Naira: The gods are not to be blame

By 

Sam Omoruyi

THE naira exchange rate is perhaps one of the most problematic preoccupations of the Nigerian monetary authorities since the introduction of the Structural Adjustment Programme (SAP) in July 1986. This reflects the fact that, as a relative price, the exchange rate has implications for virtually all sectors of the national economy. Lately, the naira has experienced significant bouts of depreciation so much so that it provoked the holding of the first ThisDay Town Hall Meeting on the subject at Abuja (April 30, 2001). At that meeting, most of the relevant economic agents presented papers for the way forward.

Most speakers rightly pointed out many causative factors in the depreciation episodes including the high import intensity of industry, the high propensity of Nigerian to buy imported goods, grossly inadequate domestic production, a reflection of low capacity utilisation in manufacturing and low financial intermediation by commercial and merchant banks, high interest rates and government spending especially the alleged recent release of Federal Government capital votes for execution of some projects for 1999 and 2000 fiscal years, etc.

There is great merit in all those causative factors mentioned, but by far the most poignant, most professional, explanation for the naira woes is that given by the governor of Central Bank of Nigeria, Chief Joseph Sanusi. The governor rightly noted that the naira depreciation reflected "faulty" economic fundamentals, and cautioned "that there is no magic by which the naira can be made strong unless the economy becomes diversified and productive."

This essay is aimed at drawing attention of all who are seriously concerned with naira depreciation to the CBN Governor's robust statement because it articulates the causes of the problem as well as the appropriate solutions or the way forward. In dramatising agreement and support for the Governor's professional diagnosis and solution to the problem, this brief outlines the theoretical nexus for the Governor's statement and provides basic lessons in the management of exchange rate.

In theoretical literature movements in the real exchange rates, that is, nominal exchange rates deflated by relative inflation rates, have been linked to the difference between the prices of tradable and non-tradable goods, changes in the current account of the balance of payments and changes in nominal interest rate differentials between the home country and her trading partners. The three major determinants of movements in exchange rate are changes in relative prices across countries, changes in the current account (external resources) and changes in relative interest rate.

Those determinants reflect the prescriptions of the three major models of exchange rate determination: the Purchasing Power Parity (PPP), underlying payments disequilibrium (UPD) and the asset market disturbances (AMD), respectively.

However, while the above models particularly emphasise prices, current account position and interest rate differentials as major determinants of real exchange rate, it is possible in general to group a number of causative factors otherwise known as economic fundamentals. They include:

Structural factors:

• International terms of trade

• Net flows of capital

• World real interest rates

• Import intensity of industry

• Technical progress

• Trade/commercial policies such as import tariffs, import quotas and export taxes

• Exchange and capital controls

• Rate of growth of domestic output (GDP).

  Short-term factors:

• Inflation differential

• Inflationary expectations

• Fiscal and monetary policy actions

• Market expectations, etc.

  When any of those fundamentals (Structural or Short-term) changes, the real exchange rate will also change. In particular, real exchange rates also respond in the short and even medium run to monetary and fiscal disturbances. For instance, expansive fiscal and monetary policies will usually depreciate the exchange rate and veer it away from equilibrium, a misalignment occurs. Indeed at any point of time misalignment in exchange rate is determined by changes in economic fundamentals, and the expected rate of change (depreciation) of the exchange rate.

  Basic lessons:

  Exchange rate is not an immutable statistic, it changes from time to time. When there are sustained changes in any of the economic fundamentals, there will also be changes in the real rate. In other words, the problem of exchange rate depreciation will always rear its head especially in a fledgling democracy such as ours so long as there are explosive increases in economic fundamentals. This is what the CBN Governor aptly referred to as "Faulty" fundamentals. The Governor cannot stop the depreciation; he can only mitigate it by "sterilizing" part of the resultant excess liquidity through changes in reserve requirements and the operation of both Open Market Operations (OMO) and sale of CBN certificates, etc.

  The exchange rate mirrors the economy. A weak economy with expanded fundamentals produces a weak or depreciated currency, because the exchange rate evolves from the movement of the economic fundamentals. The Central Bank alone cannot cause the exchange rate to appreciate unless its actions are supported by complementary actions of government (in the form of maintenance of regime of reduced deficit, avoidance of extra budgetary expenditures, and the provision of necessary infrastructures for production), Commercial and Merchant Banks (in the form of their compliance with Central Bank guidelines on lending to the real sector and interest rate spread), export promotion council (through much more aggressive policies that will lead to expansion of exports for needed foreign exchange inflow), National Planning Commission and the Fiscal Monetary Policy Co-ordination Committee etc. Indeed all hands must be on deck to boost economic performance and stabilize the exchange rate.

  Following from (2), there is urgent need for the monetary and fiscal authorities to make constant adjustments to policies, review monetary implications of any intended huge lump sum releases to the economy, in order to avoid unsustainable expansion which further depreciates the exchange rate through higher price inflation. Monetary expansion results largely from Central Bank financing of government deficit and monetization of foreign exchange earnings. Thus depreciation of exchange rate tracks monetary and credit expansion. No magic wand can stop this transmission mechanism. The CBN can only seek to moderate the depreciation to some extent.

  Exchange rate appreciation cannot be done by fiat; appreciation will result from sustained substantial reduction in inflation, increased external reserves, reduced interest rates, reduced government deficit/GDP ratio to more than 3 per cent, greater accountability/transparency in governance, etc. In other words, exchange rate movements inexorably respond to movements in economic fundamentals. It is the economy which imparts appreciation or depreciation o the exchange rate. Where economic fundamentals are allowed to move to "faulty" levels, - a feature of a distressed and weak economy - the exchange rate will experience worrisome waves of depreciation episodes such as the naira had experienced. Where economic fundamentals are religiously controlled as in countries with convertible currencies, e.g. UK, U.S.A., exchange rate stabilizes and even appreciates.

  Put more succinctly, if economic fundamentals, especially those that are positively related to exchange rates (such as government spending, money supply, inflation, interest rates etc.) continue to rise steeply unabated from their current levels, the naira exchange rate may depreciate to even N200.00 to the U.S. Dollar by the end of the year, regardless of the rescue exchange management efforts of the Central Bank. We believe that government will not allow that episode to materialise. But if it does happen, the gods are not to blame.