Wednesday, July 08, 2015 10.15 PM /Proshare Research
The Central Bank policy on the management of the foreign exchange market came under sharp focus recently when the Economist sharply criticized the bank's recent policy to place under “restrictions” certain categories of imports into the country. The CBN has announced that 41 items will be affected. The importers will no longer have access to foreign exchange at the official Interbank Foreign Exchange market.
It will appear that The Economist anchored its position on its traditional support for open economies and trade liberalization with all the attendant consequences especially in developed economies. In fact, major Western economies have embraced devaluation as a major policy plank while OPEC countries such as Venezuela have been on the devaluation steroid for a long while now.
When there are only bad options to choose from, you take the best bad option that offers the best chance of success, not anyone that looks good or the easiest way out. Nigeria was faced with one of such situations with its reserves; where it had to take steps to slow down demand and rate of depletion in its bid to defend the naira in the face of dwindling dollar revenues (mostly oil).
Where The Economist got it wrong therefore was in their understanding of the nature, structure and fundamentals of a mono-product economy without an export base in tradables and manufactures.
HOW WE GOT HERE
The BearWhale analogy developed by Izabella Kaminska (FT Alphaville/November 7, 2014) offer us a veritable means of illustrating what Nigeria is currently going through in managing its foreign exchange position. The BearWhale is "a large mythical creature known to operate in FX markets with the explicit intention of shattering upstanding and well managed currencies like the Naira, Bitcoin and Rubble. If found to display extreme speculative dumping behavior, defences must be organized by the champions of the superior currency zone so as to scare the wunderbeast away. These defenses usually involve feeding the BearWhale large amounts of unwanted inferior dirty currency until it can physically consume no more and withdraws to its cave. A successfully slain BearWhale is usually cause for much jubilation and festivity within the defending community."
The ever declining oil prices makes a devaluation of the Naira a fait accompli, thus creating room for a BearWhale attack in its currency zone. The CBN has maintained a stoic resilience to the BearWhale attack by its insistence on its readiness to defend the Naira via conventional strategy of BearWhale dollar-feeding by utilizing FX Reserves.
According to BusinessDay, Nigeria had spent till date, a total of $3.4 billion to prop up the Naira since February when it officially devalued the currency.
While the political will to keep the Naira stable is not in doubt, it is crystal clear that our country's FX reserves is not sufficient enough to stem the Naira's downward spiral in the face of continuous fall in oil prices globally.
An assessment of the level of FX Reserves adequacy to safeguard financial stability in Nigeria is estimated as between $44billion and $66billion; and the current FX Reserves of $29billion ($37billion @Nov 2014) are some 15% below this level. The recent triumphant feeling of bringing this to $32billion from “blockage of leakages” and other sources confirms the dire straits the supply side is under.
Against the background of Nigeria's macroeconomic fundamentals and fiscal federalist state, the new breed of BearWhale cannot be dealt with successfully through tight monetary policies and depletion of FX Reserves alone. The trilemma has run its course.
The question is: what options are available and what criteria should guide its deployment and implementation to ensure financial stability, predictability, growth and employment generation. This is a question for which an answer would not come from the central bank alone; and one for which the Senate President can redirect his appreciation to/of.
It can however be agreed by all sides that the inelastic demand for FX needed to be curbed by the CBN through a resort to some form of restrictions and controls. The natural question would then be – to achieve what?
We believe it is this unanswered questions that provides a veritable basis for the perception issues arising and the lack of a clear direction as to what success is likely to look like for the country; what the end game is and indeed, how these sets of actions would impact its productive sectors.
