Nigeria: After The Devaluation

Frontier Friday: Higher Inflation, Deep Contraction Ahead for Nigeria

Nigeria’s official currency, the naira (NGN), has fallen by 30% following the Central Bank of Nigeria‘s (CBN) decision to move from a fixed foreign exchange policy to a market-determined exchange rate. The adjustment was long overdue, with the preceding 15 months of naira stability against the dollar “glaringly out of step” with fundamentals.

Essentially, as oil prices collapsed from mid-2014, export earnings have fallen by USD50bn, leaving the economy starved of foreign exchange and with what market analysts refer to as “widening macro imbalances”.

An Overdue Devaluation

Overall, the FX move has helped reduce the overvaluation of the naira. It has also lessened the backlog of so called pent up USD demand, and should trigger some rebalancing of the external position, creating conditions in which import demand moderates, and crucially, capital inflows pick up.

“But it will only be if the Central Bank of Nigeria builds on the initial devaluation and works toward full liberalization that FX reform will ease the scarcity of foreign exchange and reinvigorate growth,” David Faulkner, a South Africa-based economist with investment bank HSBC wrote in a note to clients on July 4th. “We expect the naira to end the year at 300 against the USD.”

Assuming the CBN pushes ahead with a more flexible currency, the economy is likely to endure a painful adjustment process as FX devaluation adds to already-elevated inflation pressures and pushes the CBN into more aggressive policy tightening.

The bank now expects inflation to average 15.3% in 2016 (up from 13.8% previously) with the CBN delivering 300bp of hikes during the second half of this year (up from 200bp). “We have also made deep cuts to our growth forecasts, following the surprise contraction in the first quarter, and the sharp fall in oil output as militant attacks on oil infrastructure severely disrupted production during Q2,” Faulkner wrote. “We now see the economy contracting by 1.7% this year (2.2% expansion previously) before expanding by 2.6% in 2017 (3.0% previously).”

Nigeria, Faulkner says, needs broad-based policy action to respond to the current economic landscape and to re-establish macro stability within the country as well as  provide a solid foundation for future growth. “Beyond a flexible naira and more aggressive rate hikes, we continue to argue that higher non-oil taxes have to be part of this macro policy package, reducing the reliance on oil revenues and diversifying the tax base”.