Problems of the Continued Devaluation of the Naira

Problems of the Continued Devaluation of the Naira

Since December 2008, the Naira has declined by 55% from N116 to approximately N180 and it appears that it is heading even lower. At the current pace the Naira will be trading at over N200 to $1 Dollar before the end of March 2009. The continued volatility in the Naira will prove disastrous to the Nigerian economy. Although the Central Bank of Nigeria (CBN) has implemented several measures to slow the devaluation, it appears none of the measure has worked thus far. There appears to be panic in the forex market either due to real concerns or fears spread by speculators.

It appears that the world economic crisis is hitting the Nigerian economy with unyielding vigor. Since March 2008, Nigerians have experienced a significant increase in the misery index as the NSE index has declined approximately by 44,405 or 66.9% from its 2008 high, and the stock market capitalization has declined by about 7.1 trillion or 59%. The financial institutions that have lost millions of Naira from defaults on margin accounts and investors that have lost their nest eggs in the downtrend are still reeling from the impact of the downtrend. To compound matters, the current devaluation of the Naira is set to impact more people than the capital market collapse. The full ripple effects of the current devaluation of the Naira will eventually be felt throughout the Nigerian economy. Nigeria as a country is a net importer of product as opposed to a net exporter.  Majority of the basic goods (consumables and non-consumables) sold in Nigeria are imported from overseas. Therefore as the Naira continues to free fall, the wholesalers and retailers of goods will have to adjust the prices of their products upwards to reflect the amount being paid for these goods.

 The problem is that this devaluation will eventually curtail foreign investments in Nigeria. If the current trend continues, it will truly give any investor a pause before investing in Nigeria because it appears that at the current rate of volatility of the Naira there is no investment in Nigeria that will produce a good return on investment.  In most of the developed world (United States, Europe, etc), the interest on customer deposits has averaged under 5% for over six years, therefore for most Nigerians in the diasporas, putting their funds in a certificate of deposit in a bank in Nigeria that paid 12% annual interest was a superior alternative. Therefore some Nigerians borrowed funds against their assets or borrowed from credit cards, invested them in Nigeria where the interest on their deposits was higher than the interest they paid on the borrowed funds.

For example, as highlighted in the schedule below a $10,000 investment in a certificate of deposit in November 2008 when Naira was trading at approximately N116 to $1 Dollar will be worth $6,844 as of March 3, 2009, a loss of $3,156 or 31.6%. Which investor in their right frame of mind will be encouraged to make future investments on this type of prospect?

This type of horrors in terms of returns is not limited to investments in certificates of deposits. Even people who purchased cars and goods overseas for sale in Nigeria are now realizing that at the rate the Naira is free falling, converting the funds to Dollars, Euros, or Sterling to repatriate their funds will be nothing short of “Harakiri seppuku “.  Therefore most of them are resolving to keep the funds in Nigeria and curtailing all further investments until the currency stabilizes.

Although the Governor of the CNB has been doing his best to curtail the free fall of Naira, I believe that more has to be done because the continued devaluation of the Naira will have a far reaching negative impact than the havoc the collapse of the capital markets has ripped on the Nigerian economy. If the current situation is not checked we might be viewing stagflation in our future because our economy isn\'t growing but prices for goods will skyrocket due to importers passing the increased prices to consumers.

Countries devalue their currencies only when they have no other way to correct past economic mistakes or problems forced on them by unforeseen circumstances. In the case of Nigeria the precipitous decline in crude oil prices has significantly limited the amount of foreign currency that Nigeria receives from the sale of petroleum. Since majority of the goods utilized in Nigeria are imported, the demand for foreign currency appears to be exceeding the rate at which the country’s foreign reserve is being replenished. So far the CBN has tried several measures to halt the freefall, but has refused to support the currency using our foreign reserves. I truly do not blame the CBN for refusing to support the Naira with our foreign reserve because recently Russia tried to support the ruble with about $200 Billion Dollars of their foreign reserve but it did not stop the free fall. Russian which had over $1 trillion dollars in foreign reserve has seen it drop below $400 billion, and the CBN does not want to make the same mistake.

In general, there are two known exchange rate systems: the fixed and floating.  A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

Unlike the fixed rate, a floating exchange rate is determined by the private market through supply and demand. A floating rate is often termed \"self-correcting\", as any differences in supply and demand will automatically be corrected in the market

In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also influence changes in the exchange rate. Sometimes, when a local currency does reflect its true value against its pegged currency, a \"black market\" which is more reflective of actual supply and demand may develop. A central bank will often then be forced to revalue or devalue the official rate so that the rate is in line with the unofficial one, thereby halting the activity of the black market. It appears this is primarily what is currently happening in Nigeria.

Life, being more complicated than any exchange rate system, there are no pure cases, because it appears countries use both system interchangeably. For a long time during President Obasanjo’s term and the first year of the current administration, Nigeria used a fixed exchange rate system. Although the stable exchange rate attracted foreign capital, it had other problems. The stable exchange rate brought in speculative, hot money in pursuit of ever higher returns. It is the type of investment that aims to benefit from the stability of the exchange rate and from the high interest rates paid on deposits in local currency.  It is not the kind of foreign capital that countries are looking for because it is not Foreign Direct Investment. However, it appears that the CBN is now trying to use a floating exchange rate system, but they do not have complete control in determining the exchange rate because it is being driven by other external forces (i.e. speculators and other independent currency traders).

In a recent article I read “how countries devalue their currencies”, Dr. Vaknin represented that some countries have used the mechanisms enumerated below to deal with exchange rates fluctuations.

·        Many countries (Argentina, Bulgaria) have currency boards. This mechanism ensures that all the local currency in circulation is covered by foreign exchange reserves in the coffers of the Central bank. Government, and Central Bank alike - cannot print money and must operate within the straitjacket.

·        Other countries peg their currency to a basket of currencies. The composition of this basket is supposed to reflect the composition of the country\'s international trade. Unfortunately, it rarely does and when it does, it is rarely updated (as is the case in Israel). Most countries peg their currencies to arbitrary baskets of currencies in which the dominant currency is a \"hard, reputable\" currency such as the US dollar. This is the case with the Thai baht. 

·        Some countries have a \"crawling peg\". This is an exchange rate, linked to other currencies, which is fractionally changed daily. The currency is devalued at a rate set in advance and made known to the public (transparent). A close variant is the \"crawling band\" (used in Israel and in some countries in South America). The exchange rate is allowed to move within a band, above and below a central peg which, in itself depreciates daily at a preset rate.

However, measures by the Central Bank of Nigeria to stabilize the Naira should not be a substitute for superior macro and micro economic practices and policies. As noted by Dr. Venin, a currency is the reflection of the country in which it is legal tender. It stores all the data about that country and their appraisal. Therefore, a currency is a unique measure of past and future with significant implications on the present. Finally, I believe that the lack of infrastructure (energy, water, transportation, etc) contributes to the high demand for foreign currency which is used to purchase goods that are not manufactured domestically depleting our foreign exchange reserves due to the massive capital outflows by the private sector. Again this is why the Federal government should strive to improve the country’s infrastructure.

Implications of the Continued Devaluation of the Naira – realmoneyandinfo

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