At the start of the hawkish era (period of rising interest rates), I raised that we often look to central banks to shoulder the burden of economic management and post-crisis adjustment. With good reason too. Central banks have proven to be effective with their independent and swift decision-making. Take quantitative easing (QE), for example. Central banks have used this unconventional tool to spur economic activity during periods of economic distress (see the pandemic and the global financial crisis). While the bold and innovative moves are laudable, we must also apply some caution.
Key takeaways:
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The CBN’s recently announced policy to issue new banknotes in January 2023 has caused quite a stir. Through this exercise, the apex bank hopes to reduce counterfeits, the unbanked, and the money supply and inflation.
- However, if the policy is not organised properly, it can lead to a cash shortage, and money supply might not even
As history has shown, when central banks experiment their way out of a crisis, we never know the full impact of their policies until after the fact. For example, some might agree that the easing of monetary policy during the pandemic supported small businesses and households adversely affected by lockdown measures. While others believe this also contributed to the rising and persistent inflation pressures we are seeing today. Essentially, central banks are so integral to how our economies function that their decisions must be well-planned and thought through.
It is this particular point that has motivated today’s piece.
You see, on Wednesday afternoon, the central bank of Nigeria (CBN) held a special announcement. While the apex bank has been quiet for some time, keen observers will remember that it’s wise to pay attention when the CBN governor speaks. Previous CBN announcements have ranged from shutting down the operations of bureau de changes (BDCs) to freezing the bank accounts of wealthtechs. So, when we learned the announcement was about releasing a series of new banknotes—essentially swapping out old currency for new ones—the whole event might have felt anti-climactic. For all the issues ravaging the world, issuing new notes might seem like the last thing that should be on any central bank's radar.
Add that to the fact that phasing out old currencies in many parts of the world is routine. Last month, the Bank of England replaced the £20 and £50 paper banknotes with polymer-based notes of the same denomination. Central banks issue new banknotes to reduce the amount of counterfeit notes, which protects the currency's integrity as legal tender.
Indeed, the CBN Governor’s remarks also noted that the last time Nigeria issued new currency notes was over 20 years ago. According to the CBN, it is standard practice for central banks to redesign, produce and circulate new local legal tender every 5-8 years. So it was about time.
But, this move is slightly controversial because, as we will soon see, it’s not just about reducing the risk of counterfeit money. The central bank also believes this exercise should help with other key policy objectives such as driving its cashless policy, fighting corruption and reducing inflationary pressures (a thorn in the apex bank’s side for decades now).
In particular, Godwin Emiefele noted that issuing new ₦200, ₦500, and ₦1,000 notes to replace the existing notes in circulation should reduce the level of money supply in the economy. When the money supply in an economy grows at a faster rate than the economy’s ability to produce goods and services, that can cause inflation. The press conference revealed that the CBN is concerned that over 80% of currency in circulation sits outside commercial banks' vaults. This makes it hard to control money supply, which has more than doubled between 2015 and 2022.
That brings us right back to where we started earlier, central banks using unconventional approaches to deliver on their policy objectives.
By the time we are done, we should know what to expect as the new bank series notes are rolled out. To do this, we will look at how this process has played out in another developing country to get a sense of the potential benefits and risks the Nigerian economy faces. Then we will end with recommendations that the apex bank should consider to minimise the effects of these risks.
What happened in India
We have seen so far that demonetisation—the act of withdrawing a coin or note as legal tender to be replaced by something else—can be enlisted for different reasons. Either to reduce counterfeit notes or, in more extreme cases, to stabilise the economy. For example, in Zimbabwe, the government was forced to replace the Zimbabwean dollar with the American dollar. Before this, Zimbabwe had a currency denomination of 1 trillion Zimbabwean dollars. The multiple currency system was then replaced by the Reserve Bank of Zimbabwe when a new Zimbabwean dollar known as the RTGS dollar was installed.
A better parallel for Nigeria’s case is India’s demonetisation exercise back in 2016. I’ll note that this does not imply the outcomes in India will entirely dictate what will happen in Nigeria. Still, drawing out where the similarities lie is useful so we can understand the CBN’s reasons and make recommendations.
