Week 30, 2022 Ingest
The Devaluation of a Currency; using the Naira as Case Study.
It’s no longer news that various countries around the globe are battling inflation and devaluation of currency; we can all agree that it hasn’t been the best year economic-wise. While almost every country has been fighting this same battle, we can also agree that some are having it hotter than others.
Take Naira - Nigeria’s currency for example, which fell as low as 718 to the dollar on black market this week. This post will address the most probable cause of this rapid devaluation of the currency and that of many other currencies too. I will try to explain this to the best of my knowledge even for a 3-year-old, while also addressing the elephant in the room. I will try to balance this post as macroeconomics can be complex and has a lot of moving parts. Now, let’s begin.
The Strength of a Country’s Currency
A lot of factors affect a country’s currency strength. From internal factors such as its economy, and money printing to external factors such as debt, trade, and global demand (especially if it’s a reserve currency). These are some of the factors working at the same time to determine the value of a currency. But they all boil down to Supply & Demand dynamics, which is the elephant in the room around which all these factors revolve.
Let’s start with the external, how countries like Nigeria get their foreign currencies in the first place. Countries get foreign currencies majorly through foreign trades. For a resource-rich country like Nigeria, the Federal Government trades its resources like Crude, Gold, and Agricultural products for foreign currencies like U.S dollars, the Chinese Yuan, etc. But it’s usually the U.S. Dollars because it’s the reserve currency for world trade. This is the major way a country like Nigeria gets foreign currencies and it represents over 60% of the inflow of foreign currency in the country.
What does the Federal government do with these foreign currencies gotten from trades? They give it to the Central Bank (or Federal Reserve) of the country, which will store it in the country’s reserve. In most cases, this is regarded as the country’s main external economic indicator, especially for borrowing. Take note of these keywords mentioned so far, Products (resources) for trades and borrowing power because we will still come back to these.
Sponsored Ad - Binance
If you are in a third-world country probably battling currency devaluation, we can’t possibly overemphasize how great an option, Crypto is for you. From storing Value from currency devaluation to seamless transactions to exciting utilities, Binance is the best place to start your Crypto journey!
Sign Up for a Binance Account Today!
Now that the Federal government has given its foreign assets and currencies to the central bank to store in the country’s reserve, the Central Bank will now print an equivalent of that amount in its local currency. Let’s say there’s $1B worth of foreign reserves, the central bank is expected to print an equivalent of that amount and give the Federal Government. This money will be sent into the country’s economy through Government allocations, Workers’ Salaries, Infrastructure, Supporting local businesses, and many more. Of course, it’s more complicated than this, especially since the U.S. set a bad example for countries by leaving the Gold Standard in 1971, which was basically a “value-backed currency standard”. But we are keeping things simple in this post, let’s not digress.
Also bear in mind that this is not the only way a country earns revenue, as a country earns in many ways like Tax that goes to the government and is also expected to flow back into the economy to run the country. You are most definitely aware of this too.
The First Stage of Calamity - Shortages
What does this foreign reserve to local currency balance mean for a country like Nigeria where foreign exchange is predominant even at the local level? In our example, it means that for every supply of $1B, there’s an accompanying demand for it. And this balance must be kept always.
But what happens if say, a supply of $900M is in the foreign reserve supposedly backing a demand of $1B? As you can see, there will be an offset because now there’s more demand than supply. It will also mean that there’s more local currency (naira) in circulation than there actually is foreign currency (Dollar) backing it - Supply & Demand. This is the first stage of currency devaluation.
Now, what will happen if the Federal Reserve in our example keeps decreasing, say from $900M to 800, 700, 500, and so on? Well, there would be an even lesser supply of foreign currency backing the demand which means more Naira chasing fewer Dollars. We know how this goes, the rates will keep going up and the local currency will keep depreciating to the foreign currency.
More people will become spooked that the local currency is devaluating, they also join the hunt for foreign currency to store their wealth from the devaluating local currency. This means even more local currency chasing the lesser foreign currency and rates go even higher. And this horrible cycle keeps spinning out of control.
What causes these shortages in Federal Reserves? We all know! Enter corruption and mismanagement of the country's resources! But that’s a story for another day.
Sponsored Ad - Canva
Create and collaborate with your team. Review, comment, and approve all in one place. Team up for free today.
Sign Up for a Free Canva Account!
