THE CBN AND MONETARY/FISCAL POLICY SOLUTIONS TO NIGERIA’S ECONOMIC & FX CHALLENGES.

With the last Monetary Policy Committee (MPC) meeting of 2016 fast approaching, the Federal Government of Nigeria (the FGN) and its central bank (the CBN) are hard pressed to set the tone for economic recovery and a moderation of both inflationary and currency devaluation trends that have plagued the nation in the last 18 months. Both parties have managed to drop the ball more often than they have caught it so far within the tenure of the Buhari administration. The Nigerian economy has undergone tremendous pressure and change for the worse in the last 18 months. The Naira’s purchasing power is down by roughly 40% and the Nigerian economy is facing inflationary trends not experienced in the last 20 years, while approaching its third quarter of recession.

The nation’s management of its foreign reserves/markets and its foreign trade policies have been held up as chief culprits and quite rightly so. However, as economists, financial experts and armchair policy examiners, it is not just on us to apportion blame, the onus also lies with us to suggest viable & sensible economic and financial solutions to these problems.

In taking a look at what the FGN and the CBN have actually gotten right with regards solutions to the foreign currency challenges it has faced in the last 18 months, top on that list would be the official ban of foreign currency loans to customers by financial institutions if the customer’s repayment source is not in foreign currency. While this step has already been implemented by a couple of financial institutions to curb an increase in their non-performing loan ratios, given a devaluation of the Naira and the corresponding pressure on customers with Naira flows to meet up with payments, it is a very bold and intelligent move at the macro level. The simplest and most common means of money creation is by financial institutions undertaking lending activities. A bank which grants a N1 million loan at 10% for a year (assuming a single interest payment regime) has in effect generated N100,000 as interest. Interest and principal repayments would come to N1.1 million, with the interest payment portion accounting for new money generation. Applying this same principle to foreign currency loans, a foreign currency loan of $1 million at 10% for a year, also assuming a single interest payment, would create demand for an additional $100,000 which would have to be funded. In the event that the customer’s earnings are mismatched (earnings are in Naira and interest generated is in US Dollars), there is creation of additional pressure on the Naira, further driving its devaluation. Thus this policy reduces generation of additional demand for foreign currency that would needlessly put pressure on the Naira.

While this is quite an innovative and novel approach to take in plugging foreign currency leaks in the Nigerian economy, it has been foreshadowed by the mistakes, inaction and complacency that have occurred within the same time period. So how can this situation be rectified, put on the road to recovery or at the very least be stopped from further worsening? Below is a list of steps that I believe both the Federal Government and the MPC (through the CBN) can take in tandem towards solving this issue.

Firstly, all state governments Federal Accounts Allocation Committee (FAAC) distributions and other allocations should be paid in USD or the currency these funds are earned and not in Naira. This would reduce the pressure on the Naira, as an influx of FAAC in USD would increase the supply of foreign currency in the economy, effectively bringing down the exchange rate. Alternatively, payment of FAAC and other allocations earned in foreign currency in Naira will increase the amount of local currency chasing USD in the economy, driving up the exchange rate and fuelling devaluation of the Naira. To illustrate this, assuming a closed economy with complete market information and no leakages which has a fixed supply of N1 billion and $10 million, the exchange rate in this instance would be N100 to USD. Given FAAC generated is $1 million and the government can either distribute in USD or Naira, the following alternatives can occur.

Option A, the government decides to distribute FAAC in Naira and thus releases N100 million into the economy. This brings Naira supply to N1.1 billion against a stagnant supply of $10 million, effectively driving the exchange rate upwards by N10 to N110, given the emergence of more Naira chasing the same quantity of dollars.

Option B, the government decides to distribute FAAC in dollars and releases $1 million into the economy. Naira supply remains stable at N1 billion against an increased supply of $11 million. The exchange rate in this scenario drops to N90.91 to an American dollar, as USD supply has increased against a stagnant supply of Naira.

Even with a relaxation of the closed economy conditions and the fact that all these monies may not be sold by the state governments at once, there will still be an easing of pressure on the Naira, as less Naira liquidity would abound. The FGN should therefore pay FAAC in USD, while in conjunction with the CBN focus on strict monitoring of these funds to guard against misappropriation and embezzlement, putting in place measures that only allow for onward sales to the official interbank market (should the states decide to sell), while ensuring no leakages occur to the parallel markets to ensure maximum benefits accrue to the financial markets.

A second step which the CBN can and should employ is the re-inclusion of the 41 banned items back into the FX interbank market approved list. The best argument for this is given there is a demand for these goods which has not been satiated by the ban, then the government should bring them back into the market to ensure government control and monitoring of these items. As aptly captured by Kayode Ehiwere, a good friend and fellow market risk analyst in a series of tweets, the CBN bans 41 items from the FX window forcing the importers of these goods to go to the black market to source for funds, driving FX rates up in the parallel market as demand is moved from the interbank market to the black market. The CBN in turn then technically funds these goods by allowing inward transfers which were meant to get to banks and businesses to be funnelled to BDCs (technically the black market) while also auctioning funds to these BDCs on a regular basis (official funding of the black market). Thus in effect, the CBN indirectly funds the items banned at the official window at a higher rate than if these items were allowed to access the official FX market in the first place. Allowing these goods back unto the interbank market would drive down the informal demand of dollar and reduce the corridor between interbank and parallel market rates. In place of banning these items from the window, the federal government could instead increase tariffs and taxes for these items to discourage their importation. This would affect these items directly and would not have a spill over effect on the foreign exchange rates.

