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The Case Against Redenomination and Demonetization of the Naira At This Time

Proshare

Thursday, March 30, 2017 09.10 PM / Proshare Research

Nigeria has been afoot with multiple transition effects from the global economy which have led to a persistent clamour for either a policy reset or a much needed recalibration of the economic structure of the country that will act as a policy response to the new dynamic (cyclical).

Proshare seeks to widen the scope of the policy options by looking at the hush-hush in certain quarters about whether knocking off a few zero(s) or pulling away particular notes from circulation at this particular point of the cycle will be beneficial and provide the required policy response, which goes beyond currency management.

Redenomination Or Knocking Off Zeros
Redenomination of a currency refers to reduction in the par value of a currency, usually by a factor of ten. While the nations’ nominal currency has not undergone a redenomination before, Nigeria is not new to such policy. Indeed, Nigeria almost attempted redenominating its currency in 2007 but had to ditch the plan for many reasons, none the least being political considerations at the time. 

Quick RECALL
The new ‘Strategic Agenda for the Naira’ announced by the Central Bank of Nigeria on August 14, 2007 is generated a healthy national debate. The CBN announced a 4- point agenda designed to make the Naira the “Reference Currency in Africa”, as part of the Financial System Strategy 2020 (FSS2020) and the elements of the agenda are:

         Currency Re-Denomination

         Adoption of Inflation-Targeting Framework for the conduct of monetary policy

         Sharing part of the Federation Account funds in US Dollars to Deepen the Forex Market and for Liquidity Management

         Current Account liberalization/convertibility and accession to Article VIII of the IMF

To sell the case the, the CBN took the 4-point agenda as a package and posited that it will achieve the following:

         better anchor inflation expectations,

         strengthen public confidence in the Naira,

         make for easier conversion to other major currencies,

         reverse tendency for currency substitution,

         eliminate higher denomination notes with lower purchasing power,

         reduce the cost of production, distribution and processing of currency,

         promote the usage of coins and thus a more efficient pricing and payments system,

         promote the availability of cleaner notes,

         deepen the Forex market,

         ensure more effective liquidity management and monetary policy,

         convertibility of the Naira and hence greater confidence in the national economy and lead to greater inflow of foreign investment

         position the Naira to become the ‘Reference currency’ in Africa.

Thus Redenomination is a process of currency recalibration in response to hyperinflation or significant currency devaluation.

Countries, which are experiencing high nominal currency to dollar ratio, are favourable inclined to redenominate their currencies as it deadens accounting problems and a feeble scale.  Holistically, it involves eliminating or knocking off zero from the currency. It is therefore expressed through the national currency to a new monetary scale.

The new monetary scale can take place in two forms – first, the scale reduces  nominal value to a current price whereby the entire prices of goods and services immediately align to the new scale immediately e.g. Turkey; and secondly, prices adjust to the new scale in an evolving path e.g. Euro.

History has shown that the later process creates a problem, whereby individuals find it hard to understand and re-adjust to the time value. As prices is still experiencing an evolution to the new scale.

Redenomination kills off possible treat of money substitution that occurs when devaluation takes a strong momentum of its own or under a current of high inflation e.g. money substitution.

While redenomination reduces the face value by eliminating zero, it does not translate into an increase in purchasing power.

In reality it provides a failed solution to monetary illusion, even though the quantity of money has shrunk. Certainly the intrinsic value of money remains static.  

Fig 1: Examples of countries that have carried out a redenomination


Source: Wikipedia

Demonetization
Demonetization is not an alien concept to Nigeria as well. In 1984, Nigeria underwent a demonetization process. The process of demonetization involves either introducing new notes or coins of the same currency or completely replacing the old currency with a new currency unit.

It is carried out in order to curb money laundering and eliminate black money in the financial system. Moreover, it has become a means of transiting from a cash dependent economy to a more cashless one. 

Objectives

      It acts as a measure of repairing the relationship between monetary aggregate and aggregate output.

         It serves as a process of bringing the informal sector into the financial system.

         It is a measure of reasserting monetary control, restabilising financial stability and means of determining heterogeneity.

Fig 3: Examples of other countries that have carried out demonetization


Breaking Down 'Demonetization'
There are multiple reasons why nations demonetize their local units of currency. Some reasons include to combat inflation, to combat corruption, and to discourage a cash system.

In 2016, the Indian government decided to demonetize the 500- and 1000- rupee notes, the two biggest denomination notes. These notes accounted for 86% of the country’s cash supply. The government’s goal was to eradicate counterfeit currency, fight tax evasion, eliminate black money gotten from money laundering and terrorist financing activities, and promote a cashless economy. By making the larger denomination notes worthless, individuals and entities with huge sums of black money gotten from parallel cash systems were forced to convert the money at a bank which is by law required to acquire tax information from the entity. If the entity could not provide proof of making any tax payments on the cash, a tax penalty of 200% of the tax owed was imposed.

In 2015, the Zimbabwean government demonetized the Zimbabwean dollar as a way to combat the country’s hyperinflation that was recorded at 231,000,000%. The 3-month process involved expunging the Zimbabwean dollar from the country’s financial system and solidifying the US dollar, Botswana pula, and South African rand as the country’s legal tender in a bid to stabilize the economy.

Another example of demonetization occurred when the nations of the European Monetary Union adopted the euro in 2002. In order to switch to the euro, authorities first fixed exchange rates for the varied national currencies into euros. When the euro was introduced, the old national currencies were demonetized. However, the old currencies remained convertible into euros for a while so that a smooth transition through demonetization would be assured.

The Coinage Act of 1873 demonetized silver in favor of adopting the gold standard as the legal tender of the United States. The withdrawal of silver from the economy resulted in a contraction of the money supply, which subsequently led to a 5-year economic depression in the country. In response to the dire situation and pressure from silver miners and farmers, the Bland-Allison Act remonetized silver as legal tender in 1878. - Pritesh Tiwari / Resource Investopedia.

How Much Of An Alternative Does Either Redenomination and Demonitization Provide?


The questions of why, when and how any policy will be carried out inclusive of both demonetization and monetization determines the success of the policy. Thus, policy timing and taking into consideration the roundabout effect on the economy becomes key decision criteria for intelligent outcomes.

Apart from taking into consideration the monetary cost and how much of a friction such a policy would pose at this point of the cycle; it is imperative that questions be asked and answers received as to “what will be the actual cost on the real economy in the short term”?

Therefore, how much of an alternative do either demonetization or redenomination provide in specifics? Such a conclusion cannot be arrived without a litmus test.

Running A Litmus Test  

Fig 4:  Cycle vs. Policy Response



Conclusion
Empirically, Nigeria has not reached the threshold, where redenomination is needed. Even if carried out as being discussed, it will not address inflation or cyclical downturns.

More importantly the net value of money will remain largely unchanged. It will be more of a distraction than a solution at this point in time.

Demonetization can help to erode illicit money and bring the informal sector into the financial system. The downside risk of monetary sterilization, which would cause self inflicted shrinks in the growth of the currency in circulation, will exacerbate downside risk and cause vagaries in the economy.  Such vagaries are not needed in a period of recession.

Therefore, both policies cannot serve as an alternative presently.

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