SOLUDOCONOMICS: The Nigerian economy 101.

  
How a small, open market economy responds to terms of trade shocks and not trivial debate on ‘devalue’ or ‘not devalue’: Unfortunately, the debate around the issue has been wrongly trivialized as whether to ‘devalue’ or ‘not to devalue’ the Naira. Much of what I have read have little basis in theory or empirical evidence or even counterfactual analysis but a rehash of the sterile but polemical diatribe between ‘neo-liberals’ and ‘neo-socialists’, or simply selective partial analysis. This is not helpful and diverts attention from an otherwise serious policy issue.
The issue basically is how a small, open economy such as ours responds to (ever continuous) shocks in today’s world. In the specific case of Nigeria currently buffeted by a terms of trade shock, with macro imbalances (especially fiscal and current account deficits) as well as supply side constraints, and with the economy skidding to a halt with rising inflation and unemployment, how should relative prices or asset prices (including exchange rate and interest rate) adjust to reflect as well as shape the economic fundamentals? External shocks do not kill an economy: the choice of specific policy regime is what can lessen or worsen the effects of the shock. How policymakers respond depends on the source of the shock (nominal/monetary vs terms of trade/real sector shock). If you do not allow relative prices to adjust when faced by a terms of trade/real sector shocks, then you put the full burden of adjustment on real variables or quantities (especially output and employment)— and they will adjust with vengeance because you cannot fix price and quantity. Both economic theory and evidence from around the world are relatively unambiguous: faced with terms of trade shocks, countries with flexible exchange rate adjust faster and better and with less negative impact on growth and employment than those with fixed rate. Put differently, countries that allowed relative prices (including exchange rate) to become the key “adjusters” during terms of trade shocks have almost always done better than those that resorted to price (exchange rate) and other distorting controls.
ii) From Nigeria’s evidence, current policy regime is inconsistent with objective of growth, job creation and poverty reduction: Since 1973, Nigeria has had episodes of positive and negative oil price shocks, and the impacts on the economy have depended on the policy regime. We can broadly distinguish two policy regimes: when relative prices/flexible exchange rate and quantities were allowed to adjust simultaneously versus a regime of relatively inflexible prices/fixed exchange rate and controls. A casual empiricism nevertheless reveals a powerful result (there are not enough data points to undertake rigorous econometric work, and so we do the usual ‘before and after’ evaluation). Whether you compare episodes of positive oil price shock or episodes of negative shocks, the regime of flexible prices clearly outperform the regime of fixed rates/controls. Just take an example of the 1981- 91 negative oil price shock with two different regimes of fixed prices/controls of 1981- 85/mid 1986 vs the SAP era of late 1986 to 1991. According to data from NBS, the economy did far better under SAP especially in terms of employment, output growth, poverty and in some years even inflation. Many people don’t like to hear this but as one of my mentors, Prof. Emmanuel Edozien always says, you can’t quarrel with statistics. Since 1999, relative prices have adjusted and this was central to the minimal impact of the global crisis of 2008/2009. The world economy experienced the ‘great recession’, and despite the collapse of oil price from $147 to $41 at some point, Nigeria still grew by over 6%. Compare with the experience of many other oil producing countries, and the difference in outcomes relates to the different policy regimes. Of course, things are a little more complicated but at least we need to insist that the debate be evidence-based.
iii)The current economic hardship is largely our choice and not just oil price shock: The current slump of the economy was predictable and largely avoidable. Just as it happened in 1981-85, the economy has been on a tailspin. There is now about 4% growth shortfall relative to past trend, and this cannot be explained by fall in oil prices alone. For the first time since 1990s, per capita growth rate (on annualized basis) is now negative implying that poverty is also escalating; capital market has lost trillions, inflation and unemployment are on the rise. JP Morgan has delisted our local currency bonds and Barclays is threatening same, while the cost of borrowing for Nigeria rises. Foreign capital is on the run, while domestic savings is miniscule. It was ‘headline news’ when FG paid October salaries, while states are steeping in massive debt.
