Nigeria is in the middle of a monetary quagmire that has seen the exchange rate devalue by up to 25% in the past year. Based on our analysis, we believe that Nigeria needs more than $ 30 billion to avoid further depreciation at the official exchange rate.
A repeat of recent history?
Before getting to the reason for the current crisis, let’s take a step back.
In 2016, when Nigeria faced what was then an unprecedented currency crisis, apex bank critics called for the exchange rate to float. The debate raged for months in the media, academia and political circles. Several webinars were also hosted by supporters and opponents of the exchange rate float.
The CBN has responded with a multitude of policies in an attempt to trial and error to alleviate the problem. One example was the stillborn flexible exchange rate policy which turned out to be another version of capital controls, disappointing supporters of a floating exchange rate. Eventually, the CBN introduced the investor and exporter window, giving foreign investors the confidence to return to the market, albeit at a (depreciated) rate different from the official exchange rate.
What ultimately gave the exchange rate the stability it needed then and for the next 3 years was not the introduction of the I&E window but another central bank policy that offered foreign investors attractive interest rates. The central bank has attracted foreign investors with interest rates reaching 17% per annum for risk-free treasury bills and OMO bills in exchange for their hard currency. This was between 2017 and 2019 and as the graph below shows, this costly influx of dollars has kept Nigeria’s exchange rate stable for years.
Towards the end of 2019, the central bank had decided it was time to cut the costly selling of risk-free securities by eliminating liquidity and pushing interest rates down in single-digit territories. The plan, it seemed, was that the expensive sale had given the economy enough stimulus and it was time to slow down.
Unfortunately, covid-19 has struck, resulting in the dual effect of a major collapse in the price of crude oil (impacting government dollar earnings) and a large outflow of foreign portfolio investment from the country.
Thus began the disparity and the increase in the premium between the official rates and the parallel market rates that persist until today.
What’s the fastest way to go?
So, how do we get out of the monetary imbroglio we have found ourselves in?
Referring to recent history, the data suggests that we need an urgent increase in foreign investment (REIT and FDI), at least in the short term, an increase in interest rates and ‘a painful but useful devaluation.
As most readers know, Nigeria is heavily dependent on oil for over 90% of its export earnings (see graph above). When oil revenues decline (as you can see above) we often face a currency crisis. Unfortunately, since 2015, when oil prices hit the first major crash, we have yet to regain the income levels we were used to.
Specifically, over the past 10 years, the average crude oil export product of $ 45 billion between 2015 and 2020 ($ 36 billion in 2020) is far from the average of nearly $ 90 billion between 2011 and 2014. Unfortunately, Nigerian imports financed by the dollar have increased. over this period. To close this gap, Nigeria will need to either export more, borrow more (in dollars) or attract foreign investment.
In 2019, we had a net outflow of $ 95.8 billion from the import of goods and services. It fell to $ 68 billion in 2020 due to the pandemic, however, we estimate that demand at over $ 100 billion today. Nigeria’s imports increased by 22% in the first half of 2021 compared to 2020 and by 79% compared to the first half of 2019.
Juxtapose that with import revenues of $ 40 billion on average and we see a gaping hole of over $ 55 billion or so (assuming demand of $ 95 billion). Nigeria also receives an average of $ 20 billion in remittances, which helps meet our dollar demands. Clean that up and you’ve got roughly $ 35 billion unmet demand.
In a more stable economy, an increase in portfolio inflows may have helped close that hole, but the plunge we’ve seen in recent years means that it’s not a silver bullet and won’t even be an option if we continue with our current forex strategies. Total capital imports in the first half of this year amount to just over $ 2.7 billion, barely enough to plug the hole. Foreign investors are unlikely to return en masse to this economy in the near term.
This leaves us with two main options. The first is to borrow heavily in foreign currency and the second is to reduce the demand for imports. While Nigeria has a low debt-to-GDP ratio, its high debt service-to-revenue ratio means that we have little room for borrowing. The $ 4.5 billion recently borrowed through the sale of FG Eurobond is welcome but will not go far enough either as that leaves us with an estimated excess demand of over $ 30 billion to satisfy.
The plausible option, which is to reduce demand, can only be achieved through capital controls or massive devaluation. The CBN has been practicing capital controls since the onset of this crisis last year, which is why we have seen many restrictions on dollar outflows and crack down on currency speculators. But given the plethora of options that Nigerians have to ask for dollars, the CBN simply cannot dampen the demand enough.
Massive devaluation seems like an inevitable pill as an inevitable option. Perhaps this is the wake-up call Nigerians need to turn in on themselves. This is perhaps the fastest way to reduce the demand vacuum that we cannot fill.
We have seen this happen twice in the past three decades. First, was under Abacha when we went from less than N22 / $ 1 to more than N80 / $ 1 at Inter-Bank. The second time was between 2014 and 2017, when we went from 187 N / $ 1 to around 360 N / $ 1.
It’s an unpopular move, and it’s easy to see why the umbrella bank won’t go down this route, especially since it wants to control the forex market in pursuit of its perceived price stability goals.
But we think it’s inevitable except that a miracle happens. This miracle will have to lead to a combination of higher oil prices, higher oil revenues, increased non-oil revenues and an influx of tens of billions of dollars of money from foreign investors.
In summary, the options before the Central Bank are:
Increase the interest rate: The central bank may need to raise interest rates to attract foreign capital inflows into the country. An increase in interest rates will also encourage more Nigerians to save in naira and to forgo speculation in the dollar or dollar-denominated assets. It’s a costly but inevitable path when you have the kind of current account deficit we are facing.
Devalue the currency: Or a monetary adjustment, as the umbrella bank calls it, will lead to a further devaluation of the currency. The central bank often does this when it is pushed to the wall with nowhere to go. The last devaluation was a few months ago when we went from N380 to N410 / $ 1. Most analysts believe this is not enough given the gap in current account deficits and the disparity in the black market. The devaluation is also dampening Nigeria’s thirst for foreign imports.
Encourage foreign investment: This is often a natural sequence after interest rates rise in an economy. Foreign investors are encouraged to keep their dollars in the country if interest rates are encouraging. It is milder when this is also supported by a devaluation of the currency.