There is a lot of concern in Nigeria today about the rate at which the Nigerian Naira (NGN) exchanges for the United States Dollar (USD) and the size of the parallel market premium. Currently, the NGN/USD official exchange rate is about 420/1 while that in the parallel market is about 650/1. This means a parallel market premium of about 55%.
The USD is the principal currency the World uses for international trade. Therefore, every country wants to hold it to be able to engage in international trade. Countries also benchmark the value of their currencies to the USD.
The long-term rate of inflation of a currency compared to that of the USD has a significant role to play in the value of that currency relative to the USD. Let us think of inflation as the rate at which a currency loses purchasing power and use the NGN as an example. The average rate inflation of the NGN for the past 10 years is 12.3% and the averages for 15 years and 20 years are 11.9% and 12.4% respectively. Whereas, the average inflation of the USD for the past 10 years is 1.9% and the averages for 15 years and 20 years are 2.1% and 2.2% respectively.
This means that the long-term rate of inflation of the NGN is 12% and that of the USD is 2%. It also means that, on average, the NGN loses 12% purchasing power annually while the USD loses 2% purchasing power annually.
ALL economists agree that the currency with the higher long-term rate of inflation is the weaker of the two currencies and, in the long-term, will depreciate by close to the difference in inflation.
In our example, the difference in inflation between the NGN and the USD is 10%. Should we not expect the NGN to depreciate by close to 10% annually relative to the USD? In the table below, we have chosen 2005 as our base year, taken the NGN/USD exchange rate at the end of that year, and depreciated the NGN by the difference between NGN inflation and USD inflation every year. Based on this simple model, the NGN/USD exchange rate should be about 602/1 by the end of this year. The choice of the base year was influenced by the fact that in 2005, Nigeria was building reserves, running budget surpluses, accumulating USD savings, and had a single exchange rate.
Why is the current exchange rate in the official market so far away from the projected rate based on the difference in inflation? Our government has promised Nigerians “stable exchange rates”. They have therefore fixed/pegged the rate at which the NGN exchanges for the USD at around 420/1. Can the government deliver on this promise?
Countries that earn a lot of USD may peg their currencies to the USD. The most prominent examples are the oil-rich countries of Saudi Arabia (since 2003) and Qatar (since 2001) but there are others like Panama (since 1904) and Belize (since 1978). Source: World Bank
All these countries would sell USD to willing buyers at the exchange rates they have set. Can Nigeria sell USD at 420/1 to all those who want to buy? The fact that Nigeria cannot has led to the development of a parallel market that commands a large premium. At 420/1, everyone wants to buy USD from the Central Bank of Nigeria (CBN) but no one wants to sell it. This means that a rate of 420/1 is below equilibrium and is unsustainable. Nigeria has tried several times in the past to peg the NGN to the USD and has failed every time.
A second option is to float the currency. This means allowing the forces of demand and supply to determine the rate at which the local currency exchanges for the USD. ‘Countries that have been able to do this successfully are those who are able to achieve a long-term rate of inflation that is not significantly different from that of our benchmark currency – the USD. Examples are the UK, Eurozone, Japan, and Singapore. We do not recommend this option for Nigeria as there will be a lot of exchange rate volatility because of the large difference between NGN inflation and USD inflation and the fact that, oil revenues, Nigeria’s principal source of USD fluctuates wildly.
The final option is to adopt a crawling peg. 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.
The next question is - how does Nigeria manage her long-term inflation downwards and significantly reduce the annual rate of currency depreciation? To do this successfully, we must first understand what causes inflation in Nigeria. Economists say three things cause inflation – too much money in circulation, the rising cost of inputs, and too much demand relative to supply.
Inflation in Nigeria is not caused by too much money in circulation. One of the ways the central bank controls the supply of money is through cash reserves taken out of bank deposits. Currently, this is about 50% of bank deposits and this rate is usually between 5% and 10%. The current cash reserve ratio is above normal thus ensuring tight control over the money supply.
Cost of inputs includes materials, labor, and overheads whether produced locally or imported. These are certainly rising in Nigeria, particularly materials and overheads but labor costs are not keeping pace with inflation. However, is this the root cause of inflation in Nigeria? We don’t think so.
Nigeria adds five million people to her population every year. This results in a significant increase in demand for food, housing, clothing, healthcare, and other things. In addition to this, over 22 million Nigerians, willing and able to work, are unemployed. We believe that If Nigeria is better able to manage her population growth (demand) and can get a greater proportion of her people to work and produce (supply) she can reduce long-term inflation significantly. These, in our opinion, are the nuts that Nigeria needs to crack to reduce long-term inflation. Nigeria’s unemployed population is roughly the size of Burkina Faso and this is a huge security problem that needs to be cracked.
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.
It is important for Nigerians to know that it is an empty promise when any politician or policy maker promises stable exchange rates without explaining how he/she would bridge the gap in long-term inflation.
Bode Agusto
July 2022