A Really Simple Model of How We Got Here.

A friend asked a simple question yesterday with regards to the Nigeria foreign exchange and domestic production problems: how did we get here. Which I have translated to mean how did we get to the point where we appear to import so much while local manufacturing does so little. The sentiment, in general, is partly driven by articles which kind of pin the blame on Nigerians for having a romance with imported goods.  “If only we bought locally we wouldn’t be in this mess”. The ideology is championed most notably by our Central Bank governor via his “demand management” policies.

The answer to the question, how we got here, is a very complex one. It has multiple unclear answers based on policy and politics and history and geography and …. you could go on really. What I will attempt to do here is to give a simple answer of the contribution of (bad) foreign exchange policy to the answer to the question.

We know the world is very complex and too difficult to model so we will simplify things by assuming we have just two countries in the world, “A” and “B”. The countries are identical in most ways. They both eat the same stuff, they both make they same stuff, they both have the same endowments, they both have the same history. There are also only two goods in both countries which both countries make. “A” and “B” are different in only two ways; first they use different currencies, although they both have significant reserves of each others currencies, and second they have different monetary and foreign exchange policies.

 

At time 1:

Price of identical basket of goods: Country A = N1000 || Country B = $10

By Implication Exchange rate must be: N100 => $1

Buyers should have no preference between buying from A or B.

 

If we start of at an ideal scenario where everything is balanced then exchange rate should be N100 to $1 given the prices of the basket of goods. Country A and country B however have different monetary policies which by implication may lead to different rates of inflation. Again for simplicity lets assume that inflation rates are a result of monetary policy alone. Its also easy to use inflation because its something we can easily measure. Say country A targets an inflation rate of 10% while country B targets an inflation rate of 1% then:

 

Inflation between time 1 and time 2: Country A: 10% || Country B: 1%

By Implication:

Price of basket of goods: Country A: N1100 || Country B: $10.1

Exchange rate should be: N109.89 => $1

 

But what if the authorities in country A decide that they don’t want the exchange rate to change? What if they use their stock of foreign reserves to “stabilize” the exchange rate at N100 to $1?

 

Country A forces exchange rate of N100 => $1.

By implication:

Price of basket of goods: Country A: N1100 || Imported from Country B: N1010 ( i.e. $10.10 X N100 )

Buyers should prefer to import from country B because it is N90 cheaper per basket.

 

In essence if you observe a difference in inflation for the same basket of goods in two countries then the currency must adjust to take that into account. If it doesn’t then it must be true that the basket is cheaper in the lower inflation country relative to the higher inflation country.

How can country A manipulate its exchange rate to keep it fixed at N100 per $? By selling a bit of its foreign reserves. The easiest way to think about it is the authorities in country A contributing N90 in $ for every basket of goods you import from country B. The consequence of course is that if you are normal you should prefer to buy from Country B. Not because you are unpatriotic or because you hate your country A or because you are addicted to imported goods, but simply because it is cheaper.

The problems continue if we move from time 2 to time 3. Again between time 2 and time 3 inflation in Country A is 10% and inflation in Country B is 1%.

 

Inflation  between time 2 and time 3:  Country A: 10% || Country B: 1%

By Implication:

Price of basket of goods should be: Country A:N1210 || Country B: $10.20

Exchange Rate should be: N118.63 => $1.

But authorities in Country A intervene forcing: N100 => $1.

Then:

Price of basket of goods: Country A: N1210 || Country B: N1020 ( i.e. $10.20 X N100)

Buyers should prefer to import from country B because it is N190 cheaper per basket

 

Again we see the effect of the authorities in Country A fixing the exchange rate. The incentives for buyers is pushed towards importing from Country B because it is even cheaper than buying from country A. Again buyers import from country B not because they are lazy or unpatriotic but because the authorities are literally subsidizing every imported basket by N190.

The further in time we go, and so long as the authorities in country A keep “fixing” the exchange rate, the bigger the subsidy on imported baskets and the bigger the shift in demand to imported baskets.

Back to the Real World.

Of course the real world is a lot more complex than our simple model. In the real world conditions are different, preferences are different, politics is different, geography is different, history is different and so on. In the real world there are lots of complications through multiple countries using multiple currencies and investment flows and exchange rate pass throughs and all that economic jargon. The basics are however still the same. Given different levels of productivity and inflation and interest rates, without intervention currencies should adjust to equalize the implied price of a general basket of goods in different countries.

