Need for the Dollarization the Nigerian Naira

It must be said that exchange rate depreciation can have both positive and negative effects on an economy. It can encourage exports and discourage imports. That is why a country like Japan (and most Asian economies) that is export-oriented winks and frowns whenever the Japanese yen appreciates because the appreciation of the yen makes Japanese goods more expensive in the world market. Thus essentially, depreciation (or devaluation) is used as export-oriented macroeconomic strategy. So why are Nigerians so worried by the depreciation of the Naira? Well, it all depends on the nature of your exports and imports and the elasticity of demand and supply of the exports and imports. Mind you; Economics is full of jargons, I can hear you grumble. Elasticity just means how demand and supply respond to small changes in prices (of imports and exports). Since we import virtually everything, it makes our demand for imports price inelastic – that is changes in prices is unlikely to let us change our demand for imports in any perceptible way. And remember, to buy imports from say America, we need American dollars, and this puts so much pressure on the value of the Naira. What about our exports? Who needs so much Oil, Groundnut and Cocoa? And there is some much Oil in the world market. If we increase the price of our Oil, consumers will shift to Arabian oil, or simply other substitutes like Natural gas. And if we reduce the price of our oil, which we must through depreciation in order to be competitive in the world market, consumers are not going to increase their consumption of Oil because of that. Think about it this way: are you going to consume more salt because the price of salt has declined? Absolutely not! Even though we decrease the price of our Oil, the demand does not increase much to make up for the decline in price. The supply of foreign currency from the sale of our exports is thus low, and this makes the value of the Naira depreciate.

In a 1992 study, economist Allen Kremfield found out that if Nigeria adopted the trade and real exchange rate regimes of Bangladesh, Nigeria could add almost 5 percentage points to its growth. Similarly in my 2003 graduate study thesis I developed a macro -econometric model of Nigeria (available on request). In spite of its imperfections, the model closely predicted the real economic growth of Nigeria (an average of 3.84% for the period 1989 – 2004, which is similar to what Nigeria has been achieving during that period). In this model, I found out that if the Naira appreciated by 40 points, economic growth declined from 3.83% to 3.61% for the period 1989 – 2004, while real export growth declined from 3.80% to 2.05% in the same period. The implication of such studies is that keeping the price of the Naira right is imperative for economic development of Nigeria. Depreciation (devaluation) of the Naira may have two significant advantages: first it may act as incentive to producers to produce for export; second, it may increase the country’s competitiveness in its exports by making the prices of Nigeria’s exports cheaper in terms of foreign currencies.

The key questions are that to what extent can the Naira be allowed to depreciate? What level of exchange rate reflects the economic fundamentals of the country? These are really hard questions that require answers from lot of studies. I hope the Ministry of Finance and or the Central Bank Of Nigeria (CBN) is/are commissioning such studies. If they are not, they need to do that. It must, however, be said that relying on depreciation (devaluation) alone to promote exports may not be effective, especially for a country like ours that exports primary commodities whose demand is low and face severe competition even from synthetic substitutes. It may take the support of other policies such as concrete incentives (such as export subsidies) to exporters who put value to their products before export, gradual liberalization of imports, and the maintenance of positive interest rates and low inflation to encourage savings and discourage investment in unproductive “inflation hedges” and speculative activities.

Well, it seems to me that there is nothing, or very little Nigeria can do to arrest the decline in the value of the Naira in the short-run as so long as we take the path of floating exchange rate. The CBN or the monetary authority apparently does not have enough reserves to intervene in the foreign exchange market. In the long run, our only hope in stabilizing our currency along this chosen path is through SOUND MACROECONOMIC MANAGEMENT: deal with inflation, cut down government deficits, shore up interest rates, export more but add value to our exports, address the current account deficits, etc. Why have we not learned that by now? Have we?

In addition, Nigerians abroad may have to increase the remittances to their relatives (it turns out that this is a very good source of foreign currency supply in Nigeria). Not only should Nigerians resident abroad send remittances, they should be encouraged to invest in Nigeria in productive activities or buy Nigerian stocks and bonds and save in Nigeria. While on remittances from Nigerians abroad, let me make one suggestion in that regard. I think Nigeria should consider entering into Tax Treaties with some of the developed countries, especially Britain, Germany, Holland and the North America (US and Canada) which host most Nigerians abroad. Such treaties should allow Nigerians working abroad to pay a portion of their taxes, for example 50%, to Nigeria. I intend to write in detail about this proposition in another article, time permitting.

Again, there are two other options available to Nigeria that can be pursued to ensure exchange rate stability. These are “dollarization” or “poundization” (adopting the dollar or the pound as our currency) and entering a monetary union or a currency board such as the CFA with our Francophone friends in the sub-region. A currency board and dollarization are not very different – technically they are substitutes. The basic difference between the two systems is that under dollarization (poundization) a country loses seigniorage (the profit from issuing the monetary base) to the United States (Britain) whereas under a currency board it retains the profit. In the light of this, I would like to restrict the discussion to explaining the basics of dollarization (poundization).

