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Naira Struggles Nigeria's Response to the Crude Oil Price Shock of 2014

The monetary and exchange rate policy, here on referred to as ‘monetary policy’, are significant tools for economic growth and development. Although monetary policy is not the only thing that counts towards a country’s economic prosperity, it plays an important role. In general, the aim of effective monetary policy is to provide the best set of conditions for economic growth, both in the present and, sustainably, into the future. To this end, monetary policy is typically focused on price stability, i.e. keeping inflation within a certain range.

Price stability and exchange rate stability are, however, inexorably linked. A rapid depreciation or appreciation of a currency implies that relative prices of imports and exports change rapidly, too. The implication, therefore, is that—as a key component of subsequent price stability—exchange rate stability is often considered a goal of monetary policy. However, it is important to note that exchange rate stability does not imply the maintenance of a fixed exchange rate. Instead, it implies the absence of rapid exchange rate movements.

Rapid exchange rate movements are unlikely in economies that operate flexible exchange rate policies. In these economies, the probability of an exchange rate movement above a certain threshold is unlikely, except during major events. These major events may occur occasionally. Sometimes, such events can even lead to a change in expectation of future policy or future economic activity. A change in expectation can lead to changes in capital flows, which would affect the currency. A recent example is the decision of voters in the United Kingdom voting to leave the European Union. The change in expectation of future policy and future economic activity led to turbulence in capital markets which saw the British pound weaken from US$1.46 to US$1.30 per British pound in the space of a week in June, 2016.

In many cases, however, exchange rate shocks occur as a result of significant changes in terms of trade. That is, significant changes in the value of exports or imports for any given country. In this context, the question for monetary policy is how to survive these terms of trade shocks or what the best set of polices to mitigate the negative consequences of these shocks are.

The Reality of Terms of trade shocks

The Nigerian economy is peculiar in its reliance on crude oil exports as a source of foreign exchange and government revenue. Since its discovery in 1956, crude oil has grown to become Nigeria’s major export. More specifically, since 1972, oil has made up at least 80 per cent of Nigeria’s export value. This reality of dominant crude oil exports implies that for decades Nigeria has been exposed to frequent terms of trade shocks, driven by the relatively frequent collapses in the price of crude oil.

Crude oil is the perfect example of the commodity super cycle, which refers to the high frequency in the rise and collapse of the prices of commodities. Although the prices of many commodities go through periods of booms and busts, few are as volatile as crude oil. Figure 1 shows the inflation-adjusted price of crude oil between 1960 and 2016. From the graph, it is apparent that price volatility is a feature of the crude oil industry.

Unfortunately, these price movements are very difficult to predict, and the unpredictability of commodity price shocks in general, and crude oil in particular, has been documented by various authors. In essence, even though policy-makers know that a crude oil price crash is inevitable and always “around the corner”, no one quite knows when the next shock will hit. The main issue, then, for policy-makers is how to prepare for the next set of shocks, and how to best survive them.

Economies that seem healthy can suddenly, in a couple of weeks, fall into a precarious situation due to external shocks. The gravity of the shocks can be seen when examining trade balances, and balance of payments. For this, we can use Nigeria as example. Figure 2 shows the trade balance between Nigeria and the rest of the world. The trade balance here is the difference between the value of exports and the value of imports. A positive number implies a trade surplus: that is, that, value-wise, exports exceed imports. A negative number implies the opposite.

Figure 2 is very clear on this: things seem to be ‘healthy’ with a trade surplus in almost every quarter, however, in a few quarters between 2015 and 2016 the surplus becomes a deficit. Similar patterns can also be seen between 2008 and 2010. Figure 3 shows the effects of terms of trade shocks on balance of payments as well with the net balance going negative in a few quarters.

The two graphs highlight the fundamentals of the problem that occurs due to a negative terms of trade shock: a sudden trading deficit and balance of payments problems.

Given that relative to other commodity price shocks crude oil price shocks happen frequently, it is crucial for oil-dependent economies to decide early on how to manage potential shocks and achieve the best possible outcome. In this area, a couple of best practices have emerged. The set of best practices are based on the experiences of other countries who have dealt with, or failed to deal with the consequences of commodities shocks.

