Foreign Currency

Paper Money: How the money supply myth kills growth

Despite remarkable growth in FX inflows for Q1 of 2024, the naira remains embattled, having depreciated substantially from its N900/$ rate at the close of 2023.

Substantial volatility has left many weary and sceptical of the gains we have seen in recent weeks. Inflation is at levels unseen since the Abacha years, driven by piercing food inflation which eats incessantly at the buying power of ordinary Nigerians. Supply side challenges persist and exchange rate pass through, pushes basic necessities out of the reach of ordinary Nigerians.

It’s against this backdrop that the Monetary Policy Committee met last week. Anticipation was high. After an agonising wait, the analysts were near unanimous in their desire to see the committee double down on their commitment to inflation busting and monetary tightening.

The committee delivered once again, prescribing a further 200 basis point hike in the monetary policy rate to 24.75%, and an increase in the cash reserve ratio (CRR) for merchant banks from 10 to 14%. They kept CRR for commercial banks at 45% and the liquidity ratio at 30%.

The move was met with little surprise. Finally, it seemed, CBN was serious about taking on the burgeoning money supply which has become synonymous with inflation. Markets reacted positively. However, the data suggests that we’ve been getting it wrong.

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While it may sound heretical, sober reflection on trends in money and credit suggest that much of the angst for hawkish tightening is misplaced. MPC is prescribing the right medicine for the wrong diagnosis to anchor inflation expectations, and if the alarm is not sounded, the consequences may be dire.

Printing Money?

In February 2024 panic set in. M3 jumped by 18.21% in January 2024, when compared to December 2023, to N93.72 trillion, an alarming 76% compared to January 2023. Social media swirled with accusations, how could the government deny that it was printing money, just like the ways and means excesses it had criticised the Buhari administration for.

Much of this drove and justified the rapid depreciation in the currency to a low of N1900/$ in people’s minds. The focus on the headline figures obscured a shift which has important implications for how we approach our persistent inflation.

There are three tools that we generally use as a measure of money supply: M1, M2 and M3. M1 measures all the actual naira which can be used on demand. That’s the money in your deposit accounts and the cash that’s out of banks – so basically everything that can be spent as it is.

M2 takes M1 and adds all the stuff that’s so liquid that it could soon be money but is a bit more difficult to spend – that’s things like savings, fixed deposits and, importantly, foreign currency deposits. Finally, you have M3, which is M2 + any CBN bills held by the money holding sectors.

M1 is the closest measure of the actual money chasing goods in the economy, hence its name, narrow money. M1 has consistently fallen as a proportion of M2. What does that mean? As money supply grows, less and less of it is flowing in the real economy.

This trend is to be expected, indeed, those locked in deposits are a sign of a deepening banking system. However, if most of the new money supply was tied down, how could it have been driving inflation, and how could it have been chasing the dollar?

(Data Source: Money and Credit Statistics, CBN. Graph by Author.)

M3 – Growth on Paper

The angst about ‘money supply’ grew further still when it hit a new all-time high of N95 trillion In February. Pundits grappled with how money supply could have increased by 79% year on year; many pointed fingers at the Federal Government with the now familiar accusation of “printing money”.

One popular economist, in a Channels TV presentation, argued that “the big elephant in the room is money supply growth”. He went on, “if your GDP is at 3.4% and your money supply growth is at 79%, you have issues – you’re 73% underwater… so we need to tighten at this time, you can’t call it choking.”

The analysis follows the same argument which dominates the public discussion: there is a positive correlation between inflation and money supply growth; ergo money supply must be curtailed to combat inflation.

It’s based on a fallacy which fails to see the shift in the dynamics of money over the near and longer term. Worse still, the analyst misleadingly related nominal M3 growth, which does not account for inflation, to real GDP growth, which does.

For the first six months of 2023, growth in broad money was driven by increased lending, with a 31.15% increase in domestic claims, and a 39.64% increase in net claims on central government over the preceding December 2022.

Quasi money was being driven by increased holdings in government securities (borrowing). One thing we seem to have missed is that, with naira floatation, M2 is vulnerable to the kind of illusory growth implied by rapid depreciation. For the next 6 months, and indeed ever since, the primary driver of the growth in M3 has been the impact of revaluation in the aftermath of the CBN’s move to float the currency.

Indeed, this revaluation effect has distorted the data, giving the impression of rapidly expanding credit and monetary laxity, when this new “money” only exists on paper, just like the exchange rate gains which propelled paper profits in the banking sector to levels they will be unlikely to replicate this year.

