The Central Bank of Nigeria (CBN) devalued the Nigerian naira last week as an unavoidable step to restore balance in the FX market. On June 15 the CBN abandoned its peg for the naira in favor of a purely market-driven exchange rate.
Foreign exchange (FX) analysts, market participants, and economists (including Dun & Bradstreet) had long warned that the government would not be able to defend the naira peg without significant disruptions to the economy, as the sharp drop in FX revenues from crude oil exports have drastically eroded the CBN’s FX reserves.
Additionally, the peg was causing major disruptions to business continuity. While the CBN fixed the naira at the official rate of 197 to $1, the parallel-market rate had spiked up to 350 to $1 on June 15, before the CBN decision. This wide spread was leading to a severe shortage of dollars for businesses dependent on FX to make payments.
Thus, the abandonment of the naira peg amounts to an effective devaluation of the local currency. The immediate effect of the devaluation, as expected, has been a sharp weakening of the naira towards the parallel-market rate. When markets opened this week for the first time after the CBN decision, the naira immediately slumped to a level of around 280 to $1.
The devaluation will help the economy in two main ways. First, it will ease the shortage of dollars and the strain on the CBN’s reserves, abating the imbalances in the FX market. Additionally, as the effects of the weaker naira work their way through the economy, Nigeria’s exports will improve. A weaker domestic currency makes exported goods cheaper and imported goods costlier, thereby narrowing a country’s trade deficit and improving its external position.
While the devaluation is generally expected to be positive for the economy, it will complicate the CBN’s monetary policy strategy. Domestic inflation, already high and rising, will accelerate further due to the currency weakness. Headline CPI inflation jumped from 13.7% year over year in April to 15.6% in May; inflation breached the upper limit of the CBN’s 6%-9% target range in May 2015. At its last meeting in late May, the central bank acknowledged its challenge of having to stimulate growth in an environment of high inflation; the CBN held the policy rate unchanged as the “least risky option.”
The short-term economic outlook for the Nigerian economy remains bleak. The latest data show that the economy contracted 0.4% in Q1 2016. This is a sharp slowdown compared with real GDP growth of 2.1% in Q4 2015, and 4.0% in Q1 2015. In fact, the risk of a recession (defined as two consecutive quarters of contraction in output) remains high, as indicators of Q2 activity have been weak so far. Worryingly, both oil and non-oil GDP contracted. Following a sharp slowdown in real GDP growth from 6.2% in 2014 to 2.8% in 2015, we forecast growth of only 2.3% in 2016, recovering to 3.5% in 2018.
Security risk has increased in the strategically important crude-oil-producing Niger delta in recent weeks due to a spate of attacks and pipeline vandalism by militants. The militant group, the Niger Delta Avengers (NDA), has claimed ownership of these attacks, although law enforcement agencies have disputed their hand in some of them. The attacks pose a major downside risk for Nigeria’s crude-production targets; production has already dropped by more than 100,000 barrels per day.
With oil prices already low and Nigeria’s FX revenues eroding, a drop in production will further hurt the economy. Additionally, the security implications are also negative. The NDA agreed on June 13 to join talks with the government of Africa’s second-largest crude producer if certain conditions are met. The new attacks indicate such cooperation is unlikely in the near term. The CBN recently stressed that the government must “aggressively earn and build up” FX reserves to be prepared for exogenous shocks. A reduction in oil production certainly won’t help with that despite the respite provided by the currency devaluation.
Bodhi Ganguli is a Senior Economist on D&B’s Global Data, Insight & Analytics team. Based in Short Hills, NJ, Bodhi covers sub-Saharan Africa as a contributor to D&B Macro Market/Country Insight Products. He is also a member of D&B’s US Economic Advisory Panel. He received his Ph.D. in economics from Rutgers University and his bachelor’s degree in economics from Presidency College, India.