Policy choices entail costs and benefits, but the preference of one to another should be based on the “net positive effects”, depending on the stated objectives. To sustain the current arbitrarily pegged exchange rate will require a steep rise in interest rate and squeezing of bank credit to the private sector. Alternatively, intensifying the ever opaque and distorting controls and ‘bans’ will also severely harm the private sector. I will be surprised if the productive sector is not already feeling the heat. The irony is that it is the small businesses (which have no voice or power) that are suffering the most. Many are simply being choked to death by the ‘controls’. To repeat, the current policy regime is inconsistent with the objectives of creating jobs, growing income and reducing poverty!
iv) There are better ways of implementing capital controls if needed: Some commentators have sought to couch the debate in terms of a struggle between ‘market fundamentalism’ and ‘state capitalism’. Again, this is distracting. Every economy is ‘controlled’ in one way or the other. The question is what kind of controls or regulations can be implemented to address observed market failures that will be credible, transparent, and without distorting or perverting the incentive structure so that we can have sustainably shared prosperity. Uncertainties about what will be in the ‘black-list’ tomorrow or next hurt capital flows, while the retroactive ‘bans’ on pre-existing commitments by banks and producers damage the economy. I support sensible regulations on cash transactions that prevent money laundering but not ones that obstruct the payment system. Some countries suffering from the disruptive effects of massive portfolio flows introduce some taxes on capital flows. We had speed bumps on capital outflow through mandatory holding period but this has been scrapped. We seem to be approbating with one hand and reprobating with the other. The point is to make the rules of capital flow transparent and credible and announce the transition period. We can’t exacerbate the impact of external shocks with dramatic policy shocks.
v)Avoiding the Great Mistake of the 1970s: competitive REER is the issue. Perhaps a worrying aspect of the public discourse on exchange rate is the obsession with the level of nominal exchange rate rather than the real effective exchange rate (REER) or volatility of exchange rate. The question that matters most is whether the currency is overvalued or undervalued in real terms. Government has not shown that N196 per dollar as fixed for months now is the rate that maintains a target competitive real exchange rate. Let me make another strong statement: no developing country has diversified its economy in the last 40 years or so, especially into competitive manufacturing with an overvalued REER over an extended period of time. In the late 1960s and early 1970s, Nigeria was in every aspect comparable to Indonesia as agrarian societies before both experienced oil boom in 1973. Books and articles have been published describing Nigeria’s ‘great mistake of the 1970s’. Indonesia decided on a deliberate strategy to avoid an overvalued real exchange rate, while Nigeria fixed its nominal rate with overvalued REER. Our argument then was that we had nothing but oil to export and therefore would not benefit from a weak currency regime. Indonesia used weak currency to protect its infant industries from imports, thereby encouraging domestic production. After two decades, Indonesia’s export of manufactures accounted for more than 25% of its exports while Nigeria’s was still less than 1% as was the case at the beginning. More than 40 years since 1973, the debate in Nigeria has not changed, while our comparator countries and rest of the world have moved on. When it suits us, we cite examples of the East Asian countries and the newly industrializing economies, but conveniently ignore their real exchange rate strategy. Even the Communist Party in China knows better. Indeed, China and several Asian countries deliberately keep a weak currency (in real terms) as instrument to protect their economies from cheap imports, thereby creating a productive base for the exports in the future. In Nigeria, the logic is going in the reverse. Oil has indeed been a curse!
vi)Nigeria’s experience of competitive REER and outcome: But Nigeria has also deliberately experimented with an undervalued REER even during an export boom (which is typically difficult because of so-called Dutch disease). As Governor of CBN, we deliberately maintained an undervalued REER, and even resisted IMF’s advice to shore up the Naira (which would have brought the nominal rate to around N80 to a dollar instead of N117- N120). Of course, that would have earned us street populism given Nigerians emotional attachment to the level of the Naira. But I insisted on not repeating the ‘great mistake of the 1970s’. This was the secret why we had the highest rate of reserve accumulation in our history (over $62 billion) even in comparison with other times of oil price boom (and lower average monthly oil price for the 60 months). It was also central to the massive capital inflows into Nigeria at the time such that the CBN became a minor supplier of forex in Nigeria: private sources of forex were dominant (many times we could not sell more than $20 million at auctions even when we wanted to sell $200m). This undervalued REER plus stronger banks following consolidation that could finance the emerging private sector were central to the observed ‘diversification’ of the economy since 2005. Our calculation is that if we did not do this, the exchange rate during the global crisis would have exceeded N500 per dollar (this story is for another day). The point here is that we have been through this road before, and also made conscious efforts to remedy past errors.
vii)Delayed or dysfunctional adjustment is costly: Crude controls to sustain an artificially fixed exchange rate create permanent uncertainty and the currency remains under siege: it becomes a dead weight loss to the economy! Fixing the rate and reliance on controls to sustain the peg is a casual way to prove to everyone that the currency is overvalued and discernible investors exercise their option to ‘wait’ or expect policymakers to frontload incentives to more than compensate for the future exchange rate risks they are taking today. In either case, investment and the much needed capital inflows into the economy wait or as is happening now, continue to flow out. It is an irony that in the global economy of today with surfeit of liquidity, Nigeria (with very low savings rate and desperately in need of foreign savings) is suffering from massive capital flight. What a paradox!
