Exchange Rate Reforms: Five Links
Fixing the strange and possibly corrupt exchange rate system that developed under suspended central bank governor, Godwin Emefiele, is one of the biggest economic stories in Nigeria in the past month. Many people have commended the new government for acting swiftly and boldly, as this was necessary to restore confidence and bring investors back into Nigeria.
It is still too early to tell how it fits into the overall reform agenda of the government — as there is still uncertainty about the leadership of the central bank and what future monetary regime will look like. But for context, I want to share some links (including quotes) to commentaries I found interesting and relevant on the subject.
Feyi Fawehinmi wrote a brilliant history of exchange rate policy in Nigeria — and it is the absolute place to start if you want to understand the chaotic relationship between the Naira and Dollar. You can hardly do better than a lead like this:
Since 1986, the Nigerian naira’s relationship with the US dollar (and other foreign currencies) has been erratic, (un)predictable, violent and full of heartbreak and tears. The built-in dysfunction has also made a lot of people very rich.
If you think Emefiele and Buhari were rigid in their exchange rate stance, then you are not familiar with ‘’Abachanomics’’:
From the day that Abacha took power to the day he died on June 8 1998, a period of some five years, the ‘official’ exchange rate of the naira to the dollar never changed from 22 naira to $1. The Autonomous Foreign Exchange Market (AFEM) was introduced in 1995 as a way for the Central Bank of Nigeria (CBN) to sell forex to end users at ‘market’ rates.
But it is one thing to declare that the naira is worth 22 naira to $1. It is quite another thing to be able to satisfy all the people who will demand to buy dollars at that price. Given that oil prices were below $20 a barrel in this period, there was a very limited amount of dollars available (whatever was left after those in charge had helped themselves). This rigid exchange rate gave birth to a phenomenon that is now a permanent fixture today — the mainstreaming of the forex black market. At one point, the naira was trading as high as 88 naira to $1 while the official rate remained at 22 naira
Bode Agusto, who was a director of Budget and special adviser to former President Obasanjo had an essay from a year ago that is making the rounds again. He advocated for a crawling peg approach to exchange rate management:
This means that a country starts at a near market LCY/USD exchange rate and then allows its currency to depreciate (or appreciate) against the USD by close to the difference in annual inflation. This is the option we recommend for Nigeria. Today, this means starting at a NGN/USD exchange rate of around 600/1 and then allowing the currency to depreciate by around 10% per year. It also means allowing knowledgeable willing buyers to do business with knowledgeable willing sellers at contracted rates. The CBN may intervene in the market when rates are significantly higher or lower than its target. Kenya and Botswana have successfully managed their exchange rates for a number of years using this option.
Will Nigeria’s politicians and policymakers accept a 10% annual depreciation relative to the USD? This is the reality they need to face. They need to eat humble pie and accept that a peg to the USD though desirable is unattainable. A 10% annual depreciation against the USD is predictable, businesses and households that are dependent on imports can plan for it.
Agusto closed his argument with a question that very much agrees with sentiments I have expressed on this blog:
The current policy of pegging the NGN/USD exchange rate at 420/1 has the benefit of dampening imported inflation but it has several disadvantages. It reduces the Naira amount of oil revenue that goes into the Federation Account, it also means that importers are undercharged duty on their imports. Exporters are forced to sell their USD at the official exchange rate thus subsidizing importers.
Most importantly, this policy makes imports (whose prices go up by 2% p.a. USD inflation) cheaper than locally produced goods (whose prices go up by 12% p.a. NGN inflation). What does Nigeria really want? Does she want to stimulate local production or does she want to import cheaply? If she wants to stimulate local production, then she must ensure that importers pay a competitive price for USD! We hope this article has shown Nigerians clearly why pegging the NGN to the USD is impossible given the 10% difference in long-term rates of inflation.
Economist and blogger Brad Setser has a paper from 2007 on why currency pegs (or fixed exchange rates), which Nigeria has repeatedly experimented with, are bad for Oil- Exporting countries.
The most often cited advantage of pegging to the dollar is that it allows an emerging economy — especially one with weak economic and political institutions — to import the United States’ relatively stable monetary policy.
However, the advantages of importing the monetary policy of a more stable economy — and the associated moves in its currency — have to be balanced against the costs of importing a monetary policy that does not meet local needs. This risk is particularly important for oil-exporting economies, as they often end up importing the monetary policy of an oil-importing economy.
Personally, I am worried that the current narrative about exchange rate reforms is obsessed with investment in the capital market. The complementary fiscal and trade reforms that will bring investment in traditional ‘’brick and mortar’’ sectors are not getting enough attention.
Maybe I am impatient, but I was glad to read an essay from Dumebi Oluwole of Stears, which struck a cautionary note on the dangers of wooing foreign investors with FX reforms. Drawing on lessons from the infamous Asian Financial Crisis of 1997, she highlighted the pitfalls for Nigeria and what needs to be done:
First, making the naira more market reflective can backfire if we do not overcome our economic risks (insecurity, debt and inflation), as investors will price these risks before investing in Nigeria.
One step to overcoming these risks is meaningful government spending. There is a better time than now to increase recurrent spending, especially on ministers’, politicians’ and executives’ salaries.
As the IMF recommended to Southeast Asian countries, Nigeria has to stop unproductive government spending but put revenue into lucrative aspects of the economy like infrastructure, education and health that have positive multiplier effects and attract investors.
There’s also the need to support the industrial sectors with the ability to create jobs and contribute positively to GDP. Before the 1997 crisis and even after, Southeast Asia countries spent time developing their industrial sectors.
As far back as the early 1990s, they were already exporting semiconductors and microprocessor chips. We’ve talked about how Special Economic Zones helped them do this by attracting investors. Nigeria has to do the same. But we must be cautious to ensure that our capital inflow mix favours FDIs to avoid the hot money bubble Southeast Asian countries experienced.
Still on the Asian Financial Crisis and the lessons therein, veteran trade economist Jagdish Bhagwati made a characteristically clear and strong argument against advocates of unfettered capital flows:
Until the Asian crisis sensitized the public to the reality that capital movements could repeatedly generate crises, many assumed that free capital mobility among all nations was exactly like free trade in their goods and services, a mutual-gain phenomenon. Hence restricted capital mobility, just like protectionism, was seen to be harmful to economic performance in each country, whether rich or poor. That the gains might be problematic because of the cost of crises was not considered.
However, the Asian crisis cannot be separated from the excessive borrowings of foreign short-term capital as Asian economies loosened up their capital account controls and enabled their banks and firms to borrow abroad. In 1996, total private capital inflows to Indonesia, Malaysia, South Korea, Thailand, and the Philippines were $93 billion, up from $41 billion in 1994. In 1997, that suddenly changed to an outflow of $12 billion. Hence it has become apparent that crises attendant on capital mobility cannot be ignored.
The whole thing is worth reading, although the paywall is a little aggressive.
The good news, if one can call it that, is that Nigeria is not embarking on some strange unheard-of journey. The challenges the country faces with the management of its exchange rate are fairly well understood both in Nigeria and across the world. If there is a debate on the exact solution to adopt, there is no debate on what not to do.
So maybe this time will be different.
