If you have an M.Sc in Finance or a degree in economics, you can skip this piece. The point of it is to try to explain what the CBN did today at the MPC meeting and how it all relates to the wider Nigerian economy.
The communique they released is here
Larry Summers, I think it was, who once said that it is not so easy to understand how the economy works. And Summers has more than one brain. Everything below is a simplification to get the basic points (as I understand them) across.
Increase the MPR by 100bps from 12% to 13%
First thing to know – 100 basis points equals 1%. It really is as simple as that – the CBN increased the Monetary Policy Rate (MPR) by 1%. But what is MPR anyway?
Every Central Bank in the world has a broad goal that it seeks to achieve. For most central banks, this goal is controlling the rate of inflation usually around a certain target. This is known as – wait for it – inflation targeting.
If there is only one guy in a village with enough money to buy a motorcycle, it’s safe to say the motorcycle seller cannot easily increase the price of his motorcycle. But if a bunch of other rich guys suddenly move to the village and they happen to like motorcycles too, the motorcycle seller now has an opportunity to make more money by increasing his selling price. In other words, there is now more money in the village chasing the same amount of motorcycles. That’s a simple definition of inflation and the downside of it is that it makes people poorer. If the motorcycle seller increases his prices overnight it means you could possibly afford the bike yesterday but not today.
It’s possible that those new rich guys in the village borrowed money from the bank which they are now flashing in front of the bike seller and turning his head (making him increase his prices). This is where the central bank can tackle inflation – by increasing the MPR – which is the interest rate at which the central bank lends to other banks – it can set off a chain reaction that means those new money miss road guys have less money to throw around. CBN lends to the banks, the banks lend it to money miss roads, money miss roads flash it in front of bike seller i.e. CBN is at the top of the food chain, in theory and is throwing meat down at everybody else. The economic principle at work here is the simplest one – if the price of something increases, people will demand less of it (with the exception of a few types of goods). If you think of interest rates as the ‘price’ of money, by increasing the MPR, CBN is trying to reduce the demand for money.
There’s a smaller point as well. If you increase the price of money, obviously it becomes more valuable and anyone who has it suddenly becomes a big(ger) boy. So, if banks were willing to offer you 5% for you to keep your money with them before, they might now be willing to offer you 6% for the same money. All of a sudden, simply keeping your money in the bank has become more attractive than spending it. The new money miss roads in the village won’t be able to buy the bikes anymore and the former local champion will now rather keep his money in the bank given that he will get more for it. And motorcycle seller? With no customer in front of him, he has to drop the price of his bikes.
Increase the CRR on private sector deposits by 500 basis points from 15 per cent to 20 per cent with immediate effect
Imagine you just opened a bank called Dorobucci Bank. You rent an office, buy a generator and hire a couple of staff to run the place. The cost of the office, diesel and staff salaries on a monthly basis is N1,000. The first customer to come to your bank, Mr Jonathan (Jona for short), deposits N10,000 with you in a savings account. You offer to pay him an interest rate of 5%, say monthly. So at the end of the month, if Jona turns up to demand his money, you need to hand over N10,500 to him. Don’t forget your N1,000 for running the bank i.e. in total, at the end of the month, you have to pay out N11,500. Also you have to make a profit to make it all worthwhile so let’s say N500 is a good profit for you. We are now up to N12,000. Jona is your only savings account customer so somehow you need to turn that N10,000 he gave you to N12,000 before he comes back i.e. a rate of return of 20%. One way of doing this is to buy chemical that turns paper to money but this is very risky and it might not work. Luckily for you, just after Jona gave you the money and left the bank, one guy walked in, Mr Bagajan and says he needs a N10,000 loan.
That’s when you remember that CBN says you can only lend out a maximum of 85% of deposits that customers keep with you. You must keep the rest as cash. So now, out of Jona’s N10,000 you can only lend out N8,500 and he’s coming back to ask for N10,500 in 30 days time. Hmmm.
You already have N1,500 to return to him since you kept it in cash so you need to find another N9,000 for him plus your own N1,500 for running costs and profits. In other words, you need to turn N8,500 to N10,500. You now need a 24% return and not 20% as you earlier thought.