(Data Source: Weighted Average Rate – Nigerian Foreign Exchange Market (NFEM); Money and Credit Statistics, CBN. Graph by Author.)


This is clear when one looks at the CBN’s Monthly Economic Reports for 2023. In May, M3 was being driven by a sharp expansion in domestic claims. Claims on the Central Government (in layman’s terms, government borrowing) grew by 22.57% over December 2022, contributing 14.25 points to M3 growth. The expansion in net domestic claims outweighed a decline in net foreign assets of 28.8%.

By November, this trend had reversed against the same benchmark of December 2022. Net claims on Central Government had fallen by 78.2%, constituting a drag of 35.5% points on M3 over December 2023, while net foreign assets grew 738.2% and contributed 54.36 points to M3 growth.

Indeed, the trend of money supply fell in step with fluctuations in the bilateral N/$ exchange rate as soon as the CBN floated the currency. Now, broad money is not driving depreciation, it’s the other way around.

A Looming Credit Crunch

This illusory growth is not limited to M2 and M3 alone, revaluation effect created a perception of rapidly expanding credit too. As the naira was floated, there was a sharp increase in both consumer and sectorial credit allocation.

Sectorial credit allocation kept step with fluctuations in the N/$ exchange rate from June through October, highlighting a significant FX credit exposure to the private sector. Increased consumer credit broke relationship with the N/$ exchange rate in August as people borrowed more to manage the sharp uptick in living costs but fell back in line by September.

What’s most concerning is that both forms of credit broke relationship in November. As the naira depreciated further, nominal credit to both consumers and the private sector trended downwards, suggesting a significant recession in both naira and FX denominated credit available. This was before the two MPC meetings which spoke and acted tough on liquidity.

(Data Source: Weighted Average Rate – Nigerian Foreign Exchange Market (NFEM); Monthly Economic Reports, CBN. Graph by Author.)

So, if by November, the FG was borrowing less (net), consumers were borrowing less and the private sector was borrowing less, where was all the money? Initially, the average net closing industry balance trended upwards, from N236.99 billion in April to N568.42 billion in July.

Since then, it has been in steady decline – reaching N146.45 billion in the most recently available data from November 2023. Throughout this period, usage of the CBN’s standard deposit facility has grown substantially from a year low of N224.29 billion in April 2023, to a peak of N3011.3 billion in October 2023, moderating slightly at N2801.7 billion in November.

By the time the MPC met in February 2024, MPC member Aku Pauline Odinkemelu noted that most banks already “had CRR above the regulatory threshold of 32.50%” and that the industry average was 39.36% – 6.86 percentage points above the MPC imposed requirement. In short, banks were not on a borrowing spree, at least outside the financial sector.

(Data Source: Money Market Indicators; Inter-Bank Rates; Money and Credit Statistics, CBN. Graph by Author.)

The money was with the CBN. Worse still, some banks were evidently borrowing to meet their short-term liquidity needs as key money market indicators – open buy back and interbank call rates – rose sharply from October when they sat at a monthly average of 6.3% and 7.2% respectively, to February when they averaged 19.33% and 19.39% respectively.

That increased deposits coincided with significant growth in interbank borrowing rates suggests that the macro-prudential picture is insufficient, either for understanding the conditions of liquidity in the banking sector, or for setting policy for it.

Naira Illiquidity through the Micro/Macro-Prudential Paradigm

Indeed, as Dr Ayo Teriba argues in a 2017 paper on monetary policy conundrums for Nigeria, the macro approach to the question of prudential policy has real costs in sacrificing growth by hamstringing banks that have no excess liquidity issues to target the specific ones that do. MPC, in mistaking a screw for a nail, has prescribed a hammer. This approach arises from two structural weaknesses in the Nigerian banking sector.

On one hand, despite advances over the last two decades, the banking sector still has very weak exposure to the critical sectors of the Nigerian economy.

As of November, sectorial credit allocation for agriculture was just 5.06% despite a contribution of 24.65% to GDP in Q4 2023.

On the other hand, there has – for decades – been a systemic weakness in “micro-prudential” regulation, forcing MPC to push up the cash reserve ratio – which has risen from just 1% in 2009, to 45% today – at the cost of growth.

The interplay of these structural weaknesses has clear implications. In a July 2016 communiqué, MPC noted that when monetary policy was loosened, “rather than deploy the available liquidity to provide credit to agriculture and manufacturing sectors, the rate cuts provided opportunities for lending to traders who deployed the same liquidity in putting pressure on the foreign exchange market”.

