BY JONES EDOBOR-OFORMIYON, PHD
This paper contains two parts, with the first part being a continuation of the paper “FLOATING EXCHANGE RATE MODEL AND ITS DISCONTENT FOR EMERGING ECONOMIES”, published recently by this author and the second part being on the current critical forex liquidity situation in Nigeria.
For clarification, floating exchange rate model, simply “The value of a currency fluctuates with the global supply and demand for the specific currency” was only introduced recently, in 1976, during the so-called Jamaica agreement after the Bretton Woods system was abolished. The model is hinged on the theory of demand and supply, under the assumption that there is equilibrium and all transactions are done in a perfect market environment, a market environment without oligopoly or monopolistic characteristics between nations. The model supposes that all countries could compete with one another on more or less equal/similar terms, and all have equal access to similar production factors and market relevant tools. During its conception, probable negative impacts on emerging economies were not seriously considered. Meanwhile, the dynamics of the apparent inequality and their negative impacts are increasingly creating vulnerability of economies and societies that were once buoyant around the world. The far-reaching negative impacts of the model are now so glaring that they can no longer be ignored.
Actually, the abolition of the Bretton Woods system led to the development of three parallel systems: They are dollarization, pegging and managed floating rates. It is unnecessary to go into details as to how they function in this paper, however, it is important to note that although such institutions as the World Bank and the IMF have adopted floating, this is because of the assumption that the famous invisible hand would always create an ideal equilibrium that is beneficial to all participants. But when participants are not equal, market forces tend to tilt towards benefiting the stronger partner. That these institutions do not differentiate between economic superpowers and dwarf economies does not mean they do not exist or make the arrangement a fair one. It is important to note at this point that there is nothing like free-floating exchange rate as sometimes implied by some African economists. Actually, floating is also a managed concept that usually allows floating only within a predetermined bandwidth. Central banks around the world have a number of tools they employ to manage the value of their currencies, this includes direct intervention of buying or selling forex, raising or lowering short-term interest rates, amongst others. These interventions are to influence the value of the currency in desired directions to promote economic growth through currency stability, predictability and reliability. In fact, the intentions of exchange rate policies for a developed economy and an emerging economy, employing a similar tool, may be at variance.
Indeed, it is incorrect in economics theory and there are no proven empirical data to support any assertion that floating or devaluation leads to the preservation of any foreign reserve, if the Marshall – Lerner condition is not fulfilled. The assertion that floating exchange rate automatically balances out deficits in trade is good on paper as this is built around the general assumption that devaluation automatically leads to a surge in export and reduction in imports. This may be so only when all partners are equal. However, empirical observations from numerous emerging economies have shown that this is often not the case, because trade between emerging and developed economies tends to be inelastic in the short term, often, emerging economies have no immediately available equivalent local substitutions and in many cases, substitutions do not exist at all. The model tends to ignore the impact of such core issues as economics of scale, productivity and quality, and trading standards as well as market access and structures. In fact, floating in emerging economies can lead to the trade deficits growing faster, caused by a negative correlation between exchange rate and economic growth. The inflationary impacts on domestic prices of non-traded goods should not be left out of focus so that the negative overall impacts on the economy may not surpass any anticipated benefits of the policy.
For illustration purposes, let us take the whole of Africa’s economy as example for our discourse. Africa is a continent with a land mass of about 33 million square meters that could contain China, India, the USA and most of Europe, with a population of about 1,171 billion inhabitants (about 16% of current world population) but produces about only 2% of world trade. Most of Africa’s consumption of finished products is produced outside the continent and the compositions of most of Africa’s exports are primary or unprocessed. In a capitalistic market condition, it is plausible that 98% is more likely to work out what is best suited to them with little regards to 2% but it would be naïve of the 2% not to find effective ways to protect themselves from the weight of the 98%, through smart regulations.
