DOUBLE TRILEMMA AND CENTRAL BANK BEHAVIOUR IN NIGERIA

Abstract

Free capital flows, stable foreign exchange rate and independent control of money supply by the Central Bank are necessary for a robust economy. However, a combination of any two of these policies is possible at a time and often referred to as macroeconomic trilemma. Export growth through increased credit to the private sector could counteract this trilemma. This could lead to financial trilemma which is constraint faced when combining financial stability, national financial policy and free capital flows. Both trilemmas become double trilemma. The Central Bank, therefore, behaves carefully and in a forward-looking manner to use its policy variable of exchange rate. The literature is extensive on macroeconomic trilemma but little attention is paid to financial trilemma. Hence, this study was designed to investigate double trilemma and central bank behaviour in Nigeria in the presence of political risk.

The study used an extended Mundell-Fleming Theory to examine how the Central Bank of Nigeria (CBN) stabilizes the exchange rate when faced with the double trilemma. Associated macroeconomic variables are real exchange rate policy (fixed and managed-float regimes), real gross domestic product, growth of broad money supply, net export, interest rate, consumer price index, growth of credit to the private sector and political risk variable (computed by the International Country Risk Guide). The statistical properties of the variables were examined using the Augmented Dickey Fuller, Ng-Perron, Kwiatkwoski-Phillips-Schmidt-Shin and Zivot-Andrew tests. The Markov Switching Dynamic Regression technique was employed to ascertain the number of regime switches and to further estimate the CBN behaviour when faced with the double trilemma. Also, the Structural Vector Autoregression technique was used to trace the shock transmission of the exchange rate policies of the CBN to the economy. The data were sourced from the CBN Statistical Bulletin, the International Country Risk Guide and the World Development Indicator. All estimates were validated at .

The behaviour of the CBN was largely affected by shock from the political risk variable to the tune of 78.6%. Reduced political risk enhanced exchange rate appreciation in Nigeria; both with fixed and managed-float regimes . Political risk increased the transition of switching between exchange rate regimes (2.2%) but reduced the degree of persistence of exchange rate regimes (9.8%). Under fixed exchange rate regime with political risk, economic growth , foreign interest rate and credit to the private sector resulted in exchange rate appreciation, while growth of money supply and trade balance caused exchange rate depreciation. However, for fixed regime with no political risk, foreign interest rate insignificantly worsened exchange rate depreciation . For managed-float regimes with and without political risk, the variables were insignificant.

The stability of the exchange rate was found crucial for Nigeria as the Central Bank of Nigeria switches between fixed and managed-float exchange rate regimes in trying to manage the double trilemma. However, the monetary authority traded-off its independence in trying to do so. Sound macroeconomic policies, stable financial sector and low political risk are factors capable of moderating the Central Bank Behaviour in Nigeria.