The first thing to highlight is that, as the CBN intends, the Reserve Bank of India (RBI) announced the issuance of new ₨500 and ₨2,000 banknotes in exchange for existing ₨500 and ₨1,000 that were in circulation at the time. The two notes were worth $7.50 and $15, respectively, representing 86% of the cash in circulation. After depositing the old notes, Indian residents could withdraw funds in the new ₨500 and ₨2,000 notes. The government claimed the action would curtail the shadow economy, increase cashless transactions, and reduce the use of illicit and counterfeit cash to fund illegal activity and terrorism.
Sound familiar?
Let’s take a look at how exactly this should work.
I’ll start with the money supply issue because that’s one big agenda for the CBN. Money supply typically refers to the total volume of currency (cash, deposits, and other liquid instruments) held by the public at a particular time. So while it is true that demonetisation will decrease the currency held by the public when they go in to deposit their old currency, that is only one component of money supply. The other component, which is the deposits held in banks, will also increase by the same amount. So in a sense, the effect of the entire process ends up being neutralised.
The exception is when fraudsters (or people holding counterfeit money) have to forfeit their old notes because they know the banks won’t issue them new notes in exchange. India’s case shows why this is so important.
To elaborate, after the RBI announced the demonetisation exercise, illegal actors and black market agents still managed to find workarounds to exchange their cash instead of abandoning it. There’s also the fact that savvy criminals might actually store their illegal currency in other physical assets or even more convertible instruments like dollars.
During the demonetisation period, money laundering networks that converted black money continued to thrive. Consequently, a 2018 RBI report found that 99.3% of the money withdrawn from circulation had been returned to banks. This indicated that there was either less “black money” than was previously (demonetisation was unnecessary) or that schemes to launder black money were successful (demonetisation was ineffective).
Demonetisation also reduces money supply by supporting an increase in the cash reserve ratio (CRR). Remember that the whole point of demonetisation will involve people putting the cash they have in hand into banks before they can get new notes out. So, while the CBN has attempted to curb money supply by increasing CRR, money supply has continued to increase. One potential explanation for this is the CRR only affects the money in banks, not cash. Side note: that’s why Emefiele kept emphasising how unacceptable it was that more than 80% of the money in circulation was held in cash. So through demonetisation, CRR should ideally become more effective.
The problem, however, is the CBN has actually been thwarting its attempts to curb money supply by lending to the federal government through the Ways and Means Advance. In Q1 2022, the CBN’s loans to the government increased by 37% to ₦2.6 trillion in Q1 2022 from ₦1.9 trillion in Q4 2021 and by 49% from ₦1.74 trillion in Q1 2021. This figure is above the threshold set by the law, which is 5% of the previous fiscal year’s revenues, which should be just ₦231.3 billion. The Finance Minister recently admitted the government would have to convert the loan to bonds to give the federal government more fiscal room amid dwindling government revenues and rising borrowing costs. All of this shows that the CBN should be looking to reign in its lending to the federal government. Sadly, any inflationary pressures we might be feeling from too much money in circulation won’t magically disappear just from issuing new banknotes.
The next thing to note from the India example is the timeline. This is where we start understanding the economic costs of a demonetisation exercise.
The Indian government essentially gave people roughly six weeks to exchange their old currency notes for new ones. Within that time, people had cash they couldn’t use because the RBI effectively banned the old notes within four hours of the announcement. The government was also slow to produce and distribute the replacement bills, which caused a temporary but sharp cash squeeze. Researchers used data on the geographic distribution of the new notes to uncover how only 13% of the old notes had been replaced by December 2016 (the deadline) in one region. Luckily, Nigerians have about 6 weeks when the new notes become available, and the old ones stop working.
Still, the adverse effects of a poorly planned demonetisation exercise are hard to miss.
The Indian economy was significantly disrupted as people could not access the cash needed to complete their transactions. At the time, 90% of transactions in India were cash-based. The impact was devastating. Some academics likened the contraction in economic output to the same impact a 200 basis point tightening of the federal funds rate would have on US economic activity. The move wiped out at least 1% of the Indian economy’s GDP and cost at least 1.5 million people their jobs.
