In the end, this dead cat did bounce. But not for the reasons being bruited about. Nothing about General Muhammed Buhari’s election victory altered the fundamentals of the economy. Oil prices are still where they were before the polls. Government’s public expenditure management framework is probably more burdened than before the vote. And no one knows how much the banks’ growing exposure to local foreign currency deposits increases their vulnerability — even though there is a general sense of the direction in which this might be happening.
So, why did the naira suddenly strengthen? I have had arguments to the effect that much of the “bounce” at the All-share Index was the result of the spate of recently released corporate results.
Anecdotal evidence would seem to support the claim that all of the so-called “Buhari effect” on the foreign exchange markets was due to the fact that much of the pre-election dollar spend returned to the market in the wake of the polls, as beneficiaries sought to cash in their takings. This demand for naira in exchange for dollars, apparently helped bid up the price of the former. There is strong empirical confirmation of this claim. The naira seemed to improve only on the black market; and largely for cash-based transactions only.
This process is significant in two respects. First is that current estimates of unmet, and legit demand for foreign exchange in the country is put at about US$2bn — these are the cumulative bids which banks have taken from their customers to the official market, only to have these turned down. Addicted to the cheap “official dollars” of old, these customers — a category, which domestic banks refer to as the “large corporates” — have been loth to access the interbank or parallel markets to fund their dollar needs.
This leads to the second significance. Since much of this pent-up demand awaits the official market, it would matter for the naira’s near-term exchange rate how the central bank proceeds to structure the market in the next few months. All of these, however, make the recently released report by the IMF on its Article IV Consultation with Nigeria much more interesting reading. For starters, the Fund recommends both “allowing greater flexibility in the exchange rate to facilitate the adjustment to external shocks”, and further tightening of monetary conditions “to avoid a disorderly adjustment of the exchange rate”. Conversely, defenders of “official naira” point to our import dependency, indicate the pass-through from higher import prices to domestic prices, and ask that the transition to a flexible rate be deep-frozen until more comprehensive reforms to the economy are agreed and implemented.
Of course, defenders of “official naira” then ignore the implied subsidy that is a part of this mechanism. In its “Nigeria: Selected Issues” report, the IMF estimates the “implicit subsidies (and taxes)” from maintaining the “official rate” of the naira below the rate at the interbank market at “N71bn (and N197bn)” last year alone. Clearly, if the chosen benchmark were the black market, then this numbers would be scarier still.
But ought those who prefer that the dollar subsidy continues be concerned about the IMF’s worry that when monetary policy focuses on the stability of one price measure ─ the exchange rate ─ “international reserves have to adjust to balance supply and demand in the foreign exchange market, and the CBN has less room to manage its inflation target via monetary expansion or contraction”?
Besides, a movement to more market-driven exchange rates would be a one-off adjustment. True, a more volatile naira would then make the central bank’s job of managing stable domestic prices much difficult. However, all this does, is to radically alter the context and content of domestic discourse on the economy. Two things would then need to happen to address naira volatility. First would be a drive towards genuine diversification of the economy, in order that we are no longer dependent on oil exports for all of our foreign exchange earnings. Second, fiscal spending would have to be less inflationary. In other words, it would have to move from its current focus on recurrent to spending on building domestic capacity.
Essentially, therefore, a freer market exchange rate moves the burden of domestic economic adjustment away from the central bank and back to the fiscal authorities. Now, this movement matters for two reasons, both of which the IMF’s report addresses. First, is the possibility that the central bank, burdened by its new quasi-fiscal roles may have missed the newest trick in the financial services sector: the rise in domiciliary accounts as a proportion of bank deposits.
The IMF estimates this component as constituting about 20% of total deposits as end-2014. But this is only a part of the problem. Last year, banks’ total naira deposits appear to have dropped off, while their loans and advances grew. If growth in the latter was funded out of foreign currency deposits, then the industry may be more vulnerable from naira exchange rate volatility than it would seem at first blush. It would then be crucial for mitigating “potential foreign currency liquidity risks” that the central bank follows through on the IMF’s counsel, and puts in place a reserve requirement on foreign currency deposits.
The other reason why we ought to worry about the possible return to preeminence of fiscal policy in response to a change in the foreign exchange management mechanism, is the simple one that over the last 15 years, the fiscal authorities have not been in as terrible a position as they currently are. It would seem that the burden of this transmission, including through the anticipated decline in capital spending would be borne by provincial and municipal governments. The IMF’s numbers, using the current revenue allocation formula, shows that revenues for these tiers of government will “fall by about a quarter billion dollars for each $1 drop in oil prices”.
There is thus clear need to (1) improve the public expenditure management framework across the three tiers of government; (2) review, as part of this process, the current revenue allocation framework; and (3) look at the possibility of stabilising fiscal transfers from the federal government to fiscally constrained states and local governments.
How well these would be done would depend on public policy planners’ having their finger on the economy’s pulse. Alas, by insisting on an “official naira” we have long since applied Band-Aid to the pulse beat: neither curing the pulse, nor permitting its message to be heard.