The Nigerian Naira has lost close to 30% in value within the last one year, and more than 200% in the last 10 years. The situation has led to a spike in capital outflow, high unemployment, the alarming rate of inflation and other direct and indirect consequences associated with exchange rate crisis. While greater attention has been placed on COVID-19 as the root cause of the diverse economic challenges this year, the current FX situation should be looked at from diverse perspectives; primarily, the existing structural and policy challenges that have been limiting the country’s FX earnings over the years and also the COVID-19 induced shock on global energy demand.
The COVID-19 Effect
Earlier this year, as a result of restrictions imposed by countries when COVID-19 was declared a global pandemic, the fall in global energy demand put pressure on the oil price and we saw Brent down by about 57% closing below $20 per barrel. Nigeria, an oil-dependent country with over 81% export earnings from oil, had earlier benchmarked the oil price at $60pb in the 2020 budget with daily production estimated at 2.18mn barrels per day. The oil crisis forced a review of the oil benchmark to $28 per barrel. Consequently, the Nigerian government oil export between January and May contracted by about 77%. This put pressure on the FX reserve and led to the first devaluation of the year despite the $3.4bn loan from the IMF. The official exchange rate was reviewed from N306/$ to N360/$, while sales to the BDC was pegged at N379/$ and then followed by suspension of FX sales to the BDC with limited intervention across different FX windows.
Is COVID-19 the Main Factor behind the current FX Crisis?
While we can’t neglect the adverse impact of COVID-19, a look at the country’s trade account last year shows that the country started a trade deficit run from Q4-2019 despite the moderately buoyant oil price in the year. From a N2.4trn trade surplus as of the 3rd quarter of 2019, the country recorded a trade deficit of about N500bn in the 4th quarter. Similarly, from the latest 3rd quarter trade data released by the NBS recently, the country recorded a N4.6tn trade deficit within the first 9 months of this year. Even with the COVID-19 restrictions on international trade, the country still recorded a 19% growth in imports despite a 37% and 38% decrease in crude oil and non-oil export respectively. This tells of the overarching consequences of structural inadequacy that has been limiting domestic production and thereby leading to trade deficit with unnecessary pressure on the currency. Despite the various intervention into the agriculture sector via the CBN Anchor Borrowers Program (ABP) and other development finance initiatives, the import of agricultural goods still increased by a whopping 109% compared to Q2-2020 with agricultural export dropping by 21% in Q3, 2020.
The backlog of FX Demand Putting Pressure on Reserve
From the review of the foreign reserve; as of May 2019, it was comfortably around $45bn due to fairly stable oil price in the year. However, we have seen a continuous decline as the CBN kept on defending the Naira at all costs. It is an indication that the issue actually started even before COVID 19. Notably, FX reserves had been depleted below 40bn before the end of 2019. In short, the first, second, and third devaluation are long overdue with added pressure from COVID-19.
Following the suspension of FX to the BDC and other FX operators in March, the backlog of FX demand from both manufacturers and foreign investors was estimated at $7 billion in June 2020. $2 billion was attributed to the manufacturers and $5 billion estimated for foreign equities investors and investors in the OMO bill who were queuing to repatriate their funds. As restrictions were lifted and economic activities improved in the 3rd quarter, demand pressure aggravated amid declining reserve and low prospects in oil price. As the major source of FX inflow in the I &E window and interbank segment, the CBN had no option than to devalue the currency again.
Basically, COVID-19’s impact on the oil prices, slow recovery from the 2016 recession and structural issues limiting diversified export earnings triggered the various devaluations we have witnessed this year including the recent one.
How about the 2016 FX Crisis and Consequent Recession?
One striking similarity between the current FX situation and that of 2016 is the fact that both are linked to oil price crises. This clearly shows that the diversification policy action of the government has not yielded sufficient result to insulate the economy against oil price shock. The oil price crisis which started in mid-2014 severely affected the Nigerian economy via lower export earnings. The oil production shortage significantly aggravated the decline in the oil price that led to a contraction of the oil and non-oil sector. The drop in oil price and decline in volume due to militant operations depleted the FX reserve significantly, the government had failed to devalue the Naira, and investors struggled to get forex. Due to the uncertainty, foreign investors got frustrated over the shortage of FX and impeding problems from the recession.
Though the economy exited recession in Q2’17 with marginal GDP growth of 0.5%, the growth trajectory has been flat and the economy has not shown significant signs of returning to the pre-2016 GDP growth of about 6%. One major difference between the two crises is the absence of the Investors and Exporters window in 2016. The I&E window was introduced after the 2016 FX crisis. The introduction of the I&E window in April 2017 improved price discovery in the interbank market, resulting in increased market participation and FX Liquidity with CBN as a key player.
What has been Happening to Capital importation?