The Second Stage of Calamity - Money Printing
With this cycle already getting out of control, the government might be tempted to print more money to run the economy and “cover their tracks”. Remember, there are still very few reserves backing this new amount of local currency the central bank is about to create out of thin air. And this now means even more local currency in circulation which adds fuel to the already ravaging fire.
The Third Stage of Calamity - Debt
Ok, let’s say the government comes to its senses and now realizes that printing money isn’t the way to go at this point, they are still very limited with options. Oh! We can borrow money! But with which reserve as borrowing power? The depleted one? Lol. Even if they get a lender to lend them funds to keep their economy by the thread, they are now desperate. And we know what happens when you borrow money desperately - you could even sign your life away.
The governments might not even care about the terms and policies behind these debts as they need those funds urgently. Most of these international debts involve clauses to give something valuable from the country, such as ports, landmarks, and resources. These devaluate your currency even more. It’s almost like signing a whole country out to slavery.
So, you sell your soul to the devil. But just like everything from the devil, you won’t do much with them. The economy is under pressure, and turmoil is everywhere. Besides, if you mismanaged funds up to this point, why would it be any different now with this burrowed fund? And when the borrowed funds are exhausted, you look to borrow more, sign more of the country’s assets away, devaluate your currency more and you have yourself another lever in the horrible cycle.
All these levers will be working at the same time, to cause a chain reaction that will keep driving the country into deeper turmoil. This is usually the effect of years of recklessness while the rot keeps eating deeper. Before you know it, you have a case of people buying a loaf of bread with truck loads of worthless cash.
Whether it’s to say the country in our case study is going to get there or how far it is from there, those are not even the point of this post. The point is that this is a terrible condition to be in the first place and is always due to recklessness. It’s a horrible shoe to be in and should be avoided by all means!
Are you an online seller or freelancer in a country where it’s difficult for you to receive and convert funds from your foreign clients? Worry no more because Payoneer has got your back.
Create a Payoneer Account Today!
Let’s talk about solutions.
In a case like this where the deed has been done, it’s best to find better ways forward. Well, I don’t have all the answers, we can all agree this can be a lot already. But here’s my advice anyways.
The country needs to pause and account. This is the first step to solving a problem as you can’t solve a problem if you don’t even know how bad it is! The country needs to determine where it is at that moment, the available cash flow, assets, and liabilities - like some sort of “macro accounting”. Look, a country is just a bigger version of an individual/company. You know the same way a company runs an account to identify and solve financial problems, well it applies here too on the macro level.
At this point, the country knows what it has, owes, and doesn’t. Now, it will need to allocate available resources in such a way that it will gradually keep paying its debts, while also reserving some funds to run the country. This means cutting down unnecessary expenses to the minimum, and increasing interest rates to gate borrowing in the country, among many others. This will drive the country into a recession or even a depression but it’s a necessary price to pay for the greater good.
Produce more, deal best:
Here comes the real work. Now that we have found out where we are, and stabilized what leaves the economy (expenses), let’s figure out what adds to it (revenue). The country needs to produce more, all hands on deck!
“The greatest resource of a country is its people and the economy of a nation is a factor of its productivity.”
More hands on deck working smarter this time means the country will produce more. But then we need to rectify a major issue that led to this condition in the first place - mismanagement of resources. It’s not just about production, but also about getting more out of available resources. Fight corruption at this level, as much as possible. Every penny must be accounted for to make sure the country is getting the best out of trades with its international counterparts.
From our company - C2S Library
Visit our library today and check out the various ebooks and files we have available. Our e-materials are educative and informative, and you also support this newsletter when you patronize us. So, start reading today.
With all these levers working at the same time, the country should theoretically start crawling back to stability and even growth.
This might sound like a lot for beginners or too shallow for professionals but remember that the goal of this post from the beginning is to give the most balanced explanations possible. It’s definitely more complicated than this as macroeconomics has a lot of moving parts. However, we can all agree that every country needs smart people running it. The point of democracy is supposed to elect the best in power, and not as a tool for mediocrity. When you have financially smart people in power, they are most likely going to do the job of managing a country’s finance well.
On that note, we’ve come to the end of this awesome nugget. I’m sure you enjoyed this.
If you are reading this as a visitor, I will urge you to subscribe to our newsletter below to keep getting more of this excellent content directly in your email inbox. Also share it with your friends if you feel like it.
See you at the next one!