Citi’s Ivan Tchakarov offers us a glimpse into why such “restrictions” or demand management instruments may be tenable within the current context, in an FT op-ed summing up the Central Bank of Russia (CBR’s) defence strategy of the Russian ruble:
"The menu of options to address the RUB weakness are limited, yet well known. The CBR all but eliminated the currency corridor against the RUBBASK on Nov 5th, reducing its fixed intervention and making its presence in the FX market less predictable….And if that doesn’t succeed, the CBR could well bring out the big guns: namely the building of giant capital control wall that is some forms of capital controls may no longer be considered an exotic avenue to pursue but maybe a legitimate policies tool to be employed to preserve financial stability. We have argued elsewhere that the current policy mix in Russia is characterized by a tight fiscal and tight monetary policy and that the current macroeconomic and geopolitical backdrop correctly necessitates such a policy mixture. However, the sliding currency creates now an environment that may no longer be properly managed only by tightening monetary policies and that may need to be addressed by introducing some restrictions on the ability to freely move capital. This may take the form, for example, of enforcing obligatory sales of FX revenues to alleviate pressure on the FX market."
A Stitch in Time?
It is recognized that the latest CBN policy is a measure of its frustration with the apparent ineffectiveness of conventional policy initiatives that have been deployed to stem the tide of the downward spiral of the Naira but it might just be coming a bit too late, too little.
The use of monetary tools as a bridge for achieving pseudo-fiscal objectives in the absence of a fiscal response must be seen only for what it is – a stop-gap tool; and not an import-substitution sovereign decision as being marketed by the central bank. We will explain presently.
As at the last quarter of 2014, the indicators in the international environment as to the price of oil, observed leakages in our revenue basket and the U.S. Fed's tapering moves meant that a depreciation of the Naira was inevitable. Inaction at an early stage (for whatever reason, political or otherwise) meant that the CBN gave room for enormous arbitrage opportunity in a dual market system for foreign exchange. The Naira exchanged for less than N170 before being moved to N199 at the official market reflecting approx N32 spread against the parallel market as at today.
CBN’s consequential retention/deployment of traditional FX management strategies as the guardian of the value of the Naira unintendedly widened the gap between the official and parallel market and created arbitrage activities in the market with dire consequences for the real economy, growth and employment prospects.
It should be said thought that the fundamentals of the Nigerian economy did not present palatable options for monetary policy management in isolation of the fiscal side. Nigeria faced a productivity and competiveness issue in our tradables, the consequence of which meant that the main driver of FX inflow was subject to vagaries in the market.
The CBN was in denial of this reality up till now as revealed by its monetary policy committee minutes wherein it ought to have been apparent that the drastic fall in dollar earnings from crude oil in itself delivered a devaluation of the Naira.
Therein perhaps lies the irony and a shock to the proponents of further devaluation (which we believe may not happen) - Nigeria's export trade is dominated by one commodity – oil, manufactures are exported in negligible volumes and can therefore not benefit from devaluation; especially when the level of agricultural cash crops exports has fallen drastically over the years.
WHAT ARE THE OPTIONS AVAILABLE?
The choices available to the Central Bank in the situation under reference can be categorized into two pillars:
Short Run: Reduce the Pressure on the Naira
The short run option is to reduce the pressure on the Naira by influencing the interplay of the demand and supply forces. It can only increase the supply of the fx by releasing part of the external reserves, an option has been exhausted to the point where we now have $29.1billion worth of external reserves that can serve the nation for only 4.7 months.
The other leg of the short run option is to tinker with the interest rates - a policy tool that has been applied on several occasions without success. The demand for dollars in a nation that has an insatiable appetite for import consumption, low quality and high priced local substitutes, is almost always tending towards inelasticity.
The third leg of this option is a direct intervention in the form of disguised or open capital controls i.e. various forms of “restrictions” on the demand for and utilization of the foreign exchange.
In delivering on this third leg, three critical elements need to be in place:
1. A clear framework and methodology for determining non-essentials, and immediately available local substitute for items not qualifying for official FX;
2. The indices or indicators of measuring effectiveness of interventions and a clear idea of what success will look like; and
3. Fiscal side complements necessary to engender productivity
What is wrong with the recent Policy Initiative and why do people have problems buying into it? For one, the communication of the action opened the esteemed institution to doubts in the absence of the three (3) elements mentioned above.