Furthermore, foreign investments are no good arguments to justify floating exchange. First, there are two types of foreign investments. They are Direct (FDI) and Indirect foreign (FII) investments. A Foreign Direct Investment (FDI) is an investment made by a foreign company directly into a company through setting up a subsidiary, associate, going into merger or a joint venture in Nigeria. Skilled workers, infrastructure, profitability and good growth prospects are essential in attracting FDI. The Foreign Indirect investment (FII), on the other hand covers foreign institutions investment in equities listed on a nation’s stock exchange. While the FDI is normally a medium to long-term investments, FII are short term investments that seek to take advantage of prevailing market opportunities. According to some data, foreign investment portfolio in Nigeria fell from around N53,20 billion ($267 million) in April 2015 to about N14,52 billion ($73 million) in April 2016 – thus this is a relatively turbulent market that requires careful evaluations. Of course, there is no doubting the benefits of foreign investments, whether direct or indirect as all foreign investments lead to demand for the local currency, which amongst others, has a positive effect on its value. However, the impact of policies geared towards this market should always be weighed against impacts on other domestic sectors, such as the crowding-out effects on local manufacturing. For illustration, for a foreign destination to be attractive, a couple of factors are considered and they include the portfolio correlation coefficients and the following risks analysis: Political risks: The political climate of a destination; to the extent as it may have impact on economic and business sectors. The question is, does a destination have a business friendly political climate?
Foreign taxations: Foreign investments sometimes lead to double taxations, first taxed at the source country and then again, when the investor repatriates the funds. The taxation laws of a target destination on foreign investments may play a role.
Currency risks: The most important of all the risks is currency risk. In this regard, before foreign investments are made, investors are interested in two things: they are what is the expected level of return on investment (profitability) and whether the capital plus profit can safely be repatriated home at such an exchange rate (predictability) that does not consume the profits. This is because the returns associated with a particular foreign stock when converted into the currency of the investor in the future, should not yield less than envisaged when making the investment. For a simple illustration, let us say an investor has two options and intends to do an indirect investment of $1000 for one year. In country A, the investment is expected to generate 15% return on investment at the end of the year (see table 1), while in country B it can only generate 9% (see table 2). However, the currency of country A is volatile and evaluated with a risk of about 10%, table 1 shows that the invested capital plus return on investment will amount to $1.035 at the end of the year. In comparison, let us look at country B, with a currency considered rather stable and evaluated with a risk of about 2%, the expected returns on investment plus capital will amount to $1.068,20. In spite of the higher return on Investment offered by country A, country B will be considered more attractive to invest the $1000.
Country A Table 1
Capital $1.000,00 Return on Investment 15% $150,00 Subtital $1.150,00 Net depreciation Exchange rate 10% $115,00 Total capital + Interest $1.035,00
Country B Table 2
Capital $1.000,00 Return on Investment 9% $90,00 Subtital $1.090,00 Net depreciation Exchange rate 2% $21,80 Total capital + Interest $1.068,20
Country A Table 3
Capital $1.000,00 Return on Investment 19 $190,00 Subtital $1.190,00 Net depreciation Exchange rate 10% $119,00 Total capital + interest $1.071,00
Now to be competitive, country A has to raise its return on investment to a minimum of 19%, which is more than double of country B offer. Ordinarily, this may appear smart to attract the investment, the problem is that this policy will negatively impact on the domestic manufacturing sector and consequently on the employment market caused by a crowding out effects to the detriment of the domestic companies that require affordable loans to grow their economy, in country A. Therefore, it is important to continuously weigh the aggregate gains of such policies against the aggregate cost to the economy. The domestic economy should always be the focus.
Concerning export and import trade, it is important to note that exports and imports do not only affect our exchange rate and our external trade balance. In fact, exports lead to economic and GDP growth. This also increases the volume of money supply in a market economy. Consequently, revenues from exports form basis upon which additional money (good money) is drawn from the central bank (minted). Simply put, the CBN buys the forex, pays in local currency, and sells the forex back to importers when needed with a premium. The point is that export increases money volume in a market economy. Implicitly, the earnings from crude oil exports are converted into naira, which the federal government draws from the CBN to finance most of its expenditures. Therefore, the dramatic fall in crude oil price plus decline in export volume are having severe and direct impacts on the ability of the Federal and State governments to plan and execute budgets. All available data show that the economy is in a bad shape, in recession and heading towards depression, if nothing changes. There is really no money to freely dispense by government now.
