The Naira: Papering over the cracks
When you continue papering over the cracks, rather than fixing the foundations, eventually the walls can come tumbling down. Similarly, Nigeria’s unconventional efforts to manage the naira in the wake of the collapse of the oil price in mid-2014 are leading to increasingly complicated measures. They are increasing the cost of capital for Nigerians and distorting economic activity. Based on the experience of other countries, we can expect that the accumulating pressures caused by the distortions will prompt a sharp dislocation before the workings of the market are restored.
While the currency was steadily devalued over the remainder of 2014 from approximately N160 per US dollar to N200 per US dollar, further devaluation is needed to restore equilibrium. The Central Bank of Nigeria (CBN), however, is loath to allow this, failing to recognise or accept that a correctly priced currency, combined with effective anti-inflationary measures, minimises the impact of external shocks.
The CBN initially pursued open market operations, buying naira to create support for the currency. This was an expensive and unsustainable approach, initially pursued combined with a negligible increase in the benchmark rate by 1%, which has even been reversed in recent days.
Thereafter, the CBN has since sought to shore up the currency through increasingly unorthodox measures. Some are more for show, and have little impact beyond inconveniencing the country’s people. These include the supposed removal of tree branches which provide shade to moneychangers, and the reduction of daily withdrawal limits from foreign currency accounts.
Other measures, though, are more serious and intersect with the economy’s fundamental workings. The most crucial are: that banks operate with narrower net dollar exposures, and requirements that currency trades be in relation to specific transactions. The latter eliminates the ability of market participants to hedge against currency risk, and has other serious consequences.
To date JP Morgan and Barclays Bank have acted out of concern about the ability of foreign investors to convert the proceeds of the sales of naira-denominated bonds into foreign currency. They have announced the withdrawal of Nigeria from the Global Bond Index for Emerging Markets and the Emerging Markets Local Currency Government Index, respectively. Appetite for Nigerian government bond issuances is thereby shrinking, which will necessitate higher yields for prospective investors.
In addition, the CBN has stopped providing dollar liquidity for payments of 41 import categories ranging from tomato paste – Nigeria is one of its largest consumers – to iron rods. The CNB has justified itself, arguing that hard currency should not be wastefully expended on goods that can be produced locally. This is a curious manner way to use a monetary policy remit to drive industrial policy. In reality, Nigeria does not produce the listed goods at all or in sufficient quantities (it is already Sub-Saharan Africa’s largest tomato grower in the case of tomato paste supply).
Most people probably will not miss private jet or toothpick imports. However, limitations on industrial inputs such as galvanised steel sheets, iron rods and wood products, and foodstuffs are likely to fail. An artificially high exchange rate ensures that demand remains unchanged without incentivising domestic production. The devaluation of the currency, by contrast, would prompt market participants to increase domestic production of those goods for which capability and capacity exist, while also reducing demand for imports.
Commercial banks that need to secure US dollars for clients’ currency requirements, and unable to obtain such funds from the CBN, are increasingly raising fresh dollar funding abroad, doubtlessly at higher rates than before. Sterling Bank, for example, announced a loan from Turkey Exim Bank – and it is not the only one. This introduces inefficiencies in the economy as attention is shifted to addressing immediate worries.
The CBN Governor draws attention to his success at defending the exchange rate, but neglects to mention the emergence of a parallel rate, where the naira currently trades at some 20% below its official rate. This introduces some market discipline into the economy. But, dangerously, it also creates the opportunity for rent seeking behaviour that will allow well-placed parties to profit by arbitraging between the two rates. Nigeria cannot afford for non-productive individuals to exploit the system for their enrichment.
None of this is to suggest that investment opportunities in the country are lacking. Indeed, the scale of Nigeria’s economy and the scope for greater diversification ensure the opposite. But at some point the internal strains generated by the CBN’s policies will cause the system to implode, resulting in sharp and painful external realignment. The impact of such dislocations will affect the real economy, banks and the government itself.
The ability of the country’s financial sector to withstand the inevitable shocks is likely to weaken the longer the adjustment is deferred. This is as they assume growing quantities of increasingly expensive funding, and undertake ever more complex measures to provide liquidity to their customers. Foreign investors need to ensure that their investments are well structured and Nigerian banks need to implement measures now to minimise the impact of the inevitable economic adjustments.
It is necessary for Nigeria’s government to address the fundamental issues, rather than papering over the cracks, before a collapse will allow a return to equilibrium. But in the absence of gradual realignment, those who are prepared will be best positioned to ride out the resultant economic instability.