A fundamental issue many analysts miss in the case of Nigeria is the link between exchange rate and government revenue. Alternative paths to exchange rate adjustment could have pumped a few trillions of Naira in extra fiscal revenue into the economy and refuelled it. Even if it was just used to pay off the contractor debt, the economy would have been back on its feet. Since N196 is an arbitrary figure, why don’t we fix it at N100 and see if any government in Nigeria will be able to pay salaries. This is a mute but powerful point about deciding the choice of the rate.
viii)Lobbying for forex as the new ‘oil rent’ in town?: We are literally back to a form of import licensing regime, and portfolio carrying ‘agents’ are back in town to ‘lobby’ for forex. While the arbitrary list of ‘banned’ items has left the economy haemorrhaging, those reaping the rents are lobbying to make their gains permanent, while others are lobbying to join the new rent industry. Oil rent is drying up and the new source of easy money is forex. With a black market premium of about 20%, a successful roundtrip creates instant jackpot. Furthermore, if a group can get items in their sector ‘banned’, they will reap the monopoly rent instantly. If you stretch the logic of the ‘ban’, it will be difficult to justify allocation of forex for anything. After all, you can argue that denial of forex should ‘force’ Nigerians to produce just any good for that matter at home or patronize substitutes. After all, during the Nigerian civil war, Biafran engineers were forced by the blockade to “invent” their own refineries, bombs, etc. So, why don’t we close our borders and seek to be ‘self-reliant’ in everything (whatever that means!). No, it is the power and influence of the lobbying groups as well as subjective preferences of policymakers that determine the content of the list. There is no objective basis, and I am sceptical of the ‘national interest’ argument. Let me illustrate with an absurd example. Going by the logic of the ‘bans’, why should Nigeria allocate forex for school fees, medicals and mortgage abroad when we have thousands of schools and hundreds of universities; hospitals etc? So, why not ‘ban’ school fees and medical fees as a way of forcing the elite to patronize our local schools and hospitals? What about mortgages abroad? These three items also cost billions of dollars per annum. We won’t ‘ban’ them because they are goods consumed by the powerful elite and policymakers. That is the problem with this kind of opaque policy regime. So, where do we stop, and who determines the list? As an anti-corruption government, APC/PMB must not be unwittingly creating institutions/processes that by definition are havens for corruption. This policy is creating instant briefcase millionaires while businesses especially SMEs are dying!
ix)Five Myths about the relationship between exchange rate/import ban and Nigerian economy: When a lie is repeated very often, it starts sounding like the truth. Let me add some footnotes to some of the clichés in the public discourse. First, it is claimed that Nigeria is an import-dependent (consumption-dominated) economy and therefore a depreciation/devaluation will not be beneficial. It will take pages to argue against this fallacy but suffice it to say that it is tautological and superficial. I don’t know how many countries that do not ‘depend’ on imports, or where consumption does not dominate aggregate demand. Nigeria’s imports as a share of its GDP do not bear out the claim. Check out the size of imports of other countries. Furthermore, a corollary of this argument is that if ‘devaluation’ is harmful, then a ‘revaluation’ should be beneficial. So why don’t we just fix the rate at N1 per dollar? The issue is that real exchange rate is central to resource allocation in an economy, as well as capital flows, savings and investment. At the extreme, exchange rate and tariffs can combine to provide powerful protection to domestic production against imports. Exchange rate may not be the magic bullet that cures all ills but getting it wrong can cause major havoc to the macro economy.
Second, there are exaggerated claims about the inflationary impact. Inflationary impact depends on other complementary measures but the substantive issue is the sacrifice ratio— what degree of unemployment do we want to tolerate to achieve a 1% reduction in inflation rate? Evidence from episodes of ‘high’ currency depreciation does not bear out the exaggerated inflation fear in Nigeria. The Naira has depreciated by about 22% this year and the ‘increase’ in inflation has not exceeded 1%. Check out inflation figures during the SAP era when Naira floated for the first time with hundreds of percent depreciation. In one year inflation was 5.5%. Even with the massive liquidity injections during the global crisis of 2008/2009 (as every central bank did then) plus over 24% depreciation, the ‘increase’ in inflation rate was only 4%. The issue is whether it was worth the price for preserving employment and maintaining growth of 6%? Some analysts confuse the price level with its rate of change (inflation).
