THISDAYonline

Gone are the days when the naira was so closely pegged to the dollar, that N5 or less could buy you a piece of Uncle Sam. This sounds like a fairy tale or an urban myth. Was there really ever a time in Nigeria when people were willing to pay so little for foreign exchange? It seems so. It is also quite interesting to note that the people old enough to remember such good financial days are now holding the top economic decision making spots in the Central Bank.

On July 18 these old 'wise' men recently scrapped the 30 months old Inter-bank Foreign Exchange Market (IFEM) in favour of the Dutch Auction System (DAS). According to the Central Bank, IFEM was dropped because an overwhelming demand for forex was outstripping supply. Nigeria is heavily dependent on imports so businesses need foreign currency to pay for the goods they buy from other countries. The negligible amount we export is usually in its crude state. This is particularly true for our number one exported commodity - oil. Proceeds from the sale of crude oil are the source of 98 per cent of the nation's foreign exchange.

During IFEMs days the demand for foreign exchange was hovering between $35 million and $50 million a day. Meanwhile, Nigeria's foreign reserve has been persistently crashing, with each new month recording a further drop. In January 2001 our foreign reserves registered $10.116 billion and fell to $9.23 billion in August 2002. The country's gross external reserves at the end of May amounted to $9, 226.3 million representing a decline of 1.9% from the $9, 403.4 million recorded in April 2002.

The naira has also continued a dangerous slide, depreciating at an alarming rate from N83.8 to one US dollar in 1999 to N125.65 to one US dollar, hence naira has lost 4,185 kobo or 49.58 per cent of its original value under the present management of the CBN. No wonder the inflation rate, which was 13.5 per cent in 1999, rose to 18.9 per cent at the end of 2001.

This might all sound like goobly gook to the non-business mind. However, it doesn't take an expert to see that since the introduction of DAS, the dollar has been selling at N135.00 compared to the N125.65 it was trading at on the last day of IFEM and Nigerians are now spending N203.50 to buy a pound. One pound that can barely get you a bus fare or a weekend newspaper in London can buy you a taxi ride in Nigeria, if you are lucky.

You don't need a Harvard graduate to tell you that it is an underestimation to say this doesn't bode well for the nation's economy. It's quite a depressing picture but before your mind is blown apart by complicated business terms, you need to understand what exactly the Dutch Auction System is and how it works and if it will heal our sick exchange rate.

The A-Z of DAS
The Dutch Auction System is popularly used as a bidding method on those internet auction sites that claim to sell everything from a new heart to diamonds. In this format the seller places one or more identical items on sale at the same time listing a minimum required price. Bids are ranked in order of price, then quantity, and lastly time. These auctions are timed events usually lasting either hours or days. Bidders submit the number of items they want and how much their bid per item is. The final selling price in this type of Dutch auction is determined by the lowest of the winning bids.

Another name for it is the descending-price auction, commonly known in academic literature as the Dutch auction. It is the technique used in Netherlands to auction produce and flowers (hence, a "Dutch" auction). It uses an open format rather than a sealed-bid method.

In Nigeria, the DAS bidding takes place on Mondays and Wednesdays. The minimum bid amount by an authorised dealer is $100, 000.00 and the currencies of transaction are the naira and the United States dollar. The CBN announces every Tuesday and Thursday the result of each auction and the official exchange rate. Nigeria is not alone in using the Dutch Auction System.

Dutch auctions have been used to finance credit in Romania and for foreign exchange in Bolivia, Jamaica and Zambia. In America the national treasury sometimes uses it to sell its new treasury notes or treasury bonds. The Treasury opens up all bids and determines the lowest acceptable bid price. All successful bidders pay this stop-out price.

An example could make it clearer. Let's say the Central Bank has 20 million US dollars on sale and the minimum selling price for a dollar is N20. Buyers can ask for as much as they want as long as it is not lower than $100, 000. Five companies bid N30 for one dollar each and ten others bid N50 for one dollar. These fifteen companies will want different quantities of dollars. Some would be bidding for $6 million, while others would be bidding for $20 million. Because the ten companies bid higher than the other five, they will definitely be guaranteed foreign exchange. But all fifteen companies will pay N30, the lowest successful bid. It is this minimum price that becomes the Central Bank's exchange rate. Anyone who wants to buy a dollar from the central bank will pay N30.

It might sound complicated, but the majority of Dutch auctions are simple. Most users win the items they bid on at the minimum asking price. Here are the key points.

_ Sellers start by listing a minimum price or starting bid for one item, and the number of items for sale.

_ Bidders specify both a bid price and the quantity they want to buy.

_ All winning bidders pay the same price per item - which is the lowest successful bid. This might be less than what you bid!

_ If there are more buyers than items, the earliest successful bids get the goods.

_ Higher bidders are more likely to get the quantities they've asked for.

