Nigeria’s rising budget deficits are a major driver of exchange rate depreciation and exert delayed upward pressure on interest rates, according to a study published in the Central Bank of Nigeria (CBN) Journal of Applied Statistics.

The study, titled “Budget Deficit Dynamics and Macroeconomic Performance in Nigeria,” was authored by Ndubuisi E. Uguru and examined the relationship between fiscal deficits and key macroeconomic variables using annual data from 1981 to 2024.

Its findings suggest that persistent fiscal imbalances can weaken exchange rate stability, constrain monetary policy and create pressure on investment, although the study found no statistically significant direct relationship between budget deficits and inflation.

Budget deficits weaken naira stability

Using a Vector Autoregressive (VAR) framework, the study found that budget deficits were a major source of exchange rate fluctuations, accounting for a substantial share of movements in the immediate period and contributing to sustained currency depreciation.

It also found that fiscal deficits exert delayed upward pressure on interest rates and can trigger a contraction in money supply, which the study linked to defensive monetary tightening.

• “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 study found.

Other findings from the research include:

• Budget deficits account for 100% of their own variance initially and retain about 53% by the tenth period, indicating that fiscal imbalances can reinforce themselves.
• Investment is largely self-determined in the short term but becomes increasingly influenced by inflation and money supply over the long term.
• The study noted “the study finds no statistically significant direct link between budget deficits and inflation, suggesting that price levels are driven more by supply-side shocks, structural bottlenecks, and exchange rate pass-through than by fiscal policy alone.”

It described the findings as evidence of fiscal dominance, where government borrowing and spending pressures can undermine exchange rate stability and limit monetary policy autonomy.

Study recommends fiscal and monetary reforms

To address the risks identified, the study recommended a binding fiscal rule that sets a legal limit on the budget deficit relative to gross domestic product (GDP). It argued that this could help contain fiscal imbalances, reduce the crowding-out effect on private investment and ease pressure on interest rates.

• It also proposed strategic reserve management and proactive trade policies, including the establishment of a non-oil Fiscal Stabilisation Fund and incentives for domestic production, to reduce the economy’s vulnerability to deficit-related exchange rate shocks.
• The study further called for a transparent framework for monetary and fiscal coordination, allowing the CBN to manage money supply more proactively rather than relying on abrupt restrictive measures in response to fiscal expansion.

For investment, it recommended improving private-sector access to credit, lowering borrowing costs and stabilising inflation expectations to support capital formation and long-term economic growth.

Nigeria’s borrowing plans and interest rates

The study’s findings come amid increased government borrowing requirements and changes in monetary policy.

On the monetary policy side, the CBN in September reduced the Monetary Policy Rate (MPR) by 350 basis points to 23% following the 307th meeting of the Monetary Policy Committee (MPC) in Abuja.

The reduction was the biggest cut in Nigeria’s benchmark interest rate since December 2006. It followed the MPC’s July 2026 meeting, when the committee retained the rate at 26.5%.