This was also reflected in the CBN’s intervention at the end of January to tackle the wide Net Open Positions of the banks which starved the foreign exchange market of liquidity and were effectively holding positions which were effectively short the naira.

It seems, the real driver of this squeeze is not the fear of liquidity, but of its misallocation. Our history tells us that such fears are not unfounded. In 2009, when liquidity had been channelled into an illusory stock market boom, the bust came with far reaching consequences.

Non-performing loans skyrocketed by 600% in just one year, that’s one of the reasons why we have the HoldCo model today, to stop banks from using deposits to speculate or engage in high-risk investments. With this new model, came new risks.

Consequently, the absence of the Financial Services Regulation Co-ordinating Committee, established in Section 43 of the CBN Act 2007, in recent moves to curb arbitrage in the banking sector is rather striking, and somewhat concerning.

The committee, comprised of the heads of all the key financial services regulators (CBN, SEC, NDIC, CAC, NAICOM and the Ministry of Finance), have an explicit mandate to “cause reduction in arbitrage opportunities usually created by differing regulation and supervision standards amongst supervisory authorities” and to “eliminate any information gap” between regulatory agencies.

Bizarrely, its interventions into public discourse have been preoccupied instead with illegal financial operators and Ponzi schemes, rather than the licensed entities that its mandate is explicitly anchored on. MPC is filling this lacuna, but its instruments don’t match the predicament.

Finding a Way Forward

The MPC has made clear that its intention is to signal aggressive regulation and monetary tightening to anchor inflation expectations and draw in FPI. To do this, the committee has mobilised both price (MPR) and quantity (CRR) instruments simultaneously.

It is evidently building credibility with both citizens and foreign investors and the naira is regaining its footing in response to substantial FX inflows. The question is, at what cost?

It seemed like basic economics, right? Inflation is too much money chasing too few goods. We knew there were too few goods. There were long term supply constraints. Then, there was rapid money supply growth. The data suggests a different configuration, one which has plunged millions of Nigerians into hunger: we have too little money, chasing too few goods.

What little we do have on the supply side is heavily exposed to the depreciation of the naira through dependence on imported inputs at all stages in the value chain. What little money we do have is increasingly constrained as reserve requirements bite, and narrow money falls. Things are getting more expensive, and Nigerians cannot afford it.

The danger then of tightening in such conditions, is creating such a choking environment that you end up creating long term damage to our production capacity to boost supply, whilst failing to address the root problems:

  1. Excessive liquidity in specific banks which is being mobilised towards profits from arbitrage. This can be addressed at a micro-prudential level through stronger supervision and leveraging the role of injections from FAAC in driving liquidity. As CBN Governor, rather than raise CRR, Charles Soludo withdrew public sector deposits from banks with excess liquidity as a means of targeting with specificity.
  2. Anchoring inflation expectations, after over 18 months of year-on-year inflation exceeding 20%, cannot sidestep the question of dispelling some of the myths regarding our position on the monetary side. It is evident that exchange rate pass-through is now the single biggest driver of inflation. We have seen moderations in month-on-month inflation twice in those 18 months, from June to October 2022, and from August to October 2023. Both were reversed by arbitrary shocks, the former by the Emefiele’s cash crunch, and the latter by significant depreciation in the naira after the relative stability in the months after the floatation of the naira. The failure to disaggregate measures of money supply, identifying the decline –  both proportional and nominal – of M1 (narrow money), counter intuitively fuels the unnecessary panic and entrenches a distortion in inflation expectations from factors which are not directly impacted by either MPR or CRR.

What is the Outlook

We don’t have a naira liquidity crisis; we are staring down the barrel of intractable illiquidity. Combining this with 24 months of new capital raising requirements for banks to meet the recapitalisation mandate, and the turmoil that this may create in the industry, the present position of the MPC on CRR especially is untenable.

The committee has made little effort to reorient the underlying assumptions in public discourse with data. This isn’t helped by the lack of focus that questions at the MPC press briefing have on the committee’s actual decisions.

Treasury bills and OMOs can be auctioned at higher rates without moving MPR, but the signalling effect made sense in February alongside a wide asymmetric corridor to mitigate the impact on liquidity flows to the real sector. Now the asymmetric corridor has been narrowed, pushing up the cost of credit for banks.

However, what should be the most urgent, is loosening the grip of excessively high, and untargeted cash reserve requirements on banks.

If the CBN is committed to creating an aggressive regulatory environment, the test will be its willingness to face down individual offenders, not its collective punishment of the sector and, as a result, the Nigerian economy.


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