Nigeria and state of Naira

On the 20th of February 2016, Nigeria’s
President Buhari hardened his stance against
devaluing the Nigerian Naira because he believes
devaluation will not help the country “as it had
few exports apart from oil and depended on
imports whose cost would rise with such a
move.” This view is shared by Governor Emefiele
of the Central Bank of Nigeria (CBN), who
noted on 17th November 2015 “Our major export
commodity which accounts for more than 80% of
our income is crude oil…and what is supposed to
be the non oil export, we are not producing
effectively.” CBN governor, Emefiele, also
warned that that naira devaluation would lead to
hyperinflation.
According to the famous quote from the
philosopher George Santayana, “those who ignore
history are doomed to repeat it.” Thirty years
ago in 1986, Nigeria’s policy makers made the
exact same argument against devaluing the naira
under extreme pressure from a similar oil price
collapse. The powers at the time said: “Oil is
dollar-denominated and virtually our only export.
What purpose then would be served by an
exchange rate adjustment?”
This argument is incomplete and ignores many
important issues: the credibility of
macroeconomic policy; subsidies for the rich
hidden in the overvalued exchange rate; and the
constraints placed on pricing and production by
new restrictions pushed by policy makers hoping
to regulate their way out of the current currency
crisis.
Thirty years ago, as a young economist at the
World Bank, I studied foreign exchange markets
across the developing world, including in Nigeria.
Parallel markets for foreign exchange (typically
illegal) were rampant in Africa and Latin America
during the mid 1980s. These parallel markets
have resurfaced in recent years, usually in
countries with serious problems in economic
governance. Argentina and South Sudan are
examples. Yet both have taken steps to eliminate
parallel foreign exchange markets through
appropriate, market-based exchange rate policy.
On December 17, 2015, Argentina’s peso
depreciated sharply, with the official exchange
rate rising to 13.95 pesos per dollar from 9.8
pesos per dollar, much closer to the parallel rate
of 14.5, after a new administration floated the
currency. This was seen as a key step in
reestablishing macroeconomic policy credibility
which has been in tatters since Argentina’s
sovereign default of 2001.
Earlier, on December 15, South Sudan’s central
bank dropped its fixed exchange rate. The
official price of the dollar shot up by over 500
percent, from 2.95 South Sudanese Pounds per
dollar to the parallel market rate of 18.50 per
dollar. The country is an oil exporter and
embroiled in conflict.
In contrast, Nigeria has taken steps to ration
foreign exchange instead of letting the market
determine the exchange rate after oil prices
began their most recent fall. By April 2015, when
CBN reintroduced foreign exchange rationing
with restrictions on credit cards, the dollar oil
price had fallen some 40 percent from its peak in
June 2014. The official naira-dollar exchange
rate had depreciated by 21 percent over this
period, to 197 naira per dollar from 162.8 naira
per dollar. In June, CBN declared 40 imported
items as “not valid for foreign exchange in the
Nigerian foreign exchange markets” purportedly
to “conserve foreign exchange reserves as well
as facilitate the resuscitation of domestic
industries and improve employment generation”.
The items range from toothpicks to private
airplanes and jets.
Oil prices fell another 48 percent between April
2015 and January 2016. But the official rate has
been held at its April 2015 level of 197 while the
parallel market premium (the difference between
the official and parallel market exchange rates)
has skyrocketed ten fold to 80 percent from 8
percent in April 2015. The naira presently trades
at 360 to the dollar. The chart below shows the
value of the naira on the official and parallel
markets against the decline in global oil prices.
It is apparent that the parallel exchange rate is
driven by the oil price, since oil accounts for 70
to 80 percent of government revenues and the
lion’s share of Nigeria’s exports. But it could also
be capturing growing risk from macroeconomic
uncertainty linked to the stop and go exchange
rate policy: CBN was slow to let the naira
depreciate when oil prices started falling with the
onset of the global financial crisis in late 2008.
In January 2009, it virtually shut down the
interbank foreign exchange market, fuelling a
significant parallel market premium. Fortunately,
exchange restrictions were phased out later in
2009; but not before the CBN burned $17 billion
to artificially prop up the naira.
The quotes above from Governor Emefiele and a
paper on Nigerian economic policy written in
1987 indicate that history has come full circle
once again. In September 1986, the parallel
exchange rate in Nigeria was 5 naira per dollar,
implying a premium of 230 percent over the
official exchange rate of 1.5 naira per dollar.
How did Nigeria get to that point?
