As Nigeria struggles with a sinking local currency and surging inflation, the International Monetary Fund (IMF) has cautioned that dollarisation will be difficult to reverse.
The IMF issued the warning in a new report titled “Digital Money and Central Bank Balance Sheets.” In the study, the IMF found that when inflation is severe and persistent, market players strive to protect themselves by holding dollars.
The IMF also stated that the dollar is used by the majority of economies for international commerce and financial invoicing. However, with an increasing rate of dollar scarcity and high inflation, Nigeria’s dollarisation levels have been cause for concern. According to a portion of the study from the Washington-based multilateral lender:
“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 restricts the function of the exchange rate: According to the IMF research, a bi-monetary system reduces the exchange rate’s role as a shock absorber since real dollarisation implies a substantial pass-through from exchange rate depreciation to inflation.
“Financial dollarization causes currency mismatches and liquidity hazards for the financial sector and the whole economy.” As a result, rather of absorbing negative external shocks, the exchange rate amplifies 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 inflation rate grew to 20.77% in September 2022, up from 20.52% the previous month. In September 2022, the annual food inflation rate was 23.34%, up from 23.12% the previous month.
According to the National Bureau of Statistics, the country’s inflation rate may have risen due to a disruption in food supply, an increase in import costs due to a falling currency, and a general increase in manufacturing expenses. The Nigerian currency rate has plunged to N800/$1 against the US dollar on the black market, while the official rate between the naira and the US dollar via the importer and exporter window (I&E) has fallen to N441.13/$1.
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