The Central Bank of Nigeria (CBN) seems to be fighting numerous battles on all fronts these days.
It is rapidly expanding its balance sheet in a bid to support the cash strapped Federal Government to finance the fiscal deficit, issuing enormous amounts of expensive OMO bills to help support a naira under pressure, and providing direct interventions to various sectors of the economy.
The CBN is also battling persistently elevated and sticky inflation levels that has stubbornly remained at double digits for years.
Some of the actions the CBN is taking is making it difficult to achieve some of its other stated goals. For instance by directly financing the Federal Government (FG) to the tune of N4.5 trillion (ex FG deposits) as at August 2019, the apex bank is heightening inflation expectations, despite its attempts to sterilize funds through OMO issuance.
Consumer prices rose 11.02 percent in August from a year earlier compared with 11.08 percent in July.
Higher inflation in turn makes it difficult to maintain a stable foreign exchange (FX) rate between the dollar (USD) and naira (NGN), another goal of the central bank, as this tends to weaken the real effective exchange rate (REER).
The real effective exchange rate or REER is a calculation that strips out the effects of inflation.
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So as an example if Nigerian inflation runs at 10 percent on average and US inflation runs at 1 percent, the NGN would need to sell off (or adjust lower) by 10 percent annually in nominal spot terms, just to keep the currency stable against the US dollar in real terms.
The key thing to note is that if a currency peg is held under these circumstances, then imbalances will grow quickly after a while, necessitating a sharp weakening of the currency exposed to high inflation to bring it nearer to equilibrium.
This happened when Nigeria saw sharp devaluations under CBN Governor Chukwuma Soludo in 2008 and again in 2015 and 2017 under Godwin Emefiele.
Recently investment firm Renaissance Capital compared the REER rate for all of emerging markets (EM), most of Frontier and a few beyond Frontier countries – against both their long-term average REER implied currency rate – and against the weakest point seen over the last 20 years.
The investment Bank used the Bruegel database which arbitrarily chooses December 2007 as 100 and compares how currencies have moved over 20 years around that level, relative to inflation.
The results from the data shows that if the NGN had kept pace with inflation differentials since its 20-year low in 1995 – it would be exchanging at $1/NGN 1,063 today!
Since Nigeria is a major oil producer which can defend its currency peg in times of high oil prices, Renaissance Capital also provides 2 REER estimates for the country, one for when oil is trading at around $60 per barrel and a second one for when it’s higher at about $80 per barrel.
The former puts “fair value” at around $1/NGN464, while the latter (higher oil prices) at $1/NGN382.
The investment firm notes that inflation of 10 percent pushes both numbers higher by roughly 7 percent each year – implying N500 or N410 as the average rate versus the dollar next year.
If a global recession emerges next year that hits oil prices then the REER number should weaken further, given that CBN reserves fell by $2.2 billion in the last two months.
The current account deficit has already surged to $5.6 billion in the first half of 2019 amid a negative balance in the financial accounts.
Atedo Peterside a renowned Banker noted in a speech last week at the Nigeria Economic Summit Group (NESG), that “with U.S inflation at 2 percent and Nigerian inflation at 11 percent, the 9 percent per annum differential is too high and is inconsistent with the declared goal of maintaining exchange rate stability.”
Analysts at Cardinal Stone argue that consensus expectations of double-digit inflation in the next two years implies that a devaluation of the naira at a later date would be of a higher magnitude.
To defend the currency following the devaluation in 2017, the CBN increased its issuance of OMO bills from N4.2 trillion in 2016 to N7.7 trillion in 2017 and N17.0 trillion in 2018.
Between 2017 and 2019, the CBN issued N35.8 trillion at an average stop rate of 15.1 percent, which translates to an associated interest expense of about N5.4 trillion in the period, according to estimates by Cardinal Stone Partner’s research.
The interest expense incurred by the CBN in 2018 alone is over 6 times the average interest expense recorded in the 4 years leading to 2017. The CBN’s 2018 interest expense is also some 75 percent of Federal Government’s actual retained revenue, showing that it is clearly unsustainable.
The most important thing for the economy is having a flexible exchange rate that clears at (or near) the market rate so that there is incentive to take risk by entrepreneurs as well as an elimination of corrupt practices of round trippers and those that benefit from arbitrage.
