costs n benefits of redomination (the empirical study)

I. The Theory of Currency Redenomination

Technically, currency redenomination is defined as the process whereby a country’s currency is recalibrated due to significant inflation and currency devaluation. In general terms, however, it is simply referred to as the “dropping of zeros” from a currency.

For example, in January 2005, Turkey dropped or removed 6 zeros from its currency, the Lira (L), and replaced it with the new Turkish Lira (YTL) with conversion rate of million lira (1,000,000L) = one YTL (1YTL). Also, in July 2005, Romania dropped or “knocked off” four zeros from its currency, the leu (ROL), when it replaced it with the new Romanian leu (RON) with a conversion rate of 10,000ROL = 1RON. In July 2007, the Ghana redenominated its currency, the cedi, by making one new Ghanaian cedi (GHc) equal to 10,000 old cedi (c), i.e. by dropping four zeros. Come August 2008, the CBN plans to convert 100 naira into one new naira, i.e. drop two zeros.

The introduction of a single European currency, the Euro, on January 1, 1999 can be viewed as a redenomination of the national currencies of some of the participating countries that had high “old currency”/Euro or dollar ratios such, as Italy, Portugal, Spain and Belgium because their conversion rates were fixed at 1 Euro = 1,936.27 Italian Lira (ITL) = 200.482 Portuguese Escudo (PTE) = 166.386 Spanish Peseta (ESP) = 40.3399 Belgian Franc (BEF) = 1.18 US Dollar. However, the Euro was physically non-existent until January 1, 2002 (“E-day”).

Currency redenomination is not a new phenomenon. It dates back to the 19th century but the most spectacular one was that of the German currency in the 1920s. According to Layna Mosley[i], “Among developing and transition nations, currency redenomination was employed on 60 occasions during the 1960-2003 period. These redenominations varied in size, from removing one zero from the currency (14 instances) to removing six zeros (9 instances); the median redenomination was three zeros, dividing the currency by 1000. Nineteen countries have used redenomination on one occasion, while ten countries have redenominated twice (sometimes, with many years in between, as in Bolivia, in 1963 and 1987; in other cases, redenominations follow rather quickly, as in Peru in 1985 and 1991). Argentina (4), the former Yugoslavia/Serbia (5), and Brazil (6) are the most frequent users of redenomination”.

In the ongoing debate about the redenomination of the Nigerian currency, some commentators have been using the terms redenomination and revaluation interchangeably, i.e. to mean the same thing. Technically, this is wrong. Currency redenomination is different from both currency revaluation and currency appreciation. In strict terms, redenomination does not increase the “value” (or strength) of a currency in relation to other currencies per se. What happens when a currency is redenominated is that some zeros are dropped in the official exchange rate at “conversion” date, e.g. one US dollar = 1.25 new Naira (NN) = 125 “old naira” (N) on August 1, 2008 (i.e. NN1.0 = N100.00). On the other hand, currency revaluation is an increase in the value of a currency vis-à-vis other currencies under a fixed exchange rate system, i.e. when the government or monetary authorities arbitrarily fix the exchange rate. For instance, the naira is revalued when the exchange rate is changed from IUS$ =N130 to 1US$ = N125, i.e. increase in the value or strength of the naira because you now need fewer naira to buy a dollar. Devaluation is the opposite of revaluation, i.e. a decrease in the value of a currency via-a-vis other currencies under a fixed exchange rate system, e.g. change from 1US$=N125 to 1US$ to N130, meaning a decrease or fall in the strength or value of the naira because you will need more naira to buy a dollar. The terms currency appreciation and depreciation are used to describe a decrease and increase, respectively, in the value or strength of a currency vis-à-vis other currencies under a floating exchange rate system, i.e. when market forces generate changes in the value of the currency. However, it is possible for currency redenomination to occur (pari passu) with revaluation or appreciation, for instance, if on the day of redenomination in August 2008, the new exchange rate is fixed 1US$=NN1.25 when the exchange rate just before the redenomination was 1US$=N128 (with NN1.0 = N100). Similarly, redenomination can occur with devaluation or depreciation if the exchange rate is fixed at 1US$=NN1.25 when the exchange rate just before the redenomination was 1US$=N123.
It appears that the CBN is aiming for both redenomination and revaluation or appreciation (depending on how they intend to go about it) in August 2008 since the official exchange rate is likely to be above 1US$ =N125 by that time.