The third myth is that crude capital controls ‘save our reserves’ from being exhausted. I heard the same argument when we were about to migrate from the retail to the wholesale Dutch auction system (RDAS to WDAS). Many argued that our reserves would run out in three months, and I insisted that the opposite would happen, and we won. The market functions on reverse psychology and incentives. When you have the incentives for economic agents to bring their forex and they have confidence that your policy regime is transparent and sustainable, capital would flow in. On the reverse, when they know that policymakers are panicky, it is a confirmation to everyone that they have lost control and private capital runs. If people are unsure how they will take back their money as and when needed, they won’t come in the first instance. Crude controls become a race to the bottom: as private flows dry up, the pressure on official forex pool becomes unsustainable thereby leading to more perverse controls with all the distortions that kill the real economy. A vicious circle sets in. If the current policy regime continues, I can bet that policymakers will soon be under pressure to expand the list of items to ‘ban’. It is simple logic. Alternative adjustment paths could have led to stability in exchange rate and reserves without the distorting controls and bans.
The fourth myth is that if we don’t fix the rate, the currency will depreciate without bound. It is a funny arithmetic. Well, incomes and money supply are not infinite and so the argument is untenable. As you hit the liquidity ceiling, the currency will stabilize and might even start appreciating (in nominal terms). I believe the TSA as implemented, together with a few other measures would since have stabilized the Naira without the capital controls.
The fifth myth relates to import ‘bans’. It is claimed that a country like Nigeria should not import things that it can produce, and that bans will help the economy. Well, this is not just a theoretical debate. Nigeria and the world have more than 50 years’ experience to draw from. It surely appeals to the emotion but that is not how the world works. Otherwise there would be no World Trade Organization (WTO) to which Nigeria is a member, and there will be little trade among nations. Nigerians forget that the major importers of our oil are themselves oil producers. The US has higher oil reserves and produces more oil than Nigeria and yet for many decades it was a major importer of our oil. China is also an oil producer. Imagine if most countries to which we export decide to ‘ban’ Nigeria’s oil on the ground that they ‘can produce’ it (in quest of their own ‘self-reliance’). The debate in the world is how countries like Nigeria can build competitive advantages to produce quality, cheaper goods than others. Besides, analysts need to study episodes of ‘bans’ in our history and show the sectors/industries that emerged and survived under the protection of ‘bans’. There are several concessions and non-tariff barriers (NTBs) available to us under the WTO and other bilateral agreements that we are not even exploiting. With poor electricity, costly finance, little research and development (R & D), decadent infrastructure, insecurity, policy inconsistencies and mostly unemployable graduates of the educational system, does Nigeria now hope to ‘ban’ its way to prosperity?
x)Clarity on government objectives and CBN to return and focus on its mandate: Government needs to clarify the confusion on its policy regime: is exchange rate an objective, or an instrument or simply a price? Sometimes, you hear officials explaining the ‘agenda to strengthen the Naira’— does this mean we are going into exchange rate targeting? Are we going to target the level of the nominal rate (and what is the target rate?; how do we pick the rate to target)? More specifically, how did we determine that N196 is the ‘appropriate’ level? Why not: N1 or N50 or N140 or N200 or N230, etc? If we are emotionally against ‘high’ figures as exchange rates, why not redenominate the currency— take away two zeroes and at current rates, exchange rate will instantly range from N1.96 to N2.33 to one dollar? Alternatively, are we targeting the real exchange rate? Between exchange rate, interest rate and inflation, we need clarity as to which one(s) is/are objectives and which one(s) is/are instruments. I do not want to join in criticising the Central Bank because it is not even clear whether the policy regime is from CBN or ‘orders from above’. A proverb says that you don’t tell the king that he is wrong. You rather tell him ‘Our father, please take a second look at the issue’. That’s all I can say for now!
If it is true that CBN was simply “directed”, then it has been put in a rather untenable situation. But if CBN indeed crafted this policy, then reasonable people will have serious cause to worry— even with our recent experiences? Currently the CBN suffers from the classic Tinbergen’s problem: it has far fewer instruments than the myriad of (sometimes confusing) objectives on its plate. Now that the federal cabinet is in place, I earnestly pray that CBN will return and focus on its mandate. The fifth function of the central bank is to provide economic and financial advice to the federal government. The CBN should lead the charge and advise government on a coherent and internally consistent policy strategy. The current one is not the kind of policy that ‘will work with time or in the long run’. This is one example where, as Maynard Keynes reminded his critics in the 1930s, “in the long run, we are all dead”! Sometimes on public policy issues, sheer ego can stand in the way of self-correction. We quickly corrected ourselves during the 2008/2009 crisis. I believe the APC/PMB team loves Nigeria enough that faced with superior facts or logic, would make necessary changes. Besides, it is still morning on creation day. Enough said for now!