EXCERPTS FROM JULY 2015 MPC

6.0 GARBA, ABDUL-GANIYU

Context of Decision

The global economic outlook remains uncertain, tenuous and tough for emerging markets and resource driven economies. The Euro-Greek crises, the busting of the Chinese asset market bubble and the persisting uncertainty about the timing of the US Fed’s rate increase have heightened uncertainties in global financial markets. For oil exporting countries such as Nigeria, the economic effects of the Iran P5+1 nuclear deal (potentially good for global security) are not likely to be positive if it leads to a weakening of the crude oil prices. Weaker oil prices could have adverse consequences for public, private, external and national accounts and cause expectations to be even more pessimistic with resultant pressures. Available macroeconomic data show that GDP growth has slowed down considerably from 6.33% in 2014 and 5.9% in the fourth quarter of 2014 o 3.96% in the first quarter of 2015. The GDP growth rate in the first quarter was 1.54% below the 5.5% projected for 2015. It would be short-sighted to ignore the fact that GDP has been trending down in the aftermath of the commencement of monetary tightening that began at the September 2010 MPC. Much of the opportunity costs of the deflationary policies have been disproportionate in terms of growth and employment losses. It would seem therefore, that the downward trending of the real GDP of real sector activities is part of the costs of the price stability that was achieved between 2010 and November 2014 as well as that of the exchange rate stability that was achieved until the ‘’Bernanke effect’’ of May 2013 began to unravel the stability of emerging markets.

Headline inflation which had trended downward from 2008:07 to 2014:11 began trending upwards in December 2014 such that between November 2014 (7.9%) and June 2015 (9.2%) headline inflation had risen by 1.3%. The 9.2% rate of inflation is above the 9% upper band of the target inflation band. The 9.2% rate of inflation is also, the highest rate since May 2013 (9.3%). NBS data indicates that most of the items that make up core and food inflation contributed to the rise in headline inflation in June 2015. It is not a coincidence that the rise in domestic price inflation started a month after the major policy shifts of the November 2015 MPC. Indeed, the evidence indicates that the paths of headline, food and core inflation have been sensitive to the downward revaluation of the value of the Naira on 25 November 2014 and on 19 February 2015. It is however, important to note that the exchange rate markets of emerging countries have been under pressure since June 2013 well before commodity prices slumped. It follows that the commodity price slump simply worsened an already deteriorating situation. The underlying cause of pressures has deeper roots in capital account liberalization (equity and debt) where it was a deliberate policy to fund the forex market and some foreign and Naira denominated bank loans with the savings of foreign players.

As far back as September 2011, I had been concerned about the lack of ‘’harmony between the fiscal system and monetary system’’ which I believed was ‘’critical to the medium to long term success of fiscal and monetary policies and indeed, macroeconomic management.’’ I argued, in my personal statement (September 2011) that it was of ‘’the outmost necessity, that the fiscal system be brought into harmony with monetary policy and to be bounded by the requirements for price stability, sustained growth in investment, employment, productivity and output. It is also, important that monetary system is similarly, bounded.’’ Then, it would have been possible to increase fiscal savings, build needed buffers and limit the need for foreign savings as means of funding the forex market and government deficits. However, the failure to bring fiscal operations within the provisions of the Fiscal Responsibility Act, 2007 meant that the fiscal savings did not reflect rising oil prices. The decision to relax capital account liberalization (equity and debt) was a choice for short term stability at great risk of medium term instability which began to crystalize in June 2013. The dangers of portfolio flows to medium term stability and the risks to the value of the Naira, the stability of the capital and money markets, to growth, employment, external balance and to financial system stability led me in January 2013 to warn against the ‘’sharp growth in portfolio flows (i) after October 2011 and (ii) after July 2012 (which were) well above trend’’. I argued that the effects of the growth in portfolio flows ‘’on the capital market already (signaled) that financial and macroeconomic instability (lay) in the future unless the right forward looking policies are implemented now . . . (and that the) effects of the last episode of outflows in 2008 . . . on the capital market, the banking system and the costs of bailouts are still fresh.’’

In voting for a rate cut at the January 2013 MPC, I sought to signal ‘’a commitment to macroeconomic stability now and, in the future and, to avoid history repeating itself at an even greater cost.’’ About four months later (May 2013), the dangers of portfolio flows to medium term stability began to crystalize in most emerging countries which imprudently raised rates to attract portfolio flows. The Bernanke’s mis-communication about tapering after the meeting of the US Fed on May 19, 2013 sent shock waves through the global financial markets triggering flight of portfolio capital from emerging countries. The evidence that the competitive capital account liberalization in emerging markets was imprudent is the forex crisis that was a consequence of the Bernanke effects.

Analysis made it clear that the financial flows to emerging markets triggered by episodes of quantitative easing in the global Central Banks which purchased toxic assets as means of injecting liquidity into their economies were unsustainable. While emerging countries including Nigeria raised rates to attract the ‘’hot money’’, the US Fed, European Central Bank and the Banks of England, Japan and China were reducing rates to stimulate their economies. Thus two traps prevailed globally: a low interest rates (US, Germany, UK and Japan) and high interest rates (most emerging countries). It was clear that exits from low interest rate traps by the US would unsettle global financial markets. It was also obvious that emerging markets will suffer the adverse consequences of the inevitable reversal of hot money flows. This is why one warned against the dangers of ‘’hot money’’ and repeatedly argued for forward looking and coordinated strategies to ward against the looming dangers given the experience of 2008 and its costs. The malfunctioning of the forex market is a major constraint to policy effectiveness and the way it is being addressed has significantly altered the framework for monetary policy.

