CBN Report: Fiscal Deficits Impacts Naira, Spikes Interest Rates

■Says fiscal expansion remains major source of exchange rate instability

■Study advocates legally binding fiscal rule establishing a ceiling for budget deficits relative to gross domestic product, others

James Emejo in Abuja

The country’s persistent budget deficits are exerting significant pressure on the Naira, fuelling exchange rate instability and complicating efforts to lower interest rates, a Central Bank of Nigeria (CBN) research has disclosed.

The study, published in the CBN Journal of Applied Statistics, identified government’s fiscal imbalances as a major driver of currency depreciation, warning that sustained borrowing and spending pressures could undermine monetary stability, restrict credit to businesses and weaken private-sector investment.

The findings provide further insight into the consequences of a prolonged fiscal expansion, particularly as the federal government continues to rely heavily on domestic and external borrowing to finance its widening budgetary requirements.

Titled, “Budget Deficit Dynamics and Macroeconomic Performance in Nigeria” and authored by Ndubuisi E. Uguru, the research examined the relationship between fiscal deficits and major macroeconomic indicators using annual data spanning 1981 to 2024.

Employing a Vector Autoregressive (VAR) framework, the researcher established that budget deficits were a primary source of exchange rate fluctuations, accounting for a substantial proportion of currency movements in the immediate period and contributing to sustained depreciation over time.

The research also found that fiscal imbalances exert delayed upward pressure on interest rates and could trigger a contraction in money supply, suggesting that monetary authorities might be forced to adopt restrictive measures to contain the consequences of government’s expansionary fiscal operations.

The study stated, “The results revealed that budget deficits are a primary driver of exchange rate depreciation, accounting for a substantial share of exchange rate fluctuations in the immediate period and triggering a sustained currency decline, while also exerting delayed upward pressure on interest rates and paradoxically inducing a significant contraction in the money supply likely reflecting defensive monetary tightening.”

The implications are particularly significant for an economy where government borrowing competes with private-sector demand for credit, potentially increasing financing costs for businesses and constraining investment.

Fiscal pressures and monetary policy constraints

The reserach established that the country’s fiscal imbalances tend to perpetuate themselves, with budget deficits accounting for 100 per cent of their own variations initially and retaining approximately 53 per cent of their influence by the tenth period.

The finding suggests that fiscal pressures could become self-reinforcing, making it increasingly difficult to reverse the cycle of borrowing, rising financing obligations and further deficits.

It also highlighted the evolving relationship between investment and other macroeconomic variables, noting that investment was largely determined by its own dynamics in the short term but became increasingly influenced by inflation and money supply over the longer term.

However, contrary to the assumption that fiscal expansion necessarily translates directly into higher prices, the research found no statistically significant direct relationship between budget deficits and inflation.

It stated that Nigeria’s inflationary pressures were more closely associated with supply-side shocks, structural bottlenecks and the transmission of exchange rate movements to domestic prices than fiscal policy alone.

The researcher described the broader findings as evidence of fiscal dominance, a situation in which government financing requirements and spending pressures constrain the ability of the central bank to pursue monetary stability independently.

Calls for binding fiscal rules

To contain the risks, the study advocated a legally binding fiscal rule establishing a ceiling for budget deficits relative to gross domestic product (GDP).

Such a framework, it said, would impose greater discipline on government borrowing, limit persistent fiscal imbalances and reduce competition between the public and private sectors for available funds.

The research also recommended establishing a non-oil Fiscal Stabilisation Fund to strengthen the economy’s capacity to absorb external shocks and reduce the vulnerability of public finances and the exchange rate to volatile revenue sources.

It further called for more strategic management of external reserves and proactive trade policies, including incentives for domestic production, to reduce import dependence and exposure to external pressures.

On monetary policy, the study urged the establishment of a transparent framework for coordinating fiscal and monetary operations, arguing that better coordination would enable the CBN to manage liquidity more proactively rather than resorting to abrupt restrictive measures in response to government spending pressures.

It also recommended improving private-sector access to credit, reducing borrowing costs and stabilising inflation expectations to encourage capital formation and support sustainable economic growth.