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.