12 April 2015, Lagos – “There are known knowns; there are things we know we know. We also know, there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know-” Donald Rumsfeld, Secretary of Defense under President George W. Bush
As I was finalising preparation for this article, originally titled “Oil Price, Naira, and the Economic Titanic,” the Standards & Poor (S&P), on March 20, 2014, downgraded Nigeria’s sovereign credit ratings from BB- to B+, pushing the country further into investment junk territory by four levels. Earlier on February 10, 2014, S&P put the country’s sovereign rating on CreditWatch negative, suggesting that there may be a downgrade after subsequent “review of the government’s policy response to a lower oil price environment.’ As S&P actually followed up with a rating downgrade, it seems to imply that the policy responses were inadequate and insufficient.
However, I deem the country’s recent rating downgrade by S&P as actually good news! The good news is that most of the bad news on Nigeria’s macroeconomic fronts may now be behind us barring a further precipitous fall in Brent oil price below $40, undiscovered deep fiscal holes, and widespread political crisis following the presidential elections. S&P has simply confirmed what some Nigerians, including myself, have been echoing, never mind the media spin and the knee jerk reactions to economic news by the economic managers. But as a contrarian, it is safe to note that the worst of the macroeconomic gloomy news is out of the bag. Of course, the fundamental microeconomic issues of poverty, unemployment, and inequality, and the real difficulties of paying for school fees, house rents, and food by most Nigerians would worsen as devaluation with its inflationary pressures, high borrowing costs, and austerity measures percolate across the economy. Moreover, the structural issues of institutional and infrastructural deficits remain entrenched. Addressing these challenges is paramount to Nigeria realizing its medium to long-term developmental potentials.
There are lessons to be learnt from the phenomenal titanic crash of oil prices, the devaluation of the naira exchange rates, and worsening of other macroeconomic indicators and the policy responses. This is where Rumsfeld’s rhetorical weapons of choice relate to economics and finance. They actually originated from a University of Chicago economist, Frank Knight (1885-1972) who tried to distinguish between risks, uncertainty and ignorance in a complex and non-linear world.
The first categories, known knowns are trends and risks in which both outcomes and likelihood of an event or occurrence are specified. The second categories, known unknowns are referred to Knightian uncertainties or tails, where outcomes or events are specified, but probabilities of occurrence are not. Our ignorance or limited imagination is reflected in the third categories of the unknown unknowns—the ones we don’t know we don’t know.
The Titanic was imagined to be an unsinkable ship ever built. Mark Fisher of the Federal Reserve Bank of Atlanta in “Monetary Policy, Economic Modeling, and Unknown Unknowns,” considers the maiden voyage of the Titanic and the decisions her captain made regarding course and speed, based on what he knew and believed. Every captain of every ship must assess the risks associated with the second category– location of every iceberg in the shipping lanes–in light of the knowledge of the first category—the specific designs of the ship. Fisher noted that the captain of the Titanic—taking into account only the first and second categories—may have believed the ship would not sink if it hit an iceberg, and therefore his decision to steam at high speed through waters where icebergs were likely carried with it an acceptable risk. The specifics of the third categories– the potentials for a breach in the hull large enough to sink the ship–are unknown and very difficult to assess the risks. Nevertheless, a healthy regard for their existence might have led the captain of the Titanic to change course or reduce speed. Of course, with today’s knowledge and technology including satellite imagery and the Global Positioning System, it may now be possible to know the location of every iceberg, with the consequence that the second categories can now be turned into first categories.
Oil Price: Knowns and Unknowns
The Titanic reminds us of the over-hyped re-based economy. First, there were known knowns in relation to oil prices, but were essentially ignored by our economic managers. We know that oil is a commodity, with its own boom and bust cycles. We also know that by historical standards, the 2014 oil price decline episode is not unusual. According to the World Bank, between 1984 and 2013, five other episodes of oil price declines of 30 percent or more in a six-month period occurred. Over a longer period, Stayajit Das, author of the book: “Trades, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives,” provides a more detailed narrative of “Reverse Oil Shock” noting that in 1973, the oil price quadrupled from US$3 to US$12 per barrel. In 1979, it rose from US$15.85 to $39.50, the highest real price until March 2008. In the 1980s, it fell by 70 percent from around US$35-40 to below US$10. In 1990, it climbed from US$17 to $36, followed by a 60 per cent decline to a low of US$20 in 2001. Between 2003 and 2008, it increased from around US$25 to US$147 per barrel before falling by 70 percent to about US$40. The price of oil, which was above $100 for four years and fell by over 50% since June 2014, adjusted for inflation reached 1979 levels. In “Understanding the Decline in the Price of Oil since June 2014,” Christiane Baumeister of Bank of Canada and Lutz Kilian of University of Michigan show that more than half of the cumulative decline in the price of oil (about $27) was predictable in real time as of June 2014, using publicly available information. Demand shocks contributed $11, about a quarter, supply shocks accounted for $16; about a third, and the remaining price decline was attributed to shock to oil price expectations.