_ Proxy bidding is not used in Dutch Auctions.

_ Bidders can refuse partial quantities. For example, if you place a bid for 10 items and only 8 are available after the auction, you don't have to buy any of them.

This isn't the first time that the Dutch Auction System has been used to sell forex in Nigeria. DAS had earlier being implemented in April 2, 1987 and December 14, 1990. It was scrapped because it failed to improve the dire exchange rate situation.

Will It Work This Time?
Considering that DAS was used twice and it failed on both occasions, no one is placing bets in favour of it succeeding again. Why? There are two major flaws to the DAS system. The first one is that demand tends to exceed supply and although everyone pays the lowest successful price, DAS actually does more favours for the high bidders. How?

Its success in reducing excess demand of foreign exchange is hinged on the Central Bank's ability to reassure bidders that there is more than enough foreign currency to meet their needs. If they can do this, the naira will appreciate with every trading session. However, every Nigerian is aware that the nation's foreign and external reserves have been reducing every month because of capital flight and falling crude oil prices. In January 2001 our foreign reserves registered $10.116 billion and fell to $9.23 billion in August 2002. The country's gross external reserves at the end of May amounted to $9, 226.3 million representing a decline of 1.9% from the $9, 403.4 million recorded in April 2002. Yet government spending has been on the increase since the beginning of the year, culminating to a deficit of N93.2 billion within the same period.

So despite statements by the CBN Deputy Governor, Monetary Policy, Dr Earnest Ebi that "we are in a position to put out any amount of foreign exchange we want to put into the market. We are not just flying blind, we have a pre-determined view of where we are going and we are not going to allow any arbitrariness in the system," it seems buyers are not convinced.

This week out of the $85 million offered for sale by CBN, the total amount demanded by 42 banks stood at $107 million. Demand outstripped supply by $22.02 million. Also, the seventy-two successful bids amounted to $88 million so CBN overshot its amount on sale by $3.14 million.

Demand exceeding supply is the key flaw of the DAS system and it can only lead to further depreciation of the naira. On Tuesday the naira depreciated by N1.00 against the US dollar at the seventh session of the DAS. It is important to note that the excess demand led to the naira's depreciation. The naira has persistently appreciated on the two occasions when CBN flooded the market with forex.

It appreciated two Friday's ago when the CBN exceeded the $150 million it offered by $46 million. It also firmed up last week Wednesday when a total of $115 million was offered. CBNs ability to keep the forex storehouse adequately stocked up is the key to DASs success, but with the strained foreign reserves this might not be possible.

Already financial analysts are criticising the CBN of a big conspiracy to dump the blame for high exchange rates on buyers. Is there any justification behind this claim? There could be.

If you are the lowest bidder in a Dutch auction and you specify a multiple quantity, you may not get to purchase all that you specify. Why? Because there may be little left over after the high bidders get their share. So although everyone pays the lowest price, those who bid the highest are more likely to get the amount of forex they requested for. The only way to avoid this problem is to make sure you are not the lowest bidder! If everyone is trying to make sure they are not the lowest bidders then the end result will be a high exchange rate. This is the second flaw of the Dutch Auction System.

Is There A Better Alternative?
There is no doubt that the three-year-old IFEM aggravated the huge gap between the parallel market and the official market. As soon as IFEM was introduced banks began to exploit the system making speculative and artificial demand for forex, which was thereafter sold at a higher exchange rate at the parallel market. It is believed that about 60 to 70 percent of demand for forex in IFEM were speculative or artificial demand as reflected by the amount of forex involved in the forex malpractice perpetrated by the 21 banks recently banned from IFEM.

The root of our exchange problem is Nigeria's dependence on imports. Nigeria imports the most basic of goods, including goods that we produce in the country. This creates pressure on the naira and an exaggerated demand for foreign exchange. Also as capital spending increases and the government awards contracts, businessmen need more foreign exchange to bring their goods into the country.

Concerning the parallel market, anyone who has ever been through the long and headache inducing process of buying forex from the CBN knows that the appeal of bureaux de changes and black markets is hard to resist. If the CBN really wants to discourage people from patronising the black market it needs to make it easier for honest individuals and companies to buy from the CBN while creating disciplinary measures for some of our dodgy banks and businessmen. According to an analyst when most businessmen calculate the hassle as well as expense of buying from the CBN they eventually decide to go to the simple, less difficult, less questioning black market. CBN should reduce the red tape and actively promote the apex bank as the most profitable and efficient avenue for foreign exchange there is.

Obviously, the burden doesn't lie only on the CBN. The federal government has to make macro-economic steps to industrialise our economy. Wouldn't it be great to see trucks taking finished goods to foreign countries for export? Or to walk into a supermarket and sixty percent of the goods are from our factories and industries?

As for the new initiative, only time will tell if it is going to be third time lucky for the Dutch Auction System.