- Improved competitiveness, in part through the real effective exchange rate, can transform the structure of a country’s domestic production.
- An overvalued naira is functioning as an export tax and challenging Nigeria’s economic transformation and diversification away from the oil sector.
- Learning from Indonesia and other countries, devaluations can be an effective currency intervention to allow diversification for economic transformation.
Competitiveness as a precursor to transformation
Economic transformation often denotes a move away from low-productivity to high-productivity growth. Promoting economic transformation in the aftermath of shocks is one strategy for developing economies to build resilience to further shocks. This is particularly true for resource dependent economies, given that they are more vulnerable to shocks. Many of these countries are still managing the fallout from multiple economic shocks, including the continued effects of the commodity price downturn. Fuel exporters saw GDP growth fall from 5.7% in 2014 to -1.6% in 2016 and these countries now face the risk of external debt distress.
Devaluation has long been considered a successful part of industrial policy. It has stimulated growth in both China and India, as well as in Uganda and Tanzania, making them more competitive economies in the long term. A competitive economy engaging in foreign trade can transform the structure of its domestic production. Knowledge transfer is an important element in this transformation. A more inward-looking economy with a large domestic market can hinder or delay this transformation because it can lead to an over-reliance on consumption at the expense of investment and exports.
The real effective exchange rate (REER) is an important metric for a country’s competitiveness. It can determine the degree to which a resource-dependent economy can use its resource rents to achieve transformation through growth in non-extractive sectors. Here, we look at the recent REER experience of Nigeria and compare it with that of Indonesia. Where Indonesia’s currency policy was an important precursor to its transformation, Nigeria has remained largely resource dependent.
Nigeria’s transformation deficit
Nigeria has a ‘transformation deficit’. Growth in its gross domestic product (GDP) per capita and the share of manufacturing have lagged owing, in part, to a low level of investment. At 9%, Nigeria’s share of manufacturing is well below China’s 30% and Indonesia’s 25%. Nigeria’s trade share of GDP has also declined over the past decade to roughly 20%. In comparison, Rwanda and Ethiopia’s almost 40% trade share has been steadily increasing. Additionally, Nigeria has an export basket that remains largely undiversified and continues to be dominated by crude oil and gas-related products.
Following its de-pegging in mid-2016, Nigeria’s naira nominal effective exchange rate is around 77% below its peak in October 2014. Intermittent US dollar selling by the Central Bank of Nigeria (CBN) has led to uncertainty over the timing and extent to which the CBN plans to let the naira fully float. This uncertainty is important. Currently, it is not affecting the ability to tap into markets because of the recent launch of $1 billion Eurobonds that was eight times oversubscribed. However, the continuing lack of clarity regarding Nigeria’s foreign exchange policy could trigger an unexpected reversal in inflows.
Exhibiting ‘Dutch disease’ type symptoms, Nigeria’s economy has been buoyed by oil-related inflows during the oil price boom. Subsequent naira strength has coincided with a stagnant non-oil sector, which has been at the expense of a largely undiversified manufacturing sector. Looking ahead, CBN naira support at the current rate is consistent with overvaluation, further evidence of which can be seen in the approximate 40% gap with the parallel market naira rate.
The naira’s overvaluation functions as a tax on exports and will limit prospects for Nigeria’s manufacturing capacity. This capacity continues to decline due to foreign exchange shortages. Overvaluation will continue to present a challenge to Nigeria’s economic transformation.
Lessons from Indonesia
As an oil producer, Indonesia has faced many of the same shocks as Nigeria. Between 1974 and 1978, amid higher oil prices, the Indonesian rupiah’s appreciation was as pronounced as the naira’s. However, during that period, using the windfall from higher oil prices, Indonesia actively diversified its economy. Following multiple devaluations from as early as the 1970s, rupiah management was aimed at limiting speculation, thus using the REER to support exports.
Indonesia’s foreign reserve position was stronger than Nigeria’s is currently, and such differences create clear points of divergence for Indonesia and Nigeria’s experiences. However, Indonesia’s experience remains relevant for Nigeria. Most importantly, the Indonesian experience shows that extra wealth can be used to invest in capital-intensive industrial projects. This includes agricultural development and manufacturing, with the latter attracting significant foreign direct investment (FDI). In Indonesia, this manufacturing FDI was followed by instrumental FDI into services, which would be a transformative outcome for Nigeria too.
With oil prices expected to recover moderately in the year ahead, Nigeria could pursue a similar policy. Combined with freely floating the naira, which would allow adjustment in its REER, it would aid diversification and export growth (rather than consumption-based growth). This, in turn, would increase Nigeria’s resilience to future shocks in a world where oil prices are unlikely to reach previous highs.