Nigeria - On the Verge of a Currency Crisis. .. fundamental weaknesses exposed



Thursday, August 20, 2015 4.55AM / FDC

The naira appreciated by 3.15% against the U.S. dollar last week to close at N215/$ at the parallel market and in a matter of hours it depreciated to N225/$.

Currency volatility is not peculiar to Nigeria. For example China, the 2nd largest global economy, recently unsettled the financial markets by devaluing its currency and moving to a managed float. The country had maintained a tight grip on the Yuan, allowing it to float on either side of the 2% reference rate. Such a development raises concerns for other global manufacturers, as China is a major trading partner of most countries.

According to the World Trade Organization, China’s share of world exports is approximately 12%, while its share of global imports is 10%. For import dependent countries like Nigeria, this is beneficial yet damaging as a result of the negative impact it has on domestic production. Other Asian currencies have experienced a depreciation against the U.S. dollar. The Indonesian rupiah and Malaysian ringgit have taken the lead with a year to date (YTD) depreciation of 9.8% and 8.4% respectively. In addition, the fear of a currency war emerges as monetary authorities in developed economies such as the UK and the U.S have indicated a possible hike in interest rates in the coming months.

These issues are relevant to Nigeria, considering its trade flows. Nigeria imports 25% of its total trade from China and 10% from the U.S. A devalued Yuan (implies cheaper imports) coupled with lower oil prices will make exchange rate management more difficult given the current state of foreign reserves.

The Central Bank of Nigeria appears to be indifferent about the continued pressure at the parallel market as it maintained its 13% p.a. interest rate at the July MPC meeting. Recent administrative measures to defend the naira has led to an increased level of capital flight and currency speculation. This has contributed to the selling pressure at the Nigerian Stock Market. The NSE ASI has broken the psychological threshold of 30, 000 points on August 17th, 2015 to close at 29, 909.44. The Nigerian foreign exchange market maintains its status quo, trading at N215/$ as at 10th of August 2015 at the parallel market compared to N190/$ at the beginning of the year. Coupled with energy market’s gloomy outlook, at $48per barrel as at 10th August 2015,

Nigeria is on the verge of a currency crisis and the solution lies in increasing inflows and decreasing outflows from the reserve account. Hence, it is imperative to have a look at the necessary steps that will need to be taken to avoid a currency crisis and promote economic stability in the long term.

The evolution of the Nigerian Foreign Exchange Market  

Nigeria has adopted various exchange rate regimes, from the fixed regime pegged to the British pound in the sixties and seven-ties, to different types of floating exchange rate regimes in the eighties, moving to the current managed-float exchange rate sys-tem in 1995. The initial 1980s move from fixed to floating was instigated by the oil shock of the period and it was this shift that exposed the overvaluation of the naira.

In order to have access to the debt relief program initiated by the International Monetary Fund (IMF), a flexible exchange rate through the Second Tier Foreign Exchange Market (SFEM) was required. With SFEM in place in 1986, the foreign exchange rate was determined by the demand and supply of the naira at the free market. The SFEM brought about a significant depreciation in the naira from a pre-SFEM nai-ra-dollar parity of N1.12/$, to N4.5/$ by the end of the first week; a depreciation in excess of 280%. The week after, the depreciation rose to about 322%, confirming the prejudice of the over-valuation of the naira prior to the SFEM.

With the fair value of the naira identified, the government was forced to exercise some control at the exchange market for policy alignment and budgetary planning. An exchange rate is an economic variable that should be monitored closely due to its spiral effect on inflation (i.e. imported inflation) and interest rates. Therefore, a managed floating exchange rate was adopted in 1989 as it fulfilled the objective of letting the naira float while the government determined its floating range.

The Central Bank of Nigeria (CBN) has been resilient in its efforts to maintain a stable exchange system in the country. However, all efforts appear to be futile and have since provoked a debate on whether the naira's value should be determined by the free market or if the CBN should continue with its managed float system.

Foreign Exchange Today
In the last 10 years, the exchange rate has depreciated by over 53% from N130/$ in 2005 to N199/$ in 2015 and the factors that contributed to the first devaluation of 1986 are still very much present; Nigerians are now dependent on imports for items as basic as toothpicks, and low competition in the domestic market along side low foreign reserves continue to be a problem despite oil booms experienced in the past. Additionally, Nigeria’s continued dependency on oil for the bulk of its foreign earnings makes it vulnerable to the whims and schemes of key players on the inter-national stage.