What will push a country to redenominate its currency and risk the costs and uncertainty associated with the exercise? The answer to this question is implicit in the technical definition of redenomination offered above. Most countries redenominate their currencies because of prolonged high inflation (or hyperinflation) coupled with significant devaluation/depreciation of the currency resulting in a situation where hundreds or thousands of their currency is exchanged for a unit of major international currencies. For instance, almost 10,000 Ghanaian cedis were exchanged for 1 US dollar before the redenomination of the cedi in July 2007. However, not all countries suffering from high inflation and/or are having very high local currency dollar ratios find it necessary to redenominated their currency. Some countries are very cautious about redenomination. Still, other countries with relatively low currency/dollar ratios (less than 200) and relatively low inflation rates (less than 30%) still go ahead to redenominate their currency for variety of reasons. The latter appears to be case of Nigeria
In an Press Release issued on October 13, 2004, Robert Mundell, Professor of Economics at Columbia University, cautioned South Korea on its planned redenomination, noting that “the redenomination the Korean government pursues should not be considered as a cure for all currency issues….the 1923 German Currency Reform… was pushed through because the German currency unit back in 1923 was a `trillion' and the elimination of zero triggered significant economic repercussion... Korea does not have to rush the introduction of a currency redenomination because the Korean currency unit is not in jeopardy, as was witnessed in Germany… Asian countries should put priority on creating `Asian common currency'…Korea should make the economy more productive,…in order to heighten productivity, it is of great importance to take excellent advantage of human capital. It includes increasing quality human capital, expanding work force by reducing unemployed and encouraging active participation of female workers."

So, why should a country with moderate inflation rates (say less than 15% p.a.) and/or has a relatively stable currency redenominate its currency? This is the question the CBN must answer because Nigeria’s rate of inflation and exchange rate have been relatively stable over the past five years.[iii] Under these conditions, there is need to exercise caution to ensure that the cost of redenomination does not outweigh the benefit. This is why many countries with exchange rates of less than 200 units of their currency to the US dollar do not deem it necessary to embark on redenomination. For instance, Japan with an exchange rate of 117Yen = 1USdollar has resisted the temptation and pressures to redenominate the Yen. Clearly, there may be other compelling reasons why a country may decide to go ahead to redenominated its currency even when less than 200 units of its currency is exchanging for the dollar. In his speech, the CBN alluded to some of these reasons such as: a) to restore the value of the Naira (in the short-term) close to what it was in 1985 before the commencement of the SAP in 1986; and b) to lay the foundation for the convertibility of the Naira as well as make it the ‘Reference currency’ in Africa. The later reason is based on the fact that “The African Union has granted Nigeria the right to host the Headquarters of the African Central Bank when the common currency in Africa materializes. Nigeria must therefore lead the way in terms of properly aligned currency structure and sound monetary policy framework”. What is not clear is when the ACB will be established and when the common African currency (which I will call “Afro”) will materialize. It is also not clear what is meant by “reference currency” in Africa.

II. Benefits of Redenomination

The following are some of the standard benefits of currency redenomination.
1. Generally, redenomination leads to a more efficient local currency by knocking off some zeros. When there are too many zeros, many transactions are conducted in thousands, millions, billions and trillions which make counting and calculation difficult and put stress on book-keepers and electronic calculators. For instance, many traders in Nigeria hire people to count money for them in banking halls. In Ghana, before the recent redenomination, the rent of an average apartment was about 4,950,000 cedi (i.e. US$500) a month or about 59,400,000 cedi ($6,000) a year which landlord usually demanded upfront. Imagine paying almost 100,000,000 (100million) cedis for a Kia Rio sedan car!

2. Redenomination facilitates business transactions because it leads to the use of smaller units of money. For instance, Ghanaians now pay only 10,000 New Ghanaian Cedi to buy a new car instead of 100,000,000 cedi previously. In Nigeria, we will pay only about 5,000 New Naira to buy a used car instead of 500,000 naira currently. Such a reduction in the unit of money required for transactions will relieve both buyers and sellers of the burden of counting large sums of money.

3. Redenomination leads to a more portable currency and a significant reduction in the dead weight of the money people carry and the associated risk, e.g. attack by robbers. For instance, before Germany redenominated its currency in 1923, people carried currency (money) in bags to the market and returned home with the items purchased in their pockets. In other words, the money was bulkier than most items purchased. Although Nigeria has not reached that stage, many traders now carry money in the so-called “Ghana-must-go” bags. Most people are afraid to withdraw large sums of money (say N500,000) from the bank because they have to put the bales of money in a bag and whenever they step out of the bank it is clear to people outside that they have withdrawn large sums of money. Robbers are known to have trailed people as soon as they come out of the banks with bags of money. After redenomination, it will be possible to put NN5,000 (=N500,000) in a small wallet or in your breast pocket.

4. Redenomination reduces the phenomenon of money illusion that people suffer from when there are many zeros. Money illusion tends to generate inflationary pressure.

