It also led to a widening of the premium between the official and parallel market rates, which currently stands in region of N6.00 to N10.00, and is well above the band of three percent successfully maintained by the CBN for two years.

Nigerian banks are not unmindful of this widening premium. Like greedy sharks, some of them have started to engage in round tripping to take advantage of the price differential between the official and parallel market rates. As a matter of fact, market watchers are worried that the rising demand for forex in the official market is being driven by banks to finance visible and invisible trade transactions that are not genuine. If care is not taken, some so-called Form Ms being opened by banks that are meant to support the importation of physical goods (visible trade) into the country, may turn up at the nation's ports as containers of sand in order to beat the prying eyes of the authorities. For banks and several speculators, the opportunity for arbitrage presents the perfect opportunity for them (especially banks) to recover the losses made in the stock market and the downstream oil sector where most of them got burnt.

Obviously, the CBN has its work cut out. It has to move promptly to vet the demand for forex from banks by establishing the true level of domestic requirements for hard currency in order to flush out speculators from the market. Early in December, the Bank announced that it will become an active participant in the inter-bank forex market once more and take part in the two-way quote system as means of dousing pent up demand for foreign exchange. But save for last week when it actively bought up forex in the inter-bank market on Tuesday and sold it back in the market the next day, its participation has been irregular, thus leaving room for speculation that is driving up the exchange rate further. It is apparent that the Central Bank has to intervene more frequently in the inter-bank market, and if necessary, become a permanent feature in the market until speculators are scared away.

In addition, the Central Bank may have to reconsider its policy on the liberalised foreign exchange regime currently in place. The present dynamics of the Nigerian economy do not support a liberalised regime through which arbitrage and capital flight are allowed to take centre stage. If the situation is allowed to persist, it will leave room for price distortions given Nigeria's dependence on imports.

One option the Bank may explore is by selling forex directly to big or blue chip companies and customers with a consistent track record as far as their operations and importation of raw materials and other inputs are concerned. To ensure that the blue chips or customers do not themselves engage in arbitrage, the CBN and the Nigerian Customs Service will have to device means of verifying prices of their imports and double checking on them when they arrive at the sea and airports. That way the activities of the banks that are presenting bogus Form Ms will be curtailed.

Another will be for the Central Bank to wield the big stick decisively. By catching and publicly sanctioning one or two banks and their management caught round tripping, this will serve as a deterrent to other would-be round trippers. The banking industry's dread for the imposition of a massive penalty and the removal of a bank's top executives, will certainly force others to clean up their acts.