Since 2014, oil prices have fallen by well over 50 percent, from $115 per barrel in June 2014 to under $50 per barrel.1 For many countries, this has brought a welcome boost to their economies as consumers and businesses have benefited from lower fuel and energy prices. But for some oil producing countries, falling oil prices have been disastrous, bringing rapid foreign exchange rate falls and affecting government and private sector finances. Few have been harder hit than Nigeria.
Dependence on oil production creates economic fragility
Nigeria’s principal export is oil. In fact, oil is almost all it exports. Despite worsening terms of trade, oil production still contributes over 10% of Nigeria’s GDP.2 Nigeria is dependent upon imports of essential foodstuffs and raw materials. It is even dependent on gasoline imports, since it produces no refined petroleum products itself. Nigeria’s economy is a clear example of what is known as “Dutch disease.”
As defined by the Financial Times’s Lexicon, “Dutch disease is the negative impact on an economy of anything that gives rise to a sharp inflow of foreign currency, such as the discovery of large oil reserves. The currency inflows lead to currency appreciation, making the country’s other products less price competitive on the export market. It also leads to higher levels of cheap imports and can lead to deindustrialisation as industries apart from resource exploitation are moved to cheaper locations.”3
During the boom years of oil production, US dollars flowed into Nigeria, causing the foreign exchange rate of its currency, the naira (NGN), to rise versus the US dollar and enabling the country to accumulate billions of US dollars as foreign exchange (FX) reserves. The rising dollar exchange rate attracted imports and made non-oil exports uncompetitive, while the oil revenues discouraged other forms of production. As long as the oil price remained high, Nigeria was a rich country. But once it began to fall, the underlying fragility of the economy became apparent.
Manipulating currency exchange rate has repercussions
The price of oil started to fall in mid-2014, as demand from Asia slowed and American shale oil production increased. Like most other oil producing nations, Nigeria initially responded by allowing its foreign exchange rate to depreciate versus the dollar, protecting the country’s FX reserves but risking inflation. But in March 2015, Nigeria’s central bank decided that the risk of inflation from allowing the naira’s foreign exchange rate to fall was too great. The naira was pegged to the US dollar at around 198 to one. And there it remained for over a year.
Pegging the naira to the US dollar did not prevent inflation, as the central bank had hoped. Price inflation – already high at around 8 percent in mid-2014 – rose despite the peg, reaching 16.4 percent by June 2016.4 This was due to the growth of an unofficial USD-NGN FX market. The unofficial rate soared, pushing up prices in Nigeria’s import-dependent economy.
Meanwhile, maintaining the peg was fast burning through the country’s US dollar reserves. In an attempt to stem the outflow, the central bank restricted the availability of US dollars to “strategic imports” only, starving businesses of essential hard currency and deterring much-needed inward investment. In the first quarter of 2016, the economy went into recession, amid rising unemployment and growing shortages of essential goods and fuel due to the US dollar shortage.
Averting a foreign exchange crisis
Despite the central bank’s restrictions, US dollars continued to drain out of the country as the official and unofficial US dollar foreign exchange rates diverged.5 By June 2016, the unofficial currency exchange rate was well over 300 NGN to the US dollar and Nigeria’s reserves had fallen to $26.5bn, sufficient for less than five months of imports.6 The spectre of a foreign exchange crisis and an IMF rescue began to loom.
On June 20, 2016, the Nigerian central bank abruptly floated the currency. The naira’s currency exchange rate versus the US dollar promptly collapsed to around 282. The central bank soft-pegged it at 282-285 for the next month, but the reserve drain to maintain this proved unsustainable: in July, the central bank stopped supporting the currency. On July 28, the US dollar exchange rate dropped to a record-low of 322 NGN. It had fallen by 14.2 percent in one month and 61.8 percent in annual terms.7
Rapid currency exchange rate depreciation can be painful. In July 2016, high inflation forced Nigeria’s central bank to raise interest rates to an unprecedented 14 percent.8 For an economy already in recession, this was very bitter medicine.
When a country is experiencing FX outflows, for example because it is an oil producer and the oil price is falling, its foreign exchange rate naturally falls. If the central bank tries to prevent the currency exchange rate from falling, the country’s FX reserves may gradually be depleted: if the country imports more than it exports, and is unable to pay for imports in its own currency, it can conceivably run out of money.
Nigeria was facing such a crisis until it allowed its currency exchange rate to float against the US dollar. It is not yet out of trouble: its FX reserves are very low, it has high inflation and its economy is in recession.9 Now the question is whether Nigeria has created an opportunity to supplement its dependence on oil production by developing a well-diversified, sustainable economy for the future.