Getting Inflation Regulated In Nigeria!

For Nigeria, inflation rate remains high and is causing great pain and misery to much of the teeming population. It has increased steadily in recent time. The attempt to control prices, to build up a parallel market system, and to police the existing market participants will not work. Price controls and other regulatory interventions will have the opposite effect intended. A parallel market will turn out to either be too small to be relevant or will be extremely expensive for the economy. There is widespread agreement among economists that such market interventions will not work.

Policies to arrest traders, raid local enterprise, accuse persons of speculation; etc will all have the opposite effect intended. If you make people sell out their local entrepreneur then there will be nothing for the future and the prices will go higher than ever. If you accuse a trader of criminal behaviour he will stop trading. It is easy to say that the banks should make loans to new importers not really known to the bank but this is risky. If the new importer does not repay his loan who is going to help the bank? These are complex judgments – the ideas of an infantry officer on credit extension is about as valuable as the idea of a loan officer on where to place a machine gun.

The government should stop these at once. A restrictive monetary policy will work to control inflation if the Naira revalues significantly and then stays approximately marginal to the dollar. The Central Bank can implement a tight monetary policy by insuring that foreign exchange reserves do not increase, foregoing accumulation of foreign exchange reserves by allowing the Naira to appreciation and then allowing the growth of private sector credit consistent with the money supply target. The cost of this will be borne by the exporters who will lose significant competitiveness. But it will limit the inflation.

There are three ‘pure’ reasons for the inflation; reality may be a mixture of two; but one of the suggested explanations is bogus. These three are: (1) There is too rapid a growth of the money supply arising from excess demand in the economy and a permissive monetary policy; (2) the prices are rising due to external price increases and depreciation of the exchange rate; and (3) there are syndicates that artificially raise the prices through monopolistic pricing. These three views in one way or another dominate the discussion of inflation everywhere. Economists largely believe that the inflation is caused by excess growth in the money supply arising from too much credit being made available to the private sector or to the government. Although these concepts are commonly used I will explain their significance as I understand in the context of the Nigeria economy.

Excess demand is easy to understand – if the government circulates more money to build a lot of roads then the recipients of these funds, the workers and contractors will spend and the money will circulate around. The increased purchasing power will cause prices to rise if the supply is not available to meet the demands. If the cost of producing these additional demands is higher than the existing production costs then there will be a tendency for prices to increase. If the economy is near full employment then indeed production costs will have to increase to raise output. This is the case for an economy where international trade is not important.

Usually the inflation rates are quoted at annual rates based on the price index at time periods one year apart or the inflation rate on an average of the index over a 12 month period. In this write-piece I am using a more appropriate measure of the ‘instantaneous’ inflation rate that indicates the rate now relative to the recent past. Rather than use monthly rates which are too volatile or annual rates which do not show current changes I present the data in my monthly “nigeria4betterrule” analytical quarters using annualized rates of change. This more appropriately reflects the changes that are taking place now referred to the recent past. Referring to the rate over a year does not reflect the sense of price increase that the population is confronting. The approach used in this of looking at the inflation rate I think better conveys the sense of how prices behave. This suggests things are worse than the annual data indicates; annual data does not convey the sense of increased prices felt by the public. The inflation rate is around 10 per cent but there is one quarter when prices are stable and another where the rate is now much higher than 10 per cent.

There are two special cases. First, if there is a lot of unused capacity and unemployed labour, then domestic production can increase to the advantage of all and there will be little inflation. The increased demands will be partly for traded goods, that may be imported, and partly for non-traded goods and services that cannot be imported but must be supplied domestically. Thus the demand for electricity may increase – generally cannot be imported – and again the demand for television sets may increase, these can be imported if domestic producers cannot produce enough. This is the Keynesian situation where an economy is positioned far below its production capacity and increasing purchasing power will raise output with limited inflationary impact.

The second special case is for an economy where international trade is important, the economy is near full employment, and demand pressure is largely managed by increased imports. This may not involve any change in prices. Thus in response to greater demands goods may be imported at the old price so there is no inflation. The non-traded goods that cannot be imported may or may not experience rises in price due to the domestic demand. But eventually unless one borrows more and more from abroad without difficulty the rising flow of imports will cause the exchange rate to depreciate and prices of traded goods in domestic currency will increase. In Nigeria, cost push inflation comes from external prices rising.