The first part of dealing with crude oil shocks is preparation before the shock. If there is an expectation that revenues from a particular export might collapse in the future, then implementing policies to mitigate the risk from that outcome in advance are ideal. Many crude oil exporters implement such risk mitigations polices. Mexico, for example, hedges its oil revenue by locking in oil sales at specific prices in advance. This has the advantage of guaranteeing prices and removing the uncertainty from future oil price collapses, at least for the duration of the hedge. In Norway, the bulk of oil revenue is saved in a sovereign wealth fund and drawn from only in specific circumstances.

Although most of these policies are more fiscal in nature, they do have implications for monetary policy. From a monetary policy perspective, preparing for future oil shocks involves two key measures. First, ensuring that there are significant financial buffers to deal with temporary balance of payments problems. This is influenced—although not entirely—by the actions of fiscal authorities in saving during boom years. Secondly, ensuring the exchange rate is flexible enough to absorb shocks with minimal costs. Here, especially, it is important to ensure that exchange rates are not overvalued during the boom period, as overvalued exchange rates fall harder during the busts.

The second set of tools is focused on best practices once the shock hits. Recall that the fundamental problem of negative terms-of-trade shocks is a decline in either export values, or a rise in import values; such problems are, typically, exacerbated by speculative capital flows. This leads to worsening trade balances and balance of payment problems. A vital policy response in resolving these issues is an exchange rate adjustment. Depreciation of the currency makes imports more expensive and increases the value of exports in local currency terms. This has the joint effect of slowing demand for imports, with exception being products that lack substitutes, the demand for which is typically inelastic.

Exchange rate adjustments, however, do not necessarily increase commodity exports, as commodities are priced internationally and, as a result of negative terms of trade, prices are falling. The adjustment, however, gives governments and companies who rely on commodity exports a bit more leeway to deal with the consequences of the price fall. The exchange rate adjustment means that relative wages and other domestic costs fall, while foreign obligations remain the same.

Another set of tools, which is a bit less certain, is the adjustment of monetary policy to boost the non-commodity sectors of the economy. Lower interest rates, for example, typically improve the productivity of businesses as lower rates result in lower borrowing costs. The downside, however, is that lower interest rates may exacerbate the exchange rate problem as lower rates typically incentivize capital outflows.

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The suggested set of policies to deal with shocks does not come without consequences. Exchange rate depreciations typically lead to an increase in inflation, which has its own set of impacts. The focus, however, is not on if exchange rate adjustments have consequences but on what consequences there are relative to the alternatives. The alternative, refusing to let the currency adjust, typically results in worse outcomes.

Theorists of macroeconomics commonly speak of the concept known as the impossible trinity. The impossible trinity is based on the idea that an economy cannot sustain a fixed exchange rate, independent monetary policy and free movement of capital at the same time. A country can maintain only two of the three states. Attempts to try to violate the trinity result in economic collapse. This rule comes to the fore when economies are hit with terms of trade shocks. In the event of a negative terms-of-trade shock, economies naturally try to adjust. However, countries that try to prevent their exchange rates from adjusting must either implement capital controls to prevent capital from leaving the economy, or must give up on independent monetary policy and keep raising interest rates until the incentive for capital outflows disappears.

Implementing capital controls is impractical in many economies. In the context of financial markets, just purchasing foreign currency and storing it is equivalent to capital outflows, as the value of foreign currency is effectively withdrawn from the domestic economy. The result of trying, and failing, to implement capital controls and a fixed exchange rate is that black markets for foreign exchange appear, with rates different from official rates. The presence of black markets creates perverse incentives for currency round tripping between official and black markets, and further exacerbates the effect of the shocks on exchange rates. The economy is then hit with the side effects of capital controls and inflation from exchange rate movements, which are worse than would have been without the attempts to implement capital controls.

The second option, raising interest rates continuously to induce capital inflows, also has the outcome of depressing economic activity in the rest of the economy. Higher borrowing costs typically have a negative impact on economic activity.

