Nigeria’s multiple exchange rate regimes continue to give reasons for concern.
We estimate the Naira to be overvalued by ~14% despite the recent devaluation.
A weaker exchange rate could pass through to already high headline inflation.
However, monetary policy tightening moderated the impact during past episodes.
Thus, the transition to a market-determined exchange rate appears manageable.
Nigeria’s multiple exchange rate regimes remain a contentious issue as it has created uncertainty for the private sector, encouraged smuggling, and created arbitrage opportunities for a small segment of the population. Last year, FX shortages had a profound effect on foreign investors in local currency debt.
Furthermore, the exchange rate issue has been a major roadblock for a possible arrangement with the IMF. In this CEEMEA Views, we undertake a detailed analysis of the potential implications of FX unification and liberalization and conclude that a significant passthrough to inflation could be moderated by tighter monetary policy conditions.
However, this would likely result in weaker economic activity—a serious issue considering Nigeria’s already sluggish growth.
As part of our analysis, we
- take a closer look at the spread between the official exchange rate and the parallel market rate to assess the Naira’s current overvaluation;
- document recent inflation dynamics in Nigeria which have been used to justify the continuation of the current multiple exchange rate regime;
- attempt to quantify the potential FX passthrough based on estimated passthrough coefficients for peer countries and on a study of past devaluation events; and
- demonstrate how prudent monetary policy can be used to soften the effect of a substantial and sudden Naira devaluation.
On May 21, 2021, the Central Bank of Nigeria (CBN) adopted the somewhat more flexible Autonomous Foreign Exchange Spot Rate (NAFEX) as its official exchange rate. This represented a roughly 8% depreciation of the Naira.
Since 2014, the CBN has devalued the currency six times—from 155 NGN/$ to 410 NGN/$ (Exhibit 1). The spread between the parallel market exchange rate and the official rate has fluctuated between NGN75-100 (or 20-26%) since early 2020 (Exhibit 2).
In previous research, we have shown that parallel exchange rates are not always an accurate predictor of the official rate’s future path and, thus, do not necessarily represent a correct estimate of the official rate’s over-or undervaluation. The IMF estimated in early February of this year that the Naira was overvalued by 18.5%.
Since then, Nigeria’s real effective exchange rate has depreciated by 4.1% as detrimental inflation dynamics partially offset the 8% devaluation of the official exchange rate. Based on this information, we can conclude the Naira likely remains overvalued by more than 14%. This is, however, substantially lower than the current premium in the parallel market (22%).
For Nigerian authorities, the primary concern with a market-determined exchange rate has been the potential impact on inflation, which has risen substantially since late 2019 and stood at 18% y/y in May—significantly above the CBN’s target range of 7%±1 (Exhibit 3).
During the same time period, the central bank cut its key interest by 200bps to support economic activity during the COVID-19 shock. However, broad money growth has slowed in recent months and inflation declined marginally in April-May.
We attempt to gauge the possible implications for inflation dynamics by estimating FX passthrough coefficients for 30 emerging markets and 25 Sub-Saharan African (SSA) countries (Exhibit 4).
Our results show that half of the SSA sample experiences an increase in inflation of more than 0.25pp from a 1% depreciation after eight months while the median for the EM sample stabilizes at around 0.1pp. A passthrough coefficient of 0.25 would mean that a 12% depreciation of the Naira would result in a 3% increase in inflation.
However, the estimated coefficients for SSA countries vary significantly and, consequentially, do not allow for a sufficiently precise estimate. Thus, a closer look at the country’s own past devaluation episodes appears necessary.
The CBN devalued the Naira six times since 2014: in Nov.-2014 (by 27.2%, which includes the Feb.-15 devaluation), in Jun.-16 (by 55.2%), in Mar.-20 (by 17.6%), in Aug.-20 (by 5.3%), and in May-21 (by 8.2%). As the first two episodes overlap and no CPI data is available yet to gauge the impact of the most recent case, we shot annualized m/m (sa) headline inflation for four episodes (Exhibit 5).
While headline inflation indeed increased following the two devaluations in 2020, no such dynamics can be observed for the other two episodes. In late 2014-early 2015, inflation remained broadly stable, and in the aftermath of the substantial 2016 devaluation actually fell sharply.
A look at monetary policy conditions provides important context (Exhibit 6). Broad money growth slowed significantly in both late-2014 as well as mid-to-late 2016, helping to keep inflation under control. In contrast, the 2020 devaluations occurred during a period of high, and rising, broad money growth.
We conclude that Naira devaluation, even of a significant order, can be undertaken without detrimental effects on inflation if it is accompanied by tightening of monetary conditions in the economy. It is also important to note that current inflation dynamics may already partially reflect the parallel exchange rate. However, tighter monetary policy will come at the price of lower economic activity.