The most dramatic example is the cost of petroleum products; the world price goes up but in Nigeria the government is controlling the domestic market price. As a result, the price does not increase until the government decides it is appropriate. Of course, the government has to pay for the difference between what people pay for the petroleum and what is paid to the foreign supplier; so the government does not do something that it would like to do [e.g. raise policemen’s salaries] as so much money is needed to pay for the petroleum products. In contrast, if the price of rice goes up, due to higher import price, then if it is to be sold for what it costs to buy, the price will become higher. If petroleum products are cheaper in Nigeria than her West African neighbourhood then these products will be smuggled out to her West African neighbourhood.

More important are the food prices which are linked to the West African neighbourhood food prices as the border is effectively open. Of course, there are fences and guards etc, but these are not sufficient to separate the markets and food will move back and forth according to the price differences. As the West African neighbourhood food market is so large Nigeria will be a price taker; whatever the West African neighbourhood market price it will strongly influence the price in Nigeria. The Nigeria wholesale price will be the Indian wholesale price multiplied by the exchange rate plus the cost of moving the rice. The retail prices may be quite different depending on the marketing procedures. If the price in Nigeria is lower than in West African neighbourhood, rice will leak out to West African neighbourhood tending to raise the price in Nigeria; if the Nigerian price is higher than the West African neighbourhood price then there will be rice moving across the border from West African neighbourhood. This will tend to lower the price in Nigeria. The prices will move towards a

common value but most of the adjustment is likely to come on the Nigeria side. Food price inflation in Nigeria comes from either rising West African neighbourhood food prices or the Naira/dollar exchange rate increasing [i.e. the Naira getting weaker with respect to the dollar.]

Unfortunately, this is one of those arguments where no one is listening. The academics are so convinced that some evil businessmen are engaged in this collusive monopolistic pricing that there is no sustained attempt to investigate the behaviour of prices carefully. Work has been done on the share of the market that may be covered by a group of merchants but this turns out to be pretty small once one includes the domestic production. Generally controlling the import market is not enough to keep raising prices from exercise of monopoly power. Refined oil products are imported by many persons, smuggled, and produced and traded by even more. It is very difficult to imagine a conspiracy that includes all of these people. Indeed in most markets in Nigeria the competition level is fierce and people are undercutting each other to try to get advantage. Business behaviour is to sell at all costs and worry about the gains and losses later.

In Nigeria the favourite cause of anything going wrong is an evil businessman or government official. There is a great deal of press attention and even from academic economists that the evil businessmen are sitting in the backroom getting together to raise the prices and exploit the poor Nigerian people. This is a constant refrain in Africa – middlemen are taking advantage of the people by raising the prices when they are selling and reducing the prices when they are buying. There is remarkably little empirical support for such a claim. To make this work it seems to me that there are two possibilities. One is that the ratio of the retail to the wholesale price would increase…since the retail prices are rising; one place the margin may be increasing is between the retailer and the wholesaler. There is no evidence in Nigeria for this. The ratio of the retail to the wholesale price does not vary very much for the main crops and certainly there is no systematic increase that would be necessary to sustain a substantial inflation. The ratio for rice and wheat fluctuates with the season and with supply conditions, but there is no systematic trend.

Another possibility is that that there is a systematic increase in the wholesale price compared to farm gate prices. This is harder to determine as the data on farm gate prices are not as good as market prices and the ratio will differ with the time since harvest. Of course it tends to rise as there are storage costs and losses incurred from a farmer refraining to sell. Such information as is now currently available on the farm gate – wholesale market link does not show any systematic change in this ratio. So I see little reason to think that the price of rice is systematically rising from this source. The difference between the retail price and the farm gate price has not increased more than can be explained by transport costs. Over time improved transport systems are actually lowering the costs of moving commodities. With the farm gate to wholesale market ratio and the wholesale to retail ratios not increasing where is the inflation caused by the marketing system?