However, if this condition persists and the economy is not to slip into recession, the Nigerian government may be left with no option than to issue bonds to be primarily subscribed to by the CBN, increase taxes (not recommended currently) or take a loan. As a last resort, it could consider temporarily increasing money supply (bad money) to finance some key labor-intensive capital projects (infrastructures) directed at stimulating domestic consumption and growth. Due to the inflationary impacts of bad money policy, the money increase should not exceed 15% of the average money volume of the last 3 years. The increase of bad money should be done with caution and in better times be withdrawn from the economy.
Generally speaking, there are two ways of balancing foreign trade accounts; they are either through increase in export earnings or cutting down on import expenditures. To be specific, let us look at the current forex liquidity situation in Nigeria, using the recently released CBN data:
- Price of crude which contributes the largest share of Nigeria’s Foreign Exchange Reserves has dropped significantly falling over 70%; 2. Nigeria’s Foreign Exchange Reserves have depleted from about US$42.8 billion in January 2014 to about US$26.7 billion as of 10th June 2016 (an average depletion of about $0, 95 billion monthly). 3. In the same period, Nigeria’s foreign exchange earnings have fallen from about US$3.2 billion monthly to current levels of below a billion dollars per month.
Nigeria’s demand for foreign exchange has continued to rise significantly, with an average import bill for 2015 standing at around N917.6 billion ($ 4,60 billion) per month.
Using the above data, this paper shall attempt to calculate different scenarios for Nigeria’s trade balance for up to the next 24 months. Table 4, contains the current FX reserve, current FX earnings and current average monthly bills. Please note that the dollar value of average monthly bills was calculated using the official exchange rate of N199 to the dollar being the exchange rate at the time of presentation by the CBN. All things being equal, table 4 shows that Nigeria is likely to exhaust its forex reserve and begin running foreign debts in 8 months. Foreign debts mean paying high interest rates that will affect future consumptions.
Amount in Months Total in Description $ billion $ billion per annum Current Foreign Reserve 26,70 $ FX earnings monthly 1,00 $ 7 7,00 $ Sub Total FX Reserve in 7 months 33,70 $
Import bill 4,60 $ 7 -32,20 $
Balance Account in 7 Months 1,50 $ Table 4
Table 5 assumes that Diaspora and other net transfers were not included in the FX earnings presented by the CBN. According to the annual report “Migration and Development Brief” of the World Bank, Nigerians in Diaspora remitted $21 billion (average of $1,75 billion monthly) to Nigeria in 2015. As figures for 2016 are yet available, let us calculate with 2015 figures. This yearly transfers that are almost as high as the current total foreign reserve, have become Nigeria’s largest source of forex, a strong backbone without which Nigeria would have long run out of forex. Table 5 further assumes a net sum of $2 billion (average $0,17 billion monthly) would accrue to Nigeria from other transfers. With these transfers, the calculations show that if nothing is done to curtail import, all other things being equal, Nigeria will be running out of forex in 15 months.
Amount in Months Total in Description $ billion $ billion per annum Current Foreign Reserve 26,70 $ FX earnings monthly 1,00 $ 15 15,00 $ Diaspora transfer 1,75 $ 15 26,25 $ Other Direct Transfers 0,17 $ 15 2,50 $ Sub Total FX Reserve in 15 months 70,45 $
Import bill 4,60 $ 15 -69,00 $
Balance Account in 15 Months 1,45 $
Even, if Diaspora transfers were to rise to $23 billion in 2016 and other net transfers rise to $5 billion, table 6 shows that without reduction in import bill, Nigeria will still run out of forex in about 21 months.
Amount in Months Total in Description $ billion $ billion per annum Current Foreign Reserve 26,70 $ FX earnings monthly 1,00 $ 21 21,00 $ Diaspora transfer 1,92 $ 21 40,25 $ Other Direct Transfers 0,42 $ 21 8,75 $ Sub Total FX Reserve in 12 months 96,70 $
Import bill 4,60 $ 21 -96,60 $
Balance Account in 21 Months 0,10 $
table 7 shows that to maintain our current import bill and achieve a growing forex reserve, Nigeria’s forex earning must rise to $2.7 billion monthly.
