What is causing Nigeria's dollar shortage?

Nigeria’s dollar scarcity is no longer news.

From reducing spending limits on international transactions via your naira debit card, banks are now suspending the transactions altogether.

Our fx shortage woes are not new. Because the Central Bank of Nigeria (CBN) practices a managed exchange rate regime, it draws on our external reserves to maintain the price of the currency at a predetermined value. This is not entirely problematic, as leaving the market to determine your currency's price can lead to a lot of volatility, making it difficult for businesses and investors to plan. However, the CBN’s approach to managing the naira's price can be described as unorthodox since it no longer attempts to control supply but demand as well.

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In a simpler world, exchange rate management is typically done by raking up large reserves (Saudi Arabia, for example, has roughly $450 billion in reserves versus Nigeria’s $38.5 billion). Unfortunately, our main source of earning fx (oil) is largely volatile. So when there’s an oil price crash (like in 2016 and 2020), our fx supply follows. However, despite the current oil price rally, oil theft, vandalism, and pipeline shut-ins have compromised our ability to earn much more dollars.
 

We can see from the charts above that Nigeria hasn’t benefited from high oil prices, as the supply of fx into the economy has declined 31% y/y to $15.3 billion. Even our foreign reserves have dropped 5.1% year-to-date. 

Clearly, this is not a desirable position. As we have seen so far, the current fx supply shortage makes it difficult for banks to carry out their operations. In addition, they put a strain on the apex bank’s ability to maintain exchange rate stability. As such, we should be concerned with going deeper into the causes of Nigeria’s fx illiquidity. To do this, we will examine the sources of fx inflows and the factors impeding inflows. We will follow up by looking at some of the CBN’s responses to stimulating fx inflows.

So let's begin. How does Nigeria get its fx? 

Nigeria’s dollar sources

According to the CBN, Nigeria’s major sources of fx include trade (oil and non-oil exports), investment flows (FPI & FDI), remittances, and external debt. 

The chart shows that oil exports are Nigeria’s primary fx source. So we will start with oil and non-oil exports, i.e. trade. We will also look at investments, remittances, and external debt.

Trade

According to the CBN, Nigeria’s balance of trade (exports minus imports) moved into positive territory ($6.5 billion) in H1 2022 versus a deficit of $7.3 billion over H1 2021. The improvement reflects a surge in exports (up 73% to $35.5 billion) versus an 8% growth across imports to $29 billion.

The surge in exports is consistent with higher oil prices over the period, while muted import growth reflects import suppression as the fx illiquidity continues to limit importers. 

So how is it that despite the over $6 billion increase in net exports, Nigeria’s reserves have reduced by $2.2 billion in 2022? 

From the charts above, Nigeria’s export earnings as of August 2022 are already more than the entire 2021 earnings. Despite this, Nigeria’s fx reserves have dwindled. 

The main reasons for this mismatch are lower oil production and subsidy payment.

Firstly, Nigeria isn’t earning as much as expected from export proceeds due to the persistent drop in oil production (down 35% YTD to 972,394 barrels per day in August 2022). This has prevented Nigeria from benefiting more from record high oil prices, as we see in Saudi Arabia (reserves had gained $18.4 billion as of July 2022).

Noelle, our energy analyst explained the lower production could have cost us up to 900,000 barrels of oil PER DAY in August 2022.

 

Quick tablecloth maths shows the lost crude oil would have amounted to about $2.4 billion (at an average of $90/bbl) in August 2022 and could have increased FX supply.

Secondly, the Nigerian National Petroleum Company Limited (NNPCL), the sole importer of refined petroleum, engages in a crude-for-fuel swap arrangement with petrol suppliers (refiners). This arrangement involves paying for the true cost of the refined petroleum directly from crude oil sales or swapping crude oil for refined petrol (which is also priced in dollars). We then pay the subsidised cost in naira.

So what do you get when oil production is at a record low, and subsidy payments keep ballooning? According to the CBN, you get a national oil company that isn’t remitting to the country’s reserves.

Elsewhere, non-oil exports contribute little to Nigeria’s trade earnings, accounting for about 10% of export earnings in H1 2022, as structural issues like bad/inadequate infrastructure, insecurity and fx scarcity, continue to limit local production.

