Makings of a Currency Crisis

The Naira BearWhale Awakening

I recently came across an interesting study written by Bernd Schatz. It examined some key macroeconomic fundamentals and the roles they play in making currencies vulnerable to speculative attacks in emerging markets.

Besides Nigeria being an emerging market, this study piqued my interest because of the current state of the economy — the currency crisis gripping the nation.

By posing 5 questions, i will go into detail about the study, relate it to the happenings in the country and round off with my view.

1. What is this study all about?

Basically, the objective was to prove/disprove the cause of currency crises. The author started by stating:

some blame fickle speculators for triggering speculative attacks virtually at random, others argue that the typical currency crisis is attributable to myopic economic policies

in other words, posing this question:

are fickle speculators who attack currencies almost at random to blame, or are the players on the international financial markets only living up to their assigned monitoring role by mercilessly penalising policy deficiencies?

Using 26 emerging markets as samples, some key macroeconomic variables from the period prior to the speculative attacks on their currencies, with some statistical models (i’m not going to bore you with the details), his study was able to conclude that currency crises are not random acts that emanate out of the blue.

2. What does that tell us?

Currency crises are borne out of poor economic foresight and policies that allow foreign players to strategically position themselves, waiting to take advantage of the foreign exchange market when things go awry.

In addition, Bernd came to another conclusion;

It has identified a number of macroeconomic variables to which political decision makers would have to pay attention when striving to minimise the vulnerability of their currencies to speculative attacks.

However, it is worthy to note that he went on to say using these variables as requirements, in establishing a warning system, to determine future crises, may be too ambitious.

3. What are these macroeconomic fundamentals/variables that we can pay attention to?

The author divided these macroeconomic variables into three categories: external, financial and real.

External sector variables focuses on elements of the balance of payments and the real exchange rate. Some of the variables included:

• YoY drop in exports.
• YoY percentage drop in real exchange rate (and a clear deviation from its trend).
• Rising U.S money market rates.
• YoY drop in foreign exchange reserves as a share of imports.
• High current account deficit.

The financial sector variables focuses on identifying when monetary policies are excessively expansionary with a rising inflation differential (against the U.S). The key variable being the YoY growth of domestic borrowing as a share of GDP.

Lastly, the real sector variables had economic indicators that identifies:

• a relatively low rate of output growth. — using the YoY production index of the economy.
• below-average-trend of the stock market — determined by tracking the stock market index.

4. How do we relate this to our nation?

Nigeria has already experienced speculative attacks following the gradual drop of oil prices and is still amidst a currency crisis.

It is common knowledge that the country was not prepared for the oil crisis and once oil price started trending downwards 18 months ago, speculation became rife.

The Naira started depreciating at an alarming rate, breaking the upper limit of the currency band, which was at 159. The CBN intervened regularly, selling dollars to help keep the rate within the band (they were literally throwing money at the problem).

Despite all these efforts, the free fall of the Naira could not be halted, they had no choice but to announce a new official exchange rate in November that year — moving the the midpoint of the exchange rate band by devaluing from 155 to 168.

But the Naira continued its free falling as it became obvious that an oil crisis was imminent. And by February, the next year, CBN acted impetuously by introducing some drastic foreign exchange controls (part of which technically devalued the currency, for the second time, to 199).

Different policies were coming out every other week as CBN tried to curb speculative activities and manage demand; Bringing us to where we are now — a foreign exchange market where the CBN controls majority of the supply, leaving little (or no) autonomy to the banks; an active parallel market, trading at a premium of 40 percent.

Prior to the trying times explained above, signs indicating these macroeconomic fundamentals from the study, were glaringly evident.

• in 2014, the current account temporarily entered a deficit of $185.9mn by the end of Q2 (first time in two years) and by Q4 reached $3.123bn (before hitting a record low of $5.398bn by Q1 2015);
• real exchange rate averaged 74.67 in 2013 and by July, 2014 was at 59.47;
• all share index had dropped by 17% from Q3 to Q4 2014.
• YoY growth of domestic borrowing* as a share of GDP grew from 3.80% to 4.29% in Q3 2014; Just to name a few.

Surely, it was only a matter of time (or the right trigger) for our poor economic fundamentals, and myopic policies, to backfire. Making room for speculators, and other economic agents, to run riot once the opportunity presented itself – in other words – awakening the BearWhale.

Based on history, triggers for a currency crisis, that brings out the Bearwhales, were either falling oil prices, unmanageable fiscal deficit or poor monetary policy decisions. In Nigeria’s case, all three triggers hit.

5. Where do we go from here?

The only logical step will be first steer the nation away from poor macroeconomic fundamentals by gradually rebuilding the economy. This will ultimately require a consciously longstanding effort in the monitoring and evaluation of the outputs from some of these variables identified by the author.

As a result, i will commend the Government with regards to some of the steps (both short-term and medium-term) taken so far in this direction:

• For the short-term, which are visible in the budget for 2016, mainly include the boosting of non-oil revenue and an increased capital expenditure —a 30 percent allocation of budget (I only hope they can implement it judiciously);
• While the medium-term steps, expressed in the Medium Term Expenditure Framework (MTEF), some of which include: plans to diversify the country’s foreign exchange earnings through agriculture and solid minerals; and the setting up of an infrastructure development fund.

However, these fiscal-driven steps need to be bolstered by monetary policies; this is where the CBN needs to step up to the plate, by being more forward-looking in its policy decision-making.

In the last year, in managing the currency crisis, most of the actions taken by the apex bank have been reactive and this extract from The Economist and the Central Bank – In Plain English lucidly expresses my view:

..the CBN keeps churning out circulars upon circulars that appear to be uncoordinated and an ad-hoc monetary policy reaction, suggesting panicky measures instead of a well-thought out comprehensive package of policy mix and direction based on sound economic principles.

The CBN needs to come up with a well-thought-out policy plan (one of which should firstly address the exchange rate conundrum) to support the action plan presented by the fiscal authorities, on — what hopefully is — the long painful road to economic recovery and reorientation.

*Summed up the figures from CBN’s financial statistics of sectoral analysis of Deposit Money Banks’ credit.

References

1. Schnatz, B. (2000), Speculative Attacks in Emerging Markets: The Role of Macroeconmic Fundamentals. Intereconomics, 2000, 35, 2, 81–79; and Deutsche Bundesbank Discussion Paper 3/98.
2. National Bureau of Statistics. 2015. Economic Statistics. [ONLINE] Available at: http://www.nigerianstat.gov.ng. [Accessed 13th January, 2016].
3. Reports from Central Bank of Nigeria Statistics Database. 2011. Available at: http://statistics.cbn.gov.ng/cbn-onlinestats/DataBrowser.aspx [Accessed 13th January, 2016].