Devaluing the Devaluation Delusions

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Wednesday, January 06, 2016 5.37 AM / By Temitope Oshikoya**

 

 “I am not here (in Nigeria) nor is my team in this country to negotiate a loan with conditionality….”However”, there could be more added flexibility in the monetary policy...” Christine Lagarde, IMF’s Managing Director.

Christine Lagarde, the Managing Director (MD) of the IMF is currently visiting Nigeria. Following her meetings with the Nigerian Authorities including President Buhari, the IMF’s MD was at pain to emphasize that she was not in the country to negotiate an IMF loan program, which often include a devaluation pill, with Nigeria.

Why the emphasis on an IMF loan program by the MD? Flash back to 15th January, 1998. What comes to mind is the symbolic signature picture of Indonesian President Suharto signing an IMF loan program agreement with the then IMF’s MD Michel Camdessus, to the left arms-folded hovering over the President.

At the time for Indonesia, the scent of change was in the air. The IMF simply helped along in sealing it with an economic reform program including removal of subsidies and devaluation of the Indonesian currency.  As noted in the Financial Times by the then World Bank’s Country Director of Indonesia, the economic reform was driven largely by external agency of restraints.

The symbolic captioned picture of Indonesia’s President of nearly two decades ago, which went viral during the Asian Financial Crisis, capitulating to the IMF’s MD is clearly what the current MD is trying to avoid with her Nigerian host. Of course, Christine Lagarde was also careful to note that Nigeria needs a more flexible monetary policy.

Of course, market participants lean on rating agencies and international financial institutions including the IMF to try to persuade governments in developing countries about market-oriented policies, including a more flexible exchange rate regime.

On the other hand, President Buhari has clearly indicated in his exchange with the IMF’s MD that Nigeria’s economic reform program would be inward looking and home grown. In the context of 2016 Budget of Change presented to the National Assembly, President Buhari had also made some interesting remarks on the country’s current exchange rate regime.

In this article, we try to situate those remarks in the political economy context of the three key factors—economics, markets, and politics-- that determine the choice of exchange rate regimes.

 

Economics, Markets, and Politics

These three factors impose constraints on policy-makers. First, on the economic front, governments are faced with the monetary policy trilemma and its systemic constraints. Then, policy makers can only two out of three options at any point time.

Second, in an open economy with increasing capital globalisation, markets constrain the government’s ability to conduct policy in response to economic shocks. In general, markets participants would favour a more flexible exchange rate regime with another round of devaluation, an open capital flows regime, and a higher interest rate regime.

Third, governments also face political constraints imposed by their domestic constituencies applying pressure to select exchange rates regime that favours specific domestic goals and interest groups. The dominant political interest group may favour fixed exchange rate system and the status quo, a lower interest rate and strict capital controls.

It is the interface and tension between the market constraints and political constraints that lead governments to respond in a predictable manner to the structural constraints imposed by the monetary trilemma (Ben Carliner, 2005: What determines exchange rate regimes?).

 

Economics

In contrast to perceived wisdom, the remarks by The President appear to suggest an understanding of the economics forces of supply and demand, the implications of scarcity and the choice that it entails.

The President stated in his own words, “I am aware of the problems many Nigerians currently have in accessing foreign exchange for their various purposes…these are clearly due to the current inadequacies in the supply of foreign exchange to Nigerians who need it. I am however assured by the Governor of Central Bank that the Bank is currently fine-tuning its foreign exchange management to introduce some flexibility and encourage additional inflow of foreign currency to help ease the pressure.“

More importantly, one of the key insights in the Budget statement is the following: “The status quo cannot continue. The rent seeking will stop. The artificial current demand will end. Our monetary, fiscal and social development policies are aligned.”

There is indeed a need to coordinate monetary and exchange rate policies with fiscal policy.  A flexible exchange rate and a depreciation of the naira should indeed boost government revenue allocation. However, there is no guarantee that this would generate a higher fiscal multiplier on the economy without us successfully plugging the fiscal leakages at both the State and Federal levels. Furthermore, Nigeria’s high import dependency means that rising fiscal spending may just be diverted towards imports of consumer goods.

How about monetary policy? In this period of stagflation (inflation and unemployment both rising) and negative output gap (actual output below potential output), the task of the monetary authority is a bit complicated. The current stance of accommodative monetary policy moving towards a low interest rate environment is expected to be supportive of expansionary fiscal policy change intended to raise aggregate output in an economy with less than full employment.