The CBN has, however, expressed improvements in its RT200 fx program, which it introduced in February 2022 to stimulate non-oil export proceeds. The program offers monetary incentives to exporters who repatriate their dollar earnings through the importers and exporters window. The CBN hopes this policy will raise at least $200 billion in non-oil exports in the next three to five years. 

Notwithstanding, experts have concerns about the monetary incentives’ effectiveness in raising $200 billion in five years from our current levels of $5 - $10 billion. Structural factors that affect domestic production still exist and will continue to limit fx inflows from non-oil exports.

Summarily, we have seen that the performance of one of Nigeria’s most important sources of fx (trade) has been underwhelming due to low oil production and ballooning subsidy payments, coupled with low non-oil exports.

Next, we have investments.

Investment flows

According to the NBS, Nigeria recorded a 12% y/y increase in investment inflows (FPI, FDI and other flows) in H1 2022 to $3.11 billion. However, despite this increase, inflows have remained at a post-covid low.

Comparing investment flows into the Nigerian economy in H1’22 ($6.22 billion annualised) with total inflows of $6.7 billion in 2021 versus $9.66 billion and $23.99 billion in 2020 and 2019, respectively, we see the investment inflows have remained subdued since covid era.

The thing is, persistently high inflation discourages investments (foreign portfolio investments)  as it erodes gains. So investors always seek to invest in economies where the returns on their investments (interest rates) tend to be higher or appear to be keeping up with inflation.

 

From the chart above, we see that Nigeria’s real interest rate (difference between inflation and interest rates) is negative because inflation is higher than interest rates, thus discouraging foreign portfolio investors (FPIs).

This investment flow a.k.a “hot money”, has been the primary focus of the CBN, which used high-interest rates and the creation of the I&E FX window in 2016/17 to lure FPIs in. However, as we see from the chart above, interest rates fell in 2020 as the CBN tried to support the economy by lowering interest rates to cushion the negative effect of the twin shocks from the oil price crash and covid-19 induced recession.

So investors started fleeing the Nigerian economy in 2020. It's only become worse because advanced economies are raising interest rates rapidly, making their markets more attractive.

As we all know, the onset of the Russia-Ukraine war-induced global inflationary pressures due to higher energy and commodity prices, with advanced economies like the US and UK recording 40-year high inflation rates. This prompted central banks worldwide to raise interest rates to tame runaway inflation.

The most recent being the 5th rate hike by the US Fed by 75bps to the upper limit of 3.25% in September 2022, and the European Central Bank (ECB) raising rates for the first time in 11 years to 0%.

Surging interest rates in advanced economies make these countries more attractive to investors. On the one hand, the interest rates are higher. On the other hand, these more “mature and stable” economies have fewer investment risks than emerging economies. JP Morgan estimates that investors have withdrawn a record $70 billion from emerging markets in 2022—the highest annual outflow since its records started in 2005.

The bid to attract foreign inflows and curb inflation underscores the CBN’s third monetary policy rate (MPR) hike in September 2022 to 15% versus 11.5% in May 2022.

Meanwhile, foreign direct investment (FDI), which the government should focus on, has been struggling. FDI is patient capital, i.e. funds invested into the real economy (e.g. A Swiss gold company setting up a factory in Ondo State) versus FPIs, who just seek to profit and exit (hence “hot money”). 

FDI has struggled largely due to structural issues like persistent insecurity, lack of infrastructure and bureaucratic bottlenecks that discourage businesses and investors.

From all that’s been said, we see that Nigeria’s second most important fx source has been declining majorly due to higher interest rates in advanced economies, which has triggered outflows and persistently high inflation, discouraging investors.

Next up, remittances. 

Remittances

Concerns around a rising cost of living and falling naira have contributed to a boost in migration out of Nigeria.

Unfortunately, most of the people migrating are skilled workers, with the UK witnessing a significant surge in student visas issued to Nigerians in 2021. 

So, as more Nigerians with family ties back home search for better opportunities abroad, they should remit more fx home to family members and dependents—at least in theory. 

However, it is well known that the CBN can not account for all remittance inflows because most are through informal channels (like sending cash home through a travelling friend) rather than formal channels (like Western Union). 

The IMF estimates that informal remittances into Subsaharan Africa represent between 40 - 60% of all inflow, so there’s a high chance that less than half of the fx remitted into Nigeria goes into the CBN’s arsenal.

