“The Central Bank must work towards a unified exchange rate” … These were the words of President Bola Tinubu after taking his oath of office on 29 May 2023. In context, the words did not elicit a comparable sense of urgency as the “subsidy is gone” remark, which prompted nationwide queues, as drivers hurried to secure a final refill of cheap petrol. However, the President, who continues to confound many with the pace of reforms, has since effectively dismissed the Central Bank Governor, Godwin Emefiele, which many market participants viewed as a necessary pre-condition for the shift to more functional monetary policy and exchange rate regimes. Under Emefiele, Nigeria operated a multiple exchange rate regime dominated by a tightly controlled official rate, with little liquidity, to businesses and individuals, which drove demand to the parallel market at a significant premium.
Speculation over a potential devaluation of the naira has been rife since the election in February. The central bank was forced to deny a report that went viral after a newspaper claimed the currency had been devalued from ₦465/$ to ₦630/$. Just days later, the apex bank announced a series of operational changes in the foreign exchange markets. The measures included doing away with segmentation completely and collapsing all the segments into a single exchange rate window – Investors and Exporters (I & E) Window – as well as the adoption of the “willing-buyer-willing-seller model”. Through its actions, the CBN appeared to have effectively liberalised the foreign exchange market given the steep slump in the value of the naira in the immediate aftermath of the policy announcement but has come out to clarify that it was adopting a “managed float” and subjecting the naira to the interplay of market forces – with some controls in place. As at June 21, the naira has lost 38.7% to trade at ₦763/$at the IEFX window– at par with the parallel market rate.
Figure 1: Exchange Rate (IEFX) ₦/$
As the narrative on the new currency regime evolves, we expect heightened volatility and persistent downward pressure on the naira due to the market’s ongoing quest for price discovery and the substantial demand backlog, estimated at around $12 billion. The fundamentals indicate that the naira should not be as weak as the parallel market rate suggests (₦756/$) and we forecast a rate of ₦700/$ after the dust settles. In the medium term, unification is likely to ensure a minimal differential of 5-10% between the IEFX and the parallel market, which should lower uncertainty, reduce the opportunity for round tripping and enhance investor confidence.
The new exchange rate framework is expected to increase transparency in the forex market, reduce currency risks and transaction costs, while also bolstering investor confidence. We believe that an equilibrium (market-clearing) exchange rate would achieve both internal and external balances and promote efficient resource allocation while also doubling as a strategic tool to make exports more competitive. We are also of the opinion that the CBN should now eliminate currency restrictions and adjust its approach towards accomplishing the import substitution objective within its development strategy.
Where will Supply Come from?
The worry, particularly in the short term, is FX liquidity. The CBN has scrapped a cap on dollar deposits into domiciliary accounts while also easing restrictions to allow account holders to use up to $10,000 a day for transactions. The hope is that account holders can sell their dollars to banks and the banks, in turn, can use it to fund obligations, boosting market liquidity. Exporters will also be incentivised by the slump in the official exchange rate and as a result, we expect increased non-oil export declarations, which will support FX supply. The adoption of a managed floating exchange rate system implies regular intervention by the CBN. We expect this to be supported by increased remittances from the NNPCL following the scrapping of petrol subsidies. A unified exchange rate would also incentivise remittance inflows through official channels, which amounted to $20.9 billion in 2022, further boosting FX supply.
Fiscal Adjustments: Net Positive?
The exchange rate adjustment will have a positive impact on Nigeria’s dollar-denominated earnings. Coupled with the expected increase in oil output and improved compliance with non-oil export declarations, we anticipate a minimum rise in export and gross oil & gas revenues of ₦10 trillion and ₦5 trillion, respectively, in 2023. Increased revenue to the federation account will allow the federal and sub-national governments to better balance their books and possibly review public sector wages upwards. However, the impact will be limited by an increase in the nominal value of external debt service obligations.