The question then, is what option allows the terms-of-trade shock get absorbed with minimal damage to the economy. Implementing effective capital controls is very difficult and often impractical. Continuously raising interest rates is, typically, more costly than exchange rate adjustments. Trying to violate the trinity is, perhaps, the worst option. Still, for a variety of reasons, different countries take different paths in trying to deal with terms of trade shocks.

The experience of others: Norway, Azerbaijan, and Venezuela
Norway

Norway was relatively well prepared for the crude oil price crash of 2014, having put in place mechanisms to deal with its crude oil dependency. Presently, the Norwegian economy is projected to return to around 1.7% growth in 2017. Photo: Oslo rådhus, Norway. Claudia Regina

Norway is the thirteenth largest crude oil producer in the world. In 2016, they produced an average of 1.8 million barrels of crude oil a day. Relatively dependent on crude oil exports, crude oil and petroleum gas accounted for about 20 per cent of the Norwegian economy and almost 60 per cent of its exports in 2014. The crude oil price collapse of 2014, therefore, hit Norway as expected.

However, Norway was relatively well-prepared, having put in place mechanisms to deal with its crude oil dependency. A sovereign wealth fund was set up in 1990, into which all petroleum revenues were paid. The government also established spending rules, limiting the withdrawals from the fund to only the real rate of return on the fund with some flexibility to spend a bit more, or a bit less, depending on the prevailing economic conditions. The funding arrangement played two important roles: first, it ensured that the domestic economy, the currency in particular, was shielded from the effects of large crude oil revenues. Secondly, it ensured that there was always a pool of funds to spend regardless of what happened to crude oil prices.

And yet, the presence of significant fiscal buffers did not limit the role of the monetary authorities in Norway. In response to the oil price collapse the monetary authorities cut interest rates consistently from 2014 through 2016. The key policy rate was cut from about 1.5% to 0.5% by mid-2016. Recall that lower interest rates tend to boost the rest of the economy but also lead to capital outflows, which worsen exchange rate depreciations. As a result, inflation in Norway rose from about 2 per cent in 2014 and peaked at almost 4.4% in mid-2016, before dropping to 2.8% as at January 2017. The Norwegian krone also depreciated from about 6.1 per US dollar at the beginning of 2014 to about 8.3 per US dollar as at January 2017.

In essence, the Norwegian authorities opted to sacrifice the currency for the benefit of the rest of the economy. The result was that, although the petroleum sector shrunk for 5 out of 8 quarters in 2016, the mainland economy was able to pick up the slack, shrinking for only one quarter over the period. Presently the Norwegian economy is projected to return about 1.7% growth in 2017, which, although lower than its pre-oil crash growth of about three per cent, is still faster than its sub-one per cent growth during the adjustment. By all intents, the Norwegian economy has absorbed the shock of the oil price crash and looks set to maintain its growth path.

Azerbaijan

Before the price crash in 2014, Azerbaijan had implemented a de facto fixed exchange rate regime with the currency pegged at around 0.78 manat per US dollar. Photo: Baku, Azerbaijan. David Davidson

Azerbaijan is not one of the largest crude oil producers in the world but it represents a good example of a crude oil dependent economy dealing with the effects of a terms-of-trade shock. Azerbaijan is the twentieth largest oil producer with about 876,000 barrels per day produced on average in 2016. In the same period, crude oil accounted for 40 per cent of the Eastern European country’s GDP and 93 per cent of its exports.

As expected, the collapse in the price of crude oil hit the Azerbaijani economy. Before the price crash in 2014, Azerbaijan had implemented a de facto fixed exchange rate regime with the currency pegged at around 0.78 manat per US dollar. The fiscal authorities had also implemented a relatively good system of crude oil rent savings. The state oil fund of Azerbaijan (SOFAZ) had accumulated assets of over $37bn as at 2014.

