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Currency devaluation: Why it happens and what we can do about it

There seems to be a common misconception by most people that Nigeria is a net importer of goods, that is, the value of our imports typically exceeds our exports of goods, and by extension, this is one of the major reasons why the economy has struggled in recent years.

But the question is, could this narrative be true and what can we do about it? In this week’s insight we explain how the trade balance impacts the exchange rate, the vulnerability of our currency to crude oil price swings and what the government can do to stabilise the Naira over the long run.

What is a trade balance?

The trade balance is simply the difference between the value of a country’s export and import of goods. When the value of exports exceeds imports, it is regarded as a trade surplus, whereas, when the value of imports outweighs exports, then it is called a trade deficit. Overtime, if a country experiences large periods of trade surplus or deficit, that country is often regarded as a net exporter or net importer.

The position of Nigeria

Going as far back as 2009, it is interesting to note that till date, Nigeria has only experienced two periods of a trade deficit with her trading partners, thereby clearly showing that the value of our exports to a large extent exceeds our imports of goods, making us a net exporter of goods.

Nigeria’s trade balance is largely driven by the price of crude oil. This is because oil exports account for a significant proportion of total exports (oil exports averaged about 93.36 percent of total exports from 2009 to 2018). For example, when oil prices rose to $108.86/barrel in 2013 from $61.86/barrel in 2009, oil exports rose considerably to about $90.57 billion from $54.78 billion and Nigeria’s trade surplus rose by about 65 percent during the same period.

Therefore, it is not surprising to note that the majority of the trade deficits that Nigeria has experienced has come during periods where the oil market witnessed a slump in prices. Oil prices crashed to about $52.37/barrel and $44.05/barrel in 2015 and 2016, respectively which consequently dragged down the value of our exports and our trade balance.

The confusion

So where does this confusion about Nigeria being a net importer of goods come from? No need to think too far, it’s the common fall “guy”, our exchange rate. Conventional economics has made us understand that countries with a weak exchange rate or currency may also have higher levels of imports compared to exports.

As a result of this teaching, this has conditioned the minds of so many people to believe that the declining value of our exchange rate is as a consequence of us being a net importer of goods without comparing the values of our exports and imports. Between 2009 and 2018, the dollar appreciated by more than 100 percent against the Naira.

However, while the economic thinking about a weak currency and high levels of imports is true to an extent, the reason why we have not seen that in Nigeria amongst other reasons has to do with the demand and supply of foreign exchange, and how international trade is conducted.

Whenever Nigeria exports crude oil, because it is quoted in dollars, we are paid in dollars and the revenue forms a portion of our external reserves. On the other hand, when we have to import goods, the importer has to exchange Naira for dollars to pay for the goods, thereby depleting our external reserves.

Stabilising the Naira over the long run

These dynamics of international trade reflects that the importation of goods into Nigeria creates a market for the demand for dollars, whereas the exportation of goods does not lead to a demand for Naira, hence creating an imbalance that puts pressure on the exchange rate. Therefore, the CBN would always have to be in a position to supply foreign exchange in order to meet the demand for dollars. The bigger the import cover buffer in the external reserves, the greater the ability for CBN to use the excess cash in the reserves to support the stability of the currency and vice versa.

So therefore, it is the size of the import cover buffer that is most important to the stability of the currency. The import cover buffer refers to the amount of money left over in the foreign external reserves after deducting the size of funding required to cover importation for the next 6 months.

The government can choose to expand the import cover buffer by enacting policies that discourage importation and by default will cause a reduction in the amount of money required to cover 6 months of importation. The government can also use economic incentives to increase the size of foreign capital it attracts into the country and reduce the amount of capital repatriated out of the country.

Lastly, the government must work towards achieving a diversification of our export by product and pricing denomination. The more Naira priced products we can export, the stronger our currency will be. Quick wins can be achieved by increasing the volume of exports in refined petroleum, processed foods, leather etc where we can easily have the products priced in Naira.

 

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