We estimate an addition of at least ₦12 trillion to total debt as a result of the exchange rate adjustment, which would push Nigeria’s total public debt profile to approximately ₦90 trillion when we consider the securitisation of Ways and Means Advances (₦22 trillion). We forecast a rise in Debt to GDP ratio from 38.77% in 2022 to over 43% by the end of 2023.
Figure 2: Gross Oil & Gas Revenues vs Exports vs Total Debt (₦’ Trillion)
Sources: NNPC, OAGF and BOF and Agusto & Co Estimates
Impact on the Economy
The first thing to consider is that Nigeria’s gross domestic product (GDP) in US$ terms will take a significant hit. Initial forecasts of a GDP size of ₦225.5 trillion ($517.73 billion) by the Budget Office of the Federation, were based on an exchange rate assumption of ₦435/$. An exchange rate adjustment to ₦700/$ will lead to a dramatic decline of over 50% to $322 billion. The aforementioned development would also result in Nigeria dropping to third position on the list of largest African economies, trailing South Africa ($419 billion) and Egypt ($404 billion).
We expect the unification of exchange rates to accelerate the depletion of external reserves in the near term as major sources of dollar inflows are unlikely to offset the pressures from pent-up demand. This could lead to a sharp decline in reserves to $30 billion as the trapped funds seek a quick exit. However, the recent fuel subsidy removal is expected to aid external reserve accretion in the long run. We do not expect the unification of exchange rates to have a significant impact on the landing cost for petrol in the near term, given that the new petrol pump prices already reflect a significantly weaker naira, which has increased intra-city transport costs and last-mile logistics costs for many businesses, further stoking inflationary pressures — particularly food inflation. When combined with the impact of the new 7.5% VAT on diesel, we envisage further increases in headline inflation to an average of 26% in the second half of the year, pushing the annual average to 24% in 2023.
In recent years inadequate FX supply from official sources has compelled most businesses to resort to the parallel market. A unified exchange rate, at a rate which we estimate should be stronger than the current parallel market rate, will lower the cost of raw materials for businesses as well as level the playing field against some of its competitors, which may have had significantly greater access to FX at the official exchange rate. However, some business previously granted access to FX at the official exchange rate for the importation of raw materials, like petrol importers as well as electricity generation and distribution companies, will be faced with higher costs, which will be passed on to final consumers. With the last major review of electricity tariffs benchmarked at $400/$, a significant upward review of tariffs of around 25% is now expected in the near term.
What exactly would a thorough housecleaning of monetary policy entail?
Overhauling a grossly dysfunctional currency regime is one thing, defining a clear path for monetary and exchange rate policy is another. Despite the fact that Nigeria is once again on the radar of international investors thanks to the quickened reform momentum, they are likely to proceed with caution as real returns remain in negative territory.
It is anticipated that the CBN will revise its monetary policy framework and provide greater clarity on its primary mandate. This may involve cutting down its unusually broad mandate, which encompasses the allocation of concessional loans, particularly to the agriculture and manufacturing sectors, as this runs counter to its monetary objectives. A robust framework is imperative to guarantee that the central bank’s monetary policy decisions are transparent, credible, and consistent in the long run. This, in turn, can amplify the efficacy of its actions in accomplishing its policy goals. The CBN’s current framework… “is based on the targeting of bank reserves as the operating target with monetary aggregates as an intermediate target. The ultimate objective is to influence the general level of prices – inflation”.
The headline inflation rate is forecast to rise further and has remained above the 9% target-ceiling since July 2015 (9.2%). Using the average 364-day treasury bill rate of 9.05% so far in 2023, the real rate of return is negative (-13.36%). Anything short of an increase in interest rates to combat inflation and push real returns into positive territory while also offsetting pressure on the currency is likely to keep foreign investors, who have been badly scarred from previous dealings with Nigeria, at bay for longer. However, raising interest rates runs counter to the president’s interest rate ideology, captured thusly… “interest rates need to be reduced to increase investment”. In the near term, it appears challenging to identify an alternative course of action for drawing significant foreign portfolio investment inflows. It is imperative that the potential ‘restart’ of the Nigerian economy is not impeded by ideological discord.