You then tell Bagajan that you can only lend him N8,500 for 30 days at an interest rate of 24%. He’s a bit desperate so he agrees. This is banking simplified. That 15% that the CBN says you must not lend out is what is known as the Cash Reserve Ratio (CRR).
So what happens when CBN hikes the CRR from 15% to 20%? In simple terms, it means you as a banker have to make your money work harder. Now you have only N8,000 to lend out but you still need a total of N12,000 by the end of the month. You now have N2,000 in cash waiting for Jona when he comes to collect his money and you need to find another N8,500 for him plus your own N1,500 to cover profits and running costs. If you lend N8,000 to Bagajan, you now need him to return N10,000 to you – the interest rate you charge him now goes up to 25%.
When you take this hike in CRR together with the increase in MPR discussed earlier you can see what CBN is trying to do – reduce the demand for money.
Why so harsh? Why is the CBN squeezing the money supply from both sides in this manner? Who hurt them? The answer is the banks. They have been naughty and CBN is not happy with them.
By increasing the MPR and CRR, the demand for money will reduce. So Bagajan might get annoyed and walk away when you increase the interest rate from 24% to 25% (and make it worse by telling him you can only lend him N8,000 and not N8,500 as you earlier agreed). As he is walking out, you grab his jacket and rub his head then offer him 22.5% instead. This means he will return N9,800 to you. Now you are short of N200. Where will this N200 come from? Jona will raise hell if you try to give him N10,300 instead of N10,500 as agreed (he knows people in SSS and Police).
Your only option is to reduce your profit from N500 to N300.
Listen to what the CBN is complaining about (Page 14):
However, available data indicates that banking system liquidity has been lavishly deployed in pursuit of speculative foreign exchange trading at the short-end of the market. While the Committee remains fully committed to the goal of promoting inclusive growth through lower interest rates in the medium- to long-term, banks as agents of financial intermediation have a critical role to play in the nation’s development process. A banking system with an overly high profit motive negates the core tenets of banking and purpose of a banking license
In simple English, the banks have refused to fear God and are using all their profits to play lottery. So the CBN has decided that the ‘solution’ to this problem of lottery playing is to punish the banks by squeezing their ability to make profits.
The problem here is that the weapons of CRR and MPR that the CBN is using are not ‘guided missiles’ where you can speak incantations into a ram’s horn and it goes directly to the person you’re targeting. They are grenades, so when you throw it in a room to target one particularly annoying guy, there is no guarantee that you won’t hit an innocent bystander. We see here that the motorcycle seller, the money miss roads and Bagajan have all been affected even though the grenade was aimed at the banks.
Move the midpoint of the official window of the foreign exchange market from N155/US$ to N168/US$
The Nigerian naira is not a freely traded currency. If you travel to Australia or Japan or Nauru and you have US dollars with you, you will definitely find someone to change it into the local currency. This means that the US Federal Reserve doesn’t really worry itself about the exchange rate of the dollar. It is traded globally and the price is open. It is hard for one person to control the exchange rate.
On the other hand, if you turn up with Nigerian Naira in Bolivia and demand that they be converted to bolivars for you, depending on the mood of the person you meet, you might either be arrested or slapped. Or both. Outside of Nigeria, you can’t really do anything with the Naira. This gives the CBN great powers to determine the exchange rate of the Naira, afterall it is the one who prints it and controls the supply. The US Fed is also the only one who prints the dollar but the supply is so plentiful across the world that Ecuador and Zimbabwe have adopted it as their currency and they don’t even need the permission of the Americans to do so.
At the beginning we talked about life goals of a CBN. Most of them focus on inflation. But for central banks like Nigeria’s, they have the added work of controlling (or trying to control) the rate at which the local currency trades with foreign currencies. For an import dependent economy like Nigeria’s, this work is quite hard and important. There is no day that people will not want dollars to buy one thing or the other from abroad.
So what the CBN has been doing is to set a ‘band’ at which it will buy or sell dollars to banks and others. For a few years the middle of the band has been N155 to $1 with a 300 basis point ‘slack’ around this. This means that the CBN will allow the Naira move between N150.35 and N159.65 to the dollar i.e. 3% up or down around the midpoint of N155.