However, the monetary response to the crude oil price shock was lacking. The Central Bank attempted to violate the impossible trinity by maintaining the fixed exchange rate, maintaining monetary independence and still allowing capital controls. They reduced interest rates from about 5 per cent to about 3 per cent by the end of 2015. The monetary authorities also kept the official exchange rate pegged at 0.78 Manat per dollar through 2014 until mid-February 2015. They then devalued the currency and attempted to sustain another peg at about 1.05 per dollar. That lasted until the end of 2015 when authorities finally allowed the currency to float freely.

In the interim, the Central Bank of Azerbaijan blew through its foreign reserves, and reserves fell from $14.15bn in 2013 to $4.12bn in 2016. The economy suffered, furthermore, with inflation rising from just over 2 per cent in 2014 to 4 per cent as at the end of 2015, and to 14 per cent upon the final float in 2016. Although it has started slowing, dropping to just under 12 per cent. Although growth held firm in 2014 and 2015, at about between 2.5% and 5.3%, the unsustainability of the policy meant that growth collapsed once the policy environment changed. The economy shrunk for four consecutive quarters in 2016 with contractions greater than 3 per cent in each quarter. The Azerbaijan example demonstrates the attempt to resist the effect of terms of trade shocks by refusing to allow exchange rates absorb the shocks. The side effects, however, are that the imbalances build up and eventually come to the fore, and the growth collapse is worse than it would have been if the recommended polices were implemented from the start.

Venezuela

“Protests are becoming more clearly distinct between those primarily demanding better security and economic opportunities and those [who] mostly want President Maduro to resign.” Photo: Las Mercedes, Caracas. February 27, 2017; during continuing protests in Venezuela. AndresAzp

The Venezuelan case is perhaps an extreme example of the wrong set of responses to a terms-of-trade shock. Venezuela is also a major crude oil exporter and is the eleventh largest producer in the world. Officially, the Latin American oil producer has the largest crude oil reserves in the world and produced 2.3 million barrels per day in 2016. As at 2014, crude oil accounted for 93 per cent of Venezuelan exports.

However, Venezuela was not well prepared for an oil shock. Even before the collapse in crude oil prices, the government was already struggling with its finances. The nationalization of the oil industry in 1976 and major production problems since the late 1990s meant crude oil production was already in decline before the collapse of crude oil prices. Although a lot was happening on the political front which was probably just as important, the policy response was just as bad.

Firstly, the Venezuelan central bank operated a fixed exchange rate policy that was not flexible enough in the face of falling oil exports. The decline in exports also created a financing problem for the government. In response to the problem, the Venezuelan government embarked on a massive monetary expansion, printing bolivars to finance government operations.

The monetary expansion, combined with the fixed exchange rate policy led to an explosion in inflation and in the black-market exchange rate for bolivars. Although the Central Bank devalued the currency a couple of times, the fixed peg persisted. The price controls in the rest of the economy also played a huge part in that. The consequences of the policy were that the economy collapsed with GDP contractions of 3.9% and 5.7% in 2014 and 2015 respectively. Inflation also soared to 800 per cent in November 2016 while the exchange rate declined from less than 200 bolivars per US dollar in January 2015 to 1600 per US dollar as at November 2016 at the black market. At present, the official exchange rate is still fixed at 10 bolivars per US dollar. The Venezuelan example, with its fixed exchange rate combined with monetary expansion, is a case study on how not to respond to terms-of-trade shocks.

Nigeria: The prequel

Crude oil plays a very important role in the Nigerian economy. In 2016, Nigeria was the fifteenth largest crude oil producer. Although, in 2015, crude oil only accounted for 10 per cent of GDP, it accounted for 90 per cent of all exports. Dependence on crude oil left Nigeria prone to crude oil price shocks. This vulnerability, however, is not new and had been discussed in policy circles as far back as during the oil price crash of the 1980s.

More so, since the return of democracy in 1999, in-built mechanisms had been put in place to hedge against sudden changes in the price of crude oil. Specifically, around 2004, the excess crude account policy was implemented. The basic idea of this policy was to assume a price and production target for crude oil that was below current prices and considered a safe bet, with any extra income above that saved in an excess crude account. In 2013, the idea was formalized into a sovereign wealth fund although, probably due to legal challenges, the excess crude account remained.

