Nigeria after May 2023People & Money

Foreign Exchange: The Next President Should Not Impoverish Nigerians With A Strong Naira Policy

Nigeria’s overvalued foreign exchange rate causes dollar scarcity, inflation, and poverty. The next president should adopt a free market rate for the naira in place of a managed rate. This will boost foreign direct and foreign portfolio investment and Nigerian exports. 

A strong currency is one that is gaining in value. A weak one is one that is depreciating. Neither is good for the economy. An economy needs a stable currency that neither appreciates nor depreciates significantly several times in a year or every year. A stable currency enables people and businesses to predict their revenue and expenditure with some certainty and plan accordingly. A stable currency keeps prices stable i.e., keeps inflation low, preserving purchasing power, and thus stimulating investment.

The Overvalued and Wobbly Naira: Managed Exchange Rates, Foreign Investment, and Inflation 

An American company may spot an opportunity to make processed leather in Nigeria. It then decides to invest $180million in setting up a factory. But they would notice that the naira depreciates by 5% every month. Why would the company decide against the investment? Because the naira equivalent of the $180 million it transferred to Nigeria would lose value every month as the company builds its factory. The constant depreciation of the naira would also mean that the purchasing power of the intended customers of the company is continuously being eroded.

The government may also decide to arrest the constant depreciation of the naira with a decisive one-off 15% devaluation. The American company (plus all others wanting to invest in Nigeria) would wait for the naira to “hit a bottom”. This means the naira settling at an exchange rate that sellers are freely willing to sell at and buyers are freely willing to buy at. This rate is otherwise known as the free market rate. Investors tend to have more confidence in the free-market rate because it adjusts flexibly and hence doesn’t fluctuate wildly.

Nigeria’s Fixed Exchange Rate: To Devalue or Not Devalue ?

The market exchange rate is the “natural” exchange rate. It is a far more accurate reflection of a country’s production of things it sells abroad and hence what it earns to pay for what it buys abroad. A country may decide to “manage” its currency. The country will, at one extreme, fix” an exchange rate that is overvalued i.e. one that is above its ability to pay for imports given the quantity and value of what it exports.  At the other extreme, the managed currency could be undervalued, i.e. the exchange rate is fixed at a level that is below the exporting capacity of the economy i.e. its capacity to pay for imports.  China is often accused of devaluing its currency in order to boost exports and limit imports

An undervalued currency makes imports more expensive and boosts foreign demand for goods made in an economy. It increases exports, thereby bringing in more forex and eventually enabling the currency to appreciate. A county could decide to keep the currency undervalued despite growing export earnings i.e., by “parking” the export dollars, pounds, Euros, etc. as central bank’s foreign exchange reserves through maintaining a low exchange rate. This greatly improves the currency’s stability. An overvalued currency, on the other hand, encourages imports, eventually leading to forex scarcity. The country could either devalue i.e. allow the currency to find its “natural value” or “manage demand” i.e. limit the supply of foreign exchange to favoured economic activities or individuals.   

Also Read: Nigeria’s inflation problem and the ‘Gbatueyos’ at the CBN

Nigeria tends to allow the naira to appreciate when oil prices are high and hence enable Nigerians to consume more imports (e.g. more Kia cars, more Toyotas, more Dubai holidays, more United Kingdom education etc.). Nigeria also delays and avoids devaluation when oil prices fall. We maintain a managed rate that deters investment because it is deemed unsustainable (remember the American leather company). The overvalued managed rate also permanently stokes inflation because it increasingly blocks the inflow and hence causes scarcity of foreign exchange. 

Foreign Portfolio Investors Too Keep their Dollars Away From Nigeria

Foreign portfolio investors (in domestic stocks and bonds) are a major source of foreign exchange for all countries. Because of Nigeria’s managed forex policy, foreign investors in Nigerian stocks and bonds cannot easily get dollars to send back their funds to their countries when they sell their investments. Remember, a managed foreign currency system means the CBN chooses the businesses to allocate its diminished inflow of dollars to. This has led to a collapse in foreign portfolio investment, declining by almost 70% in 2021

If CBN’s foreign exchange (i.e. Nigeria’s earnings from oil exports) were sold to people and businesses that could pay the highest price (i.e. under a free market method of allocation), foreign portfolio investors would be able to send their funds back home when they want. New foreign investors would buy Nigerian stocks and bonds and old ones would reenter.