Such dependence has cost Nigeria a great deal in terms of the ex-change rate and inflation. Given the persistent depreciation of the naira it is not surprising that inflation rates have spiked beyond the 9% CBN ceiling. As a result of the positive correlation between the exchange rate and inflation, the implication of a weakening currency in a country where the marginal propensity to import is high (estimated at about 0.63) is that living standards are constantly being eroded by currency depreciation. This is evident in the prices of basic commodities. In 1994 a loaf of bread was N20; currently it sells for N200. Similarly, national newspapers sold for 50 kobo in 1994; presently a paper costs N200. Though wages have increased alongside these price increases, the rate of increase has been much slower making it very difficult for many Nigerians to cover expenses. Therefore, it is important to highlight possible solutions to the dwindling exchange rates.

A Way Forward
It is now evident that the naira is overvalued and will continue to depreciate unless the supply-demand dynamics are adjusted and the domestic manufacturing industry becomes competitive on the international front. Import dependency has crippled the manufacturing sector and is a weed that needs to be uprooted. However, there are other issues to be resolved before visiting the core of the monster causing the volatility at the Nigerian foreign exchange.

First on the list is subsidy removal. Removal of the fuel subsidy will reduce the import bill by 21% as well as the importation of refined crude products, as importers will have to bear the cost of oil price volatility and exchange rate depreciation. This will make the importation of premium motor spirit a less profitable venture. Moreover, local refineries have resumed operations, expected to run at 150,000bpd, further reducing the business prospects of local importers. Hence, the indirect effect of a subsidy removal is a reduction in the outflow of foreign exchange. This will reduce pressure currently being exerted on the foreign reserves, thereby creating room for the Nigerian government to meet obligations at the foreign exchange market.

Another sector to be reviewed in terms of foreign exchange out-flows is the invisible sector. According to the Central Bank Economic Report, the invisible sector accounted for the bulk (41.5%) of total foreign exchange disbursed in April 2015, higher than the 36.9% disbursed in January 2015. According to the Global Financial Integrity, Nigeria ranked 7th among the top 10 countries with the largest illicit financial outflows. Therefore if fuel subsidy is addressed and other leakages are blocked, this will reduce the bogus demand in the import bill.

Secondly, Nigeria needs to adopt a free-floating exchange rate regime. The CBN started this process by moving from an auction system in February. The problem is that because the price (exchange rate) is not in equilibrium, there remains a significant demand overhang. The unsatisfied demand is filtering into the parallel market. The distortions created by this gap is a major source of concern to policy makers and investors.

There has also been frequent interventions to support the currency when necessary. Under a free floating exchange regime, the true value of the naira will be determined by the forces of demand and supply at the foreign exchange market. While a free float would be extremely harmful to the consumers and importers, a devaluation is no less so. The main difference is that there is no certainty attached to the magnitude of depreciation. However, in the long run, it will encourage international and domestic investments and help stabilize the naira.

It is important to note that the sharp decline in oil prices in June 2014 is considered to be the immediate cause of the sudden pres-sure on the exchange rate. This is because the oil and gas sector remains the major contributor to foreign earnings increasing the vulnerability of the naira to external imbalances. However, other remote causes remain as Nigeria would have been less vulnerable to this shock if strategic policies had been implemented to eliminate fundamental weaknesses within the system.

Historically, the Nigerian economy had experienced cyclical downturns that are tied to global oil price. Nigeria was also adversely affected by the oil glut which occurred in the 1980’s where oil prices went as low as $10pb from $35 at the beginning of the decade. One would expect Nigeria to be immune to such developments given its history, but it appears Nigeria maintains the same position with respect to vulnerability to oil shocks.

It is therefore imperative for the government to review the fundamentals with respect to export and import content and take the necessary action to ensure that Nigeria maintains a favorable trade balance. Policies adopted by the government should tend towards improving our manufacturing capacity. Credit facilities with affordable interests rates should be established to enable manufacturers to develop their products.

However, in the short term manufacturers will still need to import expensive machinery for production. This might exert pressure on the foreign reserves in the short term but the government should subsidize capital purchases as the benefits of such a venture far exceed costs incurred in the long run.

In conclusion, the weakening of the naira is partly as a result of internal imbalances arising from import dependence, an uncompetitive manufacturing industry and over-reliance on oil for foreign earnings. Taken together, if these issues are eliminated simultaneously by removing the fuel subsidy, encouraging the manufacturing sector and adopting a free floating exchange rate, the naira will be on track to recovery and trading at a fair value.

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