Nigeria’s Impossible Trinity
Since 2015, the Central Bank of Nigeria (CBN) has rolled out a string of policies geared towards maintaining an artificially strong Naira. These policies have culminated in a mass exodus of foreign investment from Nigeria and dried up liquidity in the foreign exchange market – and the naira has still lost value in the last eighteen months.
For those observing carefully, the effects of the CBN's actions were predictable. Not by people, perhaps, but by an International Economics hypothesis called The Impossible Trinity. The theory, divine in name only, explains that it is impossible for a country (or central bank) to simultaneously maintain a fixed exchange rate system, retain independence over its monetary policy decisions, and allow free movement of capital in and out of its borders. Given its relevance to monetary policy, it is sometimes called the monetary trilemma.
Though the trilemma is sophisticated and relevant enough to have earned its primary author an Economic Nobel, it is deceptively simple. It merely states that these three cannot exist at the same time:
A) A fixed exchange rate
B) Free movement of capital (money) or an absence of capital controls
C) Monetary policy independence
This implies that if a country wants to fix the value of its currency and have an interest-rate policy that is free from outside influence (Option 1), it cannot allow capital to flow freely across its borders. Also, if the exchange rate is fixed, but the country is open to cross-border capital flows (Option 2), it can no longer conduct monetary policy independently. Finally, a country which encourages free movement of capital and wants monetary policy autonomy (Option 3) has to allow its currency trade freely.
A quick illustration will show why this is the case.
Say we are pick Option 1. If a country with a fixed exchange rate decides to lower interest rates to stimulate domestic demand (by making it cheaper for people to borrow and invest), we can expect capital to leave the country in search of higher interest rates. But this foreign currency outflow will reduce demand for the domestic currency as those exiting with capital will be swapping the domestic currency for a foreign one in order to get their money out. This will create devaluation pressure on the domestic currency, but because the exchange rate is fixed, the currency's value cannot change. The central bank is then forced to either stem capital flows, to remove the devaluation pressure, or reverse its initial interest rate decision.
Note that either way, the central bank is forced to relinquish control over one of the three variables.
On paper, Nigeria operates Option 3. The government encourages a free flow of capital in the form of foreign investments in the economy, while the CBN has monetary policy autonomy to determine interest rates. And in theory, the exchange rate is "flexible". But in the last 18 months, the CBN has also tried to fix the exchange rate. By doing this, it has tried to maintain all three horns of the trilemma.
The result of this has been clear. With the exchange rate fixed and the CBN retaining its monetary policy autonomy, it has been forced to enact capital controls to stop a mass exodus from the naira to the dollar. The consequence of this is the drastic reduction in the inflow of foreign investments into the economy in the past eighteen months, and the downward slide of the naira in the parallel market as dollar supply dries up.
For all intents and purposes, we have moved to Option 1 as capital controls – of various forms – have been implemented.
The CBN's decision is even stranger considering that other countries have tried and failed to master the trilemma. Both the Asian crisis of 1997/98 and Argentina’s financial collapse in the early 2000s are attributable to this. In fact, China, the world’s second-largest economy, succumbed to the Impossible Trinity when it finally devalued the Yuan in August 2016.
Yet Option 3 remains the best option for Nigeria. A more flexible exchange rate system would ease devaluation pressure and encourage greater market liquidity. Moreover, the country badly needs foreign investment while the CBN must retain control over interest rates to regulate domestic borrowing costs. The use of capital controls is costly and unsustainable, and has created significant room for arbitrage or 'round-tripping' in an economy like Nigeria's.
The rigid exchange rate system has offered more problems than solutions. The foreign exchange market is still illiquid while the CBN continues to burn through depleted foreign reserves to defend the naira. As it stands, the gap between the interbank and parallel market rates is above ₦100, and the economy is in a recession. The signs indicate a shift in policy is required.
Floating the naira would not end the country's economic woes. But it would permit the CBN to turn to B – free movement of capital – to improve foreign exchange availability while signalling to investors that Nigeria is willing to make the hard choices needed to reinvigorate the economy.
If the Central Bank persists on this path, higher oil prices are unlikely to save it. Instead, an already deficient foreign exchange market may grind the economy to a halt. And there's nothing impossible about that.
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