Yet the policy had shown success in the past. In the years between 2004 and 2008, an estimated $20 billion was saved in the excess crude account. The savings helped steer the economy through the global financial crisis in 2008. However, despite record high oil prices between 2009 and 2014, the policy was not properly implemented. The result was that by the time the oil price crash in 2014 hit, there were very little fiscal buffers. According to reports, only just over $4 billion was saved in the excess crude account as at October 2014, and the sovereign wealth fund had a value of only $1.25 billion.

If the fiscal buffers were in poor state, the monetary and exchange rate policy also proved ill-prepared for the crash. One of the key dangers of oil booms is that oil rents create inflows of foreign currency that tend to lead to overvalued exchange rates. This was the case in Nigeria since about 2010. Figure 4 shows the real effective exchange rate for Nigeria between 1999 and 2015. The real effective exchange rate compares the naira to a basket of other currencies. A rate greater than 100 implies a currency that is overvalued and a rate less than 100 implies a currency that is undervalued.

As is clear from the graph, the naira had been inching up in value since 1999. By 2011, the naira was already considered by most to be overvalued. This was echoed by calls from the International Monetary Fund (IMF) in mid-2014, about the potential problems that could arise if there was a terms of trade shock. An overvalued currency implied a harder landing than an undervalued currency.

The risks were also exacerbated by the foreign portfolio inflows that had risen greatly since 2005. In 2005, the Central Bank (CBN) removed some restrictions on foreign holdings of domestic securities and liberalization meant that foreign funds flowed into Nigeria. Between 2005 and 2010, foreign portfolio investment grew from about $2.8 billion to $12.7 billion per annum. This is not to say that foreign portfolio flows were bad, as they did significantly reduce borrowing costs and increased general asset prices. However, the risks, if the portfolio flows reversed, did not seem to be properly mitigated. It does not appear that the sterilization of portfolio inflows to mitigate that risk was done.

The result of an overvalued currency was that the naira was already seemingly under pressure since 2013. At the time, Nigeria operated a managed float with the currency pegged within an exchange rate range. Instead of allowing the range and the currency to adjust naturally, the currency was propped up by selling reserves and raising interest rates to entice more capital inflows. The monetary policy rate (MPR) was increased from 6 per cent to 12 per cent between 2009 and 2012 while the value of external reserves fell from just over $50 billion in January 2009 to $43 billion in December 2013. Pressure on the naira was ascribed to corruption in the oil industry, with Sanusi Lamido Sanusi, the then Central Bank Governor, claiming that about $20 billion dollars was unaccounted for. The accusations eventually led to his removal and his successor, Godwin Emefiele, continued the policy direction of propping up the currency.

In summary, by the time the oil price collapse started in 2014, there were no fiscal buffers to cushion the effect of decreased export revenue, and the currency was overvalued with a hard landing on the horizon.

The 2014 oil crash

The collapse in the price of crude oil started mid-2014. In June 2014, Brent crude was priced at $111.8 per barrel. By June 2015, the price per barrel had fallen to $61 and, in January 2016, bottomed out at $30 per barrel. The collapse in the price of crude oil implied a collapse in crude oil export revenues, a classic negative terms-of-trade shock.

It is important to put the initial response of the CBN to the shock in proper context. Nigeria was in the middle of closely contested elections. In a country where the exchange rate is seen as a measure of economic performance, the reluctance to allow flexibility is understood. The exchange rate is also linked to other import prices fixed by government, such as fuel and electricity prices. An adjustment of the exchange rate, therefore, implied that these prices would have to adjust as well. In this context, it is not surprising that the CBN chose to hold the line. In its early response to the drop in crude oil prices, the CBN opted to spend its reserves to keep the currency stable and to raise the monetary policy rate to shore up the currency. There was some justification, too. Crude oil prices are typically very volatile and there was belief that the price could return to its previous highs.

The decision to not allow flexibility backfired. By October 2014, the spread between the official market and the BDC market had grown to 8 per cent, despite the Central Bank actively defending the currency. The pressure on the currency spooked portfolio funds, which, subsequently, tried to exit the economy. The capital outflows put even more pressure on the naira. In October 2014, with the continued drop in the crude oil price, the situation became untenable and the Central Bank decided to adjust.

