29th of May, 2015, Muhammadu Buhari became Nigerian Head of State during a global oil crisis. Déjà vu.
During the 1980s oil glut, Nigeria devalued the naira under a Structural Adjustment Program (SAP) imposed by the International Monetary Fund (IMF), which was controversially blamed for the resulting record inflation and high unemployment.
Fast-forward to 2015 and President Buhari, remembering the economic events that led to his removal in 1985, vehemently resisted calls from the IMF and other commentators to make the exchange rate more flexible in response to the recent oil crisis.
Was this wise?
Emefiele & Buhari vs. Economists & Investors
Buhari, along with the Central Bank of Nigeria (CBN) Governor Godwin Emefiele, argued that a weaker currency would lead to higher inflation and economic pain for Nigerians. However, the capital controls required to maintain the peg against the dollar dissuaded investors, and the resultant dollar shortage led to a thriving black market for the naira and inflation still hit 19% by the end of 2016.
Mission unsuccessful for team Emefiele.
Meanwhile, economists explained that it was better to allow the currency depreciate to absorb the effects of the oil crisis by making Nigerian exports more competitive. Unfortunately, as crude oil accounted for 90% of exports, this was largely a moot point. Moreover, Egypt's recent experience suggests that Nigeria's inflation is milder than it would have been in the event of a devaluation.
But they also argued that the effects of a weaker naira would be reduced as long as there was enough liquidity in the market i.e. enough dollars to flow around the economy. Businesses would still have been able to import raw materials, preventing the slowdown experienced in the manufacturing sector, and maybe the naira would not have hit ₦500/$1 on the black market.
Fixed Exchange Rates Make Sense
Nigeria is not an anomaly; many countries operate fixed exchange rate regimes – including rich ones. Denmark pegs its currency to the euro.
We know that fixed exchange rates provide stability in export and import prices as well as reduce the costs of exchange rate fluctuations. This is extremely attractive for businesses and encourages investment. Moreover, fixed exchange rates can help countries achieve their macroeconomic objectives; for example, by undervaluing your currency to keep exports cheaper than they ought to be, a strategy China has often been accused of employing.
In our case, Nigeria uses its fixed exchange rate regime to maintain a strong naira, which keeps inflation in check and makes our import cravings more affordable. One drawback of this policy, however, is that a strong currency makes our exports uncompetitive. This matters once we consider campaigns such as the 'Buy Naija to Grow the Naira' campaign – Nigerians won't buy 'Naija' if the alternative foreign good is cheaper because the naira is overvalued.
At the same time, one rarely discussed advantage of a properly implemented fixed exchange rate regime for Nigeria is the capacity to 'import' credible monetary policy. With a dollar peg, the CBN is compelled by the Monetary Trilemma to mimic the U.S. Federal Reserve or effectively shut its financial borders. This constraint can be beneficial for central banks that struggle with independence and credibility. Zimbabwe is intimately familiar with the danger of leaving monetary policy to a politicised central bank: 175 quadrillion Zimbabwean dollars exchanged for five American dollars.
That being said, the main disadvantage of having a fixed exchange rate is vulnerability to speculative attacks. According to one study, speculation accounts for 80% of trading in the global currency market. Ironically, speculators prefer to hunt after fixed exchange rate regimes rather than floating ones. While floating currencies constantly fluctuate, fixed exchange rates are prone to pressure during economic turmoil and the potential profits of abandoning a peg can be enormous, e.g. the naira/dollar exchange rate fell from ₦199/$1 to ₦305/$1 within a month.
As Nigerian oil revenues fell, speculators attacked the naira knowing it was unsustainable at ₦155/$1. The CBN simply did not have the dollar reserves to satisfy domestic demand even as dollar investors left the country. The CBN was forced to devalue the naira twice, despite spending billions of dollars trying to protect the peg, and Emefiele was only able to counter attack when oil prices started to rise as the Niger Delta crisis subdued. Things seem calm again but a fixed exchange rate is always susceptible to attacks. With the Federal Reserve increasing rates and the Nigerian economy crying out for lower rates, the imbalance could put more pressure on the peg. This divergence in policy is a similar scenario to how the UK was forced out of its peg with the euro.
One certain way to protect ourselves from speculative attacks is to abandon the peg with the dollar altogether. Alternatively, we could build up foreign reserves large enough to deter speculators. However, given the history of the Nigerian government's ability to 'save' in the good times, it would be a tall order. The CBN claimed we were heading towards a floating regime in June last year but did not implement it. If that's the long term route we are taking then preparation is needed - there is an academic paper's worth of IMF recommended requirements for running an exchange rate regime.
If however, we stick with the fixed exchange rate regime then we should at least decide what our objectives are. Support non-oil exports with a relatively weaker currency? Or prop up the naira to keep inflation low? In the last two years, the CBN has tried to do both. But you can't eat your yam and have it.