The CBN adopts a flexible exchange rate adjustment strategy By Dapo Fafowora

Last week, the Governor of the Central Bank of Nigeria (CBN), Mr. Godwin Emefiele, announced that instead of the fixed exchange rate strategy the CBN had decided to adopt a more ‘flexible exchange rate policy’ for the naira. All nine members of the bank’s Monetary Policy Committee (MPC) voted unanimously in favour of the new strategy in the adjustment of the exchange rate of the naira. The MPC stated that the worsening state of the economy and the slide into stagflation called for new strategies and monetary policy reforms. The economy has been in a recession since July, 2015. In response, the CBN is dropping the strategy of a fixed exchange rate for a flexible or floating exchange rate strategy.  The fixed exchange rate strategy had not worked. Some devaluation of the naira had become imperative and could not be put on hold for much longer. The naira had become overvalued because of the external oil shock and higher domestic inflation.

Now, in my article in this column in October, 2015, I had urged the CBN to devalue the naira promptly. I could not see how the unrealistic official exchange rate of the naira could be maintained in view of the ‘external shock’ caused by the sharp decline in our oil revenues. I considered the naira exchange rate overvalued. The difference between the nominal official exchange rate and the parallel market rate of the naira had widened. Now, the proposed flexibility in exchange rate management by the CBN means the naira is to be devalued by a rate to be determined by the CBN. This will be based on the supply and demand for foreign exchange. In other words market forces will, to a large extent, now determine the exchange rate of the naira. Market forces may not be perfect, but human judgment is less perfect.. It is said that a stitch in time saves nine. The fact is that if we do not devalue the naira now compelling economic and financial developments will force us to do so later at a higher cost. The delay in devaluing the naira now will prove to be more costly later. The proposed flexible exchange rate adjustment is a sensible alternative to the rigid but doomed course the CBN was pursuing in its exchange rate management. The CBN has not yet announced a new naira exchange rate.  Of course, this new policy will need to be complemented by other policy instruments, including a moderation in money supply. How this can be achieved with an expansionary budget this year remains to be seen. The delivery of the intervention funds will have to be appropriately moderated to avoid additional downward pressure on the exchange rate of the naira.

According to the Governor of the Central Bank the review was in response to the recognition that the economy was in a state of ‘stagflation’ (combined stagnation in economic growth and high levels of inflation in the domestic economy) and that a flexible exchange rate policy was the ‘least risky of the options open to the bank in Nigeria’s current economic and financial situation.’ The Governor added that one source of the stagflation was the delay in securing an early passage of the 2016 federal budget and the consequent time lag in implementing the stimulus package in the budget. But he should have added that growing uncertainties over the naira exchange rate added to the trend towards stagflation in the economy. Both local and foreign investments had to be put on hold pending stability in the naira exchange rate and other fundamentals of the economy, such as interest and inflation rates, both of which are now rising. Stability in the macro economy has to be restored. The banking sector and financial analysts have reported that foreign investment and equities have dropped by 74 per cent in reaction to currency overvaluation. Productivity in the industrial sector has also been falling in response to these uncertainties and a possible consumer resistance to increased prices, some of which is speculative. This has led to some job losses. An overvalued currency leads to currency speculation, capital flight and money laundering. It undermines economic growth. Industry has reacted to the new policy positively.

For these reasons I fully support the new CBN policy of flexibility in the naira exchange. The response of the CBN to the grave economic situation is appropriate. Like the hike in the oil price, we had to bite the bullet again on exchange rate adjustment. The adoption of the new flexible exchange rate policy reflects these realities amply. My regret is that, for political reasons, including President Buhari’s known reservations about a floating exchange rate, the CBN waited for far too long to come to terms with these realities, which include a steady decline in foreign exchange earnings and low GDP growth rate, the lowest for decades. Much valuable time was lost in the doomed attempt to avoid a devaluation of the naira promptly. This strategy was bound to fail in view of the increasing demand for foreign exchange and the fall in Nigeria’s foreign reserves. Now that oil prices are on the rise again there will be a temptation to delay the necessary devaluation or to allow it to fall below the net effective exchange rate of the naira. This must be avoided at all costs.

