Currency Myth - You need to export to benefit from a devaluation

Some countries benefit more than others when currencies lose value but it's a simple correction that must happen because the cost of inaction is huge.

The discussion on whether to devalue or not is almost as old as the Nigerian economy. There is a common myth being peddled that should be debunked, this article attempts to do that in a simple, easy to understand manner. For people who already understand the basics of the exchange rate, please skip to the third section: The Myth and the Costs.

How to make sense of the exchange rate

Always think of the exchange rate as a price that must reflect some underlying changes. Think of tomato, for instance: when there is scarcity, the price rises. When in season, the price falls.

The same applies to currencies. The exchange rate tells you the amount of your currency (NGN) you need to buy another currency (say USD). When you have a lot of USD, your currency becomes stronger. When there is a shortage, your currency loses value.

The above explanation is how it should be in theory. In reality, countries have different objectives. Some countries might decide to make their currencies weak (devaluation) even though they have a lot of USD$ (think China and other major exporters). Meanwhile, some other countries love their currencies strong, even when there is a shortage. Nigeria is in the latter bucket.

Countries manage their currencies differently

There is a good reason for the obsession with a strong currency. Before I explain, let’s go back to the China example. They love a weak currency because it means other countries will be able to buy more Chinese products with a lesser amount of their currency in the international market.

For instance, assume a pen sold by a Chinese exporter is priced 1 Yuan (¥1) and the Yuan to USD (¥/$) exchange rate moves from ¥2/$ to ¥3/$ because the Chinese devalued. Then it means someone holding the dollars can buy one more pen. This is good for China and the exporter because they are able to sell much more to other countries.

Nigeria’s policymakers believe the country doesn’t have this advantage the Chinese have. Our major export is oil & gas (over 90%), which is priced in USD and we have no influence over the pricing. This is true. However, no one mentions how we have the potential to use it to our advantage by exporting to neighbours, for instance. This is a topic for another time. In any case, it is believed that a currency devaluation will offer no benefit to Nigeria, beyond hardship.

That is why policymakers focus on imports. We all know that when your currency is losing value, imports become more expensive. Policymakers claim we are import-dependent, so devaluation leads to higher inflation and impoverishes people. But it is untrue that we are import-dependent. In fact, given the size of our economy, what the size of our import shows is that we are a poor country.

That said, there is no denying that a weaker currency makes imports more expensive and this could lead to a temporary hardship. But there is also no denying that leaving exchange rate adjustment until late will worsen the hardship and reduce the benefits from having a weaker currency.

The Myth and the Costs

It is a myth to say that only exporters benefit from a currency devaluation and importers lose. Like I said at the beginning of this article, the exchange rate is a price that must adjust when there are underlying changes.

In Nigeria, the underlying change is usually lower oil & gas exports, which result in a currency shortage. The correction should be a weaker currency. But the CBN hates to devalue because of the reasons I highlighted in the previous section.

So why is it a myth? It is a myth because when you do not make the exchange rate adjustment, you suffer deeply anyway, regardless of your export capacity:

• You deplete your reserves fast. And God helps you, you don’t have enough USD there. This is what happened in Nigeria between 2015 and 2016.

• Pressure starts to build in the parallel market. Why? Because the CBN knows they lack the USD to meet all demand at the existing exchange rate, they won’t sell. They start rationing. People and businesses will go to the parallel market to get USD instead. Demand builds up in the parallel market, and we have a falling currency there.

  This is why at the peak of the 2015 crisis, the parallel market was about N100-150/USD higher than the official market. We can see the same situation today at N40-50/USD. Also, when this is allowed to happen, the currency is driven by both speculators and those who actually need USD for economic activities. The implication is that the currency falls even more than it should normally do because the CBN has been slow to act.

• People and businesses with dollar needs will not be able to go about their business, resulting in slower economic activities. Think of manufacturers who import raw materials struggling to produce. Some of these manufacturers also export, which means we lose out on USD earnings too. And exporting the finished goods resulting from imported raw materials will earn you more than the USD used to finance the import.

  Also, even if the manufacturers do not export. Think of the cheaper finished goods you are able to buy locally because cheaper raw materials were imported from another country. During a crisis, the lack of access to these raw materials means the supply of goods could fall, leading to more inflation. So even though a currency devaluation could increase inflation, delaying adjustment as described above will make it worse. Imagine the CBN pursuing a strategy that gives loans to manufacturers, even though they can’t produce because there is a lack of access to USD - what is the point?

  Think of the people losing their jobs because factories don’t have the raw materials to produce. So in one swoop, you could have weaker growth and high inflation & unemployment. Economists call it stagflation, avoid it.

• Investors will be reluctant to bring in their USD (falling USD supply), while those in the country will want to exit (rising USD demand). This makes a bad problem worse because we need investment just as we need exports. Imagine you are a foreign investor with interest in Nigeria and plan to bring in $1m. If you think there should be a devaluation, and the CBN is quoting rates different from the parallel market, you will delay your decision to come in. Also if you are a foreign investor already in Nigeria, once you see that a devaluation needs to happen and the CBN is reluctant to make changes, you exit quickly to avoid value erosion.

  Yet a country like Nigeria needs these investors. Nestle, MTN and Guinness are examples of countries mainly funded by foreign investors.

• Imagine all the above and the devaluation in the official market eventually happens. It means you suffered more than you should normally do and you do not enjoy the benefits.

  This is the problem with CBN’s approach to exchange rate management. Despite the fact that the CBN was reluctant to devalue in 2016, they eventually did. The exchange rate moved from N197/$ to N360/$ between 2016 and 2017. The same happened in 2020, as the rate moved from N360/$ to N386/$. The CBN eventually devalued, and more adjustment is still expected to come. It is basic: when fundamentals change, price should change.

• CBN does demand management. An example is the list of 41 items + 3 other items (milk, fertiliser, maize) since 2015 for which importers cannot access USD. This is done to reduce the demand for FX and imports. The CBN would also say this is to encourage local production.

  The unfortunate thing the CBN fails to realise is that adjusting the exchange rate as and when due would lead to these objectives without all the extra costs borne above (loss of output, employment and higher inflation). I did a thread on this on Twitter.

  When you make a gradual adjustment to the exchange rate as the fundamentals (a set of factors affecting the currency) dictate, businesses take a cue: they can plan into the future to reduce their dependence on imports while still using imports to support production in the interim. This is better than when they are to deal with a sharp currency devaluation, which is unexpected and unplanned for. Many businesses are destroyed by unstable policies and it takes a long time to recover from the shock if they ever do.

So it is untrue that only exporters benefit from a devaluation. Many times, it is a correction that must happen, and doing it in time helps to prevent deeper problems. Delay is not denial, and the cost of inaction is huge as I have shown.

Feedback and comments are welcome.