Amount in Months Total in Description $ billion $ billion per annum Current Foreign Reserve 26,70 $ FX earnings monthly 2,70 $ 12 32,40 $ Diaspora transfer 1,75 $ 12 21,00 $ Other Direct Transfers 0,17 $ 12 2,00 $ Sub Total FX Reserve in 12 months 82,10 $
Import bill 4,60 $ 12 -55,20 $
Balance Account in 12 Months 26,90 $
Because the scenario on table 7 appears unrealistic under the prevailing circumstance, due to low crude price and Niger Delta Avengers hostilities that is affecting volume, a radical cut in import expenditures to an average of $3 billion per month (see table 8) appears necessary to go through the current turbulences without exhausting the foreign reserve.
Amount in Months Total in Description $ billion $ billion per annum Current Foreign Reserve 26,70 $ FX earnings monthly 1,00 $ 12 12,00 $ Diaspora transfer 1,75 $ 12 21,00 $ Other Direct Transfers 0,17 $ 12 2,00 $ Sub Total FX Reserve in 12 months 61,70 $
Import bill 3,00 $ 12 -36,00 $
Balance Account in 12 Months 25,70 $ Table 8 Ideally, a short-term scenario for Nigeria would be a situation where the average monthly import expenditures are around $3 billion and the average monthly earnings is around or above $1,5 billion.
Amount in Months Total in Description $ billion $ billion per annum Current Foreign Reserve 26,70 $ FX earnings monthly 1,50 $ 12 18,00 $ Diaspora transfer 1,75 $ 12 21,00 $ Other Direct Transfers 0,17 $ 12 2,00 $ Sub Total FX Reserve in 12 months 67,70 $
Import bill 3,00 $ 12 -36,00 $
Balance Account in 12 Months 31,70 $ Table 9
Even with the budget benchmark of $38 now reached and further increases may offset past shortfalls, the high decrease in export volume due to the Niger Delta Avengers disruptions, remain a major challenge to the budget. CONCLUSION
As knowledge is growing, so must also our approach to things be adapted. One of the major problems confronting Africa, seems that too many of our economists uncritically follow textbook theories to the letter, without standing to ask, whether a particular model is suitable for our specific circumstance. They seemed brainwashed and conquered romantic economists who always want to be seen as educated by repeating textbook theories, they have not fully understood, without any reflection or serious thoughts as to what is in the best interest of Africa, as economic crisis consume
continent. These people are taking Africa nowhere. For Africa to move forward the minds of our economists and policy makers must first be liberated. We have to fully understand what we do and first get our acts together.
In this regard, floating exchange rate model combined with open borders is like a ragtag army hopping into an open war arena with a military superpower, fighting by the same rule, which was determined by the superpower and hoping to win. A fair arrangement would be one that sufficiently takes the strengths and weaknesses of both parties into consideration and not one that rewards the stronger partner to the perpetual detriment of the weaker partner – the perpetual worsening of the terms of trade of the weaker partner – a destruction of the currency. The currency of a country represents more than just a medium for exchange of goods and services. Such countries as China and some other emerging economies in the Far East that fully understand what it represents and the workings of the floating exchange rate mechanism have refused to let their currencies float and in the case of China this has remained so despite China now rising to become the second largest economy in the world. The lack of proper understanding of economic models by economists and policy makers in many emerging economies is causing many people to be left behind. The author in other works has proposed the introduction of a mixed basket approach as adequate response to the challenges posed by this development.
For sustainable growth, it is essential that production and consumption of domestic products and services be prioritized. Only local production has the potential of creating those opportunities to meet the needs of an ever-increasing population.
Because diversification of the economy and increasing its revenue base require adequate response to numerous infrastructure deficits that continue to persist in Nigeria, a short-term policy of significantly cutting down on import expenditures (see scenarios above) appear reasonable now.
The dynamic relationship between the interbank and parallel forex rates in Nigeria makes a policy of unification, as also proposed in the author’s previous work, a good one. Undoubtedly, the elimination of preferential access to interbank rate and closing the widening premium between interbank and parallel market rates are a further good development. However, it is doubtful whether unification can actually be successfully enforced at a time of forex scarcity.
Nigeria should be cautious and conscious of the consequences of a junk currency and not promote models that through their dynamics could eventually transform their currency into a junk currency. When a nation’s currency is conquered, it is easy to conquer the people, through dictating all sorts of humiliating terms that may further impoverish them.
