Deficit Financing Threatens Naira Stability, Raises Borrowing Costs, CBN Research Finds

Nigeria’s growing fiscal imbalances could undermine efforts to stabilise the naira and make borrowing more expensive for businesses as government budget deficits continue to exert pressure on key macroeconomic indicators, a new Central Bank of Nigeria (CBN) research has found.

The research warned that sustained fiscal expansion could complicate monetary management, with the effects extending beyond the foreign exchange market to interest rates and the availability of money in the economy.

Findings from the study, titled “Budget Deficit Dynamics and Macroeconomic Performance in Nigeria,” showed that budget deficits have a significant influence on exchange rate movements, with their impact on interest rates becoming more pronounced over time.

Authored by Ndubuisi E. Uguru and published in the CBN Journal of Applied Statistics, the research analysed annual economic data spanning 1981 to 2024, with finding suggesting that fiscal policy pressures could undermine the gains of monetary interventions when government spending and borrowing continue to expand without corresponding revenue improvements.

The study identified budget deficits as a major source of exchange rate instability, noting that their influence on currency movements was substantial from the immediate period and persisted over time.

It also established that the consequences of fiscal expansion were not limited to the foreign exchange market, as deficits subsequently pushed interest rates higher and contributed to a contraction in money supply.

The contraction, according to the research, could reflect defensive monetary tightening as monetary authorities respond to the pressures created by fiscal expansion.

The study’s variance analysis further revealed the persistence of fiscal imbalances, with budget deficits accounting for all their own variations initially and still explaining approximately 53 per cent of their movements by the tenth period.

This indicates that fiscal imbalances can sustain themselves, potentially prolonging the economic pressures associated with excessive government borrowing.

However, the research found that budget deficits do not have a statistically significant direct relationship with inflation. Rather, it attributed price movements more closely to supply-side disruptions, structural constraints and the transmission of exchange rate changes to domestic prices.

“The study finds no statistically significant direct link between budget deficits and inflation,” it stated, adding that inflationary pressures were driven more by “supply-side shocks, structural bottlenecks, and exchange rate pass-through than by fiscal policy alone.”

On investment, the research found that its short-term movements were largely determined by previous investment trends, but inflation and money supply became increasingly important influences over the longer term.

The findings raised concerns about the implications of fiscal dominance, where government financing needs weaken the effectiveness of monetary policy and limit the central bank’s ability to manage economic conditions independently.

To reverse the trend, the study called for stronger fiscal discipline, recommending a legally binding deficit ceiling linked to Gross Domestic Product (GDP). It argued that imposing such limits would help prevent persistent fiscal imbalances, reduce competition between government and private borrowers for available funds and moderate pressure on interest rates.

The research also proposed establishing a non-oil Fiscal Stabilisation Fund to strengthen the country’s capacity to withstand external shocks, alongside better management of foreign reserves and trade policies that encourage domestic production.

It said incentives for local producers could reduce dependence on imports and lessen the economy’s exposure to exchange rate shocks. The study further advocated a clear framework for coordination between fiscal and monetary authorities to improve policy alignment.

Such coordination, it argued, would allow the CBN to manage money supply more proactively instead of relying on sudden restrictive monetary measures to counter the effects of government spending.