As admitted by Mr. Emefiele, the previous rigidity in exchange rate management, and the refusal of the CBN to consider some devaluation in the exchange rate of the naira, did not work. It could not have worked. Since 2015 the economy has been in a recession. Mr. Emefiele acknowledged this fact in the following statement by him: “As a stop gap the CBN has continued to deploy all the instruments within its control (including the resolve to resist devaluation) in the hope of keeping the economy afloat. These actions, however, proved to be insufficient to fully avert the impending ‘economic contraction’. In March 2016, the CBN tried the option of a tight monetary policy to stabilize the naira. But the 2016 budget is expansionary and inflationary. It was bound to put pressure on the exchange rate. A deputy governor in the bank is reported to have warned that when the 2016 budget comes into play these inflationary pressures on the exchange rate will certainly increase, compounding the CBN’s exchange rate dilemma. The planned financial stimulus package has to be moderated.

It is difficult to understand why the CBN should expect anything other than a contraction in the economy when its exchange rate management strategy was not pro growth but contraction. Inflationary pressures through an expansionary fiscal and monetary policy were bound to aggravate our economic problem as high levels of inflation tend to undermine economic growth. The administrative import restrictions introduced by the CBN were certainly not pro-growth. They were intended to reduce imports and the demand for foreign exchange. This was bound to lead to a recession. If the objective was growth these fiscal and monetary measures could not have worked unless we got the economic fundamentals, including the naira exchange rate, right. Economic growth, not stagnation, should be the prime objective of our strategy of diversification of the revenue base. Diversification of the structure of our economy, still largely dependent on oil exports and revenues, will be enhanced by a realistic net effective exchange rate of the naira. It will restore the economic fundamentals to equilibrium and substantially increase the scope for higher prices in the agricultural sector and higher income for farmers. Government’s revenue too will increase. It will also promote other non-oil exports. All the available evidence suggests that, on average, countries where currency reforms have been implemented in a timely manner have also achieved better economic performance.

Effectively, the real beneficiaries of the strategy of import controls and restrictions are our neighbors, with the loss to Nigeria of considerable import duties and revenue. This is bound to affect revenue derived by the government from non-oil sources. Increased tariff on non-essential imports would have been a better alternative to import restrictions. The same objective of reducing demand for forex would have been achieved with selective tariff increases. The CBN says it will open a ‘special window’ for vital imports. Obviously, the target here is industrial imports. But this could lead to abuses such as money laundering, capital flight and a distortion in prices.

In addition, Nigerians hold a lot of foreign currencies (including looted funds) abroad over which the CBN has no control and which can easily be utilized for imports into Nigeria. Some of these funds are channeled through the parallel market over which, again, the CBN has no control. It is a source which the CBN should not ignore. Some $5 billion is involved. But if the naira exchange rate is considered to be unrealistic then these Nigerians with large foreign currencies will not go through official sources (the CBN) in making remittances to Nigeria, but through the parallel market. It is far better for the CBN and our economy for these funds to be channeled through official sources than through the parallel market as this will continue to drag the exchange rate of the naira down. But this will only happen if we narrow the difference in exchange rates between the official and parallel markets.

Now that the CBN is compelled by our economic and financial realities to reverse itself on its exchange rate strategy and policy it should stay the course. The CBN should be given the leeway and autonomy it needs to manage our monetary policy more efficiently. Change involves breaking with the past and taking tough decisions when necessary to achieve better results. This is where we are now. The devaluation of the naira is one such tough measure needed now. In Africa, Angola and South Africa, among others, have already devalued their currencies by over 15 per cent in response to the external shock.

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