5. Redenomination leads to greater confidence in the currency. When there are many zeros, people loss confidence in the local currency and some people, especially the rich, substitute the weak local currency in their portfolios with more stable and internationally traded currencies, such as dollars and euros. When there is a high local currency/dollar ratio, many businesses quote prices in dollars or other international currencies. This leads to an increasing “dollarisation” of the local economy which in turn weakens monetary sovereignty and the effectiveness of monetary policy. After redenomination, businesses and citizens may be more willing to shift their preference to the local currency rather than to an international currency. Hence, the dropping of zeros restores credibility and confidence in the local currency and enables the government and the central bank to reassert their monetary sovereignty. It also enhances the effectiveness of monetary policy because it enables the local currency to better serve as a “true legal tender”. Before the recent redenomination of the Ghanaian cedi, it was ranked as the 5th in the list of 26 least valued (i.e. “most unwanted) currencies in the world. With the redenomination, it has left this list. The Nigerian currency, the naira, is not yet in the list of “most unwanted” currencies in the world.

6. Redenomination can sometimes reduce inflationary tendencies in an economy if the underlying causes of chronic or hyperinflation and low valued local currency are resolved before the redenomination exercise and if the process is well managed. This is why re-denomination should be implemented in the latter stages of an economic stabilization package or reform. Historical evidence suggests that redenomination had been very successful in an environment of macroeconomic stability, declining inflation, stable exchange rates, fiscal restraint and prudence and rational expectations of policy credibility.

7. Redenomination is sometimes used to indicate that era of failed economic policies has come to an end and that the economy is poised to start on a new slate. This helps to increase confidence in the economy and sends a signal to both the local community and the international markets that high inflation and general macro-economic instability are a thing of the past. In the case of the Nigeria, the CBN intends to use the redenomination exercise to signal the “burial”(and reversal) of the post 1986 SAP policies.
Multiple zeros complicate statistics and transactions and increase the length of time spent in lines at banking halls. Thus, dropping zeros enhances book-keeping and reduces the drudgery in transactions, record keeping and banking activities.


III. Costs and Risks of currency Redenomination

The main costs and risks of currency redenomination include the following:

1. Cost of printing new notes and minting new coins. In the long-run this cost may be offset by the reduced number of notes that will be printed in future due to the reduction in the amount of notes for transactions.

2. The cost of disposing of the old notes and coins. This is likely to be small but there is a risk that some of the old notes may be re-circulated or round-tripped. It has been reported in some countries that officials who were charged the responsibility of destroying the exchanged (old) notes and coins secretly “smuggle” then back into circulation to be re-exchanged into the new currency. This could result in multiple “round-tripping” of the old currency which can fuel inflation. Therefore, the banking authorities must ensure that notes and coins withdrawn do not find their way into circulation.

3. The cost of public education and advertising the change to citizens. This could be substantial.

4. The cost of exchanging the old currency for the new currency in terms of man-hours lost in waiting in banking halls, changing records and dual accounting in both old and new currencies during the “interim” period.

5. Risk of massive disruption in the pricing mechanism in the economy and short-term inflationary pressure arising from the “announcement effect”. No matter the assurances from the CBN, a major economic policy like currency change is bound to trigger inflationary pressure due to the uncertainty such changes generate. However, the inflationary impact may be curtailed with effective public education and anti-inflationary policies, e.g. ensuring abundant supply of petroleum products and stable prices of petroleum products and government-provided services. In a country with a low level of financial literacy like Nigeria, determining new prices for goods and services could be a challenge for many traders, farmers and operators in the informal sector.

6. If there is change to proposed ECO currency (for the West African Monetary Zone) or “AFRO” (for the proposed “African Union Monetary Zone”) within the next five years, then the whole exercise of naira redenomination would have been unnecessary and the associated costs would have been an “avoidable cost” to the nation. However, it is not known yet if and when the ECO or AFRO will be introduced given the fact that the proposed ECO currency has been deferred several times already. It took the European Union about five years from the decision to introduce the Euro currency to its full implementation, i.e. from 1998 to 2002.[v]

7. The uncertainty and instability that is inherent in major changes in economic policies in most developing countries could lead to increased speculation, capital flights, drop in foreign remittances, increased risk aversion, adoption of “wait-and-see” attitude by investors and increased sharp practices.

8. Likely short-term increase in the rate of armed robbery because robbers will flood banking halls and trail those who have exchanged large sums of old money for new ones. There is also a likely increase in other fraudulent activities and financial “scams” (popularly know as “419” in Nigeria). For instance, since the announcement of the redenomination of the Ghanaian currency I January 2007 and the introduction into circulation of the new notes and coins in July 2007, several cases fake new Ghanaian cedis have been reported under spectacular headlines in their newspapers such as “Three Arrested for Printing New Currency”, “Fake Ghana New Currency Notes in Circulation” and “Two Nigerians Arrested with Fake New Cedi Notes by Customs at Aflao Border”. You can trust that Nigerian fraudsters are already at work perfecting their strategies to take advantage of the proposed redenomination of the naira.

Source by: A Qualitative Cost Benefit Assessment Of The Redenomination Of The Naira By Dr. Emmanuel Ojameruaye