Analysts advocate reforms, say CBN’s impossible trinity pursuits unsustainable
The Central Bank of Nigeria seems to have demystified the impossible trinity but experts at WSTC Securities Limited have put a question mark on its sustainability. Analysts at the firm think that the economy needs more structural and institutional reforms to drive free capital inflows without necessarily having to sacrifice monetary policy autonomy.
The firm reckoned that no country can successfully pursue the three sides of the trinity –economic growth, price stability and low unemployment. However, analysts said that so far, the monetary policy authority may have demystified the impossible trinity.
In a bid to lower cost of borrowing and deleverage the balance sheet, yields on open market operations (OMO) bills have declined from an average of 17% as of the beginning of 2019.
WSTC Securities hold that the ban on other market players in the OMO market has cast doubt on the liquidity (ease of buying and selling) in the market, thus raising concerns for foreign investors.
The excess funds that were hitherto placed in OMO instruments resulted in a surge of liquidity (excess cash) in the system, thus causing a potential threat to price stability and possibly exchange rate stability.
Already, the inflation rate as of January 2020 stood at a 21-month high of 12.13%. If inflation rises further in the future, the CBN’s job will become more difficult, analysts held.
Analysts at WSTC noted that to counter inflationary pressures, the CBN might have to raise interest rates again, thereby taking the economy back to the trinity.
“In our view, we think that the economy needs more structural and institutional reforms to drive free capital inflows without necessarily having to sacrifice monetary policy autonomy”.
WSTC’s analysts also believe that economic reforms will stimulate the economy, drive local production and export base such that the vulnerabilities to the exchange rate fluctuation are limited.
“For most policymakers, the macroeconomic objectives are typically economic growth, price stability, and low unemployment.
“Other macro objectives include stable exchange rate, low debt levels, and efficient resource allocation”, WSTC Securities held. According to the firm, to achieve these objectives and attain economic prosperity, the policymakers adopt various policies.
Monetary and fiscal policies are typically used to achieve desired macroeconomic objectives, analysts stated in a note WSTC however held that the policy mix or policy combination adopted is generally driven by the goals and objectives of the policymakers.
“For example, to drive economic growth, a lower interest rate could be implemented such that the cost of capital becomes cheap.
“When the cost of capital is cheap, it encourages businesses and households to demand money, thus leading to increased investments in the economy”, analysts highlighted.
Increased investments in the economy will generally result in an increase in output, employment, household income, and aggregate consumption. By extension, this would result in higher standards of living and economic prosperity.
Analysts review holds that depending on the desired objectives of the policymakers and the extent of growth to be achieved, a combination of a lower interest rate (monetary policy) and lower taxes (fiscal policy) can be adopted.
WSTC noted that the implication of this would be an awash of liquidity in the system and an increased level of economic activity. It added that the policymakers can decide to later increase interest rates to manage excess liquidity in the system, as the focus changes from economic growth to price stability.
“However, there are limits to the combination of policies to be adopted in order for policy makING to be effective”, the Securities firm remarked.
WSTC cited the theory of “unholy trinity” which emphasises that an economy cannot, at the same time, pursue the three objectives of free capital flows, fixed exchange rates and independent monetary policy.
Analysts said the inconsistent trinity provides that a country can pursue a stable exchange rate and free capital flows, but not an independent monetary policy.
This strategy could be adopted if the objective is to ensure free flow of capital and fixed exchange rate in an economy, the interest rates in that economy would have to be high to encourage the inflows of capital.
The higher capital inflows will lead to currency appreciation of the recipient country, it stated.
Analysts said hence, the direction of the interest rate will be tailored towards encouraging the capital inflows to keep the exchange rate stable.
Another option presented is free capital inflows and an independent monetary policy, but not a stable exchange rate. This supposes an economy seeks to achieve free capital flows and keep interest rates fixed/low (i.e., not influenced in an attempt to encourage capital inflows), it implies that the exchange cannot be fixed.
Analysts explained that the currency has to be devalued or be flexible so as to encourage capital inflows while the interest rate is independent. It said the final option is to pursue a stable exchange rate and independent, but no free capital flows.
“If the overall objective is to keep the exchange rate fixed, and interest rates are low in an economy, it will be a disincentive for capital flows, thus there will be capital outflows”, analysts stated in the review.
The CBN, Policies and the Economy
Analysts at WSTC positioned that it appears that Nigeria is trying to demystify the impossible trinity by attempting all three policies. Experts held that the apex bank has a controlled exchange rate, wants free capital inflows and also an independent monetary policy.
In its multi-tiered exchange rate system, the Nigerian Naira is pegged to the United States Dollar. WSTC stated that as a result, the activities of the Fed and the interest rate direction in the US influences the interest rate direction in Nigeria.
“Due to the desire to encourage capital inflows to keep the exchange rate control, the Central Bank is prompted to increase rates. These higher rates ensure capital inflows in the economy and these inflows result in the stable exchange rate in the economy.
“Apparently, the policymakers had gone with option 1”, WSTC said. However, due to the arrangement of a fixed-exchange rate and capital inflows, the effect is reflected in the form of decreasing spending and a downfall in economic activities.
Analysts stated that a higher yield on government securities led banks to stop lending to the private sector in favour of government securities.
“The implication was tepid economic growth, as GDP growth has been sub 2% over the past quarters since the economy exited recession in 2017.”, analysts added.
However, they recognised that the weak growth is partly attributed to weak private sector credit – because the higher interest rates on government securities crowded out the private sector.
“With low credit, due to a high cost of capital, investments slowed in the economy. The problem of weak economic growth became worrisome to the policymakers and the CBN sought to change the narrative. Effectively, the CBN which had already gone with option 1 wanted lower interest rates which contradict the option it seemed to have taken.
“Knowing that the interest rates could not tamper, the CBN devised unorthodox approaches, from moral suasion to policy bans”, analysts at WSTC Securities stated. Analysts advocate reforms, say CBN’s impossible trinity pursuits unsustainable