Second, there was more or less an over-confidence on the part of the economic managers about the second categories of the known unknowns of oil prices. As previous oil price down cycles bottomed after 60 to 70 percent decline, it was therefore surprising that the Fiscal Authorities initially used $78 benchmark, when we could have turned our knowledge of the previous oil price cycles as essential risk trends to manage the uncertainties with the evolving oil prices in 2014 and early 2015, which could fall to around $40. Further, Dele Sobowale of Vanguard also wrote in “Unrealistic crude benchmark, exchange rate,” that the underlying assumptions of $78 for crude oil price and N160 per dollar for the 2015 national budget “exhibits the triumph of hope and self-delusion over reality and the verdicts of economic history and experience. Neither one of the two key foundations of our budget can, by any stretch of imagination be considered reasonable—given global current situation and trends in 2005.” We also know that on the supply side, the US alone has been adding more than 3 million barrels a day for over four years or more and as the shale gas revolution was gathering momentum, Nigeria also has a reduction in US import volumes by more than 90%. It was argued in my article on “How not to manage the economy” in The Guardian that Nigerians needed to have rational expectations about the budgetary scenarios for $60, $50, $40, and $30 oil prices. The National Assembly subsequently revised the benchmark to $52.
There are also elements of the third categories of unknown unknowns. As a result, forecasts of oil prices going forward remain fraught with wide variations. In the near term, both oil demand due to slow global economic growth and oversupply will keep pressure on oil prices to be weak and volatile. While some see the fall as temporary and prices may have actually stabilized at near $60, others argue that the oil prices have entered a new range of US$20 to US$60 per barrel. There are also other complex factors at work including the surging US dollars, disinflation, and high real interest rates. Over the medium to long term, market forces will take time to work themselves out and lower prices will increase demand and reduce supply. But we cannot also neglect the impacts of geo-political risks, shale productivity yield, conservation and environmental factors on both demand and supply for oil.
Naira Exchange Rates Knowns and Unknowns
What were the known knowns in respect of exchange rate management? First, Monetary Policy Trilemma states that a country can only choose two combinations of exchange rate stability, monetary independence, and open capital mobility. This is one of the essential points made in my article on “The Unholy Trinity and Nigeria’s Misery Index” in THISDAY in June 2014, which tries to dissect the inaugural speech of Governor Emefiele. From 1986, the country opted for more open capital mobility, less exchange rate stability, and more monetary independence. In particular, over the past five years, policies were characterized by incentives for short-term portfolio capital inflows with persistent high interest rates, with relatively low controls on short-term capital movements and heavy intervention in the foreign exchange market. The era of capital feast was followed by capital famine from 2013 when foreign portfolio investors started taking a flight putting downward pressure on the exchange rate and foreign reserves, which declined from a high of 30% of GDP in 2007 to 6% of GDP, the second lowest since the 1980s, and near 4 months of imports.
The reality of a Policy Quadrilemma then sets in as the foreign reserves now became a major constraint to maneuvering around the Policy Trilemma. It was surprising that the CBN Governor was quoted by Bloomberg as indicating that the CBN had policy window to maneuver with a reserve of $30 billion in 2015 compared to $10 billion in 2001. However, the ratio of foreign reserves to GDP was higher than 20 percent and amounted to more than eight months of imports in 2001. In absolute terms, the level of reserves is now much lower relative to $52 billion in place during the last oil price shock in 2008. Policy Trilemma and Quadrilemma also explain the resistance to the initial attempt by the CBN to have capital controls on the exchange rate, which poses risk for inclusion of Nigerian bonds in the JP Morgan index. In the article on the Central Bank’s capitulation in the Guardian, it was noted that the MPC had set itself up for the financial markets to lead it towards an exchange rate of N200 to $1; which has essentially materialized. The interbank rate has hovered around N200 to $1 and parallel market rate has touched N230 to $1 and may still widen judging by expectations of some foreign portfolio investors. Some have been predicting N300 to $1; not impossible if foreign reserves head towards $20 billion or below 4% of GDP and three months of imports respectively. At this point in time, however, this level will appear to be more of an exchange rate overshooting due to uncertainty relating to the elections and low risk appetite, which is driving people to protect them by selling an asset whose price is already declining and to load their portfolios with safer assets.
In conclusion, in a crisis period, information is highly imperfect as the combined ratio of the second and third categories are usually higher than the first categories; that is to say that uncertainties and ignorance are greater than observed risk trends. However, it is essential to capitalize and not ignore the first category of known knowns, nor be overconfident about the second category of known unknowns, while trying to be imaginative about the third category of unknown unknowns. With knowledge and imagination, efforts could be made to turn the second category into the first category, convert the third category into the second category, while recognizing that there will always be elements of the third category. But, it also implies that there is a need to be broad-minded with a pluralism approach to economic management.
*Temitope _ Thisday