Because there are multiple currencies in the world, not just the dollar, and because countries do not only trade with the United States, using the simple USD exchange rate doesn’t actually tell you much about how close a domestic currency is to its true implied value. A bunch of smart economists came up with the Real Effective Exchange Rate (REER) to deal with this measurement problem. Think of the REER as the exchange rate based on the relative prices of stuff compared with the people you trade with. A REER of 100 implies that the currency is valued at what it should be compared to others. Using our model language, the currency exchanges at a value that equalizes the implied price of the basket of goods with other countries. A REER greater than 100 implies the currency is overvalued. Again using out model lingo, the authorities are keeping the exchange rate lower than what it should be and subsidizing imports. On the flip side a REER less than 100 implies the currency is undervalued. Using our model lingo, the authorities are keeping the exchange rate higher than what it should be and kind of subsidizing exports.

 

What has the REER for Nigeria looked like since the 1980s?

REER
Nigeria REER 1980 – 2014

 

According to World Bank data we seem to have a thing for overvalued currencies. The Naira was overvalued until the forced devaluation during SAP. Abacha brought back the currency overvaluing policy until he died in 1998. Soludo largely prevented the currency from overvaluation but it has begun to creep back in again. Keep in mind that an overvaluation would not show up in the data as the Naira appreciating against the USD or Euro, but it will show up as the Naira appreciating against other currencies such as the Yuan or Rand.

So back to the main question: How did we get here? The answer is still complex but we know the Central Bank has played its part over time by subsidizing imports. How were they able to do this? Easy. The FG found a whole lot of $$$ in the ground aka crude oil.

 

Its also important to note that an overvaluation never feels like a crisis as long as the $$$ keep coming out of the ground. As long as oil prices are high the Central Bank can keep subsidizing imports. Problems only arise when the Central Bank starts to run out of dollars say because the stuff in the ground is not so valuable anymore. And of course the longer the subsidy had gone on, the bigger the pain from the adjustment to the reality, and the bigger the sense of a crisis.

What is the morale of the story? Don’t target the dollar, its bad policy. Also its better to not implement bad policy at all but if you must, the sooner you adjust to reality the better.

Questions? Ask away in the comments below.

 

 

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9 thoughts on “A Really Simple Model of How We Got Here.

  1. Does this mean the present policy of the govt is the best way to go? As it is, seems we have no choice but to intensify our local production in all aspects.

  2. But how do you suggest that these effects of switching policy are mitigated for the public. Because it’s hard to make people understand that this policy of overvaluation is bad for them

    1. The trick is, people don’t notice small changes. Think of what the price of garri was last month, and this month. It probably changed, but even if you noticed it you won’t bother. But people notice big changes. Big changes make people upset. The goal for policy makers who are trying to implement this, is therefore to not get to a situation where big noticeable changes occur. Markets do very well at dealing with that. But you have to take the jump first.

  3. True about how we got here, but why do we choose to remain here? Who benefits and who loses? Are Nigerians better off with the status quo?

  4. Wow! This was very enlightening. I belonged to the bandwagon of Nigerians criticizing fellow Nigerians of loving imported products as opposed to “Made in Nigeria”. Thanks for the eye-opener.

    Next question will be this: In order to reduce the effect of the mass devaluation, should we focus on developing more Nigerian products or increase import level until we get a sense of the real value of the naira? Should the CBN allow the naira free-float to reduce the spread between the Interbank and the Black market rates? Please share your thoughts on this.

    Thanks

    1. 1. Developing more Nigeria products is the way to go. Because salaries are probably paid in naira, a devaluation should push people into looking for domestic substitutes. It should also encourage people to sell to export as well. Since to foreigners everything Nigerian is now cheaper. Although its not that straight forward in real life, that is the principle.

      2. The CBN needs to allow the gap between the official and black market close. I won’t go so far as to propose a free float seeing as the crude oil price is still extremely volatile even in the short term. So ideally the CBN will still act to smoothen out short term volatility but not to artificially fix and exchange rate.

    1. Right now I would guess between N250 and N300 per $. Although no reason why I will stay there. The exchange rate is really just a price and prices change everyday.

  5. Spot in bro. Although I got lost and had to go back a few lines and assumed I understood( no thanks to ur economic lingua) ,lol. It largely made a whole lot of sense in the long run, but I wonder if the lay man will catch the drift.
    I’ll share all the same and hope the word gets round and these blind arguments and comments I see every day can be curbed.

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