Nigeria faces the same risks, given that it is also largely a cash-based economy. According to the World Bank’s Global Findex database, non-cash transactions in African countries amounted to only $17 billion in 2019, compared to $216 billion in Europe or $244 billion in Asia.
Looking more specifically at Nigeria, we see that more than half of the Nigerian adult population do not have access to a bank account. In addition, about 35% of Nigerians who have an account still pay their utility bills in cash. That’s compared to 20% for both Brazil and India. So imagine the mayhem that could ensue if a significant portion of the population suddenly finds that the cash they are holding has been rendered useless because it has been phased out.
The Nigerian financial system will need to find a way to bring a significant portion of its population into the banking system to ensure those with cash have a bank account to deposit their existing cash into in exchange for new notes. In any event, the informal sector, which is predominantly cash-based and employs up to 80% of Nigeria’s labour force is at risk of any negative effects of a poorly designed demonetisation process.
In addition, shortly after the demonetisation exercise was announced, the RBI noted a 2.6% drop in the value of the rupee against the US dollar. Controlling for external factors, one could attribute the rupee’s fall to a decline in GDP and negative market sentiments in reaction to the central bank’s policy. I also won’t be surprised if the difficulty in swapping the old notes for new ones caused people to change their cash to dollars. It’s exactly this kind of FX risk the CBN needs to watch out for, especially given the downward pressures the naira has been facing lately.
The Indian example has shown us that it is possible for demonetisation to not only fail in its stated objective of flushing out hidden wealth, but it can also cause some damage to the economy. But that doesn’t mean that’s definitely going to be Nigeria’s fate. So let’s get into three main things the CBN must keep in mind if it wants to ensure Nigeria’s situation looks nothing like 2016 India.
The costly mistakes to avoid
The headline message here is policies like these actually need enough time. The UK’s process of issuing new banknotes this year started in 2020. So UK residents had about two years to exchange the paper banknotes for the new ones.
Australia’s demonetisation process was carried out over four years, while in Pakistan, the general public had six years to exchange their currency. In both countries’ cases, the transition was smooth and didn’t include chaos. These timelines are eons away from the CBN’s eight-week transition period (December 15-January 31). If the CBN doesn’t know it by now, the markets don’t respond well to sudden and unexpected policy changes. Of course, it’s understandable that if the goal is to stamp out the wealth of bad actors, it makes sense to do things quickly. Unfortunately, these are the trade-offs for good policymaking.
Another important element is the importance of credibility. If people don’t believe the CBN will act credibly and stick to its January 2023 deadline, they might not take the necessary steps to deposit their old currency at the bank for new ones until it is too late. Nigerians have a useful reference point for this assumption too. If it’s not INEC moving deadlines that affect the electoral process, then it’s the NCC extending the deadline for the NIN registration. Basically, the Nigerian government has become synonymous with moving the goalpost when it comes to sticking with a deadline that there may be little faith in this January 2023 deadline. But, there is no easy fix for improving credibility. Then again, this reinforces the importance of giving enough time. An eight-week transition period is too short for the central bank to convince Nigerians that the currency notes in circulation can be replaced with the new ones.
Finally, alternatives are important. Again, we turn to the UK for what best practice might look like. Over its two-year demonetisation period, the Bank of England allowed residents to change the old banknotes in person or by post. The postal service was a new addition to support the rolling out of this policy, and the full list of branches was even provided clearly on the BoE’s website. Even with these precautions in place, news reports showed long queues (with waiting times of at least one hour) at banks as people rushed to meet the September 30th deadline. We don’t have a fully functioning postal service in Nigeria, but the key thing to point out here is relying solely on Nigerian banks to complete this exercise is a mammoth ask. Perhaps the CBN could use mobile and POS agents during the process. That would be a good advantage, especially for people who live in rural areas.
The global economy has battled crisis after crisis, and Nigeria has received its fair share. So, it makes sense to see policymakers explore radical ideas to fix rising inflation, corruption, and dwindling government revenue. However, policymakers must be careful not to amplify volatility as it is their job to manage it. As such, the CBN governor must recognise that a single press conference on a hot Wednesday afternoon is not enough to ensure this policy succeeds. The best-laid plans of mice and men often go awry. In this case, it’s not even clear how carefully planned this project is, and that will have serious consequences.
