Understanding the most recent CBN Policy Moves

How the CBN manages interest rates, and in extension, the exchange rates.

Recently, the Central Bank of Nigeria (CBN) adjusted interest rates. It was a welcome development, given the trajectory of inflation and the amount of funds circulating in the economy. Don't get me started on the genesis of these funds.

Needless to say, we did not have to wait for things to deteriorate to this level, in which inflation is at a historical high of 29.9% since democracy, before making this move. This interest rate adjustment is reminiscent of the removal of the petrol subsidy after the swearing-in of this administration. At that time, I was optimistic that many more policy moves were going to follow, but I was sorely disappointed. Increasing the interest rates is just the first step in the right direction, and this must be followed by other actions for the benefits to fully accrue to the economy. If we delay again, we will be back to where we started from.

Two things have happened since the beginning of 2024: the exchange rate went parabolic, and the inflation rate went out of control. These two economic indicators have a way of feeding on each other in a vicious or virtuous cycle, depending on the conditions.

The exchange rate is one of the several leading indicators in the direction of the economy. A higher exchange rate means that input into the production of goods and services will be more expensive. Nigeria certainly does not import as much as we are made to believe. According to OEC, Nigeria's import to GDP is just about 17% of its GDP as of 2022. Nigeria exported more than it imported in the same year (Nigeria (NGA) Exports, Imports, and Trade Partners | The Observatory of Economic Complexity (oec.world)). Unfortunately, one of the most important inputs into the production of goods and services is linked to the exchange rate - petrol and diesel. While the Government has continuously subsidized petrol, the price has been paid in more indirect ways. So the assertion that the exchange rate is driven because of the "expensive tastes" of Nigerians has no basis in reality.

So what exactly is driving exchange rates? Two of the most important drivers are liquidity and inflation. Remember that inflation is a lagging indicator. Once investors see that inflation is rising in Nigeria, the first thing they want to do is get out before it gets worse, which leads to demand for the USD. When there is excess liquidity and no productive places to invest the funds, the next best thing is to get out. Both of these factors lead to pressure on the exchange rate. Another factor to consider is corruption. (Yes, this is the kind of sensational thing Nigerians like to hear, but that narrative also falls flat on its face in the presence of an unproductive economy. I will not dwell too much on that, as that could become the basis of an entirely different article.)

How does inflation affect things? You must have heard this phrase before: inflation is a monster. It is not completely true. A healthy amount of inflation (like sugar in the body) is good, but when it is too much, that is when it becomes a problem. The inflation in Nigeria has been too much for a very long time. We have been living with an unhealthy amount of inflation for the better part of a decade, and everything happening now was bound to happen when we did not control it on time. When inflation is too high, the rate of rise of prices of goods and services increases. It becomes difficult to plan. It is easier to build a house if you can predict the price of cement in six months, than if you cannot predict it. 

There are two types of inflation: demand-pull and cost-push. These are not topics I will talk about today either. There is also an economic theory we call inflation differential: this is another topic that is too complex for this post, but the summary is that with higher inflation, the weaker the local currency is expected to be.

Now, let's go back to the most recent CBN moves. Here is the summary of what happened:

1. The Monetary Policy Rate (MPR) was increased by 4% to 22.75%

2. The asymmetric corridor was moved from +100/-300 to +100/-700 basis points

3. Cash Reserve Ratio (CRR) was increased by 12.5% to 45%

4. Liquidity Ratio was maintained at 30%

Let me now now break it down.

The MPR increase means that interest rates have gone up. This will impact you because the rate at which you can borrow from Nigerian banks has increased. On the flip side, the interest you will receive on your deposits will increase. The asymmetric corridor is like a contract between the CBN and Nigerian banks. If a bank needs money in a hurry, it will have to borrow money from the CBN at MPR plus 1%, which is equivalent to 23.75% (Note that 100 basis points is a posh way of saying 1%.) And if any bank has excess liquidity, it can lend to the CBN at MPR minus 7%, which is equivalent to 15.75%.

With a cash reserve ratio of 45%, the CBN is essentially telling banks that for every N1,000 deposit they receive from you, they must send N450 to them. So what will be available for the bank to lend out or do anything with is N550. This is one way of taking out liquidity from the system.

The liquidity ratio was left unchanged at 30%. This liquidity ratio is the amount of funds the banks must have in their balance sheet as a proportion of total deposits. These funds have to be liquid assets such as cash and treasury bills. The purpose of this fund is to ensure that banks can provide funds to meet up with customer demand for withdrawals whenever they need to.

Let us tie everything up. If you deposit N1,000 into your bank account today, the bank will have to take N450 to the CBN. After that, they will have to hold on to N300 in very liquid assets. In the end, the only amount left for any kind of lending to the economy is N250 after all these deductions.

One of the ways banks make money is by lending. With very little left for lending, the laws of demand and supply kick in. Banks have to make money and borrowers need money. So, this leads to bidding up of interest rates as many borrowers go after the little available amount. To attract funds, banks will now be forced to increase deposit rates. With higher deposit rates, people will find buying the USD less attractive.

In addition to that, foreign investors will also be attracted to the higher yields in the Nigerian economy and will be tempted to bring in more funds to invest. With more foreign investors bringing in money, the pressure on the exchange rate is theoretically expected to reduce as they demand Naira.

If the exchange rate stabilizes, the impact on inflation will also reduce, and we could see inflation rates decrease. The exchange rate does not need to drop, it only needs to stabilize. Now, the inflation rate coming down does not necessarily mean that prices of goods and services will come down. It simply means that the rate of rise will slow down. Remember, I said earlier that every healthy economy requires some level of inflation, just like sugar in the body.

Ideally, we would want interest rates to be much higher than inflation to attract foreign investors, but a much higher jump could shock the economy and lead to unintended consequences. A step-wise approach would be much better, and the rates can be adjusted as we go along. 

Lastly, this is just the first step in a series of follow-up steps. We would expect the fiscal policies, which are under the purview of the Minister of Finance to implement policies that will take advantage of these higher interest rates to jump-start productivity. We hope they get it right this time around so we don't end up coming back to make drastic moves like this in the future.