Many Nigerians view the exchange rate of a country’s currency as a gauge of economic prosperity. Based on this metric, some disapprove of Nigeria’s 2023 FX reforms. The exchange rate is a key economic variable particularly in today’s open economies. That said, the number itself does not tell us much and it is more beneficial to have a working understanding of the underlying mechanisms that influence it. In this essay, I will lean on economic theory to explain the decision to move the naira to a floating exchange rate regime.

The exchange rate can be defined simply as the rate at which one currency can be exchanged for another. For instance, if we can exchange 1400 naira for 1 US dollar, the corresponding exchange rate is 1400 naira per dollar. Exchange rates are determined in the foreign exchange market by the relative demand and supply of currencies. These rates are influenced by interest rates, capital flows, government intervention and currency speculation among other factors. When a country intervenes minimally in the foreign exchange market thus allowing the exchange rate of its currency to be set by market forces, we say that the currency has a floating exchange rate. On the other hand, when a currency has a fixed exchange rate, the central bank stands ready to buy or sell the currency for foreign currencies at a predetermined price.

Prior to the 2023 FX reforms, the Nigerian naira was fixed at a rate of roughly 460 naira per US dollar. This means that the Central Bank of Nigeria (CBN) would stand ready to give 460 naira in exchange for 1 dollar and vice versa. For a fixed exchange rate regime such as this one to be successful, the central bank must respect the monetary trilemma. The monetary trilemma is the idea that it is impossible for a country to have free capital flows, a fixed exchange rate and independent monetary policy. For a country to maintain a fixed exchange rate regime, it must either give up its monetary sovereignty like the eurozone countries do or limit the flow of capital in and out of the country like China does. If a country is unwilling or unable to dedicate its monetary policy to maintaining the exchange rate peg and at the same time unwilling or unable to limit capital flows, it has no choice but to float its currency.

Why is this the case? One might ask. The answer: there is still an equilibrium exchange rate determined by market forces even when the exchange rate is fixed. Under a fixed exchange rate regime, it is the willingness of the central bank to exchange the domestic currency for foreign currency at the announced fixed rate that keeps the market exchange rate in line with the exchange rate peg. Should market participants feel the government is pursuing policies that are inconsistent with maintaining the exchange rate peg, they would either demand more or supply more of the currency, changing the equilibrium exchange rate. If the equilibrium exchange rate depreciates, say from 460 naira per dollar to 800 naira per dollar, the central bank can respond either by devaluing the currency to 800 naira per dollar or by using its reserves to defend the 460 naira per dollar exchange rate. 

A central bank that tries to defend the exchange rate in this scenario creates the conditions for a speculative attack. Market participants, aware of the changing market sentiment, would rush to the central bank to convert naira into dollars. This rush would drain the central bank’s reserves and force it to abandon the peg causing the currency to depreciate to the market-determined rate of 800 naira per dollar. The central bank can maintain the peg only if it strictly pursues policies that keep the equilibrium exchange rate in line with the peg or imposes capital flow restrictions that control the supply of the domestic currency to keep the equilibrium exchange rate in line with the peg. The bottom line is, even under a fixed exchange rate regime, the central bank does not set the exchange rate; it instead targets one by manipulating market forces towards a particular equilibrium exchange rate. This is because in the long run, the exchange rate, whether fixed or floating, is guaranteed to converge to the market-determined exchange rate.

The figure above shows the closing naira per US dollar exchange rate, the year-over-year percentage change in the consumer price index and the average yield on 91-day treasury bills issued by the Central Bank of Nigeria for each month from January 2017 to December 2025. Low interest rates and high inflation particularly during the covid-19 pandemic would have put a lot of downward pressure on the naira exchange rate. Presumably, Nigerians would look to convert their naira holdings to foreign currency holdings in search of higher real returns. In practice, several companies offering US dollar-denominated savings and investment products to Nigerian customers gained popularity during this period. Also, banks stopped processing international transactions from naira-denominated accounts, instead requiring people to hold foreign currency in domiciliary accounts in order to make international transactions. The result of these would have been downward pressure on the naira exchange rate.

Figure 2 shows Nigeria’s current account balance in billions of US dollars for each year from 2017 to 2025. The current account deficits between 2019 and 2021, when the naira per dollar exchange rate ranged between 300 and 420 naira per dollar, may suggest that foreign goods were cheap relative to Nigerian goods during this period. Or in other words that foreign currency was cheap in naira terms. Even after a small current account surplus in 2022, CBN gross reserves bottomed out at around 33 billion US dollars in 2023 with net reserves rumoured to have fallen as low as 3 billion US dollars.

At that point, the writing would have been on the proverbial wall. Nigeria moved to a managed float exchange rate system – which is the sort of floating exchange rate system usually found in practice – where market forces will freely determine the exchange rate and the CBN will occasionally step in to dampen exchange rate volatility. Since the reforms were put in place, the exchange rate has found its new level, the CBN has been free to use monetary policy for other purposes like tackling inflation and restrictions to capital flow have been gradually lifted. Additionally, the current account balance has largely rebounded and the CBN has seen its foreign reserves surge to record levels allowing it to manage exchange rate volatility and inspire confidence in market participants. 

The 2023 FX reforms are just one part of broader economic reforms aimed at stimulating the economy and increasing overall welfare. Its success is not enough to guarantee a prosperous economy and frankly, work still needs to be done to maintain any progress already made. Nonetheless, I am encouraged by where the country is headed as I view an effective exchange rate regime as a necessary condition – albeit an insufficient one – for economic prosperity.

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Author: Ugonna Onyemere