It encouraged speculations as to how the 40+1 laundry list was arrived at given that Oil Imports and Financial Services alone accounted for about 20% and 32% respectively of FX utilized from banks conservatively. While the CBN has other information at its disposal that guided the eventual list, it would have helped to have some clear expectations as to what happens to sectors affected, when they expect to reduce or eliminate FX demand for oil/fuel imports, why some luxury items made the list and others like automobiles did not given our new automotive policy; and what is the sustainability of the measures taken so far vis-a-vis alternative supply of the items within the local economy.
Does Nigeria have the capacity to meet the demand for the basic food items contained in the list? What are the complimentary policies to encourage the switch to local production? Are local manufacturers ready to bridge the supply gap locally? What are the quantitative targets involved in this decision in terms of outcomes.
Long Run Option: Diversify Revenue Base and Boost Productivity
The long run option is to put in place policies that can aid the diversification of the source of foreign exchange as well as increase the productivity and competitiveness of the Nigerian economy. This will make our manufactured exports competitive, sustain employment and deliver on growth objectives.
This fiscal side responsibility will have to be driven through a cocktail of reforms, restructuring and regulation easing i.e. investment allowances, tax reliefs, import substitution initiatives and general improvement in the collection and management of government revenues.
This is where the Ministry of Finance, Chief Economic Adviser and the Central Bank of Nigeria has to pull together as the core of the Economic Management Team of the country; and the delay in having this team in place befuddles the mind.
THE URGENCY OF NOW
The key task for the CBN is to understand its unwritten role in the economy. Investors, businesses and players in the economy look to the CBN for signals to guide their decision making. A situation where uncertainty becomes the new normal cannot be healthy for everyone in the economy as it increases the fear factor.
It is equally important that the signals, when given; is not drowned by the noise….and there is too much noise in the ecosystem now which can only distract from the seriousness of the situation at hand.
The CBN, on its part, needs to signal clearly its understanding and in specific terms (using quantitative data) its’ desired exchange rate, interest rate and inflation rate that it considers commensurate with the country's growth and stated employment prospects.
At the very least, we must have an idea for how long the central bank expects these ‘intervention’ policies to be in force for (based on its scenario analysis and informed insight into policy changes from the fiscal side) in order to avoid the short-termism that is feeding the fear factor in exchange rate and business activities in general.
The present policy regime (and the absence of a core economic philosophy of government) does not encourage that to happen: a key negative in policy formulation at the apex of our banking regulation.
From where we stand, there is no percentage of devaluation that can resolve the country's foreign exchange challenge. In Nigeria's case, devaluation leads to contraction in the economy. Therefore, CBN’s decision to manage the demand side of the equation in the short term appears in order.
Yet, if the situation does not improve, what other options does the central bank have?
Better still and looked at more positively - for the economy to gain any traction; what monetary policies can we expect from the CBN, supported and accompanied by requisite fiscal policies to engender productivity and competitiveness?
Nigeria must accept the inevitability of undertaking well-linked structural reforms (where 81 percent of economic activity come from ten sectors) to remove rigidities and inefficiencies that hinders its real sector to be innovative, industralised and competitive.
According to Dr. Ayo Teriba of Economic Associates, “a situation where Nigeria remains cyclically dependent on global economic swings, remaining especially vulnerable to a protracted decline in global prices of crops and oil; is structurally weak with forward linkages from crops to manufacturing/industry weakened by energy supply and transport failures; and its domestic trade is boosted by high crops income, but held back by high logistics costs is not sustainable”.
We agree and hope that at moments like this, we remind ourselves that it’s the productivity of the economy that defends the Naira, not moralizing, sermonizing or engaging in a game of musical chairs with foreign exchange.
The Research Team
1. Olufemi AWOYEMI, CEO Proshare
2. Kola OGUNLEYE, CEO Decon Consulting
Additional inputs from seminal work by:
1. Dr. Ayo TERIBA/Economic Associates – New Regime and How it Can Change the Sectoral Outlook – July 2015
2. Dr. Temitope OSHIKOYA/Nextonomics - Economic Policy Trilemma and Exchange Rate Management in Nigeria – April 2015