One major problem discouraging foreign inflow into the economy is the high-risk business environment due to the security challenges and deplorable level of critical infrastructure. Due to the level of insecurity across the country where business owners and farmers are not safe to go about their business, FDI has been discouraged from the economy. Recent data on capital importation by NBS shows that capital importation decreased by 74% YoY in the 3rd quarter of 2020 compared to Q3- 2019. Notably, an 86% fall in FPI was recorded in Q3-2020 compared to Q3-2019 and 42% declined compared to Q3-2015 before the 2016 crisis. As at early 2019, about 80% of the FPI are channel into the Money market instrument. A significant contraction in yield as a result of CBN restrictions on OMO bills led to reduced FPI inflow.
One other turnoff to capital inflow is the ambiguity about the CBN’s stance on devaluation. Flashback to 2019, the CBN at an investor meeting in London stated clearly not to devalue the Naira until foreign reserve falls below $30bn. The pronouncement itself led to speculative demand for FX immediately the reserve fell below $40bn at the end of last year.
CBN New Policy on Remittance, Is the Problem Half Solved?
The new CBN policy on the disbursement of FX remittance through IMTO is a welcome development to bridge the gap between the parallel market and the official rate. It would send a message of transparency to Nigerians in diaspora on how to get a fair value for their FX exchange and consequently encourage more remittance inflow into the country with CBN targeting about $2bn remittances monthly. We witnessed a positive reaction to the circular as the Naira gained more than N30 Naira in the Parallel market from the record N510/$ it earlier closed. Nevertheless, the proportion of remittance in terms of FX need is small to offer a sustainable buffer for exchange rate stability.
CBN has disbursed over #1bn dollars to the BDC since the resumption of FX supply in September, and the gap between the official rate and parallel market rate widened. This prompted some concern from the CBN leading to measures to liberalize the supply side to close the gap.
OPEC Cautious Ease on Output Quota, A relief in the Midst of Concerns?
To some extent, decisions from the OPEC meeting on 4th December 2020 raised hope for oil producing countries such as Nigeria and Algeria. In a reaction to the meeting conclusion, Brent hit the highest level since early March as OPEC members agreed for a cautious 500,000 bpd increase in supply starting from January. This alleviated concerns as some members earlier demanded a 2 million bpd quota increase. Hopefully, the cautious increase should keep the Brent price comfortably above the $40 oil benchmark in the Nigerian 2021 budget if the 1.86m bpd production target can be achieved.
One grey area hangs on the quick recovery of global energy demand by January bearing in mind the new wave of COVID-19. Similarly, Despite UK approval of Pfizer Vaccine and FDA approval of Moderna’s, effective distribution to other economies may not be until the 2nd quarter of 2021.
The World Bank and the IMF Position on Exchange Rate Unification and Flexibility
Before granting the recently approved $1.5bn, the World Bank maintained that the present administration needed to change foreign-exchange policies if it wanted to get the loan. According to the World Bank, merging the different exchange rates and allowing the Naira to float more freely would speed up the recovery of the economy. The CBN Governor and the Finance Minister have also said they would seek a more flexible and unified Naira as part of a pledge made to the IMF for the release of $3.4 billion in emergency financing in May. The IMF also maintains that a unified and flexible exchange rate will ease external imbalances.
While a more flexible exchange rate would offer as the benefit of automatic adjustment in BOP, absorption of sudden shocks like COVID-19 impact and independent monetary policies, it comes with problems of high risk, uncertainty and inflationary character which may impose further hardship on business and investment. Additionally, one major implication of the unification is that the Naira may be depreciated further to meet up with supply and demand equilibrium, this tends to increase the prices of imported goods and services in the country.
What is the hope for the Naira in the Midst of Uncertainty?
With the external reserve still on a continuous decline, we need significant export earnings to reduce pressure on FX demand. A first-choice scenario is if oil prices can maintain the current trajectory hovering around $50 per barrel and the country can achieve the 1.86mbpd production target, pressure on the foreign reserve should reduce even as the backlog of FX demand is cleared. The onus however rests on the cooperation of major oil exporters under OPEC not to violate the present quota.
Similarly, the effective implementation of the African Continental Free Trade Agreement, which is set to kickstart by January, would also open up the economy to other Africa countries. The opening of the land borders should boost the export earnings of domestic manufacturers especially those in the consumer goods space. Some of them have lost significant revenue since the border was close last year.
What is the Way Forward?
It is clear that the Apex Bank is currently faced with a trilemma policy option of maintaining a fixed exchange rate, attracting capital inflow and having an independent interest rate decision. In the broader economic sense, the economy is currently in the midst of macro issues of negative GDP growth, near 30% unemployment rate, high inflation rate 14.89% and lastly, exchange rate challenges. While policies to tackle these challenges are not necessarily conflicting, there is some certain level of mutual exclusivity forcing a trade-off.
A fast solution from these challenges would depend on the policy response of the government on how to tackle the major challenge of insecurity and infrastructure deficiency that has taken investment away from Nigeria’s economy to the so-called “small economy” in Africa.