Under CBN’s managed forex allocation regime, the CBN allocates foreign exchange to the buyers it prefers at a fixed rate. A higher free market forex price which enables every business that can afford it to buy foreign exchange and continue to do business is better than a fixed lower rate which most businesses cannot buy at and for which there is always a long, uncertain wait to buy.  The free market rate also stimulates the supply of foreign exchange e.g., from foreign investors. 

Businesses price their goods not at the managed or fixed official exchange rate but at the black-market rate which is continuously falling i.e. the naira is continuously losing value. A stable currency is achieved when the exchange rate adjusts slowly to an economy’s capacity to pay for imports through its exports, supported by broader policy measures to ease or enhance domestic firms’ capacity to produce and export goods and services efficiently. 

Limiting inflation by limiting government spending, especially the variety which increases money supply while doing little to stimulate production, also helps keep the exchange rate stable. 

Why Do Nigerians Prefer the Managed, Overvalued Exchange Rate Despite the Evidence It Only Deepens Poverty?

With the discovery of oil in the 1950s, Nigeria was suddenly able to have an exchange rate that grossly overvalued the naira. The naira was overvalued not in terms of Nigeria’s huge oil export earnings and thus the ability to pay for imports. It became overvalued relative to the skills, capital, scientific knowledge, infrastructure base, etc. that Nigerian businesses and citizens have to produce for export.

The petrol-based exchange rate allowed Nigerians to consume a wide variety of consumer goods imports and industrial raw materials to manufacture goods that would not have been affordable without oil.  But the price of oil, a commodity rather than a manufactured export, tends to fall drastically, causing a negative foreign exchange shock i.e., deep scarcity of foreign exchange. 

Also Read: How Inflation Makes Poor Nigerians Poorer

Nigerians enjoy positive foreign exchange shock i.e. rising petroleum prices allowing us to consume more than our productive capacity and the efficiency and competitiveness of our economy would allow. But Nigerians are extremely reluctant to adjust our consumption of imports whenever there is a negative foreign exchange shock i.e. devalue the naira when oil prices fall.

The Central Bank of Nigeria maintains an overvalued managed exchange i.e. at a price it doesn’t have enough dollars to sell to individuals and firms at given the fall in the price of oil. The best time to manage the exchange rate is when oil prices are high i.e. by fixing a low exchange rate. This makes imports expensive and reduces demand for foreign currencies. Preserving the nation’s dollar earnings as foreign exchange reserves enables the CBN to smoothen the supply of foreign exchange to the economy i.e. prevent wild swings in the exchange rate even when the oil price swings. 

How inflation complicates Nigeria’s Foreign Exchange woes

Inflation happens in an economy when the money supply expands faster than the increase in available goods and services. When too much money is chasing too few goods and services, prices go up and money loses value. What causes the money supply to expand? Each time a bank creates a loan, the money supply expands. Things should be fine if this loan is going into the productive sector, which would lead to the production of more goods and services. But loans  increase government spending, it usually leads to inflation. 

The deficit spending by the Buhari administration, funded by loans from the CBN, has caused a huge increase in money supply. This, coupled with the slow economic growth throughout his presidency, has produced unprecedented inflation. If your naira can no longer buy the quantity of goods it used to buy, its value relative to other currencies will also depreciate. 

