Much of the pre-election narratives were woven around the consensus that a post-election push for reform was inevitable given the country’s grim economic picture. In line with the required sense of urgency, Bola Tinubu, Nigeria’s newly elected leader, commenced his tenure with much enthusiasm and vigour. Petrol subsidies were ‘scrapped’ and the naira was ‘floated’, igniting a sense of optimism, exciting markets and raising expectations. The reform momentum surprised even the naysayers, causing many to ponder how the past and new president, both from the same political party, could hold such divergent political ideologies – the former statist and protectionist, while the latter, pro-business and market-oriented.

From Optimism to near Despair.

However, less than five months after his inauguration, the once remarkable pace of reforms appears to have lost steam as major cracks emerge in the key pillars of the reform agenda. Petrol prices have more than tripled to an average of ₦640 per litre across the country since the subsidy regime was discontinued. In addition, the decision to float the exchange rate without a clear answer to the ‘FX supply’ question in a high-inflation and low-interest rate environment was always going to lead to a plunge in the value of the naira. Crude oil theft, vandalism and ageing infrastructure have continued to keep Nigeria’s crude oil output below its OPEC-sanctioned quota (1.6 mbpd); thus, exacerbating the FX illiquidity problem. Currency pressure continues to intensify, particularly at the parallel market, with the naira falling to ₦1,300/$ as at 26 October 2023 in comparison to the official rate of ₦801/$ – a 62% premium.

Figure 1: Official vs Parallel Market Exchange Rates (₦/$)

Source: The Central Bank of Nigeria (CBN), Nairametrics

 

The lack of transparency regarding the actual amount of net foreign reserves, which some estimates suggest could be as low as $4 billion, has only aggravated the issue. Headline inflation has now surged to its highest level in circa two decades at 26.72% in September 2023. Although many in the analyst community predicted deterioration before improvement, few predicted that the average Nigerian would be thrust to near breaking point by the ensuing increase in the cost of living.

Figure 2: Headline Inflation 2023 (%)

Source: NBS, Agusto & Co. forecast

Policy U-turn: Better late than Never

The confirmation of Olayemi Cardoso as the Governor of the Central Bank of Nigeria (CBN) completes the President’s economic team. The new leadership has taken bold moves, possibly in response to the sense of urgency required at this moment, by eliminating FX limitations on the importation of 43 products and committing to increase liquidity in the FX market. The CBN, in a press release, articulated the rationale for its policy U-turn, stating that the restrictions, among other things, had driven importers to the parallel market, exerting additional demand pressure, driving up prices and widening the premium between the official and parallel market exchange rates.

To adequately contextualise the implications of the CBN’s policy reversal, it is imperative to grasp the underlying rationale that drove the initial policy action. The CBN, over the last decade, took on increasingly more responsibility, elevated GDP growth to a primary consideration, viewed import substitution as central to its development agenda and aggressively promoted local industry. Its mandate also broadened to include interventionist policies – primarily in the form of concessional lending. In 2015, the apex bank, as a form of intervention, restricted FX access for 41 consumer imports (manufacturing and agricultural goods), including staple foods. The number of product categories rose to 43 in subsequent years. The objective was to encourage local production, conserve FX for essential imports and support the naira.

Eight years later, and with a significantly weaker naira at the official market (October 2015: ₦198/$), a 51% parallel market premium (October 2015: 13.6%), and a lack of empirical data pointing to a decline in imports or/and a rise in domestic production of the restricted products, it is evident that monetary tools were erroneously deployed to solve a largely fiscal problem. Therefore, any concerns about exposing domestic enterprises to unfair competition and jeopardising efforts towards self-sufficiency, in our opinion, are grossly misplaced. In addition, we believe the policy has been partly responsible for Nigeria’s structurally high inflation, prevented concerted monetary loosening and drove a wedge between the official and parallel-market exchange rates. As articulated in one of our previous publications, we believe that the removal of this restriction will send a positive signal, particularly to foreign investors, and that the import substitution objective should be driven by the fiscal authorities, who would then deploy fiscal tools (tariffs) aimed at making domestic production relatively more competitive than imports. This will be critical in minimising the current deep distortions in the FX market.

The CBN’s Dilemma

According to the CBN… “removing these restrictions eliminates the need for importers of these products to go to the parallel market, reducing the pressure on the naira”.  This assertion, while factual, is a bit curious as the CBN appears to be proffering a simplistic solution to a far more complex problem. The parallel market rate weakened further by 9.9% to ₦1155/$ on 19 October 2023, a week after the policy announcement, as if to underline the sheer inadequacy of the claim. The fact remains that FX illiquidity at the official market is at the centre of Nigeria’s currency woes and the limited FX earnings in recent years relative to demand is what necessitated FX demand management tactics in the first place. The higher price offered at the parallel market incentivizes supply and, as recent evidence suggests, triggered a diversion of diaspora remittance inflows away from the official FX market. So, while we acknowledge that the FX restrictions were a form of capital control as importers of these items were, by default, relegated to accessing FX via alternative channels, rescinding the policy is a necessary but insufficient condition for moderating the current FX market distortions as it was merely one of several causative factors.

Only if and when liquidity returns to the official FX market can we then expect lower demand pressure at the parallel market and a narrowing of the premium. We also expect producers and consumers to benefit from the lower prices of imported raw materials and consumables, respectively, which is positive for inflation. While the CBN has committed to “intermittently boost FX liquidity”, it is still unclear where it will get the ammunition to back its rhetoric in the face of a largely constrained external reserves position, limited crude oil output, an FX backlog of $8 billion and past-due forwards estimated at $6.5 billion to Nigerian banks.

 

Figure 3: Gross External Reserves ($’Billion)

Source: The CBN

The Road Ahead

The CBN faces a challenging task ahead. The new leadership has also pledged to whittle down its unusually broad mandate and enhance the consistency of the current framework for monetary policy operations to ensure that price stability guides monetary policy actions. The recent policy change signifies a strong willingness to address long-standing structural constraints, signaling a departure from the approach of the last administration of the apex bank. However, removing capital controls is one thing, installing transparency and confidence in the FX market is another as the FX supply question lingers. And while everyone agrees that domestic crude oil production, which has crept up to 1.35 mbpd as at September 2023, provides a glimmer of hope for a short-term boost to FX supply, overcoming the challenge of oil theft and vandalism may be easier than attracting new investment as a result of aged oil infrastructure. A World Bank loan of $1.5 billion by year-end and $80 million of financing from the African Development Bank are positive signs but barely scratch the surface. The recent statement made by Finance Minister Wale Edun regarding an expected $10 billion inflow in the coming weeks has also been received with a sense of cautious optimism.

Nonetheless, we believe the next line of reforms should be centred around building the discipline required by the fiscal authorities to effectively manage future deficits and stem their reliance on Ways and Means Advances. This would mean a return to the domestic debt market, where interest rates (365-day treasury bills) have been kept artificially low to minimise debt service costs. We believe interest rates have to rise to curb inflation and deliver positive real returns high enough to disincentivise currency speculation. This should also attract capital flows and support the naira.

Hitting the ground running did not surprise many, but staying the course was always going to be tough as the road to reform is riddled with land mines. Nigeria’s current leadership is faced with the complex task of managing the trilemma of an FX illiquidity crisis, the harsh reality of unsubsidized petrol in the face of elevated global oil prices, and a deteriorating cost-of-living crisis. The CBN housecleaning is the crucial next step.