In recent times, central banks have taken a bigger role in lifting their economies out of a crisis. There is a new normal in monetary policy, from printing money and buying bonds to providing agriculture loans.
But implementing monetary policy as a central banker is no easy feat.
Controlling the price level in the economy while ensuring stable growth and a healthy financial system is a complicated role.
For onlookers, it’s easy to miss the rationale behind some of the decisions central banks take. Luckily for us, some frameworks help us understand the decision-making process in monetary policy.
One of which is the macroeconomic policy trilemma.
The impossible trinity
The trilemma, also known as the impossible trinity states that a country can only choose two of three monetary policy instruments - i) free capital mobility ii) monetary policy independence and iii) fixed exchange rates in the long term.
Let’s look at each one.
First, when a country allows free capital flows, it means there are no restrictions on the amount of investment and foreign currency that flows in and out of the country. These could be in the form of foreign portfolio investment like stocks and bonds or foreign direct investment.
An example of when Nigeria did not have this was back in 2015 when the Central Bank of Nigeria (CBN) placed several restrictions on capital flows. It was difficult for foreign currency to leave the country. Airlines were unable to repatriate profits and consumers had dollar spending limits on their bank cards abroad.
Second, monetary policy independence is the central bank’s freedom to control the quantity of money in circulation in the economy, mostly through interest rates.
While the bank will have the right to control the supply of money in the economy, it doesn’t always have the freedom to.
For instance, when most major central banks reduced their interest rates to stimulate growth in March as a result of the pandemic, Nigeria didn’t. It had the power to but not the freedom. The reason is down to the trilemma problem, which we will discuss below.
Finally, the fixed exchange rate is achieved when the central bank pegs the local currency against a foreign currency at a specific rate and maintains it by buying and selling its own currency. But to do this, the country would need to have a large foreign exchange reserve.
Nigeria’s ability to do this depends on oil.
“In Nigeria, because of the oil inflows, the CBN had some level of control on the monetary policy and FX policy particularly when the oil price was higher but each time the oil price drops and FX flows decline or stop, we have a devaluation,” says Dr. Nevin, Chief Economist at PwC Nigeria.
Remember, the trilemma says you cannot achieve these three different policies together. Attempting to implement the third will cancel out another.
How the monetary policy trilemma occurs
Let’s see how the policies can work against each other.
As we know, Nigeria currently operates a fixed exchange rate with the dollar, but this can restrict its freedom to adjust interest rates for the real economy.
A reduction in interest rates, for example, would make investors less attracted to Nigerian assets.
The outflow of foreign currency would then cause a high demand for the dollar, putting pressure on the exchange rate.
The CBN would have to respond by going against its initial interest rate reduction (losing monetary policy independence) or using up reserves to supply the dollar requests.
With reserves, all three policies can be achieved, but only for a period. Reserves don’t last forever, and if money continues to flow out of the country, the exchange rate will eventually have to lose its fixed peg and devalue.
Alternatively, the CBN could restrict investors from leaving the country with their dollars. So in summary, trying to adopt an independent monetary policy (changing interest rates) and a fixed exchange rate means you can’t have freely flowing capital.
How does a country decide what combination to adopt?
A central bank is free to choose two of the three policies to implement. The decision of which combination is dependent on what macroeconomic conditions are prevailing in the country at the time.
The last three CBN governors have had distinct realities that defined their decisions; from the global financial crisis in Soludo’s era to two recessions in Emefiele’s time.
Let’s dive into each and explain their major decisions through the lens of the trilemma.
Charles Soludo’s tenure
Charles Soludo’s tenure from 2004-2009 could be described as the good old days. Mr Biggs was thriving, oil prices went as high as $140 per barrel, average annual growth was more than 6%, and our reserves reached a high of $60 billion.
With such a large foreign exchange reserve, the naira was appreciating at 4% annually between 2004 and 2007.
We had so much money coming in, that the government decided to open the Excess Crude Account to keep the extra cash from crude oil.
Then the 2008 Great Recession happened and changed it for us. Over 50% of crude oil funds were coming in from the US, and now they were in a recession.
Investors took out their funds from our booming stock exchange, and the banking sector suffered from loans given to oil and gas companies that couldn’t pay back.
In response to these macroeconomic realities, Charles Soludo maintained a combination of a managed exchange rate, monetary independence and free capital outflows.
He initially tried to do all three.
Source: South Centre via Flickr
Inflation was high not long after Soludo entered office - reaching 15%. He used his monetary independence and mopped up (withdrew) as much as ₦75 billion from commercial banks to reduce the amount of money in circulation to lower inflation. He increased the Monetary Policy Rate (MPR) rate on five occasions in his tenure.
When oil revenue and foreign exchange reserves were high, choosing to maintain a fixed exchange rate made sense because there were enough reserves to prevent the shocks that came with demand and supply of foreign exchange.
It all seemed ok with monetary policy freedom and the fixed exchange rate.
But as the crisis worsened, there was little or no restriction to investors taking their money out and that affected the capital market and stock prices crashed.
By allowing a free flow of capital out of the country, something else had to give way. And soon enough, as a result of the outflow of capital, Soludo had to give up the fixed exchange rate by depreciating it by 26%.
