How can the CBN control the naira better?

A few weeks ago, I wrote about why the naira is in crisis. It wasn’t fun to write, considering the impact of the currency you earn, losing roughly 15% in value within a week (so long summer holiday plans). Shortly after we published, I read this solution article to the current problems the CBN is facing with controlling the naira.

Now, it’s important to highlight that some things have changed since I came out and said the naira is in a currency crisis.
 

According to parallel market rates, the naira gained momentum. However, the current parallel market rate is still an 18% fall in value compared to where we started this year. According to news reports, this movement is likely the result of the Central Bank of Nigeria’s (CBN) direct interventions in the exchange rate market. So, not necessarily because the Nigerian economy has improved significantly and investor interest has returned. Therefore, this relief might only be short-lived.

As a quick recap, the CBN needs ample international reserves to maintain its peg of ₦420/$1. When the naira falls below this value, the CBN can sell the foreign currency it has to shore up the value of the naira. Another useful approach would be hiking interest rates to attract foreign capital—as foreign investors demand naira because higher interest rates have made naira-denominated assets more favourable, the naira’s value should increase. Unfortunately, between our inefficient economy, the decline in oil revenues (our biggest FX earner), and the US Fed hiking interest rates to make the dollar more attractive, the CBN is struggling to attract the foreign currency it needs. To add to that, its interest rate moves have done little to sway investor interest toward the Nigerian economy.

Ultimately, Nigeria’s fixed (or managed, if you will) exchange rate regime is not sustainable. For the peg to hold at ₦420/$1, people must be willing to sell the naira at that rate. Unfortunately, the gap between the official and parallel rates has resulted in a parallel market premium of about 55%. The wider the gap between the official peg and the black market rate, the harder it is to maintain the peg. The resulting arbitrage is just too tempting for speculators to ignore, which is why attacks will continue on the peg regardless of what the CBN does. In fact, back in 2016, Lamido Sanusi (a former CBN governor) once remarked on how easy it is to make billions through forex just from making a phone call in his garden. Not much has changed since then.

So, we need alternatives to our current approach to exchange rate policy, which is what I want us to focus on today. Solutions, not problems.
 

Let the naira crawl so it can walk again

That takes us back to Mr Agusto’s article I referenced earlier.

According to the author, a crawling peg is a better alternative for Nigeria. To be clear, this would still involve the CBN intervening in the exchange rate market to keep the naira’s value within a set range. The key difference between fixed and crawling pegs is that with a crawling regime, you allow some level of movement of the currency. This movement is usually pre-determined, but it’s not a necessary condition. So at the end of the day, the central bank retains control of the exchange rate (like we have with fixed), but they also allow the rate to change over time (like we have with floating).

Going down this route is an important alternative to our current system. For starters, it is one way to ensure the CBN does not wait until market pressures knock the rate off its peg—just like we saw in 2016 when the central bank unceremoniously devalued the naira even after declaring it wouldn’t just weeks before. If you have been keeping up with our coverage of Nigeria’s monetary policy, you will see why this is a problem. Central banks must behave with credibility if their policies are to hold any water. If investors cannot trust a central bank to behave consistently, anything they (the central bank) come out to say is effectively moot. Fortunately, a crawling peg can give central banks more control over the exchange rate movement, which helps with credibility. 

Avoiding market pressure through a crawling peg also means the currency doesn’t over-adjust when you are forced. In our 2016 example, few people expected the official exchange rate to go from ₦199 to ₦310. Most estimates were around ₦250. However, the rate went wild on the first day the CBN devalued the currency because of how unexpected the policy move was. Ultimately, controlled exchange rate movements are always better than unplanned ones. 

Adopting a crawling peg means we don’t have to go the extreme route of floating the currency. All that is likely to do is introduce volatility to our currency, given that oil revenues, Nigeria’s primary foreign currency source, fluctuate wildly.

From my perspective, I think the crawling peg recommendation won’t be such a bad idea. But if I were to take this a step further, there are three things I would like to see if we were to adopt this new exchange rate regime.

Who we peg to matters 

First, we need to understand that to peg your currency to another country’s currency successfully, you (the country doing the fixing) are essentially relinquishing control over monetary policy. Ironically, that’s one of the benefits of pegging your currency to another country. It disciplines you. That’s the assumption anyway. Often, countries fix their currency to another country with a reputation for having strong and credible monetary policies (remember what I said earlier about the importance of credibility and the CBN’s current struggle with that). This regime then introduces some confidence into your own country’s economy.