With economic turbulences caused by dramatic fall in crude oil price plus hostilities by the Niger Delta Avengers and the aftermaths of mismanagement of the previous administration, now seems hardly the best time to be president of Nigeria. Notwithstanding, after a year in office, a clear policy direction on how to revamp the economy is still lacking. But without a direction, how do we know whether we are on the right path or we are not where we should not be. A masterplan should clearly address the following five items:
- providing security, 2. fighting corruption 3. providing electricity, 4. refining petrol locally 5. education of the youth.
1) Security for life and property is prerequisite for economic activities. 2) The current administration has done excellently well in the fight against corruption, but given the number of cases, there is the need to create special anticorruption courts to try looters
expedite justice. Without a special court or tribunal with an expedite proceeding, the anticorruption efforts are incomplete and perpetrators have nothing to fear. They just need to use part of their loots to get lawyers to frustrate the overwhelmed courts, with a toothless bulldog that barks loudly but cannot bite. All the perpetrators need do is awaiting the bulldog run out of steam in anticipation of the return of normality soon. 3) A substantial increase in the generation and distribution of electricity will not only jump start the economy like no other measure, it will divert money now burnt on petrol to run generators to the consumption of other products and services that will grow the economy. 4) Getting the refineries to work must be a priority to reduce pressure on Nigeria’s trade balance and currency. The current shortsighted policy makes Nigeria to repatriate a good junk of the revenues from crude oil export back to the importers of the crude through import of refined petroleum products – so the export of crude is not leading to sustainable development. As export increases so do import reduces the volume of money in circulation and leads to economic contraction, the government is called upon to do a revaluation of its refinery policy. If the current approach and those currently running the refineries cannot make them work and perhaps are even the cause of the problem, then changing the approach and the people may be the right step moving forward. Because numerous TurnAround-Maintenance attempts of the last years have been unsuccessful, there is no point hoping that with the same approach and staff, these refineries will ever start working. Given the importance of the downstream sector for Nigeria, relieving the present crop of managers in these refineries and contracting the management of the refineries to foreign companies should be seriously considered. Nigeria’s economy and Nigerians now need results and not sentiments. Meanwhile, except Nigeria’s policy on PMS is now to reduce consumption, presenting forex scarcity as grounds for “deregulation” does not seem to make much sense. This is because petrol is like utility in Nigeria and demand is not likely to respond to price significantly. As long as there is no local substitution, the demand for forex to import it, irrespective of any devaluation will persist. Before policies are implemented, their negative impacts should first be analyzed and where possible alleviated so that their negative spillovers and multiplication effects do not surpass their anticipated benefits. Isolated policies carried out in panic and haste that could cause more problems than they are designed to solve should be avoided, as they are often sure recipes for economic disaster. 5) Creating new underfunded universities is not the solution to Nigeria’s educational problems. In addition to properly funding existing institutions, technical schools or centers where artisan skills can be acquired are now urgently required.
Nigeria urgently needs a visionary economic policy – a masterplan that is all sectors encompassing. The policies should be preceded by sound measurable calculations; showing for example that a devaluation of say 20%, would lead to additional export of say 25% and to an additional economic growth of say 2% that will raise employment rate by say 2%. Policies should not be based on speculative assertions. If interventions are not rigorous now, the current state could be the start of a cycle of diminishing economic returns that could lead to the next major cycles of the devaluation of the naira that could develop from what already looks like a recession into a depression.
By now it should be glaring to all that there is no way Nigeria can have any meaningful development with its current administrative structure and National Assembly overhead. If Nigeria is truly desirous to develop, it will have to downsize on recurrent expenditures and scrap such wastages as security votes, constituency projects, wardrobe allowances and the numerous remunerations the leaders pay themselves. The ordinary folks currently enduring the most of many years of mismanagement have made enough sacrifice. Because the gains from economic growth in recent past have been unequally distributed with only a small number of Nigerians benefitting, there seems not enough savings by ordinary folks that would now be required to substantially influence domestic growth through consumption. Hence, it is always more beneficial to a country and all parties to have a better and more equitable income and wealth distribution.
Dr. Jones Edobor-Oformiyon is an economist and a consultant and lives in Vienna, Austria firstname.lastname@example.org