Thirdly, a full liberalisation of the interbank foreign currency market should be pursued. The CBN and the FGN should let market forces determine the exchange rates with minimal intervention as opposed to a controlled system (the controlled system has already proven to have failed as the CBN does not have deeply rooted FX reserves to drive a currency control regime). The CBN and the FGN should ensure the blocking off of all official foreign currency seepages to the black market, including the funding of the parallel market (BDCs) by the CBN. All barriers which hinder the access, movement and use of FX by persons who have these funds in any form or manner they deem fit should be removed. If these individuals wish to fund the parallel market with their monies then so be it, the CBN however should not be seen to support this funding directly or indirectly. Liberalisation of the FX markets should also include the scraping of the policy which states that FX export proceeds can only be sold at CBN exchange rates and cannot be withdrawn as cash. This has led to non-repatriation of export proceeds and the transfer of these funds into the country through black market channels in piecemeal quantities, fuelling the speculative demand for money and funding the black market. For the logical FX owner, it makes no economic sense to sell funds at N305 at the interbank/CBN rates when parallel market rates are at N470. If the CBN allows users of these funds use their funds in whatsoever manner they deem fit, it would build back confidence in the financial markets. In turn these funds owners would over time bring back these funds into the Nigerian system, easing dollar illiquidity, reducing speculative activities and the devaluation pressures on the Naira and narrowing the official/parallel market corridor. This would also increase investor confidence, market efficiency and may even let the FGN/CBN plan its foreign reserves spending based on observed demand patterns by a more inclusive market.

De-segregation and harmonisation of the interbank market is also a key step that should be pursued by the federal government and the CBN. Currently there are two different spot rates in the interbank market. The interbank spot rate and the NIFEX rate for the settlement of FX futures transactions. In most other countries, futures transactions are settled with the interbank spot rate at the time of maturity and quite rightly so as a futures transaction is basically a gamble against the price at which the instrument (in this case FX) being speculated on will trade on that date. However, in Nigeria we have created an entirely new rate to settle these transactions, effectively segregating the FX futures market from the FX spot market when they should be harmonised. Over the period of the past month, the NIFEX rate has trended above the interbank spot rate by an average of N12.83, a huge discrepancy that is funded by the CBN and which adds to the oversupply of local currency as against foreign currency in the Nigerian economy. While this currently benefits the futures buyer and has no visible effect on interbank market rates, as the futures market deepens and FX futures sales transactions come on board, this could shake confidence in the FX markets and ultimately harm the Nigerian economy.

Say an individual enters the futures market to carry out a 3 month futures transactions of $10 million with a quote of N300. Taking 3rd of November 2016 as the settlement date with an interbank spot of N304.75 and a NIFEX spot of N318, CBN/FMDQ settles this transaction at N18 per USD (difference between NIFEX rate and contract quote on settlement date) on the $10 million as against N4.75 per USD if interbank spot rates had been used in settlement. Thus the CBN would theoretically settle this transaction at N180 million, a N132.5 million loss to the CBN and a needless influx of funds into the economy, than if the interbank spot had been used to settle at N47.5 million. If this same transaction had been a futures sales transaction, it would have resulted in an additional loss of N132.5 million to the contract holder, above the N47.5 million losses accruing to him had the interbank rates been used. The NIFEX has also proven to be liable to manipulation as seen by spikes in the NIFEX rates on futures transaction settlement days, with rates coming down sharply soon after. To avoid the segregation of the interbank market and limit the manipulation of the rates at which the futures market settles, the NIFEX rate should be scraped and the interbank rates should be used to settle both spot and futures transactions.

On a final note as the MPC meeting date draws nearer, while exploring innovative means to solve the Nigerian economic and FX problem, the CBN should not engage in policy backtracking. A large portion of our economic problems can be traced to loss of investor confidence through policy backflips and inconsistency. This has made the CBN look weak and effeminate and has also weakened investor appetite & confidence in the Nigerian economy due to lack of predictability of policy direction. As observed in the last few months, the inflation targeting policy of the CBN has not yielded benefits and thus the Monetary Policy Committee (through the CBN) needs to look for other ways to stimulate the economy.

New strategies are therefore needed to boost the economy to drive economic growth and employment. This should however be done without policy reversals or rate cutting. Nigeria’s sovereign rating is firmly in junk territory and any downward shift in rates will bring down the confidence and risk thresholds of foreign investors still bold enough to gamble on the Nigerian economy, leading to consequent valuation drops in the debt & equity markets and a further devaluation of the Naira.

First published on Linkedin Pulse, November 7 2016.

All opinions expressed are strictly those of the author and are not necessarily the view of any institution, organisation or body he may be affiliated with.

Sources: www.fmdqotc.com; www.cbn.gov.ng; Kayode Ehiwere (www.twitter.com)