Tuesday, November 25, 2014 11.43 PM / The Analyst / Sriram Sekhar / smartadvisors
Nigeria's central bank devalued the naira by 8% and raised interest rates sharply yesterday in an attempt to curb fiscal bleeding due to the dropping oil prices. The bank moved the naira's target band to 160-176 to the U.S. dollar, compared with 150-160 naira previously, while it also simultaneously increased interest rates by a substantial 100 bps to 13% - the first interest rate hike in over two years.
The main reason for the devaluing of the Naira is the the falling oil prices, combined with the high foreign money in the country over the past few years - which is now leaving the country. Meaning there is more demand for dollars than there is for Naira. Although many emerging countries are facing this issue of weaker currency due to more dollar demand, oil producing states seem to be more hit. The country’s forex reserves are also dwindling on the back of continued support for the naira.
The current devaluation of the Naira is likely to impact more people than the fall in the capital markets, and the full ripple effects of the current devaluation will eventually be felt throughout the Nigerian economy. Majority of the basic goods sold in Nigeria are imported from overseas. Therefore as the Naira continues to free fall, the wholesalers and retailers of goods will have to adjust the prices of their products upwards to reflect the amount being paid for these goods. This will result in higher inflation. The inflation has only recently been contained, and this can cause the inflation rates to soar again.
Countries devalue their currencies only when they have no other way to correct past economic mistakes or problems forced on them by unforeseen circumstances. In the case of Nigeria the precipitous decline in crude oil prices has significantly limited the amount of foreign currency that Nigeria receives from the sale of petroleum.
The devaluation of the currency will also lead to a drop in FDI into the country, since higher currency volatility will lead to lower returns for foreign investors. Nigeria’s forex reserves have been falling over the past month, and were only $36.5 Bn on 24th Nov (the amount is equal to only seven months of import cover) , since the central bank has been using this reserve to stem the fall in the Naira. However, there is only a very finite quantity of reserves in the country, and given the oil price dropping, it is likely that there these reserves are going to be required to actually run the country - hence, devaluing the currency was the only option.
Overall, this is a bold move by the central bank, in an effort to stem the free fall in the currency, but it does not bode well for the overall economy in the long run. Hopefully, oil prices will stop their decline around current levels, and give the country a chance to recover from the double blow of low oil prices and a dropping naira. However, without structural reforms, there is unlikely to be any silver lining on the horizon