However, that’s only as long as your monetary policy mirrors what the other country is doing. This “mirroring problem”, as we are now going to call it, can be very hard to solve. That’s because you have to be ready to treat your economy how the US (or whoever you peg to) treats theirs, regardless of whether it makes sense for your country or not. So it helps if you look like the other country.

This is a hard lesson that Mexico learned back in the 1990s when the Latin American country decided to fix its currency to the US dollar.

Initially, it seemed like a good idea. The Mexican government was able to use the new peso peg to the dollar to stabilise inflation in its economy. I wouldn’t get into the “why” too much, but let’s just say the hyperinflation period of the 1960s-70s forced US policymakers to improve their approach to keeping US inflation low (asymmetric around a 2% target). Unfortunately, despite the Mexican monetary authority’s best efforts, inflation in Mexico began to rise again. Rather than rapidly devalue the peso (and take on the economic instability that will ensue), Mexico put into place a crawling peg.

Unfortunately, even this experiment did not work out. The Mexican and US economies were just too different. Inflation levels between the two countries were too wide, which led to speculations that the peso was overvalued. The eventual collapse of the Mexican peso was a combination of different factors—high-profile kidnappings that reduced investor interest and increased levels of government debt, to name a few. The watershed moment was the US increasing interest rates to tame its own inflation. 

You know how the story goes; it’s even playing out right now. When the US Federal Reserve raises interest rates faster than other central banks, and during periods of high uncertainty, capital flows return to the US as investors seek safer havens. Without the sufficient international reserves needed to defend the crawling peg, the Mexican government became illiquid and financially vulnerable, which exposed the Mexican peso to a self-fulfilling panic.

The story of Mexico and the US is a cautionary tale of what happens when a country decides to follow the same monetary policy regime as another country that it is structurally different from. That’s why who you peg to matters.

But it’s really hard to find another country that looks like you. Botswana might be a poster child for solving this problem, given how small the southern African country is and its similarities to South Africa (to who it set its crawling peg). So, two options remain for countries that want to adopt any kind of peg for their currency but don’t have a viable “mirror” country. First, you can have enough resources to convince external investors that you can mirror the policies in the country you are pegged to. Second, you ensure your economy is solid enough so that you can absorb the mirrored monetary policy.

One way Saudi Arabia achieves this is their peg to the US dollar allows them to smooth out volatility in oil earnings (also their primary FX earner). Because oil is such a big part of the Saudi economy, this benefit helps cushion the economy from any drawbacks of mirroring the US’ monetary policy. In addition, Saudi Arabia has roughly $450 billion in dollar reserves, so it doesn’t always have to mirror monetary policy.  Instead, it can use its dollar reserves to sway the market directly. To get a sense of how “stacked” the Middle Eastern empire is, Saudi Arabia recently pledged $3 billion to shore up Pakistan’s severely depleted reserves—a commitment they have made on multiple occasions.

Meanwhile, Nigeria’s national oil company (the NNPC) has not remitted oil revenue to the government in the past six months. In short, Nigeria, unfortunately, doesn’t benefit from high oil prices, despite our government’s budget being based on this. In January this year, oil prices were at $70, while Nigeria’s production stood at 1.4 million barrels/day. By July, oil prices had climbed to $100, and Nigeria’s oil production stood at 1.1 million barrels/ day.

Ultimately, when you peg your currency to another country’s currency, you have to make sure that country will look and act like you. If you try to act like a rich US economy when your economy is struggling to earn fx and attract investors, you are only looking for trouble.

We need to be clear on our economic policies

But that’s not all that matters.

Before we get caught up in the “mirroring problem”, we need to understand that there’s no point following another country’s peg without having a target for yourself. That’s where the importance of having your economic policy comes in.

Take China as an example. The Chinese yuan has had a currency peg since 1994 (in 2005, this became a crawling peg to quell international criticism). This approach keeps the value of the yuan low compared to other countries. As a result, Chinese exports are cheaper and, therefore, more attractive relative to the rest of the world. The economics is pretty simple. When the yuan is low, consumers using foreign currencies (say the US dollar) can buy more of China’s exports than they would if the yuan were more expensive.