By the mid 1980s, oil prices had collapsed from
a supply glut following the oil price hikes of
1973-74 and 1979-80. As a result of large fiscal
and current account deficits during the boom
period of 1973 to 1980, Nigeria’s foreign debt
had grown to $19 billion by 1985. Agriculture,
once a mainstay of the economy and of non-oil
exports, collapsed because of competition from
cheap imports and neglect. Over the ten-year
period from 1973-1983, the Nigerian government
directed very little public spending towards
agricultural research and development or
enhancing rural infrastructure, unlike in similarly
oil rich countries such as Indonesia which spent
heavily to improve non-oil sources of revenue.
Any reprieve Nigerian agriculture might have
received after oil prices collapsed in the early
1980s never materialized because of bad
exchange rate policy during the first Buhari
regime. Instead of letting the naira depreciate in
line with falling oil prices, CBN introduced
rationing via an import license system. An
imported good costing one dollar was more likely
to sell for 5 naira (the parallel rate in September
1986) than 1.5 naira (the official rate). This
meant a huge hidden tax on agriculture, since
procurement prices were set with reference to
the official exchange rate and little attention paid
to international prices. This was perhaps the
death blow to Nigerian agriculture and a big
contributor to the growing concentration of oil in
total exports.
Nevertheless, CBN resisted devaluing the naira,
arguing ironically that no useful purpose would
be served because oil was virtually the only
export! However, by 1985, the economy was in a
bad state with Nigeria’s foreign creditors insisting
on an IMF program for rescheduling a relatively
small sum of $2 billion. This led to a series of
steps to lower the fiscal deficit and eventually
CBN was persuaded that it would be a good idea
to unify the official and parallel exchange rates.
It decided to float the naira via an auction for
foreign exchange. The main questions then:
“what exchange rate would emerge from the
float?” and “would there be an inflationary burst?”
Most of my then colleagues at the World Bank
and IMF believed an equilibrium exchange rate of
close to 1.5 naira to the dollar would emerge
from the auction because Nigeria’s oil dollars
(the bulk of foreign exchange earnings) were
allocated at the official rate. But a 1985 World
Bank survey showed that domestic prices of
traded goods were more likely to reflect an
exchange rate of 5 naira to the dollar. This fact
had three important implications:
First, the parallel exchange rate was the
equilibrium exchange rate. In other words, the
market had already corrected itself without
action from the policy makers. The official rate
was irrelevant from the perspective of the
average consumer.
Second, giving dollars at the official rate to
importers meant handing them an instantaneous
unearned profit of 3.5 naira (the difference
between the parallel rate of 5 and the official
rate of 1.5) per dollar received from
CBN. Moreover, this “profit” was at the expense
of the Nigerian government. This meant that
private individuals with access to government
could easily enrich themselves at the expense of
the Nigerian people. In addition, as noted above,
the premium was a ruinous hidden tax on the
once-flourishing agricultural sector. It decimated
non-oil exports and inexorably transformed the
Nigerian economy over time into the “mono-
economy” referred to by current Central Bank
Governor Mr. Emefiele.
Third, if the central bank were to unify the
official and parallel rates by floating the Naira,
this would lead to a large depreciation as the
official rate merged with the equilibrium parallel
rate. However, there would be no inflationary
burst because domestic goods prices already
reflect the parallel rate. Any inflationary impacts
would come from the fiscal consequences of the
float. For Nigeria the impact would be a positive
lowering of the fiscal deficit and therefore,
inflationary pressure. I vividly remember my 1985
conversation with an importer: “Would not there
be an inflationary burst if CBN were to float the
naira?” I naively asked. “You don’t understand,”
he chided me. “The inflation has already
occurred through the parallel market. All CBN
will be doing is to slash my profit!”
The present situation is eerily similar to that
which prevailed 30 years ago. It is high time CBN
and the Nigerian Government faced reality and
avoided a costly repetition of history. Returning
to a market-determined exchange rate via a float
would probably lead to a new exchange rate
close to that in the parallel market. President
Buhari’s intransigence and Mr. Emefiele’s
hyperinflationary fears are unfounded because
domestic goods pricing already reflects the
parallel rate.
To be sure, the unified exchange rate will
depreciate further if oil prices continue to drop;
but this will be because Nigeria’s national
income is falling and not because of the
currency float. Nigeria’s fiscal accounts and
policy credibility will receive a much-needed
boost from exchange rate unification. The
investment climate in manufacturing and
agriculture will improve dramatically with the
elimination of the hidden tax from the parallel
market premium. With the parallel rate at 360
naira per dollar, this hidden tax on non-oil
exporters currently stands at 45 percent.
The medium term outlook for oil prices remains
bleak. Nigeria must stop selling its valuable oil
dollars cheap. It must float the Naira to help its
fiscal accounts and to prove that it can learn
from its own past mistakes.



source: vanguard