The Bank of America recently predicted that Nigeria’s currency, the naira, will weaken further in 2023, as its current exchange rate to the United States dollar is far above fair value.
According to economist, Tatonga Rusike, in a Bloomberg report, the naira is 20 per cent overvalued based on three indicators – the widely used black market rate, the Central Bank of Nigeria’s real effective exchange rate and the currency’s fair value analysis. “We see scope for it to weaken by an equivalent amount over the next six to nine months, taking it to as high as N520 per U.S. dollar.”
While the naira will face increasing pressure “due to limited government external borrowing,” devaluation is unlikely to occur until after the February 2023 presidential elections, according to the bank.
Nigeria has a dual exchange regime dominated by a tightly-controlled official exchange rate and a parallel market, where the currency is freely traded. Bureau de Change operators note the official spot rate for the naira as N440.95 to the dollar, and the parallel rate N740.
According to the bank’s analysis, the official rate has depreciated by less than 10 per cent since December 2021, while the parallel rate has fallen by nearly a third during the same period, widening the gap to nearly 70 per cent. It added that the greater the disparity with the official market, the higher the likelihood of increasing excess demand for foreign currency on the parallel market.
In May 2021, CBN replaced the fixed rate of N379 to a dollar used for official transactions with the more flexible Nigerian Autonomous Foreign Exchange, also known as the Investors and Exporters exchange rate, which averaged N410.25 per dollar. When this occurred, the CBN Governor, Godwin Emefiele, said, “We found out that we were no longer dealing in this so-called CBN official rate for transactions.”
During the monetary policy briefing earlier, he had disclosed, “We are still running a managed float. We are monitoring the market and seeing what is happening, for us to ensure that the right things are happening for the good of the Nigerian economy.”
However, in response to tighter funding conditions and an impending policy tightening by the Federal Reserve Bank of the U.S., the International Monetary Fund advised developing countries, including Nigeria, to allow their currencies to depreciate in January 2022. It also advised the CBN and the apex banks of emerging economies to raise their benchmark interest rates.
The lending organisation stated, “In response to tighter funding conditions, emerging markets should tailor their response based on their circumstances and vulnerabilities. Those with policy credibility on containing inflation can tighten monetary policy more gradually, while others with stronger inflation pressures or weaker institutions must act swiftly and comprehensively.
“In either case, responses should include letting currencies depreciate and raising benchmark interest rates. If faced with disorderly conditions in foreign exchange markets, central banks with sufficient reserves can intervene, provided this intervention does not substitute for a warranted macroeconomic adjustment.”
IMF also clarified how such actions could force emerging markets to make difficult decisions as they weigh supporting a fragile domestic economy against preserving price and global stability. Similar to this, providing additional support to businesses over and above what is already being done could raise credit risks and weaken the long-term viability of financial institutions by delaying the recognition of losses. Further tightening of financial conditions and a weakened recovery could result from rolling back those measures.
Adding to this is the fact that fiscal policy can promote shock resistance. Establishing a credible commitment to a medium-term fiscal strategy would boost investor confidence and help restore fiscal support in a downturn.
“Such a strategy could include announcing a comprehensive plan to gradually increase tax revenues, improving spending efficiency, or implementing structural fiscal reforms such as pension and subsidy overhauls,” it added.
Devaluation of a currency leads to a currency losing its value. This refers to the purposeful reduction in the value of a nation’s money in comparison to another currency, group of currencies, or currency standard. This monetary policy instrument is used by nations with fixed or semi-fixed exchange rates. It is the opposite of revaluation and frequently gets mixed up with depreciation, which denotes the change in the exchange rate of a currency.
According to a study, a country might devalue its currency to address trade imbalance. Devaluation lowers the price of a nation’s exports, making them more competitive on the international market, which in turn raises the prices of imports. If imports are more expensive, domestic consumers will be less likely to buy them, supporting domestic businesses even more. A better balance of payments results from rising exports and falling imports because the trade deficit narrows. In other words, a country that devalues its currency can cut its deficit because there is a greater demand for less-expensive exports.
