Persistent budget deficits are a major driver of naira depreciation and exchange rate instability in Nigeria, while also complicating efforts to lower interest rates, according to research published in the Central Bank of Nigeria Journal of Applied Statistics.
The study, titled “Budget Deficit Dynamics and Macroeconomic Performance in Nigeria” and authored by Ndubuisi E. Uguru, analysed annual data from 1981 to 2024 using a Vector Autoregressive framework. It found that fiscal imbalances account for a substantial share of exchange rate fluctuations in the short term and contribute to sustained currency decline over time.
The research also established that budget deficits exert delayed upward pressure on interest rates and can trigger a contraction in the money supply. This pattern, the study said, likely reflects defensive monetary tightening as authorities respond to the consequences of expansionary fiscal policy.
“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 paper stated.
These dynamics point to fiscal dominance, in which government financing needs and spending pressures limit the central bank’s ability to pursue monetary stability independently. Government borrowing competes with private-sector demand for credit, potentially raising financing costs for businesses and constraining investment.
The study found that fiscal imbalances tend to be self-reinforcing. Budget deficits accounted for 100 per cent of their own variations initially and retained about 53 per cent of their influence by the tenth period. Investment, meanwhile, was driven largely by its own dynamics in the short term but became more influenced by inflation and money supply over longer horizons.
Contrary to common assumptions, the research found no statistically significant direct relationship between budget deficits and inflation. Nigeria’s inflationary pressures were more closely linked to supply-side shocks, structural bottlenecks and the pass-through of exchange rate movements to domestic prices.
To address the risks, the study recommended a legally binding fiscal rule that sets a ceiling for budget deficits relative to GDP. It also called for a non-oil Fiscal Stabilisation Fund to help absorb external shocks and reduce the vulnerability of public finances and the exchange rate to volatile revenue sources.
Further recommendations included more strategic management of external reserves, proactive trade policies to cut import dependence, a transparent framework for coordinating fiscal and monetary operations, and measures to improve private-sector access to credit while stabilising inflation expectations.
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