Why is the CBN struggling to defend the naira?

The tale of George Soros breaking the Bank of England is legendary. 

He did it by betting a huge amount of money (roughly the equivalent of £10 billion according to some estimates)  against the pound sterling in 1992. He then repurchased the British currency for a lot less than he sold it for, earning $1 billion in the process. The collapse led to a pound (£) devaluation of about 15%, forcing Britain to withdraw its currency from the European Exchange Rate Mechanism (ERM)—the European Union’s attempt to reduce exchange rate variability for their economies back in the day. The day later became known as Black Wednesday.
 

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I thought it fitting to kick today’s article off with this story for two reasons. 

The first (and perhaps less serious) reason is the awareness that the current state of the global economy has made money-making moves top of mind for many of us. Ps: this is not financial advice. Speculations can be wrong, and you will lose money if you bet wrong.

Second, this story is one of the best-known examples of a speculative attack on a currency—our focus for today. These typically happen when speculators (like George Soros) attack a country's currency attempting to maintain a fixed or pegged exchange rate (like the UK and its neighbours were trying to do in the early ‘90s). To be effective, these attacks typically have to be massive and coordinated. For example, George Soros convinced other investors and investment banks such as JP Morgan and the Bank of America that the pound sterling would collapse, leaving the Bank of England essentially powerless.

Of course, keen observers of the Nigerian economy will know why this matters to us. Just last week, news headlines were awash with reports of the Central Bank of Nigeria (CBN) Governor clamping down on people he believed were hedging against the naira. In a nutshell, the CBN is now attempting to reduce speculative activities by imposing a Post-No-Debit (PND), an instruction to banks to discontinue withdrawals or transfers from the bank accounts of people who are allegedly obtaining and hoarding dollars. 

The CBN Governor cares so much because persistent speculation means the apex bank might have to abandon its “managed” exchange rate regime. This is a policy objective that it has arguably been more obsessed with than controlling inflation (the actual objective of central banks everywhere).

It’s almost reminiscent of the 2016 days when the naira faced similar pressures, and the CBN imposed capital controls to limit the outflow of dollars from the country.

Now, for all the pessimistic energy I have brought so far, it might come across that fixed exchange rate regimes are a bad idea all around. They are not. There are (some) good reasons to maintain a pegged exchange rate, which we should explore.

Before I get into all that, though, I want to clarify what we will show. I initially set out to write this article to answer the following question: how far away are we from an exchange rate crisis? However, the more I considered this (and as you will soon see yourself), that’s no longer the question we should be asking because, quite frankly, we are already in one. So instead, I am going to bring you a framework for understanding why the naira is already facing a crisis, which should help us understand why the CBN is struggling to keep the naira from falling. 

To kick off, let’s look at why countries fix their currencies

So, as I said, countries attempt to control or fix the value of their currencies for different reasons. In fact, historically, most currencies today started as a fixed exchange mechanism that tracked gold or a widely traded commodity. The main play is an attempt to establish a stable currency price so businesses can plan for the future, making it easier to invest and trade (they have a long-term estimate of what the local currency is worth compared to others).

Another non-obvious benefit is that it encourages better monetary policy and discipline. Think about it this way. Fixed rates provide an anchor for countries with inflationary tendencies (like Nigeria). By maintaining a fixed rate of exchange to the dollar, that country’s inflation is “anchored” to the dollar, and should follow the policy established for the dollar.  Until recently, that would have been a safe strategy for Nigeria, given the US’ track record at maintaining a low inflation environment, roughly around 2%. Of course, all of that has changed now, given the high inflationary pressures we are seeing globally. But, even with that, the Fed has come out with an aggressive stance to fight inflation. 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. 

Talk about self-sabotage.

Someone at the CBN reading this will probably want to emphasise that what is actually happening in Nigeria is a “managed exchange rate regime”. In my view, that’s just the same as a fixed exchange rate regime. Think about it this way: we (Nigeria) currently have a NAFEX window, where the CBN attempts to keep the dollar to naira rate roughly around ₦410. So the official word is that you have to spend ₦410 for every dollar.
 

The chart above has two distinct features. The first is the minimal variation in the official exchange rate  (save for the times the CBN had to devalue when the peg couldn’t be sustained) compared to the parallel market rate. This reflects the CBN doing everything it can to maintain this rate, which is essentially what happens when you peg or fix your currency. For example, there are restrictions on who can buy and sell at the NAFEX rate (you and I can’t get access to that rate). The CBN’s string of supply and demand-side policies to manage the flow of foreign currency in the economy just to keep the rate around a set value are all the makings of a fixed exchange rate regime. So, managed, fixed, pegged, they are more or less doing the same thing.

The second is the widening gap between the official rate and the black market rate. That this gap exists and is increasing indicates that the official value of the naira does not reflect true market conditions. This is key for some of the points we will explore later, so don’t forget it.

Anyway, as we have seen, there is a case for adopting this approach to exchange rate management. In the CBN’s case, they might argue this is the best way to stabilise the naira to keep imports (of which many of our industries depend on for raw inputs) less expensive, which in a way, should help manage inflation. People need dollars to import, and Nigeria gets its supply of dollars from foreigners (usually oil sales, diaspora, or investors). Without intervention, there will be some volatility, and remember, volatility discourages investment. The wild oil price swings we have seen this year are evidence of that.

To keep moving our answer forward, we now need to consider the tools the government (or central bank mostly) has to be equipped with to realise the gains from a fixed exchange rate regime.

