The outbreak of COVID- 19, a health pandemic, sent the global economy into a state of panic as health professionals and policymakers grappled with measures to curb the spread of the novel virus. Prior to the outbreak, the International Monetary Fund (IMF) projected the global economy to grow by about 3.3 percent in 2020, but this has recently been revised downwards to -4.9 percent to reflect the severe consequences of the virus on the economy.
Two common government policy responses to the virus globally has been the announcement of “lockdowns” to halt the spread, and interest rate cuts by monetary authorities to cushion the impact of the economic slowdown on businesses. Nigeria was not left out in this as the government introduced a 5 weeks mandatory lockdown from March 30 to May 04, and the Central Bank of Nigeria (CBN) reduced her monetary policy rate (MPR) by 100 basis points to 12.5 percent in a bid to support the economy. Despite these strong responses, the Federal Government still anticipates a 4.4 percent contraction in Nigeria’s economy this year.
In this week’s insight, we explain the channels of transmission of the COVID-19 pandemic on the Nigerian economy, present a macroeconomic model that is able to capture some of the dynamics of the effect of the virus, and finally we look at CBN policy responses and review its effectiveness.
Effect of COVID-19 on Nigeria’s Economy led to a unique situation that simultaneously impacted the demand and supply of goods and services globally. Lockdown measures to halt the spread of the virus unavoidably caused a supply glut, while demand level globally shrunk, thereby negatively impacting commodity markets, especially crude oil prices. Oil demand is projected to drop by about 9 percent in 2020, the most since 1965 according to IEA, largely due to reduced travelling.
The combination of both demand and supply shocks induced by COVID-19 is expected to manifest themselves through diverse channels with varying impacts on the Nigerian economy.
As an oil-exporting economy, Nigeria heavily relies on oil revenues to fund government spending, and the dollar proceeds from crude oil sales make up a significant proportion of the country’s external reserves which is essential for the CBN to support the stability of the Naira. Hence, the decline in oil prices is expected to pile pressure on the apex bank’s ability to keep the exchange rate stable amidst reduced capital inflows from both foreign portfolio and direct investment.
Inflationary pressures are also expected to build up due to supply chain disruptions – the high cost of transporting items during the lockdown; and pressures emanating from exchange rate adjustments that the CBN has implemented. In June, Nigeria’s inflation rate rose to a 26-month high of 12.56 percent as COVID induced inflationary pressures continue to escalate.
On the demand side, due the restriction of movement and closure of businesses, the demand for goods and services is expected to fall (consumer spending), adversely impacting businesses especially in trade, manufacturing, entertainment, and tourism. Consequently, companies have responded by implementing wage cuts, laying off workers or both, implying a rise in the unemployment rate. Furthermore, individuals are now experiencing reduced purchasing power as inflation rises and real wages fall.
In summary, the reduced earnings from crude oil, fall in external reserves, declining capital inflows, weaker government revenue, exchange rate and inflationary pressures are expected to lead to a slowdown in economic growth, culminating into an economic recession in 2020 which the IMF expects to linger on for 3 years.
Possible Channels of Impact of COVID-19 on Nigeria Modelling the Transmission Mechanism of COVID-19 Pandemic and Monetary Policy Response
To simulate and understand the transmission mechanism of COVID- 19 and how monetary policy should respond, we adopt a simple Quarterly Projection Model (QPM) calibrated to fit the data for the Nigerian economy. The adopted QPM consists of two major blocs: domestic and foreign blocs, where the domestic bloc allows us to capture changes in aggregate demand, inflation, interest rate, exchange rate and monetary policy actions; and the foreign bloc captures the external environment.
We consider a situation where an economy is hit by a 3 percent and 5 percent adverse demand shock which means a decline in consumer spending that impacts the economy negatively over two quarters.
The decision to consider a scenario with 3 and 5 percent consecutive quarter-on-quarter (QOQ) decline in consumer spending is based on the assumption that, the impact on consumer spending in the last economic
recession in 2016/2017 would be at the minimum doubled because of COVID-19. In Q2 and Q3 2016, National Bureau of Statistics (NBS) reported that aggregate household expenditure contracted by about 1.63 percent and 2.39 percent, respectively.
Scenario Results: The Effect of a 3% and 5% Consecutive QOQ Reduction in Aggregate Demand
Our projections show that two consecutive QOQ decline in aggregate demand which could be explained by the expected fall in household income level and consumer spending causes the economic output growth to fall drastically below its potential and remain in negative territory for several quarters (up to 2022Q4), thereby indicating the possibility of a prolonged economic recession.
In response to the contraction in demand and output, the central bank needs to gradually cut interest rate over three quarters. However, the reduction in interest rate comes at a cost as it further builds up inflationary pressures which is seen to last for several quarters.
As a result of the cut in interest rate amidst a high and rising inflation, this may cause real interest rate to fall into negative territory. Real interest rate refers to the difference between lending interest rate and inflation. This essentially means that investors would continue to earn negative real investment return on their investment for the foreseeable future.
The nominal exchange rate gradually depreciates due to rising inflationary pressures and falling interest rate on domestic assets which is expected to induce capital outflows. As inflation continues to rise beyond target level, the central bank will begin a gradual monetary policy tightening to curb monetary-induced inflation which usually means raising interest rates.
In summary, from the simulated results, we find evidence that the central bank may be moving into a monetary policy trap because by raising interest rates they hurt the economy but reduce inflation, by reducing rates they boost the economy but raise inflation and by doing nothing they allow the full impact of COVID-19 to hurt economic growth and trigger inflationary pressure.
Thus, we find that monetary policy alone may not be highly effective in combating the effects of the pandemic. Fiscal policy measures will therefore be required to subside some of the unintended consequences of monetary policy decisions to ensure its success.
The Reality of the Simulation and How CBN Has Responded so far
One key indication from the projection is that it could take up to 3 years before an economy like Nigeria returns to PRE-COVID growth level if we solely rely on the CBN. As seen from the graph, output gap is expected to negative till 2022 without any significant changes or improvements in macroeconomic conditions. From our estimates, when supplemented with fiscal policies that spurs consumer spending, attracts investment and reduces number of new COVID-19 infections, we expect the output gap should turn positive in 2021.
Our projections also indicate that the monetary authority would have to ease interest rates till at least till 2021Q1 in order to support the economy. While we have seen the CBN respond by reducing the MPR by 100 basis points to 12.5 percent, the apex bank was unwilling to cut interest rate further instead opting to leave rates unchanged, citing the need to strike a balance between supporting output growth and maintaining price stability.
The reality of the situation is that the CBN cannot afford to go on an easing spree like some other countries without huge implications for mobilising domestic and external investment to support the economy, and also for inflationary concerns.
South Africa’s Federal Reserve Bank on the other hand has cut its benchmark rate for the fifth time this year. June inflation rate is only 2.2 percent in the country, giving the Reserve bank enough room to ease aggressively.
Further cuts to the interest rate in Nigeria could reduce the attractiveness of government securities at a time where 1-year treasury bill is trading below 3 percent in the secondary market and could dampen the demand for OMO bills. We believe that a successful implementation of the government’s Economic and Sustainability Plan (ESP), a N2.3 trillion stimulus plans, would be crucial for the economy to cover half of the production hole the virus will cause Nigeria’s economy. The only way to save the economy from a prolonged recession will have to be a much bigger stimulus plan and getting the nation back to productive work safely.