The data shows upward trending of forex market spread (difference between official and BDC) from an N2.7 (January 1, 2013) to N3.19 (June 10, 2013), N14.76 (December 31, 2013) and N16 a day before the policy shifts of November 25, 2014. The rising forex spread is a clear indication of inefficiencies in the allocative mechanism and ineffectiveness of policy. After the policy shifts at the November 2014 MPC, the spread rose steadily to N42.32 on February 18, 2015 when the RDAS auction system was abolished. The forex spread (now the difference between interbank and BDC) widened further to N44 on July 21, 2015. Clearly, the mechanism for allocating forex in Nigeria is not working and needs an urgent fix to restore efficiency, effectiveness, credibility, transparency and liquidity. The real issue for me at this MPC (July 2015) are the weaknesses of the mechanism for allocating forex in Nigeria. The failure has adverse effects on growth, inflation, external balance and capital market stability as well as on the credibility of the interest rate corridor and indeed, the credibility of monetary policy.

Given the liberalization of foreign borrowing, restoring efficiency and effectiveness of the mechanism for rationing foreign exchange is also critical to financial system stability. A key area of failure besides the widening spread and the pressures to depreciate far in excess of fundamentals is the structure of allocation of forex and its implications for growth and external balance. Available data show that between January 2013 and June 2015, industrial sector (15.6%), transport (3%), agricultural sector (0.79%), manufactures (8.35%) and food (7.56%) combined accounted for 35.3% of total transactions valid for foreign exchange while financial services accounted for 38.33% out of which asset management (cash or portfolio management) took up 20.72% of forex. With oil imports taking up 15.65%, it implies that asset management and oil imports combined took up 37.37% of total foreign exchange sold for transactions valid for foreign exchange. It is hard to see how this structure of forex utilization could promote growth, investments, employment or macroeconomic stability. The issues for me at this MPC Meeting are not about tightening or loosening or about the flexibility of the exchange rate band. It is far more fundamental. It is about institutions, incentives, strategy, coordination and forward looking.

At the heart is the primacy of mechanism design and about leveraging on the new government’s positive signals about fiscal prudence, consolidation of NNPC Accounts in the Central Bank and possibility of re-starting production in the refineries to develop a macroeconomic management strategic framework for Nigeria. I am convinced that unless an allocative mechanism that restores credibility, liquidity and confidence is designed and operationalized, the opportunities for arbitrage and currency depreciation are more likely to persist and so would be the demand and related pressures. The idea of funding BDCs to narrow spreads has not been successful: spread has widened creating opportunities for arbitrage and short positions that self-fulfills depreciations.

I have never supported the shifts from WDAS to RDAS because there is sufficient evidence from credible researches to the effect that forex spreads tend to widen in RDAS regimes than in WDAS regimes because of the restrictions in RDAS and institutional weaknesses. There is also sufficient evidence on the high likelihood of collusion or rigging of rates by buyers in the auction system. In principle therefore, the greatest challenge is how to ensure that players play by the rules. This in turn implies that the mechanism must be rules driven, non-discretionary and non-ad-hoc.

I am convinced that the management of demand is unlikely to be successful without

(1) An efficient rule-driven or rules-based mechanism and

(2) An effective coordination of monetary policy design and operations with the design and operations of fiscal policy. An efficient rule-driven or rules-based mechanism developed within the mandate and frameworks of the Central Bank will prioritize industry and agriculture ahead of asset management and oil imports. An effective coordination of monetary policy design and operations with the design and operations of fiscal policy would significantly

(i) Reduce oil imports hence, demand for forex by oil importers (average of 15.65% of total forex allocation in 2013-2015);

(ii) Reduce dollar denominated subsidy payments as well as the claim of subsidy on the budget;

(iii) Increase fiscal savings hence,

(iv) Reduce dependence on portfolio flows to superficially shore up forex reserves.

Cautious Optimism I restate five of my fundamental convictions about Nigerian macroeconomic management process. First, a backward looking short termed monetary policy stance is inappropriate in a post global financial crisis central banking, financial market operations and global economy. Second, ‘’given the multiple principal objects of the CBN as provided for in Section 2 and the dual mandate of the MPC as provided for in Section 12 (1) of the CBN Act of 2007, a feasible framework for coordinating fiscal and monetary policy with macro and micro prudential policies is the top priority.’’ Third, improving market functioning in the forex, money and capital markets are critical to policy effectiveness and to the ability of fiscal authorities to achieve macroeconomic goals of growth, employment and stability (price and external). Unless the markets function well, monetary policy would not be effective at least from the view point of the commonwealth. At the moment all three markets are malfunctioning and blunting the effectiveness of monetary policy. Applying products of fast thinking (heuristics) to problems that require slow (effortful, purposeful and deliberate) thinking is a critical strategic error as is; a shortsighted view of macroeconomic management. Four, normalizing the expanded balance sheet of the central bank due to its interventions and costs of resolving the banking system crisis through AMCON is necessary and critical to medium term macroeconomic stability and policy effectiveness. Five, a dependence on the savings of foreign players to fund malfunctioning forex, money and capital market undermines medium term stability, allocative efficiency, fiscal discipline, growth, employment and financial system stability.

There is more than enough research evidence and historical experiences before and after the collapse of the Gold Standard to support my claim. Notwithstanding the negative global and national economic outlook, I am convinced that policy and strategy should not be based on pessimistic outlooks because nothing in the future is inevitable: it is the quality of current choices that will shape future paths. Indeed, some important positives in the recent governance system give me a strong basis for cautious optimism: the rise in accretion to reserves, stronger likelihood of fiscal consolidation and savings, easing of demand pressures from resumption of production at Warri and Port Harcourt Refineries and improved credibility of government pronouncements and; greater likelihood of a buy-in by fiscal authorities to a coordinated medium to long term macroeconomic management strategy for Nigeria.

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