IMF Warns Nigeria of Dollarisation Risks Amid Naira Crash

Part of the report by the Washington-based multilateral lender said:

“Most economies operate with a foreign exchange (FX) (e.g., the dollar) bias for international trade and finance invoicing. Additionally, banking systems in many developing economies are bi-monetary.

“A bi-monetary system embodies the failure to conduct monetary policy effectively, i.e., secure price stability, efficient payment systems, and well-functioning financial markets (including long-run financial contracts at comparatively low nominal interest rates). Particularly, under high and persistent inflation, market participants defend themselves by shifting to FX.”

It’s hard to reverse a bi-monetary system: The IMF cautioned that dollarisation is difficult to reverse. The report explained:

“Once a country gets used to a bi-monetary system, the process is not easy to reverse, even when the initial trigger (e.g., high inflation) subsides, a phenomenon known in the literature as hysteresis. The optimal choice between domestic currency vs FX will depend on the monetary framework and the benefits each may offer as they co-exist as two currencies.

“The most common type of dollarization is financial dollarization (FD), or asset substitution, caused by the poor performance of the local currency. The local currency is used more for payment transactions but is replaced by the dollar as a saving asset or store of value, in line with Gresham’s law.”
It also limits the role of the exchange rate: The IMF report further noted that a bi-monetary system limits the role of the exchange rate as a shock absorber, as real dollarisation implies a high pass-through from exchange rate depreciation to inflation.

“Financial dollarization creates currency mismatches and liquidity risks for the financial system and the economy as a whole. Therefore, the exchange rate amplifies negative external shocks rather than absorbing them.
“Both financial dollarization and real dollarisation jeopardize monetary transmission mechanisms, as inflation expectations are difficult to anchor with a weak interest rate channel. Financial dollarisation-related financial instability would need to be addressed via policy responses such as a central bank forex reserve buildup and associated regulation.”

Nigeria’s forex and high inflation troubles: Nigeria’s inflation rate surged to 20.77% in September 2022, up from 20.52% recorded in the previous month. The food inflation rate in September 2022 was 23.34% yearly, marking an uptick from the 23.12% recorded last month.

According to the National Bureau of Statistics, the increase in the country’s inflation rate may be attributable to the disruption in the supply of food products, the rise in import cost due to depreciating currency, and the general increase in the price of production.

The Nigerian exchange rate has crashed to N800/$1 against the US dollar on the black market, while the exchange rate between the naira and the US dollar at the importer and exporter window (I&E) official window depreciated to N441.13/$1.