How does this work? Quite simply in theory. If people start demanding a lot of dollars and are willing to pay more for it, the price will obviously go up. Once it hits that N159.65 upper limit, the CBN will release more dollars into the system to calm everybody down. If you have been hearing the CBN ‘defending the Naira’ in the papers, this is it. When Nigeria sells oil, we get paid in dollars for it. These dollars flow to CBN. The Nigerian government spends Naira so the CBN gets to keep these dollars and gives naira to everyone instead. When the time to defend the Naira comes, it starts to dip into those dollars until the naira falls below that upper limit of N159.65.
Recently this defence work has been harder than that of a San Marino defender facing Lionel Messi. Our stock exchange is dominated by a lot of foreign investors. Recently they have been selling their stocks and running away because they are worried that you people will break bottles during the elections (and also the US Federal Reserve ending QE…ignore this for now). When they sell their stocks, they need to take their money back to their countries of course. As we have said above, they cannot take the Naira outside Nigeria so they need to change it to dollars in Nigeria before running off with it. More and more people thus need to buy dollars from CBN.
If CBN does not do anything, people will get desperate and will be willing to pay whatever it takes to get the dollars they need. In no time, the upper limit of N159.65 will be broken and the CBN will lose control totally. The investors are attacking, CBN is defending. This thing is tiring and after a while you are bound to concede a goal.
So today, the CBN allowed the attackers to score. At least, in the time it will take to remove the ball from the net, attackers celebrating the goal and getting the ball back to the centre circle, the CBN can rest small before the game starts again.
Now the mid-point is at N168 to $1 and instead of 3% ‘slack’, the CBN will now allow a 5% slack. So the naira will be allowed to move between N159.65 and N176.40. As you can see, the (former) end is now the beginning. In short, the CBN has devalued the Naira by 8.4%.
Going back to the CBN’s complaint quoted earlier, it accused the banks of ‘speculating’ against the naira ‘lavishly’. What it is saying is that banks know that when the pressure gets too much, the CBN will concede a goal. So in simple terms, if you bought dollars last week, you can sell it this week for a sweet 8.4% profit. The banks bet has been proved correct.
Of course, the other action film that is going is that oil prices are falling. Imagine that CBN used to spend $2bn a month on this defence work. Also imagine that when oil was $100 per barrel, $4bn was flowing to CBN monthly. This means that the reserves will still manage to increase by $2bn monthly. But then things have suddenly reversed. All those foreign investors running away (plus the banks speculating ‘lavishly’) have caused the CBN to increase the amount it spends on defence to say, $3bn. Meanwhile oil prices have dropped to $75, meaning that the money flowing to CBN monthly is now $3bn. The reserves are no longer increasing. So imagine what happens if say oil drops to $70 and people are still running away and are now asking for $4bn monthly. The situation will completely reverse – $2.8bn coming in, $4bn going out. The CBN will now need to dip into the reserves to withdraw $1.2bn monthly. If you had only $10bn to begin with, it means you will run out of money in about 8 months if things continue this way.
One is reminded of the ‘Micawber Principle‘ as revealed by Wilkins Micawber in Charles Dickens David Copperfield:
Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness.
Annual income twenty pounds, annual expenditure twenty pounds nought and six, result misery.
Nigeria has managed to find itself in an almost perfect storm where practically everything that can go wrong is going wrong. These days the world produces roughly 90 million barrels of oil. But of that amount, only about 30 million barrels are produced by OPEC members. So the weapon of cutting supplies that OPEC used to use to raise prices won’t really work anymore. It’s a bit hilarious to hear the CBN accuse someone of spending money ‘lavishly’ given that this is what the Nigerian government has done for the past 4 years when oil prices have been high.
The banks also now know that if you apply pressure, the CBN will concede a goal and devalue again. It is a matter of when, not if. Within a few weeks, the new trading band for the Naira will be blown apart (if it hasn’t already as we speak). Cost of borrowing will also go up for everyone else due to the MPR and CRR squeeze. Things are going to be a bit rough for the next few months and if you have cash or better still, forex, you’re the (wo)man right now.
As bad as things were for Wilkins Micawber, he never stopped living in hopeful expectation. Indeed he lived by the maxim – something will turn up. :)