The political cabals’ menace in Nigeria is not a convincing explanation. This is a view that has no empirical support and is based on the anti-business caste system somehow still alive and well in this country. When the money supply increase has been rapid it is hard to understand how the purchasing power will be distributed into the hands of the masses. Indeed the evidence is that much of the population does not gain a great deal from the strong economic growth. Foods with significant price increases include most of the ordinary goods. How the money supply is a force to raise demand for these goods is not clear.

For non-food items more of a case can be made. The best explanation for the increase in food prices is due to the changes in the external food prices and the Naira-dollar exchange rates. The food prices then induce further changes in non-food prices as wages go up to offset the higher food prices. The inflation slowly spreads through this country; Nigeria. Inflation will hurt the poorest the most, as these men and women have the least ability to protect themselves from rising prices. The growth of the money supply surely contributes to the inflation by permitting the triggering food price increases to spread through the economy. Hence, if the GDP growth is only 4 per cent then if 17 per cent growth in the money supply is maintained the inflation rate will be 10 per cent! If one thinks that the GDP growth rate is going to be low then the money supply growth target must be much lower; in this example 12 per cent. Typical of the inflation target planning is to estimate the allowed growth of GDP, the target inflation, and an allowance for financial deepening so as to determine the target growth of broad money.

If you look at the scenario and consider the probable growth of the GDP in the current financial year the growth of broad money should not exceed 12 per cent. This will stop the inflation but it will also block any prospect for coming out of the low growth rate. This is a terrible choice to be made! If the economy is encouraged to grow rapidly then the money supply growth must be 17-18 per cent and a rate of inflation of 8-9 per cent acceptable. This is a most difficult policy choice. In late-2009 following the appointment of Mallam Sanusi as the CBN governor; the demand for loans from the banking system was curtail, regulated and monitored bringing the loan-rush to decline. The credit availability impact on growth of broad money has slowed as a consequence of behaviour change. Consequently, the monetary policy now has little impact on the economy.

Summarily, cost push inflation comes from a triggering effect such as a depreciation of the Naira. This raises the essential commodities’ prices in Nigeria as well as other imported raw materials. As time passes there will be demands for higher wages to offset some or all of this increase in the food price. The higher wages in different sectors of the economy will raise the prices of non-traded goods or domestically produced industrial goods. In this manner the triggering food price increases will spread through the economy. How rapidly they spread depends on many things including the willingness of workers to work at lower real wages, institutional arrangements etc. In Nigeria little is known as to the speed with which prices and wages will respond to the change of the exchange rate and food prices.

Actually, although economists like to talk about cost push and demand based inflation, these are really the same thing. If the money supply does not increase – the central bank has a strict monetary policy – then the triggering price increase will have two effects – the price increase will be reversed or alternatively the GDP will decline. Monetary policy will always work! But the cost may be very high if the result is to reduce GDP rather than to roll back the price increases. How the division between reducing prices and reducing output will work out is a difficult question. For the essential commodities prices in Nigeria I would expect most of the adjustment would be in the level of the GDP, since reducing the food prices is very difficult due to the linkage to western world prices. However, the appreciation of the exchange rate will have some effect in reducing essential commodities prices; the impact of a stronger Naira on the prices of other domestically produced goods is uncertain.

Finally, the traders are not stupid. If they thought that there was a syndicate at work driving up prices they would buy products now and then sell when the price was driven higher. In other words the speculative behaviour of other persons outside the synd

icate would drive up the price very rapidly and persons not in the syndicate would gain a lot of the monopoly benefits. This makes running a syndicate almost impossible since outsiders are going to act in such a way as to spoil your game.

Policies to arrest traders, raid street bureau de change, accuse persons of speculation; etc will all have the opposite effect intended. If you make people sell out their street bureau de change then there will be nothing for the future and the prices will go higher than ever. If you accuse a trader of criminal behaviour he will stop trading. It is easy to say that the banks should make loans to new importers not really known to the bank but this is risky. If the new importer does not repay his loan who is going to help the bank? These are complex judgments – the ideas of an infantry officer on credit extension is about as valuable as the idea of a loan officer on where to place a machine gun. However, if the Central Bank of Nigeria (CBN) allows the Naira to revalue it will certainly slow inflation regardless of the growth of the money supply but this will contribute to slower economic growth.

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