Lamido Sanusi tenure
When Sanusi got into power in 2009, the Global Financial Crisis had occurred and although Nigeria avoided a recession, it hit us in 2009, where it hurt the most - oil.
Oil prices tanked in 2009, from about $147 to less than $40 per barrel, as usual, our foreign reserves fell, exchange rate crashed, as the dollar was scarce because of low crude earnings.
“When you go back to 2009, I suppose it was the worst time for anyone to be offered that job, it was at a time when there was a very high probability of failure because a lot had gone wrong,” Sanusi said in an interview on CNBC.
The inflation rate was also high at 15%. There was a shortage of foreign currency (reserves dropped to $33 billion) making the cost of imported petroleum high, which increased in transportation and production cost as well as food prices.
In response to this, Sanusi made it his mission to lower inflation to single digits and did so through the MPR.
Sanusi was in a fortunate position where he could have a fixed exchange rate and free capital flows while ignoring monetary policy independence in a way. Because he was focused on tackling inflation, increasing interest rates worked in favour of achieving lower inflation while boosting capital inflow to keep the exchange rate fixed.
The governor increased the monetary policy rate to as high as 12% from 8% to tame inflation.
Note that he would not have had the independence or freedom to reduce rates significantly if he needed to stimulate the economy. Borrowing rates were kept high and could have played a role in Nigeria’s high unemployment rate at the time.
Source: IMF via Flickr
Sanusi also performed other policies to restore confidence in the naira, which helped maintain the exchange rate and increase capital flows. One of which was unifying various exchange rate markets.
He also conducted some reforms in the financial sector, where he fired some bank CEOs as a result of mismanagement, and released the list of debtors who had defaulted on loans. He then created the Asset Management Corporation of Nigeria (AMCON) to buy up such loans to relieve banks of loans.
These moves encouraged portfolio investment - which came in through CBN’s Open Market Operations (OMO). Investors perceived that the financial sector was strong enough, and this increased foreign portfolio investment into the country.
Emefiele seems to have had it worse than his predecessors. During his two terms, oil prices have fallen drastically, and by current estimates, he will go through at least two recessions.
When he started as CBN governor in 2014, crude oil prices were still over $100 per barrel, but they went as low as $30 by 2015 and reserves dropped - reaching a low of $23 billion in 2016.
This delicate reserve position made monetary policy difficult for the governor.
Investors wanted to leave the country due to Nigeria’s vulnerability to the oil price crash. Interest rates were not high enough to attract them. Emefiele couldn’t increase rates because that would have been a blow to economic growth, which was negative in 2016.
But Emefiele was adamant about having control over this interest rate stance, as well as keeping the exchange rate fixed.
Therefore, the idea of freely flowing capital went out the window - the trilemma.
Investors were putting pressure on the naira by trying to buy more dollars to exit the country. To reduce the effect of this on the official rate, Emefiele put significant constraints on capital flows out of the country - a ban on importation of some items, limiting personal travel and the use of foreign exchange.
Dr Nevin reiterated this, “When oil price reduced in 2015 or 2016, that put a constraint on the amount of dollars the CBN had and forced it to start making allocation decisions on where to spend their scarce dollars.”
People then turned to the black market to source for foreign exchange which then tumbled, leading inflation to reach 15.6% from 9% in the previous year.
Eventually, even the restrictions to capital were not enough to withstand the pressure on the naira, and it was devalued.
Source: CBN via Flickr
Now the CBN is trying to be innovative. It has essentially created two interest rate markets; one for the real economy and another to entice foreign investors.
This was made clear when the apex bank banned certain non-foreign players from engaging in high-interest open market operation (OMO) bills.
“Initially, investment instrument rates moved in line with the MPR [monetary policy rate], but they don’t anymore. Today, the MPR is at 13.5%, but T-bills rates are falling significantly, at 3.5% as a result of restrictions like preventing non-bank financial institutions from participating in open market operations” says Wilson Erumebor, Senior Economist at the Nigerian Economic Summit Group.
As things stand, the CBN is fighting to keep a fixed exchange rate by restricting capital flows. And on the monetary policy independence end, it is a bit stuck. Given that Nigeria is probably in a recession, lowering the main monetary policy rate would be the desired response.
However, because of the CBN’s fear that lower rates might push even more investors out, it hasn’t been able to reduce the main interest rate. Instead, it has adjusted other loan rates such as those under intervention funds like the Anchor Borrowers’ Program.
It’s fair to say that Nigeria is barely able to achieve one (fixed exchange rate) of the three policies at the moment.
A new route is needed
One thing that has made monetary policy difficult for all governors is the combination of having a fixed exchange rate with reserves dependent on oil prices.
It’s not a sustainable place to sit.
Oil prices are extremely volatile, and Nigeria has not been able to sustain an ammunition of foreign currency reserves to take it through tough times.
This was the story in the 2016 recession and is also the reality we face today.
“What gave the CBN power to the extent that they were able to control the FX market and the exchange rate, was that they had a supply of dollars, but that supply is rapidly drying up,” says Dr Nevin.
The lower oil prices have exposed the inefficiency of adopting the fixed exchange rate component of monetary policy. After this crisis is over, the CBN needs to think of a new sustainable solution going forward.
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