To make matters worse, the central bank tried to stop currency depreciation by managing the exchange rate when it did not have the dollar reserves needed to do so. It banned importers from having access to forex for a variety of products, claiming that Nigerians’ excessive taste for foreign products is what is putting pressure on the naira. But this is not true. Nigeria’s total economic output in 2021 was 173.5 trillion Naira. Imports accounted for N20.84 trillion of that, while exports were N18.91 trillion, resulting in a balance of trade of less than N2 trillion (negative). We do not have an import dependency problem

Because of its wrong diagnosis, the CBN took measures that made things worse. Fixing the exchange rate essentially subsidises imports at a time when the government is complaining that Nigerians are importing too much. It also prices exporters out of the global economy by fixing an exchange rate that makes Nigerian products appear too costly and non-competitive. It thereby reduces demand for them from the international market. 

To illustrate this, let’s take a look at a crop like bananas. It costs 668 naira per kg in Nigeria. That translates to $1.59 at the official rate or $0.95 at the parallel market rate. From the point of view of the international market, looking at the official rate, it would appear as if Nigerian bananas are too costly, its cost ranking 69th out of 106 countries. However, if we had used the market rate, our bananas would have appeared cheaper to the global market, placing us as the world’s 10th least expensive banana producer. The result would have been an increased demand for Nigerian bananas, which would have led to more investment in banana farming and higher production and export volumes. 

Also Read: CBN Promotes Myth of Import Dependence, Asks Nigerians to Consume Less of Foreign Goods

In summary, CBN’s fixed exchange rate made Nigerian products unattractive in the global market, thereby leading to low investment and stagnation. The import and export figures also show that, unlike what government officials claim, Nigerians’ so-called appetite for imported products is not responsible for the inflation and the continuing fall in the Naira’s exchange rate. What is responsible is the government’s excessive spending, which is powered by an unprecedented amount of borrowing that is not sustainable. Deficit spending (when the government spends more than it generates in revenue) adds to the money supply. 

So, what can the next government do to halt the naira’s depreciation? 

1. Adopt an exchange rate that is determined by the market. This will help ease the forex scarcity and lead to a higher forex inflow. Many people are afraid that a flexible exchange rate will lead to a rapid depreciation of the naira. But evidence does not support this view. Kenya has a floating currency and records a single digit inflation rate, compared to Nigeria’s double-digit rate.

Between 2010 and 2022, the Kenyan shilling depreciated from 74 to 120 to a dollar while the Nigerian naira fell from 150 to 423 (official), or 735 (actual). The exchange rate of a floated currency is a signal that will help keep government spending in check. Spend too much and your currency loses value. Control your spending and your exchange rate will stabilise. 

2. Open borders for the free flow of goods and capital. The economy grows faster when it allows goods and capital to freely flow across the border. Many people worry that cheap products from abroad will kill the businesses of local producers. But this is not a bad thing for the economy. We should not be producing goods that we can buy cheaply from abroad. We should concentrate on producing goods for which we have a comparative advantage.

Doing this will give us access to a global market. Making a couple of products right could give us all the income we need to pay for all our imports. Import substitution is an isolationist policy, producing only for local consumption rather than aiming for a much larger global market. It also results in protectionism with the government favouring a few producers and forcing citizens to pay higher than market prices for their products. This results in inflation and does not add value to the economy. Banning imports of items like rice which has led to higher prices has further impoverished poor Nigerians who eat a lot of it and has stoked inflation.

3. The next government should try and balance the budget, and when it has to engage in deficit spending, it should be a fixed percentage of revenue chosen in order for the debt to be sustainable. It should also pay off the accumulated debt, especially the high-interest rate short-term instruments. A fast-growing economy has more room for deficit spending as future growth in revenue will make debt repayment sustainable. Fiscal discipline also means ceding more space to the private sector in the economy.

Nigeria needs substantial new investment to build infrastructure, expand production capacity and power economic growth. This can be done more efficiently by letting the private sector take a lead. Policies that make it easier for businesses to access loans, including foreign funds, to build infrastructure projects (railways, highways, airports etc) will ensure that Nigeria  procures the infrastructure it needs faster but sustainably. This will reduce the inflationary effects of infrastructure spending. Nigeria should also put an end to big budget expenditure like subsidy payments and reform social intervention programmes.

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