2006 BUDGET AND EXCHANGE RATE MECHANISM 02012006

“We expect the exchange rate to be relatively stable (around N129 to $1) with some possibility of minor appreciation of the naira.  With regard to inflation, the objective is to maintain a prudent fiscal stance so that monetary policy will have a chance to work as it did under the 2004 budget to help bring inflation from the relatively high double digit now to about 9%.”   The above is an excerpt from President Obasanjo’s 2006 budget presentation to the National Assembly.  The President’s admission of the failure of the 2005 budget is quite honourable; indeed, the sublime skills of the best spin doctors would have been inadequate to convince Nigerians that the 2005 budget implementation was successful, particularly with regard to the effect of monetary policy on the rate of inflation!  Even the engineers of our economic fortunes or misfortunes have recently admitted a year on year inflation rate of over 20% and the purchasing power of the naira in our pockets has become so grossly eroded that the N1000 denomination was introduced into our currency profile to facilitate the carriage of the larger nominal values of cash that is now required for simple day to day transactions by each household.

The two most important factors that impacted negatively on our rate of inflation are the excessive liquidity in the system and a rather inflexible or resistant exchange rate mechanism.  Last week, we highlighted how the CBN’s unilateral conversion of the monthly distributable dollar revenue into naira before sharing creates a regular glut of cash which is not backed by direct productivity in the capital market.  The attempt to mop up the naira avalanche results in high CBN Minimum Rediscount Rate of about 14% to stem the inflationary spiral which would be caused by unbridled credit expansion by the commercial banks.  The high commercial lending rates of about 20 – 25% which derived from the CBN base rate create increased costs for commerce and industry and generally push the costs of goods and services upwards, while wage incomes generally remain sluggish!

Most Nigerians would quickly point an accusing finger to the higher crude oil prices and the resultant higher domestic pump price of fuel as the other major factor for high inflation in 2005; the truth, however, is that the higher domestic pump price of fuel was brought about by the existing obtuse exchange rate mechanism that is non-compliant with the basic principles of demand and supply.  A brief example will explain this point.  We recall that inspite of the despotic leadership and international pariah status of Nigeria, our naira exchanged for about N80 = $1 between 1994-8 and the nation’s foreign reserve hovered around $5bn which represented 5 – 6 months import cover during this period; furthermore, import restrictions were not too much different from what obtains today.  However, in 2005, we started the year with reserves of about $10bn and earned approximately $40bn in 12 months.  Our foreign reserves peaked at over $32bn and even if we discounted the controversial payment of $12.4bn to the Paris Club, we still had imports cover for close to 20 months; but what happened to our exchange rate?  Well, after much outcry from well-meaning Nigerians, the exchange rate of the naira appreciated marginally from about N133 = $1 at the beginning of the year to about N129 = $1 in December!

Even our ubiquitous market woman would find something wrong with the mechanism that creates such arbitrary exchange rates that do not respect the forces of demand and supply.  Thus, such a high foreign reserve value and substantial international goodwill in a democratic dispensation should have resulted in a major appreciation of the naira to about N50 – N60 =$1.  Indeed, if the basic principles of a deregulated market had prevailed in 2005, we would, infact, have had stable domestic petrol prices of less than N35/litre.  In other words, the inflationary push which higher petrol prices unleashed on the economy and the dislocation to monetary policy would have been avoided.

From all indications, crude oil prices will remain above $50/barrel throughout 2006; what with severe winter in the Northern hemisphere and the aggressive and unsatisfied appetite of China in the oil market.  In this event, and barring serious technical or production problems, Nigeria could earn (2.5 million barrels x approx $50 x 365 days) approximately $45bn in 2006!  A rational evaluation would suggest that our naira should appreciate to between say N60 – N100 = $1; but once again, surprise, surprise, the exchange rate in the 2006 budget has been pegged to N129 = $1 with the possibility of a marginal appreciation!!

In a speech at a workshop for Small and Medium Industries in Abeokuta about two months ago, the President announced that the covert dual exchange regime currently in place would be harmonized in 2006!  The dual exchange regime implies that in addition to the well-known official DAS rate, another rate indeed currently exists for converting the monthly distributable dollar revenue into naira before sharing.  Simple arithmetical deduction indicate that the adopted rate for this purpose is about N109=$1; in other words, there is a silent profit of about N20 for each dollar that the CBN sells in its twice weekly Dutch Auction; so, if for example $15bn was distributed to constitutional beneficiaries in 2005 this would imply a CBN profit of N20 x 15bn = N300bn.  Now, this is a very huge sum of money which indeed could have come in handy to cover the N292bn subsidy to NNPC in 2005!  It is curious that no mention is made of this presumably covert federal asset!  Indeed, the manner of disbursement of this foreign exchange tax in the past has not always been very clear.  The monetary authorities will be well advised to come out with a clear statement on the disbursement of this foreign exchange tax in order to dispel unwholesome speculation.

Our monetary authorities cannot truly be satisfied with the current obtuse foreign exchange mechanism which puts the value of the naira under pressure whenever we earn more dollar revenue; an inexplicable contradiction, if there was one!  For example, if increased reserves make it possible to share $3bn dollars rather than say $1bn as monthly distributable revenue, this would require the CBN to find naira cover and pay the sum of ($3bn x 109) N327bn into the bank accounts of constitutional beneficiaries.  The huge liquidity position in the banks creates problems for monetary policy, but also provide ample stock of cash in the system to chase the $200m or so released into the Dutch Auction market by the CBN weekly; a case of too much naira chasing relatively smaller cache of dollars.  The net result of this imbalance is downward pressure on the value of the naira vis-à-vis the dollar.  So it’s clear that the current framework would spell doom for the value of the naira especially with the current prospect of earning more dollar revenue in 2006!  The CBN government has indicated that a wholesale Dutch Auction would replace the current retail nature of the market.  In the new arrangement, the CBN would sell dollars to a selection of a dozen or so ‘mega’ banks!  It is not clear how this arrangement would redress the abuse and continuous pressure and depreciation of the naira with increasing dollar revenue!  However, we have advocated the adoption of a protocol of dollar certificates for the payment of revenue accruable to constitutional beneficiaries.  This arrangement would correct the contradictions of monetary policy, so that more dollar revenue would bring about a comparatively strong naira and vice versa.  The details of the operation of this system have been amplified in a paper titled: “A LIBERALIZED FOREIGN EXCHANGE MARKET: a proposal for a liberalized foreign exchange market in Nigeria and its economic benefits”. 

Our monetary authorities continue to ignore the content of this paper at great cost to the welfare of all Nigerians.  However, they would have no hiding place in the annals of Nigerian monetary policy.