US$40bn reserves: Is the naira not undervalued?

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In November last year, during the Annual Bankers’ Dinner of the Chartered Institute of Bankers in Lagos, Godwin Emefiele, the Governor of the Central Bank of Nigeria had projected that the country’s external reserves would hit the US$40 billion psychological threshold ‘before the end of 2018’. He probably did not envisage that his prediction would materialize just few days into the new year.The welcome accretion in reserves does not only reflect increased inflows on the back of higher oil output, uptick in crude oil prices, proceeds from successful Eurobonds issuances, as well as improvement in Diaspora remittances and foreign investments (thanks to the Investors and Exporters forex window), but also the apex bank’s proactive forex demand management strategy.

The exchange rate is simply the price of the domestic currency in relation to a foreign currency determined by market forces except in rare cases of complete fixed exchange regimes. Against this backdrop, the unprecedented increase in the country’s external reserves toUS$40.4 billion on January 5, 2018 fromcirca US$26.7 billion in January 2017 according to data from CBN,raises the question as to whether the monetary authority should not seize the opportunity presented by the healthy reserves to significantly influence a lower exchange rate, at least one that narrows the wide gap between the official rate of N305 per dollar for priority transactions such as external debt service and the interbank rate of N360 per dollar which is used for a sizeable number of daily transactions.

It will be recalled that following a slump in crude oil revenue (derived chiefly from the proceeds of crude oil sales)and shrinking external reserves towards the end of 2014, the CBN was compelled to devalue the naira from N155 per dollar to N168 per dollar in November of that year. When the forex crisis persisted, the apex bank again in February of 2015 implicitly devalued the naira pegging it at N197-N199 per dollar which was later in June 2016 abandoned in favour of a managed floating exchange rate regime. Not long after, plummeting foreign reserves resulted in the depreciation of the naira to as low as N520 per dollar in the parallel market leaving a wide premium over the official rate of N305 per dollar that fuelled widespread speculation and round-tripping. It bears repeating that the depletion in reserves was largely on account of low crude oil price and output amidst high import bills.

Today, this narrative has changed.According to data from the NNPC, oil production is currently in the region of 2.25 million barrels per day (increasing from 1.69 mbpd in Q1 2017) due to relative peace in the Niger Delta region. Similarly, crude oil price has touched the US$70 per barrel psychological threshold while foreign reserves have surged to US$40.4 billion from about US$26.7 billion in January 2017.   On the demand side,import bill is recorded to have dropped from over US$5 billion in 2015 to about US$1.5 billion in 2017. In view of these improvements and phenomenal growth in external reserves, is the naira not currently undervalued?What is more, headline inflation has been on the downward trend from 18.72 percent in January 2017 to 15.90 percent in November last year. Yet, there has been no marked improvement (appreciation) in the interbank exchange rate since May last year in the light of the rise in the United States inflation rate from1.87 percent (year-on-year) in May to 2.2 percent in November 2017. So even from a Purchasing Power Parity perspective which takes into account relative price levels between countries, the naira seems undervalued vis-a-vis the US dollar.

To be sure, the CBN needs respectable foreign reserves to be able to safeguard the value of the naira, manage exchange rate volatility through sustained interventions, meet international payment obligations (the federal government is expected to repay US$500million on the maturity of its July ’18 Eurobonds this year), as well as provide a buffer against external shocks such as the recent crude oil price crash that plunged the economy into recession.No doubt, an optimal level of international reserves improves acountry’s credit worthiness.But the big question is: what level of external reserves is considered optimal for Nigeria? A study by Tule et al in 2015, which sought to determine an optimal level of foreign reserves for the country,provided a clue when itestablished a minimum core foreign reserves level of US$32 billion (being the equivalent of 7.2 months of import).It is instructive to note that the IMF recommends 3 months of import cover as a minimum benchmark for reserve.

At present, the stock of the country’s foreign currency, largely denominated in dollars, is said to be sufficient to finance more than 14 months of merchandiseimports. By implication, the supply of dollars has improved considerably. On the demand side, the CBN through some proactive measures including the restriction of access to official forex in respect of 41 items of import have succeeded in halting the haemorrhaging of the country’s external reserves.It is against this backdrop that a lower exchange rate is justified to support economic development.

Indeed, a weak currency is not in the interest of a mono-product country such as Nigeria especially now that the federal government is turning attention to foreign borrowing to bridge budget gaps. It is often argued that a country can boost growth by weakening its currency because doing so promotes exports but this strategy is not a one-cap-fits-all recipe. For instance, the People’s Bank of China (the country’s central bank) currently holds overUS$3 trillion of foreign exchange reserves and can afford to keep the Yuan (also known as the renminbi or RMB) weak which explains why it will buy US currency and treasury notes in the open market in order to keep demand for the US dollar high and cheapen the Yuan thereby facilitating the United States’ growing trade deficit with China which gives the latter an advantage in the export market. So, unlike Nigeria with a shallow export base, China can afford to power her export economy via a weak Yuan.

In his reaction to a call by the IMF, following the Fund’s article IV Consultation with Nigeria, to have the naira devalued some time ago, the former CBN Governor, Lamido Sanusi, had told CNBC Africa television that “we do not believe that the naira is overvalued. We do not believe that at a time when the oil price is going up and output is going up we should be losing the value of our currency. We also do not think that it makes sense, if the IMF is concerned about inflation, to ask a country that is import-dependent to devalue its currency. So the advice given by the IMF, frankly, is not based on sound economic logic”. This assertion by Lamido Sanusi is as true today as it was in 2011. By implication, the way forward is to reduce the country’s import dependency and strive to join the league of net exporting countries led by China. In the meantime however, there is the likelihood that the country’s external reserves will continue to enjoy more accretion in the course of 2018 if the OPEC/Non-OPEC member countries’ output-cut agreement (which extends till the end of this year) coupled with increased optimism about the global economy is anything to go by.Therefore, having largely achieved exchange rate stability in the forex market, the concern of the CBN now should be geared towards managing the growing external reserves in a manner that supports a stronger domestic currency.

Uche Uwaleke

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