Moreover, real borrowing cost is actually now at 1% with bond yields at about 10.5% and inflation rate at 9.5%. In essence, the government appears to be benefitting from inflation tax, but most financial analysts focus mostly on the nominal borrowing costs of financing fiscal deficits.

 

The Markets and the Open Economy

In addition, policy makers must appreciate the context of markets they operate in and in a world of free capital flows and floating exchange rate regimes, economic uncertainty is swiftly punished by foreign portfolio investors, financial markets and institutions including global rating agencies and purveyors of indices such as JP Morgan index.

The love affair of foreign portfolio investors will be severely tested even if the country relaxed capital controls and enacted a floating exchange rate. The current spread between rising US interest rates and declining Nigerian rates provides insufficient compensation for the perceived risk of Nigerian investment given rising external current account deficits, rising fiscal deficits and low oil prices. In essence, a much larger depreciation of the exchange rate would be required to compensate them for lower interest rates and bond yields.

All of this brings us to the issue of monetary policy trilemma. The unholy and impossible monetary policy trinity is not merely a theoretical construct. It is a valid practical proposition. As Michael W. Klein and Jay C. Shambaugh once noted: ‘Governments face the policy trilemma – the rest is commentary.”

The CBN cannot successfully pursue its accommodative monetary policy strategy while simultaneously controlling the currency without imposing capital controls. It must choose only a combination of two out of three at any point in time.

 

The Politics of Exchange Rate Regime

Given the distributional effects of the choice of exchange rate regimes, different interest groups lobby for the regime that they perceive to favour their group.

The economic interests of the electoral constituencies (including grass root support by owners of labour and an army of unemployed youth) that brought President Buhari to power is quite distinct from those of some owners of capital, which actually opposed his ascendancy.

This fact is not lost on the President and his kitchen cabinet; they are fully aware of it. Listen to remarks by the President; “We are carefully assessing our exchange rate regime keeping in mind our willingness to attract foreign investors but at the same time, managing and controlling inflation to level that will not harm the average Nigerian. Nigeria is open for business. But the interest of all Nigerians must be protected. Indeed, tough decisions will have to be made. But this does not necessarily mean increasing the level of pain already being experienced by most Nigerians.”

In this context, it is no surprise that the government has sacrificed capital mobility in favour of an implicit fixed exchange rate and the ability to orient monetary policy towards lowering interest rates to support fiscal and development policies aimed at tackling unemployment.

To illustrate this fact, the trade union and labour union has been quite vocal in its support for the current exchange rate regime. After all, the vast majority of Nigerians do not use foreign exchange to undergo foreign medical tourism, send their children for schooling abroad, buy exotic cars, and travel to Dubai, Paris and London on vacation and for luxury shopping.

They have realized that the promises of exchange rate depreciation from 1 to over 200 to the U.S. dollar over the last three decades have not led to increased productivity, export competitiveness, and domestic revenue diversification nor weaned the country off import dependency.

They also know that Nigeria’s domestic shortcomings—fiscal leakages, institutional, structural, and infrastructural constraints—cannot be solved by simply debasing the currency.

On the other hand, some economic agents have been subtly campaigning against it. In particular, financial institutions have seen an erosion of their three major sources of profitability—treasury, foreign exchange, and cheap public sector deposits---which are indeed tied to the policy choice arising from the trilemma. Then add the nearly 20% decline in the stock markets, you understand the pain of the whipping boys of the equity and FX markets!

 

Beware of the wisdom of the crowds

The phrase “Beware of the wisdom of the crowds” then aptly describes the perceived popular reactions within the financial markets to the statement on exchange rate regime in the Presidential Address.

Some appear to have misinterpreted this statement to mean that another round of devaluation of the naira is coming soon, perhaps early in 2016. While this may still happen, the President in his media chat at the end of 2015 appeared to have deflated those devaluation delusions by restating his stance on devaluation of the naira.

The CBN had also signaled that flexibility in exchange rate management implies prioritizing exchange allocation to hitherto well established letters of credit, importers of raw materials and essential capital goods.

While the financial markets and markets intelligence gurus tend to focus more on market constraints, they neglect the systemic constraints of the monetary trilemma and domestic political considerations relating to the choice of exchange rate regimes. They should wake up to the scent of change in the air.

Dr. Temitope Oshikoya, an economist and chartered banker is CEO of Nextnomics Advisory. He can be reached via www.nextnomics.com

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