Hard policy choices ahead for the Central Bank of Nigeria

Hard policy choices ahead for the Central Bank of Nigeria

With a sliding currency, the Central Bank of Nigeria is faced with a difficult policy choice. Its efforts to stabilise the naira and tame inflationary pressures are likely to be countered by fiscal easing measures in the lead to the February 2015 general elections.

The drop in world oil prices and the upcoming general elections have brought the Nigerian economy back on foreign investors’ radar. With the value of Brent crude falling by about 40% since a peak in late June 2014, Nigeria – like other oil-exporting countries such as Venezuela, Russia and Iran – has been suffering the consequences.

Accounting for more than 90% of export earnings and 70% of federal revenue, oil weighs heavily on the Nigerian economy. With the combination of subdued oil production (due to prevalent pipeline theft in the Niger delta) and falling oil prices, the value of the currency, the naira, has been tumbling.

Having depreciated by about 10.5% this year relative to the US dollar (graph below), the naira’s slide has urged monetary policymakers to implement necessary – albeit tricky – adjustments to address the externalities prompted by the drop in the value of crude.

NGN/USD Exchange rate (interbank)

The perils of a tumbling naira

Although it largely benefits exporters, a depreciating naira eats up consumers’ purchasing power via foreign exchange (FX) pass-through effects, which are substantive for an import-dependent economy like the Nigerian one.

Indeed, in spite of being technically self-sufficient, Nigeria has to import 70% of its consumed petroleum products due to inadequate refining capacity – engendering paradoxically aggravating inflationary pressures arising whenever the currency depreciates.

With rising demand for dollars in the aftermath of the Fed’s decision to end its QE III programme and the prospects of a gradual rise in US yields, demand for the naira has plummeted – exacerbated by foreign investors liquidating their positions in the Nigerian Stock Exchange (NSE).

With FX investors having rightly predicted a forced devaluation, the NSE has recorded a 15% drop (year-to-date, YTD) resulting from a large-scale sell-off initiated this October (see graph below) as investors vended their stock holdings in the expectation that the value of their naira denominated assets would drop.

The NSE sell-off

Moreover, investor confidence has become rather frail in view of the ongoing insecurity in the north-east and the rising uncertainty regarding the electoral outcome.

Primarily driven by the consolidation of the All Progressive Congress – which has risen to become the first opposition party to pose a serious threat to the ruling People’s Democratic Party’s political hegemony since the end of military rule – the polls are expected to be highly contested.

This uncertainty has made foreign investors wary, inducing their exit at the NSE and inciting them to find refuge in the safer haven of the fixed income market.

Policy trade-offs

The monetary and fiscal authorities are faced with significant policy trade-offs.

While the Central Bank of Nigeria (CBN) has to find the right balance between taming inflation and defending the currency, the Ministry of Finance has to weigh its options amid political pressures to bolster fiscal expenditure (which would counter the effects of monetary tightening) at a time when it needs to implement budget cuts as government revenues have fallen by 30% in the past three months.

The decision by the CBN on 25 November to devalue the naira, hike the benchmark interest rate and the private sector Cash Reserve Ratio (CRR) sheds light on the prudent preferences of the Monetary Policy Committee (MPC) for macroeconomic stability over populist temptations in the run-up to the elections.

This reflects the independent, albeit frail, decision-making power of the CBN, although its policy discretion may be undermined as the polls draw closer, particularly given the likelihood that the President’s avidity for an electoral victory will intensify.

For now, the 8.4% devaluation of the naira (higher target band vis-à-vis the greenback) will serve to stem the dwindling of foreign reserves through a more flexible exchange rate.

Moreover, the hike in the benchmark interest rate to 13% (from 12%) arose as a necessary move to halt the reversal of portfolio inflows while the 5% increase in the CRR for private sector bank deposits is destined to curb the high level of banking liquidity. These are commendable measures that should improve the prospects for macroeconomic stability, for now.

While the CBN has been able to marginally prop the value of the naira through open market operations, foreign exchange reserves – which were as high as $US43.6bn in January 2014 – have fallen by 16.3% YTD; down to $US36.5bn on 25 November. In spite of having FX reserves worth 7 months of import cover, the CBN cannot continue to draw down on them for much longer, particularly if oil production continues to fall.