The diaspora has been great at sending a steady stream of dollars, and Nigeria needs to find ways of getting more dollars out of them. This underpinned the CBN’s introduction of the “Naira 4 dollar scheme” in March 2021. As of August 2022, the CBN stated it had received about $2.4 billion in 2022 through the programme.

However, according to  Alhaji Aminu Gwadabe, President of the Association of Bureau De Change Operators of Nigeria (ABCON), “policies to stimulate remittances through official channels can only work when the CBN reduces the exchange rate gap, which would largely discourage utilising informal channels”.

In summary, while remittances are highly regarded because of their stability, the CBN can only benefit from these inflows when they come in through official channels. However, bottlenecks, like the difference between the parallel market and official rates (amongst others), continue to discourage official fx inflows into the CBN’s reserves. 

External debt
 

The chart above shows that Nigeria has increased its appetite for external loans over time but has been rather quiet this year, contributing to the low fx supply.

This is largely due to lower oil receipts and naira devaluation, which have cascaded into higher debt servicing and increased risk premiums attached to Nigeria’s debt instrument. 

Due to lower oil production, which has negatively impacted FG earnings, and persistent naira devaluation, the FG has now found it increasingly difficult to service its foreign loans, with total debt service to revenues hitting 120% in April 2022.

As such, high global interest rates, lower oil production, fx scarcity and a volatile naira have collectively contributed to the increased risk premiums attached to Nigeria’s dollar-denominated assets (i.e. Eurobonds), reducing the viability of this option as a source of fx for the CBN.

The high-risk premium attached to Nigeria is evident in rising yields. As our senior development analyst, Gbemi, put it, “when investors believe your sovereign debt is risky—they attach high-interest rates”.

Also, earlier in the year, the country raised a $1 billion Eurobond at a rate higher than it raised a $4 billion bond in 2020. Later on, the FG had to recall its Eurobonds issue because the interest rate was too high.
 

Surely it doesn't help our case that in May 2022, JP Morgan advised its investors not to be overweight in Nigerian bonds, holding fewer Nigerian bonds in their investment portfolio.

As we can see from the aforementioned, all sources of fx revenues to the CBN have declined in 2022, owing to a mix of domestic and external issues, which are not all necessarily within the CBN’s control.

So what can be done to increase supply?

One major issue that needs to be addressed fast is the foreign investors’ lack of confidence in the CBN governor. In this article, Stears’ resident economist, Tokunbo, explains the importance of a credible central bank in stimulating economic investment inflows.

He explains that “monetary policy is like running a large business”. While the owners can be doing everything right in terms of their day-to-day operations, other factors like creating a good working environment, emotional intelligence etc, are also very important to the business's success.

So while the CBN is seen to do its job in terms of setting interest rates and giving out loans, it has failed in gaining investor trust by being inconsistent in its policies and appearing to be not so independent of the FG.

In this world, confidence is everything. Once it’s lost, investors exit, and the supply of dollars falls, further exacerbating the legacy issues causing fx shortage.

Furthermore, Fadekemi, our chief editor, explains why the CBN is struggling to control the naira better and states that “because of low credibility and inconsistent monetary policy by our central bank Nigeria has had double-digit inflation for decades, even before the recent trend in global inflation”.

Dealing with inflation now seems imperative to the CBN, which has now focused on mopping up excess naira liquidity, contributing to the fx shortage and inflation.

The monetary policy committee (MPC) has now hiked its monetary policy rate (MPR) thrice in 2022 to 15.5% and raised the cash reserve ratio (CRR) for banks by 500bps to 32.5% in its September 2022 meeting.

I have explained how these rate hikes might not be sufficient to stimulate needed inflows right now due to the high-risk premium (touched on this earlier) attached to investing in Nigeria. However, should the CBN stick to its contractionary monetary policies, it will send out a positive signal to investors—it's ready to tackle inflation. The commitment to taming inflation should improve investor confidence and stimulate fx inflows going forward. 

Also, doing away with the multiple exchange rate regime and allowing a gradual devaluation of the naira will boost confidence as it removes arbitrage opportunities and the uncertainty shrouding the exchange rate movement.

From a structural perspective, the FG must also fix the fundamental issues like persistent insecurity, oil thefts, lack of infrastructure (like roads and electricity) etc., that rob us of the much-needed fx inflows.