Though some countries do not actively encourage currency devaluation, their monetary and fiscal policies still have the same result and allow them to compete in international trade. Foreign investors are drawn to more affordable assets like the stock market by monetary and fiscal policies that have a depreciating effect on currencies.
Although devaluing a currency may seem like a good idea, there are drawbacks. Increased import costs shield domestic industries, but without the pressure of competition, they might become less-productive.
Increased aggregate demand, which can result in higher Gross Domestic Product and inflation, is another benefit of higher exports in comparison to imports. The cost of imports rising can lead to inflation. Demand-pull inflation results from aggregate demand, and since exports are less expensive, manufacturers may be less motivated to reduce costs. Over time, this raises the price of goods and services.
Some of the factors influencing some countries’ decision to devalue currencies include encouraging export. Products from one country must compete with those from others. However, a more valuable currency makes exports comparatively more expensive to buy in other markets. To put it another way, exporters become more competitive on a global scale. Imports are discouraged, whereas exports are promoted. However, studies suggest there should be some caution for two reasons.
To lessen its burden of servicing its sovereign debt, a government may be motivated to promote a weak currency policy, if it has a large amount of such debt to do so. A declining currency effectively reduces the cost of debt payments over time, if the payments are fixed.
When a country’s production costs are high, its goods and services are more expensive abroad than those of its rivals, which reduces its ability to compete. It can increase exports by devaluing its currency relative to another because the price of its goods and services in the global market will decrease. This kind of devaluation, also known as external devaluation, is a common strategy to stimulate the economy.
On the other hand, internal devaluation frequently occurs when a country belongs to a common currency area. Because the area cannot devalue its currency to be more competitive, it will directly reduce its production costs through such measures as lowering taxes, salaries or the price of public services. While economists’ opinions about internal devaluation vary, it ultimately has the same purpose as external devaluation: making goods and services cheaper to increase exports.
When two or more countries compete to improve their position in international markets, each country tries to devalue its currency to be more competitive in terms of exports and foreign investment; this is referred to as competitive devaluation.
Instead of a direct devaluation of the currency, fiscal devaluation aims to reduce taxes, particularly those related to productivity, making local industries more competitive with foreign industries. A direct tax and an indirect tax must be altered concurrently to function and increase the appeal of exports. The cost of production will go down if businesses pay less in employee taxes.
Nigerian economist, Kolawole Akinwale, expressed his concern for the country’s economy in a chat with Financial Street, in response to BofA’s prediction of a 20 per cent increase in the naira’s devaluation.
He said, “This is a bad omen for Nigeria’s economy. This means that the value of our currency will decline, which means the current exchange rate of our naira to the dollar will increase by 20 per cent. Nigeria will spend more on the importation of goods and services.
“This will cause a lot of inflation. The CBN needs to step up on the monetary policy. What I think CBN needs do is to ensure that the currency of the country from where goods are imported is used to make payment via Form M – a mandatory statutory document to be completed by all importers for the importation of goods into Nigeria
He also warned the CBN to desist from payment of goods with dollars, except if the goods are imported from the U.S.
“If someone imports goods from China and issues Form M in dollars, CBN makes payment in dollars. This contributes negatively to the exchange rate. If payment is made on the currency of the country where import is initiated, there would be less demand for dollars,” Akinwale added.
Financial analyst, Ogidiaka Ovie, in the same vein, explained that Nigeria had just exited recession, and with the devaluation of the naira, wages and salary paid to workers would be reduced, and more capital flight because investors would not be willing to invest.
He also noted that importation of goods and services would be more expensive, adding, “The impact of devaluation ranges from hyper-inflation, high interest rates, a high cash ratio and a reduction in the purchasing power parity of the naira. These will make Nigerians pay higher for goods and services, leading to poverty.”
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