Foreign Exchange Volatility in Nigeria; Effect on Contractual Obligations and Possible Solutions for Businesses
Foreign Exchange and the Nigerian Economy
The endless requirement for international trade and investment across the world has continued to foster the exchange of foreign currency between trading partners. For import-dependent economies like Nigeria, there are continuous obligations to pay foreign counter-parties for imported goods using a globally acceptable foreign currency like the US Dollar. Thus, constant demand for foreign exchange by Nigerian importers.
Given the occurrence of other factors, such as the unprecedented effect of COVID-19 on global economies, which has caused a decrease in demand for oil by major importers like China and India; the price war initiated by Saudi Arabia against Russia which crashed oil prices by 64%, all occurring within a few weeks apart, the combined effect of these has been dwindling foreign exchange reserves and consequently, scarcity of foreign currency in the Nigerian market and a forced devaluation of the Naira, despite all attempts by the Central Bank to prevent devaluation. Thus, by the end of March, 2020, a currency which traded at N306 to 1 US Dollar at the official market, unexpectedly devalued to N360 to 1 US Dollar at the official market and N400-410 at the parallel market.
For many Nigerians, this situation is a vivid reminder of how the Naira lost over 70% of its value in 2015, thereby causing prices to generally skyrocket due to increased cost of purchasing foreign exchange and continuous international trade. Apart from its overall impact which gives rise to inflation, this unpredictable situation also impacts contractual obligations as discussed below.
Impact of Foreign Exchange Volatility on Contractual Obligations
For the most part, purchasers of imported commodities are obviously in a weaker position when they have made prior commitments at a fixed price. Take for instance, the real estate industry and the current era of turnkey construction projects. In transactions of such nature, the buyer and seller have agreed a fixed price, with the seller calculating value of construction materials that may need to be imported on previous foreign exchange rate. 3 weeks after closing a deal and the developer is ready to start importing, the value of the Naira has suddenly dropped and purchasing power becomes lower. Therefore, the developer suddenly has a higher financial obligation which was unprecedented at the time of selling the undeveloped property. Unfortunately, this same scenario occurs across many industries, including the oil and gas sector. The question of whether these unforeseen events can be mitigated becomes relevant.
Some contractual strategies are discussed below:
Fixed Price Hedging is particularly common in the oil and gas industry, due to the volatile nature of oil prices. Here, parties agree to fix the buying and selling price of oil over a specified period of time, notwithstanding the increase or decrease in market value of the commodities being sold. It is also commonly used in the agricultural sector to fix prices of commodities which are subject to fluctuation.
Foreign currency swap contracts are also often executed by parties who have foreign exchange obligations to third parties. From a vanilla transaction standpoint, currency swaps can be used by parties in foreign countries who exchange their financial obligations at a contractually agreed rate, without having to obtain foreign exchange from an expensive market. For example, Mr A, a Nigerian national, owes the Bank of England $100,000 while Mr B, an English National, owes a Nigerian trader, N20Million. Mr A and Mr B can agree to swap each other’s obligation at an exchange rate which is favourable to both parties and which is less expensive than purchasing from the local foreign exchange market.
In conclusion, whilst foreign exchange volatility can be unpredictable and uncontrollable, businesses may also deploy contractual methods of hedging against future economic risks.
