The history of the naira as it has alternated between fixed and floating exchange rate regimes has always been closely tied to the price of oil. In June 2016 the Central Bank of Nigeria (CBN) introduced a flexible interbank exchange rate market, effectively floating the naira in a departure from recent policy. The currency’s value has since dropped by more than 35%, trading at around N400:$1 in mid-August, but the policy shift is expected to restore investor confidence.
According to the CBN, over 90% of its reserves come from oil sales, and historically oil has constituted up to 75% of government revenue. When the price of oil is high, dollars flow into the CBN’s coffers and shore up the Excess Crude Account, the government’s rainy day fund. During periods of strong and growing reserves, the CBN has maintained the naira within a traditional band of 160-176 to the dollar. When the oil price is low, however, as has been the case since early 2015, the currency has been more strictly managed, which can have far-reaching consequences. The precipitous drop in oil prices – with benchmark Brent Crude falling from a high of above $100 per barrel in June 2014 to below $40 in the first quarter of 2015 – has put a strain on foreign reserves, slowing dollar-denominated revenues and forcing the CBN to sell off foreign exchange to support the naira. Following a 25% drop in official reserves to around $33bn by February 2015, the CBN took a number of steps to modestly devalue the currency, eventually bringing it into the range of N197-199:$1.
As other major oil-producing countries – such as Russia, Kazakhstan and Angola – allowed their currency to devalue, the CBN deployed a series of capital controls during 2015 to stem the outflow of hard currency and stabilise the naira.
In June 2015 the CBN circulated a list of 41 items for which it would no longer supply foreign exchange. The bank estimated that importation of the 41 items, which range from rice to soap to private jets, led to $12.3bn in lost foreign exchange in the first five months of 2015. Further capital controls included limits on ATM withdrawals and cross-border electronic debit transactions, and restricted access to foreign currency for those travelling abroad for education or health care. The strict regime also led to long wait times for banks and businesses attempting to source foreign exchange through official channels as the CBN increasingly rationed the $27bn in reserves that remained in its coffers as of March 2016.
The increasingly illiquid foreign exchange market led to the ejection of Nigeria from the J P Morgan Emerging Market Local Bond Index in October 2015, which precipitated the exit of billions of dollars’ worth of institutional support for Nigeria’s bond market.
Individuals and firms unable to gain access to foreign exchange through official channels at the official rate were forced to turn to the informal, parallel currency market. In March 2016 the parallel market offered a rate of N320:$1, more than 60% lower than the official rate. Despite mounting pressure to further devalue and allow the naira to depreciate to more realistic levels, for the first half of 2016 the CBN maintained the artificial rate. It was supported in this by President Muhammadu Buhari, who had vowed since taking office in May 2015 that there would be no further devaluation of the naira, citing concerns over inflation and a slowing economy.
One consequence of the government’s currency regime in 2015 was that it failed to capture a major source of foreign currency flowing into the country. Tolu Osinibi, executive director of FCMB Capital Markets, told OBG that “remittances are coming in and bypassing the official system because they can get more in the parallel market.” According to the World Bank, remittances flowing into Nigeria topped $20bn each year from 2011 to 2014, making it the sixth-largest recipient of personal remittances in the world and the largest in Africa in 2014.
The difficulties associated with sourcing currency on the official market coupled with a divergent parallel market began to create complications for the broader economy. In addition to relying on food imports for key staples such as rice, of which Nigeria is one of the world’s largest importers, the economy depends on equipment imports for construction and manufacturing. As firms faced challenges in gaining access to the foreign exchange necessary to support operations, business costs rose.
Firms sought to absorb the majority of the additional foreign exchange-related costs, but by the first quarter those costs were being passed on to the consumer. Headline inflation for January 2016 rose to 11.38%, surpassing the central bank’s estimate of 10.16% for the entire year. Core inflation, which had been steady through the end of 2015, jumped to 11% in February 2016 from 8.8% the previous month, with the CBN citing exchange rate pass-through as one of the factors leading to higher-than-expected inflation.
This is likely to be exacerbated over the next year by the expansionary 2016 federal budget, which greatly extends spending on infrastructure and other key sectors as a stimulus package.
Edgar Ebinum, head of research for Cowry Asset Management, told OBG, “When engaging in monetary policies, there should be fiscal and trade policies to complement. Devaluation makes your exports cheaper, but Nigeria is import dependent and there aren’t enough industries ready to export that could take advantage of a devaluation.”
Furthermore, concerns arose that the uncertainty inherent in the government’s stance stifled foreign investment, with the government using the currency to limit inflation and promote investment in exporting sectors of the economy. Osinibi told OBG, “The longer you delay action on currency, to act in a manner that’s impactful later, you will need a really a big push. Acting quicker may require incremental actions.”
In addition to introducing an interbank market for foreign exchange trading, the CBN has created a system of primary dealers, whereby a group of eight to 10 large banks will buy hard currency from the central bank in batches of $10m.
While inflation could rise in the short term as a result of the policy change – FSDH Merchant Bank predicted inflation could rise from a 10-year high of 16.5% in June to 17.35% in July – this was in part limited by the fact that the majority of importers were previously unable to access hard currency at the official rate, so most imported goods already reflect the higher parallel market exchange rate.
The energy industry may face near-term financing challenges as a result of the float. According to Fitch Ratings, 45% of all Nigerian bank loans – many of which are for oil and gas firms – are denominated in foreign currency. Even after oil prices fell by around 50%, many companies still had access to dollars at the cheaper, official rate to service their debts. These firms will now be buying dollars at the higher market rate, which could impact their ability to repay loans.
Despite these obstacles, the move to float the naira has been broadly welcomed by the business community and is expected to facilitate long-term economic benefits as foreign investors return. The Nigerian Stock Exchange posted a 5.38% gain on the first two days of trading after the new foreign exchange regime launched, indicating positive investor sentiment. However, the full benefits of the reform may take some time to materialise, and foreign investors may still be cautious in the near term. The process of shifting to a free float in arguably Africa’s largest economy will likely take some time too. Shortly after the devaluation, the currency stabilised for just under a month, suggesting that the float is not yet fully liberalised. Moreover, as of August, the official rate continued to diverge noticeably from the parallel market, indicating that the currency may still be overvalued.