Here, the first in what was to be a series of policy mistakes was made. In October 2014, the CBN was assuming an exchange rate around N157 per US dollar in its official market, but the interbank market had already moved to around N176 per US dollar while the black-market rate was a bit higher. The CBN, however, adjusted its floating peg to N168 per US dollar with a band of N8 around it. It also tightened monetary policy, raising monetary policy rate from 12 to 13 per cent, and increasing the private sector credit reserve ratio from 15 to 20 per cent. The assumption was that moving the peg and tightening monetary policy would reverse outflows and stabilize the currency. That didn’t happen. Instead, retaining a gap between the official and interbank market, and the continued fall in the price of crude oil meant that the currency remained under pressure.

By the end of January 2015, the spread between the official and the interbank market, and the official and the BDC segment, had risen to 15.5% and 37.8% respectively, with the CBN still spending reserves trying to keep the currency fixed. In February of 2015, the CBN acted again, this time scrapping its official auctions and, instead, choosing to intervene directly in the interbank market. The scrapping of the official auctions window implied a currency devaluation to almost N200 per US dollar in the new official interbank market. The interbank market had hit N207 before central bank intervention.

Furthermore, the CBN implemented administrative controls on the interbank market with the goal of pegging the currency at the rate of about N199 per US dollar. The administrative measures were, essentially, an ad-hoc form of capital controls, requiring anyone who wanted to officially purchase foreign exchange to get approval first. Unfortunately, capital controls are very difficult to implement. In theory, capital controls are supposed to stop capital outflows and, hence, reduce demand for foreign currency and pressure on the local currency.

However, the CBN’s capital control measures did not work, the reason being in practice, physical foreign currency does not need to leave the country to count as outflows. The purchase of foreign currency, or other assets such as gold, and its isolation, even inside Nigeria, implies that technically, capital has already flowed out. The continued spread between the now official interbank market and the black market meant that demand for foreign currency, as a hedge against imminent future currency adjustments continued. By June 2015, the black-market rate, at N225 per US dollar, was about 13 per cent higher than the rate on the interbank market.

The New Regime

In May of 2015, there was a change in government with Muhammadu Buhari replacing Goodluck Jonathan as president. The regime change provided the Central Bank with an opportunity to reform its policy and change direction. Instead, in response to the black market hitting N250 per US dollar, a 25 per cent spread between the official interbank market and the black market, the CBN doubled down on its capital controls policy, or “demand management” as they called it. The Bank placed further restrictions on who could buy foreign exchange in the official markets. It launched the now infamous “toothpick memo” under which authorities banned importers of 40 items from the interbank market. The items included palm oil, wheelbarrows and, of course, toothpicks. Rice was added to the list later bringing it to 41 items. The policy also limited sales of foreign currency to other buyers who were not on the banned list, reserving sales for items it considered essential.

After the uncertainty of the elections, the economy had started to show signs of recovery. Although GDP had been slowing since the third quarter of 2014, growth showed its first acceleration in the third quarter of 2015. The capital controls policy stance, however, meant that there were severe foreign exchange supply constraints. Although capital controls attempt to prevent foreign exchange outflows, they also dis-incentivize inflows. Inflows from other non-oil sources collapsed while foreign exchange scarcity was already creating problems in various parts of the economy.

The CBN responded by trying ease monetary policy, reducing the private Cash Reserve Ratio (CRR) from 31 to 25 per cent in September 2015 and then to 20 per cent two months later in November. The Bank also reduced the monetary policy rate from 13 per cent to 11 per cent, another policy mistake. The easing of monetary policy, combined with the controls in the foreign exchange market, implied that funds simply flowed to the best available asset, the US dollar. By February 2016, the black market had hit N395 per US dollar, almost 90 per cent above the official rate. In March 2016, the CBN attempted to reverse course and tightened its policy stance. It raised the MPR from 11 per cent to 12 per cent and raised the private CRR from 20 to 22.5 per cent.