Kicking that conversation off requires us to take a step back a little. So I know I started off with a scary story about fixed exchange rate regimes, but not all stories of a pegged currency end up in failure. For example, when a huge attack took place against the Hong Kong dollar in 1997, the combination of the ability to source large amounts of currency from China and a deliberate and aggressive approach to interest rates meant that the Hong Kong Monetary Authority (central bank) successfully defended itself.

Those two things: foreign currency reserves and interest rates, are what I mean by the tools required for a successful fixed exchange rate regime.

The typical way to conduct a fixed exchange rate regime is by controlling the supply of foreign currency flowing. As a central bank, you do this by drawing on reserves. The problem with reserves, though, is they are scarce, so when the government runs out of foreign currency, it becomes very hard to defend the peg. 

Interest rates also matter because they are a tool for controlling the value of the currency. For example, as the US Fed has increased interest rates in a high inflation environment, risk-averse investors seeking more certainty have increased their demand for the greenback. In a nutshell, higher interest rates mean investors can earn more on assets like US bonds. The resulting dollar-euro parity (not seen in the past 20 years) is evidence that higher interest rates can prop up the value of your currency.

As you can imagine, reducing interest rates has the opposite effect. So, when central banks want to manipulate the value of their currency to defend their peg, the interest rate is another tool. In the Hong Kong example we looked at earlier, the central bank increased interest rates up to 50% just to maintain the value of the Hong Kong dollar. I mean that move took a serious toll on the Hong Kong economy, and estimates show that output declined by over 5% during that period—an example of the costs you have to bear to run an exchange rate regime. Regardless, the HKMA (Hong Kong’s central bank) was able to stave off the attack. To date, the peg has never been broken. 

So how do we know when an attack is imminent?

It’s the economy, stupid

The headline here is that fixed exchange rate regimes can fail and have devastating consequences.

Many economists have spent time theorising about how these currency crises happen. Academics like Paul Krugman (2008 Nobel Prize for Economics winner) have even classified exchange rate crises into three generations.

When considering fixed exchange rates, you must look at the economy, reserves, and whether the government can repay their loans. That’s what people doing the attack (lowkey the population, bankers, and investors) are watching out for. Basically, they want answers to the following questions:

• Is the economy good enough to attract foreign currency?

• Are current interest rates high enough to attract foreign currency?

If the answers to those two questions are no (already a bad sign), then people would want to know if:

• There is too much foreign currency leaving the country, and if there is,

• Does the government have enough reserves to replace the lost foreign currency

Those are the questions speculators would be trying to judge and calculate when looking into the future of the currency. If the answers don’t indicate the government has the ability and will to defend the currency, the attack comes, and people start selling the naira.

Unfortunately (and to the Governor’s dismay), that’s done by everybody, not just investors like George Soros. If you and your friends see the naira is going to keep falling (streets are calling $1 =  ₦700), any naira you have, you will start to quickly change to dollars to avoid losing your purchasing power abroad or for imported goods and services.

So, where is the Nigerian economy today?

Well, unfortunately, one of our fundamental problems is that we struggle to raise foreign currency. To put it bluntly, the economy has not done a good job of attracting traditional foreign investors into the economy. As you can see from the chart below, foreign direct investment (FDI) has been declining. 

At the same time, our ability to earn dollars from our major source (oil) of foreign currency has taken a massive hit, even as oil prices hit record peak levels. 

So, yes, if you wanted to, you could blame our national oil company (the NNPC) for our low dollar earnings because with dwindling reserves, we will struggle to make debt repayments and pay for imports, among other things. All the ingredients that make a currency ripe for a speculative attack. However that's not the full picture.

Remember the other tool I mentioned: interest rates.

Unfortunately, on that matter, I am not too optimistic either. You see, the Nigerian economy is already in so much trouble that the CBN doesn’t have the room to raise rates as high as they need to attract investment. Higher interest rates might be good news for investors, but they also increase the cost of borrowing, which can have inflationary pressures. I could throw our double-digit inflation numbers at you to illustrate why that won’t be a good idea. But to make it land even better, just think about how the cost of everyday items like beans, yam, and tomatoes have more than doubled since 2019.

So even with the series of rate hikes we have seen from the CBN (the last time they raised rates before then was six years ago), I doubt that would ease the pressure on the naira because it would be very difficult for the CBN to raise rates to the level that will attract investors away from safer and higher rates in the US. 

So what can be done?

I read in the recently published Medium Term Expenditure Framework that the CBN Governor expects the pressure on the naira to go away after the third quarter of this year. If I were him, I would update those expectations. After all we have discussed, you can see that we are already in a currency crisis.

With businesses lamenting about how difficult it is to source foreign currency to pay for their inputs, or in the case of multinationals, repatriate profits (see this letter from Emirates to our Minister of Aviation), Nigeria’s current “dollar scarcity” is worrying. Our approach to fixing the currency's value has also received much international criticism. The World Bank/IMF has warned about the naira being overvalued, and a condition for receiving aid during the pandemic was actually based on unifying the exchange rate (essentially abandoning the peg).

Abandoning the peg might sound scary because of the resulting inflationary pressures that might occur. So far, our monetary policy regime has been based on the assumption that the negative impacts of a flexible exchange rate outweigh the benefits. This has been the basis for the CBN’s commitment to maintaining a damaging fixed exchange rate regime, even with a poor economy that lacks the fundamentals to sustain it.

This is problematic because it means we ignore more viable alternatives. Besides, with the framework we have used in today’s argument, it is clear that maintaining this peg is no longer the desired course of action. The CBN needs to come to terms with that too.