With the price of Brent crude officially falling below $78 (the price of oil per barrel set in the government’s 2015 budget), Africa’s leading crude producer would have to recur to its Excess Crude Account (ECA) – a fund used to gather savings whenever the actual price of oil is above the budgeted one.

The ECA is however running low. Currently at $4 billion, it is $2bn short of what the IMF recommends and far from the $22bn it was equipped with back in 2008. Back then it effectively enabled Nigeria to weather off the effects of a sharp fall in oil prices at the inception of the global financial crisis – leaving economic output relatively unscathed.

With slimmer external and fiscal buffers this time around – policymakers have been forced to implement urgent readjustment measures.

Urge for readjustments

Estimated to incur costs of about $1bn per month, the government has been pressed to curtail oil theft in the Niger delta as well as being encouraged to finally approve the crucial but stalled Petroleum Industry Bill (PIB), a new legislation that would serve to stimulate much-needed oil production – whose drop contributed to a 3.6% decline in oil GDP in Q3:2014.

With Nigeria’s ratio of non-oil tax revenue at a low 4.5% of GDP (among the lowest in the continent), the need to bolster oil output is urgent yet ever so challenging.

With the price of oil plummeting below $70 in the wake of the OPEC meeting in Vienna, authorities will be forced to either adopt significant budget cuts (unlikely in the run-up to the elections) or increase borrowing to finance the fiscal deficit at a time when the current account surplus is on a narrowing path while higher risk premiums are pushing bond yields upwards.

Although the current environment provides a strong incentive for government authorities to enforce their planned fiscal consolidation measures, the timing – politically speaking – is simply not ripe. Given the nature of the political cycle, austere fiscal policies are unlikely to be implemented.

As a result, much seems to rely on the monetary authorities to rebalance the economy.

CBN between hammer and anvil

In tandem to the stability of the naira, the CBN has raised concerns about the bleak inflation outlook. As electioneering gathers momentum, political jockeying between party candidates is likely to spur public expenditure as rival politicians attempt to strategically outspend each other to gain votes. Although inflation remains in single digit territory, it increased consistently from March to August 2014, marginally moderating to 8.1% in October.

Even if the 25 November decision to tighten monetary policy has been generally welcomed by investors, this has no doubt raised concerns among voter-pleasing politicians (not to mention the President), whose desires are to ease monetary policy to stimulate domestic demand ahead of the elections.

The CBN therefore finds itself between the hammer and the anvil.

On the one hand, it is challenged by the need to tame inflation at a time when it expects the government to approve increases in public spending ahead of elections.

On the other, its attempts to defend the naira through a strategic devaluation will push price levels up, with domestic purchasing power taking a hit from imported inflation. To add fuel to the fire, Boko Haram’s intensifying insurgency in the north-east has caused significant agricultural disruption, pushing food prices up.

Moreover, although the government recently approved a $1bn increase in security spending, uncertainty prevails over whether this military bolster will effectively serve to counter Boko Haram’s attacks, given the worries over corruption within the military structures.

As Nigeria edges closer to the critical 2015 general elections, the CBN is faced with the conundrum of whether to cede to political pressures for short-term electoral gains or to abide by its guiding principles to ensure macroeconomic stability. Although monetary easing would quench the thirst of Nigerian citizens struggling with the rising cost of living, this effect would only be temporary and indeed counterproductive down the line.

The CBN is therefore set to test its avowed policy autonomy at a time when the political pressures to adopt populist measures is the greatest. The upcoming months will reveal the extent to which the CBN is able to shield itself from the myopic interests of politicians – it would largely benefit the stability of the economy in the medium-term.

About Author

Jose Luengo-Cabrera

Jose currently works at the EU Institute for Security Studies. He has previously worked for the European External Action Service, International Crisis Group and the United Nations Department of Peacekeeping Operations. His research focuses on developments across Sub-Saharan Africa, principally on the drivers of political (in)stability and economic growth in West Africa. The views expressed on this site are Mr. Luengo-Cabrera’s and do not reflect those of the EUISS or any previous institutional affiliations.