The policy somersaults and the capital controls, combined with other failures on the fiscal front, implied that the economy took a beating. By the end of the second quarter of 2016, the economy was officially in recession, its first in over two decades. Inflation had risen to 17 per cent from under 10 per cent in most of 2015, and the Central Bank had blown through about $15 billion in foreign reserves. The foreign reserves fell from over $40 billion in January 2014 to less than $25 billion as at May 2016. In May 2016, the CBN announced its intention to give up on its policy of pegging the exchange rate and signalled its intention to introduce more flexibility in the foreign exchange market.

The float that never was

In June 2016, the Central Bank of Nigeria released details of its new foreign exchange policy. In summary, the CBN promised to no longer try to directly fix exchange rates and said it would allow markets, specifically the interbank market, guide things based on economic ‘fundamentals’. The Bank would still, however, occasionally intervene in markets to either buy or sell foreign exchange—a necessary caveat seeing as a relatively large proportion of foreign exchange supply enters the country via crude oil sales on behalf of the government.

Nevertheless, the CBN maintained that intervention would be market-driven, meaning the Central Bank would sell or buy at whatever price the market dictates. The Bank also launched futures contracts to deal with short-term volatility in the market. In all, the new foreign exchange policy was lauded by most. There were, however, caveats: the Bank insisted on retaining the ban on 41 items from the official market. The ban implied that a spread between the official and black market would persist. And yet, the new policy was praised as a good plan, one designed to allow flexibility in the foreign exchange market.

The true foreign exchange situation started to unravel a few days after the launching of the new floating exchange policy. Typically, in freely floating currency markets, there is always some volatility. However, in the Nigerian ‘floating’ foreign exchange market the currency was curiously stable. In the weeks following the launch of the floating policy, the currency remained at about N280 per US dollar. Curiously, the exchange rate, which allowed the price of premium motor spirit—another politically sensitive government controlled price—to remain fixed. The naira even remained stable during the turbulence in global financial markets that followed the events of the UK referendum to leave the EU.

Very quickly, it became apparent that the Central Bank did not change its policy direction but simply moved from one currency peg to another. In the days after the float, the black market exchange rate showed signs of convergence to the new ‘official’ rate, falling from N380 to about N325 per US dollar. However, once the reality of yet another currency peg became apparent, the convergence stopped. The Central Bank, again, tried to induce stability by increasing the monetary policy rate. It increased the MPR in July 2016 from 12 to 14 per cent. Unfortunately, the confidence in policy-makers was at an all-time low and the credibility of the Central Bank was already declining.

The black market has since continued to move further and further away from the official market with an exchange rate of over N500 per US dollar in the black market compared to N315 per US dollar in the official market, a more than 60 per cent spread. The economy continues to stumble, with reports stating, as at February 2017, that the economy has experienced its first annual contraction in 25 years.

The Path to stability

Although policy-makers insist that the Nigerian situation is a special case or different, the reality is that it is not. Nigeria was hit with a terms of trade shock as a result of the collapse in the price of crude oil and, consequently, the problem was how to respond. No doubt the country was not prepared for such a shock with fiscal buffers being low and with an overvalued exchange rate. However, the response to the shock was, and still is, not ideal.

In response to terms of trade shocks, the recommended policy is to allow the exchange rate absorb the shock, and implement monetary policy to boost the rest of the economy. The recommended policy is not without its pains as currency depreciations typically result in inflation. However, the alternative—which typically involves currencies eventually falling harder than they would have, and inflation rising higher than it would have—is worse.

Essentially, Nigeria is at the same point it was at the beginning of the oil shock in 2014, with imbalances building and adjustments required. The options are almost the same. On one hand, authorities can allow the exchange rate absorb the imbalances in the economy, while bearing the temporary shocks to inflation and growth. Alternatively, authorities can continue as is, praying that oil prices recover, postponing the inevitable, and, in the interim, trudge along with a slowing economy. This is the summary of foreign exchange and monetary policy over the last three years. Although many other factors played a role in the subsequent economic collapse, the response by the Central Bank contributed in no small measure⎈

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