1. Volatility: The exchange rate can fluctuate quickly, sometimes even daily, as a result of market forces that determine it. It may be challenging for firms to plan and make investments due to this volatility's potential to breed uncertainty.
2. Competitiveness: A country's competitiveness may be impacted by a freely floating currency. A strong currency may make exports more expensive, which could reduce demand for the nation's products and services on the international market. A lower currency value, on the other hand, can increase export appeal and provide businesses a competitive edge.
3. Inflation: A country's inflation rate can be considerably impacted by the value of its currency. Increased import costs might result from currency depreciation, which will raise inflation. A strong currency might also result in lower inflation since imports are less expensive.
4. Interest Rates: The value of a currency can affect the interest rates in a nation. Investor desire for higher interest rates in a sinking currency may increase borrowing costs.
Overall, a freely floating currency can have advantages including increased monetary policy flexibility and the ability to adapt to external shocks, but it also needs to be carefully managed to reduce any risks and uncertainties.
The Central Bank of Nigeria (CBN) directed commercial banks to sell forex freely at market-determined prices on Wednesday.
This means that Nigeria has relaxed its grip on the naira, allowing it to float. There were differing opinions on whether the naira should be floated by the government.
When the International Monetary Fund (IMF) originally proposed the concept to Nigeria in 2022, many financial experts argued that it would be detrimental.
To be clear, the naira's free float means that the exchange rate is no longer determined by the government or a monetary institution such as the CBN.
It also implies that the exchange rate at any given point in time is controlled by the interaction of market forces of supply and demand for foreign exchange.
Simply expressed, the rate at which the naira is exchanged for any foreign currency is determined by the agreed-upon price between the buyer and seller. This would also be free of any CBN involvement in the form of regulations or policy.
When the plan was first proposed in 2022, experts warned that floating the naira would eventually lead to the currency's total collapse.
The move would also mean that the naira's value against all other currencies would continue to fall, eventually becoming worthless and causing a currency crisis in Nigeria.
They also predicted that it would have a detrimental impact on Nigeria's manufacturing and other exchange-rate-dependent industries, resulting in a negative supply shock.
A supply shock is an unanticipated incident that alters the supply of a product or commodity, resulting in a sharp price change.
A negative supply shock reducers output, which causes prices to rise at an alarming rate.