IMF Urges Nigeria to Further Devalue Naira, Asks CBN to Stop Playing the Role of Main FX Intermediator

The article IV of the International Monetary Fund (IMF) report on Nigeria’s economy, published on Monday said the Nigerian economy is at a critical juncture.

“A weak pre-crisis economy characterized by falling per capita income, double-digit inflation, significant governance vulnerabilities and limited buffers, is grappling with multiple shocks from the COVID-19 pandemic,” the report said.

It added that Policy adjustment and reforms are urgently needed to navigate this crisis and change the long-running lackluster course.

The IMF thus made key policy recommendations that cut across many sectors of the economy but with emphasis on Exchange Rate Policies and revenue mobilization.

In the short run, the recommended policy mix is heavily tilted toward exchange rate adjustment given constrained capacity on the monetary and fiscal fronts. In the medium term, revenue mobilization is a top priority, the report stated.

The IMF estimates that the naira was overvalued by 18½ percent, urging the federal government to once again devalue the naira to reflect the current economic realities of Nigeria.

The report reads:

Exchange Rate Policies: A more transparent and market-based exchange rate policy is imperative to instill confidence. IMF recommends establishing a market-clearing unified exchange rate with the near-term focus on allowing greater flexibility and removing the backlog of requests for foreign exchange.

Structural Policies: Significant reforms are underway in the fuel and power sectors as well as in governance and business regulations. Steadfast implementation in these areas along with broad market and trade reforms to open up the economy are needed the long-running policy of a stable exchange rate has produced limited benefits. The stabilized exchange rate policy, combined with administrative control of imports, has led to periods of real effective exchange rate appreciation interrupted by episodes of forced large adjustments.

IMF’s latest estimates suggest an overvaluation of the real effective exchange rate (applied on the current level of the official exchange rate) of 18½ percent, with the external position assessed as substantially weaker than what is consistent with fundamentals and desirable policy settings. Exports remain highly undiversified. Past current account surpluses resulting from commodity price booms have made limited contributions to the build-up of buffers as sizable unrecorded outflows have continued.

Gross reserves levels are significantly below the IMF’s ARA metric and projected to remain so in the medium term. External financing is projected to rely on Foreign Direct Investment, issuance of Eurobonds and some drawdown of reserves as portfolio flows are expected to only gradually recover over the medium-term.

A clear exchange rate policy is needed to instill near-term confidence and bring long-term gains. The current system, with its multiple windows and untransparent rules of FX allocation, creates uncertainties for the private sector. The unification of various rates into one market-clearing rate, including the dismantling of the legal, institutional and operational underpinnings of the various windows, is needed to establish policy credibility and a decisive break from the highly interventionist regime. It would also eliminate existing Multiple Currency Practices (MCPs.

An appropriately valued exchange rate would foster domestic industrialization more effectively than through a system of FX rationing where winners are chosen and protected, and relative prices do not move. A clear exchange rate policy would also help attract larger capital inflows, including foreign direct investments, which have significantly dropped in recent years.

Exchange rate flexibility may have short-term negative impacts, particularly on inflation, which should be mitigated.

IMF estimates suggest that a 10 percent devaluation could push the inflation rate up by up to 2.5 percentage points, but the impact could be less if the parallel market rate is already reflected in the prices of imported goods. Experience from other countries that have undergone exchange rate adjustment generally shows less pass-through and often a more transient impact on inflation.

Some targeted support is likely needed to minimize the impact on the poor. The corporate sector and possibly the banking sector could also face significant impact given that a third of banking sector loans are denominated in FX. Strict and pro-active enforcement of existing prudential measures to limit FX loans to only those with FX earnings should limit this impact.

The exchange rate recommendations

The IMF recommended a multi-step approach to exchange rate unification and flexibility. While such an approach carries some implementation and credibility risks, it seems appropriate given the need for monetary policy to support the economy and steps needed to move from the current system to a well-functioning exchange rate system. At the same time, it will be crucial to follow through with reforms without delays and not to backtrack, to ensure maximum effect. Likewise, clear and timely communications of the FX strategy to the private sector are also important to instill confidence.

Greater adjustment in the exchange rate should be allowed to facilitate CA adjustment (mostly through import compression in the very near term due to limited non-oil exports), eliminate the parallel market premium, remove and prevent further build-up of the FX backlog, and increase non-CBN participation in the I&E market window. To prevent excessive overshooting, the authorities should be prepared to increase interest rates if needed. Higher interest rates will also be needed if inflation accelerates.

All exchange rates should be collapsed into one well-functioning market exchange rate with the CBN conducting FX auctions through a pre-announced schedule following the immediate steps. This should be accompanied by a gradual removal of import restrictions and export repatriation requirements and the phasing out of CFMs.

Medium-term steps: The CBN should step back from its role of main FX intermediator in the country, limiting interventions to smoothing market volatility and allowing banks to freely determine FX buy-sell rates.

IMF advised contingency planning to address large downside risks. Further BOP pressures, through renewed capital outflows and/or weaker oil prices, will make exchange rate flexibility and unification even more urgent. In such a situation, it may be inevitable to temporarily tighten monetary policy to temper possible overshooting of the exchange rate.

Securing external fiscal financing including through borrowing from international financial institutions and issuance of Eurobond would bolster foreign exchange reserves. All available policy options should be considered to support macroeconomic stability and adjustment.

However, the Nigerian authorities did not agree with the need to adjust the naira.

The Nigerian government told IMF that the major burden of macroeconomic adjustment does not need to be borne by the exchange rate, as current pressures are not related to the exchange rate per se but rather reflective of global developments. In their view, investors exited most emerging markets at the onset of the pandemic and will only return when the public health crisis has waned, and global economic activity has picked up.

They further emphasized that Nigeria’s stable exchange rate has contributed significantly to price stability, one of the most enduring objectives of macroeconomic policy. Allowing further depreciation would add to rising inflation. They also emphasized that they are addressing the FX backlog and noted that turnover in the I&E window is on an upward trend.

But as Bloomberg noted, the disagreement underscores the policy challenges for the administration that has resisted growing calls from some businesses and state governors hurt by an artificially overvalued currency to liberalize the exchange rate. It also conflicts with market expectations for further devaluations after the central bank cut the value of the naira by nearly a quarter last year when oil prices collapsed during the pandemic.

Jesmin Rahman, the lender’s mission chief to Nigeria, said in an interview before the release of the report that the IMF’s recommendation is gradual but clear and has multi-step exchange-rate reforms, “so that everybody knows where Nigeria’s going, which is often more important than what you do in terms of devaluation,”.

Inflation in Nigeria reached a three-year high of 15.8% in December and while a 10% currency devaluation could push the rate up by as much as 2.5 percentage points, the impact would be less if the parallel exchange-market rate is already reflected in the prices of imported goods, the IMF said.

The central bank’s financing of the budget deficit must be phased to reduce inflation and higher interest rates may also be needed, the lender said. The central bank held its key rate for a second straight meeting in January.

The IMF warned that slow economic growth coupled with high inflation could continue to fan social discontent, which spilled over last year with protests against a police unit accused of torture and assassinations.

A slow rollout of Covid-19 vaccinations in Africa’s most-populous nation could threaten the IMF’s projections for economic growth of 1.5% this year, from an estimated 3.2% contraction in 2020.

Rahman said adequate vaccine roll out will Nigeria to speedy economic recovery.

“Nigeria has a way to go before ensuring adequate vaccine doses for its population, which will be critical to economic recovery. The IMF expects the economy to return to pre-pandemic era next year.”