Sloppy devaluation in a deficit financing regime pushes the economy into recession 1

The Nigerian economy should by now, be aligned purposely with the forward looking and clear political direction of President Muhammadu Buhari’s development initiatives for the country. The nearly three decades of panel- beating the economy with narrowly focused monetary controls above a comprehensive macroeconomic management strategy must have been arrested several years ago. However, corruption, self interest, and fear of a small group that has controlled the economy has prevented the obvious.

The election of Muhammadu Buhari should have sent a signal to the Central Bank of Nigeria (CBN) to reinvent itself swiftly to function as a linchpin for strategic macroeconomic management of the economy. The CBN should have stepped up activities to be seen as a regulatory agency that ensures all financial intermediaries support its monetary targets for credit expansion, stable output growth and price stability.

Policy inconsistencies

Since 1966, after the fall of the first republic, Nigeria’s economy has functioned like anything but what is studied in economics textbooks. The formal and informal sectors of the economy have complicated the nature of the nation’s mixed economy.

Although the economy is mixed by definition (planned economy with a mixture of public and private enterprises), there is a vibrant free enterprise sector that responds to economic policymakers’ and monetary authority’s pronouncement. Inconsistencies in policy pronouncement and monetary targets have led to confusion and hindered the achievement of long-run price stability and economic growth. Nigeria’s current stagflation (a combination of low economic activity and rising prices) has been a direct consequence of macroeconomic mismanagement and policy trade-offs in a monetary regime that has underestimated the psychological impact of forward guidance in applying financial tools in analyzing policy choices.

Policy timing

The President’s remark on Monday, June 28, 2016 at the New Banquet Hall of the Aso Rock Presidential Villa during a Ramadan dinner with the business community, that “I fail to appreciate the economic explanation [for the naira’s devaluation,]” is an incidental indictment of the CBN’s poor execution of its mandate and the Ministry of Finance’s slack decision to embrace external markets for loanable funds to finance budget deficits without serious consideration on the long-run implication for the value of the naira.

Unsuspectingly, that decision was a backdoor route to a devaluation track without full disclosure to Mr.President.

Economists know that government’s borrowing to finance budget deficits, if borrowed in the domestic market for loanable funds reduces the supply of loanable funds available to finance investment by households and businesses (crowds out private sector funding), and if borrowed in the external market for loanable funds, constitutes a net capital outflow in the foreign exchange market for dollars (that is, increases the demand for dollars),and leads to the weakening of the naira relative to the dollar. So, what should have been the solution?

Rational expectations

CBN’s tightening of monetary policy in the first quarter of 2016 in anticipation of the National Assembly’s passing of the 2016 Appropriation Act triggered a major slowdown in economic activity. The third and fourth quarters of 2015 Gross Domestic Product (GDP) estimates, showed significant sluggishness of the economy for a clear activist monetary policy.

The rational expectation of the business community and households was an expansionary policy that would have lowered interest rate (Monetary Policy Rate) in the domestic market for loanable funds.

Although, the 2016 Budget seemed colossal in comparison to previous budgets, it presented an opportunity for an accommodative monetary policy which would have provided a good balance of fiscal and monetary policy mix to expand output in a fairly stable price environment.

Nigeria’s businesses and households by far demonstrated a greater understanding of budget execution in Nigeria than the monetary authority. The CBN’s forward guidance in policy pronouncement did not only freeze economic activity but also pushed the economy into stagflation or recession (that is, a period of falling output and rising prices).

Therefore, the only predictions that have turned out as predicted are the policymakers’ irrational anticipations of rising prices and weakening of the naira. This is a classical case of not knowing what to do when the sailboat is off course, and there is no wind to steer the boat back on course, as the captain is seen to be guessing for a probable solution and looking in the wrong direction.

The economy in quagmire

Stagflation (a period of falling output and rising prices) and deflation (a period of low output and falling prices) are the most difficult periods in a business cycle of any economy to proffer policy prescriptions.

However, monetary policymakers know the rigmarole of pulling the economy out of quagmire. Nigeria’s current policy choices have been surprises to many macroeconomists. For example, deficit financing in Eurobonds as a panacea to crowding out private sector borrowing in the domestic market for loanable funds seemed auspicious but has presented double jeopardy.

The strategy has increased Nigeria’s demand for dollars and weakened the naira as the trade imbalance has magnified. A strong export-oriented economy would have benefited from the current devaluation regime but the struggling import substitution industries are bleeding from scarce hard currency for capital goods.

Certainly, macroeconomic solutions to a nation’s economic ills require trade-offs. Policymakers must ensure that Mr. President is well informed about the trade-offs so that economic decisions can be properly coordinated and made in the context of political considerations.

What are the benefits of devaluation if loanable funds in naira are available for households and businesses to finance new investments but imports of new capital equipment are exorbitant due to the high cost of the dollar?