Modelling the Inflation Process in Nigeria

MODELLING THE INFLATION PROCESS IN NIGERIA 2. Nigeria’s inflation experience Nigeria has experienced all manner of inflationary episodes – from creeping to moderate and from high to galloping (see Table 1 and Figure 1). Average inflation during the period 1960–1972 was relatively low, the historical average rate being 5. 01%. When assessed on an annual basis, however, rising prices became a cause for concern for the then military government when in 1969 the inflation rate hit double digits at 10. 36%. Government’s concern seems to have been justified by the fact that Nigeria was experiencing double-digit inflation for the first time, in the face of a raging civil war whose end was not then in sight. In reaction, government imposed a general wage freeze for a period of one year. Apparently aware of possible opposition by labour unions, price control measures were introduced with the official promulgation of the Price Control Decree, early in 1970 (see Fashoyin, 1984, for comprehensive discussion of anti-inflation measures taken during this period). Inflationary pressures continued unabated, however, even with price controls. Table 1: Inflation episodes in Nigeria Period Average 1960–1972 5. 01 1973–1985 17. 96 1986–1995 31. 30 1986–2002 13. 34 Source: Computed by the authors Pressures for salary increases led to the setting up of the Wages and Salaries Review Commission. The Commission eventually granted salary increases to all categories of public service employees, and similar adjustments were later made in the private sector. These awards, which came at a time when the dislocation of domestic production and marketing as a result of the civil war had not been fully repaired, generated a measure of excess demand in the economy. This is likely to have been responsible for the rise in the rate of inflation by 16. 0% in 1971. Government’s immediate response was to lift import restrictions on several categories of goods. Excise duties on a number of goods were also reduced. A credit policy that favoured the production of food was also put in place. These efforts, coupled with the establishment of the Nigerian National Supply Company (NNSC), were credited with yielding the relatively low rate of inflation of 3. 2% recorded in 1972. The period 1973–1985 was one of greater inflationary pressures than the period 1960–1972, with an average inflation rate in those years of 17. 96%. The effects of the 3 RP 182_Olubusoye_maintext. pmd 21/10/2008, 14:29 3 6 RESEARCH PAPER 182 Exchange rate regimes and inflation in Nigeria Inflation and exchange rates have been identified as two of the key â€Å"barometers† of economic performance (Rutasitara, 2004). Exchange rate arrangements in Nigeria have undergone significant changes over the past four decades, shifting from a fixed regime in the 1960s to a pegged arrangement between the 1970s and the mid 1980s, and finally to various types of floating regime adopted in 1986 with the SAP. A regime of managed float, without any strong commitment to defending any particular parity, has been the predominant characteristic of the floating regime in Nigeria since 1986. Exchange rate policy emerged as one of the controversial policy instruments in developing countries in the 1980s, with vehement opposition to devaluation for fear of its inflationary impact, among other effects. Nigeria faced such a situation and there has since been interest in the performance of inflation and the role of the exchange rate in the process. The peculiarity of the Nigerian foreign exchange market needs to be highlighted. The country’s foreign exchange earnings are more than 90% dependent on crude oil export receipts. The result is that the volatility of the world oil market prices has a direct impact on the supply of foreign exchange. Moreover, the oil sector contributes more than 80% of government revenue. Thus, when the world oil price is high, the revenue shared by the three tiers of government rises correspondingly, and as has been observed since the early 1970s, elicits comparable expenditure increases, which are then difficult to bring down when oil prices collapse and revenues fall. Indeed, such unsustainable expenditure levels have been at the root of high overnment deficit spending. It became a matter of serious concern that despite the huge amount of foreign exchange, which the Central Bank of Nigeria (CBN) supplied to the foreign exchange market, the impact was not reflected in the performance of the real sector of the economy. Arising from Nigeria’s high import propensity of finished consumer goods, the foreign exchange earnings from oil continued to generate output and employm ent growth in other countries from which Nigeria’s imports originated. This development necessitated a change in policy on 22 July 2002, when the demand pressure in the foreign exchange market intensified and the depletion in external reserves level persisted. The CBN thus reintroduced the Dutch auction system (DAS) to replace the inter-bank foreign exchange market (IFEM). Since then, the DAS has been largely successful in achieving the objectives of the monetary authorities. Generally, it assisted in narrowing the arbitrage premium from double digits to a single digit, until the emergence of irrational market exuberance in the fourth quarter of 2003. Figure 2 charts the details of the movements in inflation and the parallel market premium over the official exchange rate. As can be seen in the figure, movements of the parallel exchange rate premium and inflation rate were very close, especially during the mid 1970 and early 1990s. Indeed, this was the period of widest divergence between the official and parallel market exchange rates. As can be seen from the graph, the peaks and troughs almost always go together, thus confirming that the parallel market exchange rate was significantly correlated with the inflation rate. RP 182_Olubusoye_maintext. pmd 21/10/2008, 14:29 6