Ironically, because of the lack of confidence in our Naira, Nigeria is already dollarized in an unofficial sense. While the Naira is still the medium of exchange, it has virtually lost its other functions, particularly as a store of value. Under official dollarization (or poundization), all Naira notes and coins (do we still have them in Nigeria?) would be replaced by dollars/pounds, and all Naira assets, liabilities, and prices would be converted into dollars/pounds at the exchange rate of 1 Naira = 1 dollar/pound. Nigeria’s monetary system would become like that of Panama, the best known dollarized system of today and like Ecuador and 27 other countries and dependent territories that use only foreign currencies. Dollarization (poundization) promises a way of avoiding currency and balance of payments (BOP) crises. Without a domestic currency there is no possibility of a sharp depreciation. Besides, sudden capital outflows motivated by fears of depreciation (devaluation) are ruled out.

What are some of the benefits of dollarization/poundization? One major benefit of dollarization (poundization) would the re-adjustment of interest rates in Nigeria. With no Naira-dollar (Naira-pound) exchange rate, currency risk would be eliminated, and the spread in interest rates between Naira and dollars (pounds) for loans within Nigeria would be closed. The elimination of sharp exchange rate adjustments will, it is expected, bring about significantly more stable international capital flows. The elimination of the risk of currency crisis would lead to a reduction of country risk premia, and a

consequent lowering of interest rates.

Consequently, lower interest rates and more stable international capital movement would lead to a significantly lower cost of servicing the public debt, and also lead to a higher level of investment and economic growth. There are other expected benefits from dollarization (poundization). It is expected that dollarization (poundization) would promote a closer economic and financial integration with the United States (Britain) and the global economy – lower transaction costs and stability of prices in dollar (pound) terms. By rejecting the possibility of inflationary finance, it is argued that dollarization (poundization) might also strengthen institutions and create positive sentiments toward investments. The impact of some of these benefits is highly difficult to quantify though.

Furthermore, it can be argued that dollarization (poundization) may make a bank run less likely. With all monetary assets dollarized (poundized) and without significant currency mis-matches in the banks’ positions, depositors may be more confident in the domestic banking system. Dollarization/Poundization is expected to encourage a strong presence and active role of foreign banks in the banking system. This would reduce the danger of a weakened lender of last resort (LLR) function of the central bank, because those banks could indirectly bring support from foreign central banks, and depositors’ confidence in the financial support of those institutions would likely be higher.

But Not Without Its Costs;If dollarization (poundization) offers such potentially great attraction because of the benefits a country can obtain from it, why is that countries have not jumped on its bandwagon? Well, like we famously say in Economics, there is no free lunch. In other words, dollarization (poundization) is not without its costs.One of the obvious problems of dollarization is that it would draw strong reaction from political quarters because our currency is our national symbol, a symbol of our political independence and autonomy. To some, the adoption of such a system will be tantamount to giving up our country for re-colonialization. In other words, politically some people argue that dollarization (poundization) constitutes an infringement on a country’s sovereignty.

Moreover, it is argued that dollarization would limit the country’s ability to deal with domestic macroeconomic issues. Thus the country loses the means of coping with external shocks to the economy, because the monetary authority is robbed of the possibility of having an autonomous monetary and exchange rate policy, including bank credit to provide liquidity support to the banking system.
Not are these all. A country adopting a foreign currency as the legal tender would forgo its seigniorage rights. Seigniorage is the profits accruing to the monetary authority from its right to issue legal tender currency. For most countries, seigniorage is a very significant source of revenue to the government because currency, and sometimes all base money (the central bank’s liabilities) is non-interest-bearing debt. Thus by dollarizing (poundizing), the country loses the seigniorage revenues to the United States (Britain), unless the US (Britain) decides to share part of the extra seigniorage it will obtain.

What is more, to adopt the dollar (pound) and withdraw the Naira from circulation exchanging it for the dollar, the monetary authority (government) would have to “purchase” the stock of Naira held by the public (and banks). This will require foreign reserves to convert the monetary base into dollar (pound) assets. Does Nigeria have the reserves to meet such a challenge? In addition, the adoption of a foreign convertible currency as a country’s currency makes that country particularly vulnerable to pressure from the country issuing the convertible currency.

Those were some of the pros and cons of dollarization. It must, however, be said that the same beneficial results of dollarization (poundization) could be obtained with a fixed exchange rate system that is supported with appropriate fiscal and monetary policies.

Given the persistence of inflation in Nigeria, the government’s penchant for deficit financing, our inability to diversify and increase our exports, thus saddling us with persistent current account deficits and balance of payments problems, I think that Nigeria should give serious considerations to these alternative exchange rate arrangements: pursuing dollarization (poundization) or forming a currency board/zone (with the existing CFA zone) or forming a monetary union with other ECOWAS members. I am not particularly sure if the sub-region is ripe for a monetary union though given the economic problems that belie the individual economies. Obviously, a great deal of studies and consultations are needed to determine whether or not such monetary/exchange rate arrangements would be helpful to our economy. As of now, we do not have enough evidence to make a conclusive decision about these alternative arrangements. One thing is clear though: none of these arrangements is the “elixir of life” for our economy. In effect it should be clear that regardless of the monetary system adopted, there is no escape from the need to implement sound fiscal and prudent monetary policies. This compares to Sound Macroeconomics of Nigerian Naira.

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