External reserves, interest rates, and external shocks, By Uddin Ifeanyi

Central Bank of Nigeria (CBN) on the need for a Trade Remedies Legislation — Central Bank of Nigeria (CBN)

Over the next two days, the policy committee of the Central Bank of Nigeria (CBN) will meet. By late afternoon, tomorrow, the central bank’s governor should, at a press conference, announce the Monetary Policy Committee’s (MPC) decision. Markets are betting on members agreeing to cut a couple of percentage points off the monetary policy rate. The size of the cut will matter. A quarter of a percentage point will be considered conservative. Half a percentage point, bullish. The point of either cut is that the rate of increase of domestic prices have continued to slow. At 20.12 per cent year on year, the headline inflation rate was down last month on July’s 21.88 per cent. The size of the MPC’s interest rate cut could then be taken as indicative of members’ sense of both the direction and pace of price deceleration through to the end of the year.

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Are there any other reasons why the cuts should matter? By increasing interest rates some months back, the central bank did, indeed, play out its role of the “chaperone who has ordered the punch bowl removed just when the party was really warming up”. There is cause to believe that business investment tapered off under the weight of the ensuing higher borrowing costs. And anecdotal evidence suggests a thinning of shop market aisles as consumers restructured their spending patterns. Government’s domestic debt charge went up a smidgen – ideally constraining governments ability to borrow more, and, hence, to spend (in ways that have previously exacerbated domestic price concerns). Throw in the price reforms in the foreign exchange markets, and the general sense of economic gloom that ensued was overt. On paper, an interest rate cut, therefore, should augur well for the economy’s general welfare. Businesses’ borrowing costs ought to trend down just as lower inflation numbers support domestic demand – ideally supporting new levels of investment over the medium-term. Government may also borrow more cheaply to finance both its reform efforts and its drive for new infrastructure.

Behind this Goldilocks outcome is the often poorly told story of the CBN’s management of the nation’s foreign reserve balance. From the low levels that the gross numbers were when the incumbent government took over, the central bank has bumped up the balance on the gross external reserves to about US$42 billion. Ideally, this ought to reassure the economy’s external partners of its ability to meet its external payments obligations on time and as promised. The current CBN leadership’s decision to free the foreign exchange markets (by reducing some of the speculative fizz in the foreign exchange markets) obviously helped ease the upward pressure on the naira’s exchange rate and allowed the naira to move within a much narrower exchange rate corridor. To some extent, however, the increase in the balance on the gross external reserves reflects the benefits of more foreign exchange inflows, on the back of more transparent price discovery processes and efforts by global fund managers to take advantage of the spread between the nominal yield on naira-denominated assets and that on dollar-denominated ones.

This carry trade is the reason the central bank reported a surplus in its balance of payments account of US$6.83 billion last year, as against the deficits of US$3.34 billion and US$3.32 billion recorded in 2023 and 2022, respectively. Disaggregate the 2024 balance of payments numbers, and worries start to build up. US$1.08 billion net foreign direct investment inflows versus (or is it, plus) portfolio investment inflows of US$13.35 billion, means that, according to an expert on this matter that I listened to last week, Nigeria has simply “borrowed the stability it has enjoyed in recent months”.

He is convinced that any shock that rapidly reverses the flow of hot money into the country would leave us in a far worse scrape than the one that the CBN’s projected benchmark interest rate cut suggests that we have seen the worst of. The shocks could be external. And if you include the possibility of Israel’s multiple wars in the Middle East lending a fillip to global oil prices, they are not all negative. But the shocks could also be endogenic. And the balance of risks to the domestic economy is on the downside, including from the fiscal improbity that we all expect will lead into the next election cycle.

What ought the central bank to do? Continue to cleave to its price stability remit. The reforms that would drive industrialisation and the flows into the economy of funds that help build plants and factories lie solely in the government’s subject area. In this context, it then matters that economics literature suggests that the naira’s exchange rate is the most efficient tool for addressing the gap between our domestic inflation level and that of our trading partners. If this is true, then an easing of monetary conditions now might be premature. Better, therefore, that the MPC refrains from acts that may worsen the negatives from headwinds that the economy may face over the next one year.