Let’s see how that has played out. In 1980, China’s GDP per capita was only $350, compared to Nigeria’s, which was at $2,000 (six times higher!) Fast forward by only 30 years, and China’s GDP per capita grew to $8,400, four times higher than Nigeria’s. Of course, a combination of policies has allowed China to achieve its economic giant status. It implemented smart industrial and agricultural policies, opened up to the rest of the world, and crucially implemented an exchange rate policy to support its economic goals.

So, even though the People’s Bank of China (China’s central bank) has to defend its peg to the US dollar, it also knows that it wants a diversified economy by becoming more competitive and exporting more. To achieve this, even when the US Fed increases interest rates, the PBOC has been known to follow suit (following the rules of the peg and maintaining investor interest), but at a much slower pace to support China’s export-promotion strategy. That’s the power of having your own internal rules for setting a peg. It will ensure that even after ceding control with a peg, monetary policy does not get hijacked for exchange rate management at the expense of everything else.

In fact more recently, as the US Fed has been increasing rates, the PBOC has been reducing interest rates—contrary to the rules of maintaining a peg. That might seem odd, but for those paying attention, the Chinese economy has been going through an economic slowdown due to a resurgence in Covid-19 cases. As a result, hiking interest rates to follow the US will only be bad news for the Chinese economy. Of course, the PBOC has been extremely cautious with this to prevent the yuan-dollar peg from breaking down. But, at the end of the day, a successful exchange rate policy should lean toward an economic objective.

By contrast, the Nigerian government has yo-yo’d between policies that boost local production (those pesky border closures) while attempting to maintain a strong currency. So to boost local rice production, we have banned rice imports, which, to be fair, supports local production but also pushes more people to the black market for rice, which increases prices. At the same time, the central bank artificially holds the naira’s value, which makes our locally produced rice uncompetitive when we try to export and keeps smuggled imports relatively cheaper than they ought to be.

These contradictory policies have only made the cost of living for Nigerians higher (estimates suggest 50% of Nigerians skip meals or reduce food consumption to manage) and have done little to improve the competitiveness of our exports in international markets.

At this point, we need to ask why Nigeria even has a peg.

So that’s recommendation number two: don’t try to eat your cake and have it. Decide on an economic policy stance, and align your exchange rate regime to that. 

The political economy matters too

My final recommendation touches on an argument I previously made when considering the usefulness of economists in policymaking. Let’s be clear. I rate economists. I’m one too. Historically, economists have produced theories about what it will take to jumpstart economies following wars and pandemics.

However, we must appreciate how we can end up in situations where key policy decisions go beyond economics and enter political territory. You see it with the multiple arguments we have made about Nigeria’s fuel subsidy bill being economically inefficient. This year alone, the NNPC’s subsidy expenditure has hit ₦1.593 trillion, surpassing last year’s bill, which was ₦1.573 trillion. This is happening as the government has struggled to meet revenue targets and is effectively spending ₦1.20 for every naira earned on debt service payments. 

So going by economic logic, it should be pretty easy to remove the subsidy, right? Wrong. Any attempt to remove the subsidy would be incredibly painful for Nigerians. The rising cost of diesel (which isn’t subsidised) and its effects offer insight into why the government isn’t jumping at that option. It will take a pretty ballsy administration to have the fuel subsidy removal as its legacy.

In the same way, a crawling peg might be hard to execute because any change in exchange rate policy is also a political decision, not just an economic one. If the crawling peg calls for a naira devaluation over time in line with inflation, we need politicians in power who can stand by that. Remember, the whole point of a crawling peg is to make periodic adjustments to the currency’s value in line with inflation. That means having a committed and transparent central bank that ensures the naira’s value always reflects our economic fundamentals by intervening in the exchange rate market accordingly.

In a perfect world, we would have presidents who understand the economy's nuances and make decisions accordingly. The absence of this isn’t peculiar to Nigeria alone. All over the world, governments in modern democracies have been proven to be short-termist in their thinking because they are only in power for a limited time. As a result, they make policy decisions with a 4-8 year horizon in mind—a relatively short period to think beyond the long-term consequences of certain policies. That’s why my final recommendation goes back to the underlying principles of any modern central bank—political independence.

So I kicked us off by saying the crawling peg wouldn’t be such a bad idea for Nigeria. I’m still optimistic. However, our chance of success is based on policymakers ramping up the resources needed to sustain the peg (reserves and a strong economy); having a clear plan for the Nigerian economy and sticking to it, and acting with credibility so they don’t get in their own way when it’s time to execute. Otherwise, we will end up in the same situation we are currently in—with the naira constantly falling and little to no control over it.