Commodity-rich countries possess a huge amount of natural and mineral resources which contribute significantly to the revenue of the economy. Most developing countries rely heavily on natural resources as their main source of export and revenue. This has resulted in an undiversified sector that is unable to withstand external economic shocks when the market prices decline.
Although Nigeria has made several attempts to diversify its economy, it has still been overly dependent on oil and gas exports. This over-dependence on the oil sector is a source of macroeconomic volatility; as a result, the economy experiences booms when commodity prices are high and busts when commodity prices decline. The situation of the Nigerian economy is what is commonly referred to as the “Dutch disease”.
In 2014, there was a sharp decline in the price of crude oil (Brent) from $112 a barrel in June 2014 to $48 a barrel in January 2015 which was an overall drop of 50%. This was due to the lowered demand and the increase in shale oil production in the US. Ever since oil was discovered in 1956 it has become one of the key sectors driving the Nigerian economy as it contributes substantially to export earnings and fiscal revenue. Crude oil accounts for over 75% of exports making Nigeria one of the largest oil exporters in Africa.
To explain the response to the oil shock, it is crucial to grasp its impact on the economy.
Prior to the shock, the Nigerian economy was projected to grow by approximately 7% however, the shock caused growth to decline. Additionally, the export earnings from oil also declined from $7.6 billion in May to $7.1 billion in June 2014 and it fell even further to $6.9 billion in September 2014. Reports show that there were insufficient fiscal buffers in the economy and this intensified the effect of the shock. There was only about $4 billion saved in the excess crude account and about $1.25 billion in the sovereign wealth fund. The current account surplus turned into a deficit as oil exports fell by 14%. Similarly, international reserves declined by $9 billion. As a result global financial markets started to lose confidence in Nigeria’s ability to defend the Naira and this led to a self-fulfilling prophecy as the economy experienced a significant amount of capital outflows.
Inevitably, the value of the Naira also fell (depreciation) as the exchange rates moved closely with the price of oil and this led to rising inflation. In order to accommodate the commodity bust, the Nigerian government employed a combination of monetary, exchange rate and fiscal policy tools.
The Central Bank of Nigeria (CBN) which is the country’s monetary authority enacted monetary tightening policies to counter the effect of the shock and ensure price and exchange rate stability.
First of all, they devalued the Naira and tightened monetary policy to mitigate the effect of the falling oil prices. They also did this to reduce political risk and maintain business and investor confidence.
The official foreign exchange rate band increased from 155+/-3% to USD NGN 168+/-5% (which was a devaluation of about 8%) and the interest rates increased to about 13%.
Furthermore, the CBN raised the required reserve ratio on private sector deposits from 15% to 20%, in an attempt to decrease bank liquidity and increase the cost of money. They did this on the assumption that adjusting the peg and tightening monetary policy will prevent capital outflows and stabilize the Naira. However, this was ineffective as the currency still remained under pressure.
In a similar vein, the CBN tried to implement capital controls that required anyone who wanted access to foreign exchange to gain approval. The goal of this was to minimize capital outflows, decrease the demand for foreign currency and lower the pressure on the Naira. However, this measure also proved to be ineffective as this resulted in strict foreign exchange constraints. Additionally, it also discouraged inflows from other non-oil sectors in the economy, thus worsening the condition of the economy.
The decline in oil prices also posed a huge problem to the fiscal authorities in Nigeria and the Central Bank intended to remedy it. Nigeria lost over $10 billion in external reserves and nearly exhausted its fiscal reserve fund which is known as the “excess crude account”. In order to adjust to the current situation, the government adopted a contractionary fiscal policy to reduce planned government expenditure by 0.5% in the upcoming 2015 budget. The 2015 budget had a specific theme; ‘the transition budget’. The goal was to promote economic diversification and strengthen the economic fundamentals.
Oil revenues which were a significant part of the economy declined due to the fall in prices, which meant that the government had to limit its capital expenditure to ensure that the deficit does not deepen further. In addition to this, the government removed oil subsidies partially and there was an introduction of a tax on luxury goods e.g. private jets, yachts and exotic cars. This was done with the intention of strengthening the contribution of non-oil sectors to the economy.
The Nigerian government should aim to coordinate both fiscal and monetary policy tools to accommodate future shocks. Nigeria does not have a strong and efficient tax sector so their use of fiscal policy as an instrument is limited. Although the CBN is attempting to broaden its tax base by implementing higher taxes for luxury goods, the revenue from this will not be sufficient to offset the shock. The Nigerian government is advised to widen its policy measures to minimize its dependency on one tool.
In summary, the severity of the decline in oil prices on the Nigerian economy suggests that the pre-shock economic fundamentals were not strong enough. The combination of policies implemented by the CBN was clearly not efficient as the economy went into a recession. The government is encouraged to shift away from its dependency on oil and diversify the economy. This will enable the country to withstand forthcoming shocks and it will also encourage inclusive and rapid economic growth and development in the long run.
The Nigerian Fiscal authority also has to ensure that they are always prepared for forthcoming shocks because if fiscal buffers are deficient, it will be difficult to implement macroeconomic policy responses. They can do this by providing financial buffers that could be used to alleviate deficit issues. Evidence has shown that countries which save their oil rents abroad during their boom years are more likely to have a buffer for the busts.