Why Underdeveloped and Developing Countries Should Avoid Aligning Their Currencies to Major International Currencies

By Dr. Emmanuel Okoroafor

Aligning currencies to major international currencies like the US Dollar, Euro, Pound Sterling, or Yuan has become a common practice among underdeveloped and developing economies. However, this strategy often undermines economic stability, leading to inflationary pressures, reduced competitiveness, and dependency on foreign economies. Countries such as Nigeria, Zimbabwe, and Argentina illustrate the adverse consequences of currency alignment, particularly how it distorts local markets in ways that defy economic logic.

The Pitfalls of Currency Alignment
When a country pegs or heavily aligns its currency with a major international counterpart, it effectively relinquishes control over its monetary policy. This significantly limits its ability to respond to local economic conditions. For instance, in Nigeria, the Naira’s value is heavily influenced by its exchange rate with the US Dollar. Consequently, economic decisions made in the United States—such as interest rate hikes by the Federal Reserve—directly affect Nigeria, despite the stark differences between their economic realities.

Inflationary Pressures on Locally Produced Goods
One perplexing consequence of currency alignment is its inflationary impact on locally produced goods that do not rely on foreign inputs. In Nigeria, vendors frequently cite the Dollar-to-Naira exchange rate to justify price hikes, even for goods entirely produced domestically.
For example, agricultural products like yams, maize, and cassava are cultivated locally without imported materials. Yet, when the Naira depreciates against the Dollar, the prices of these goods often rise dramatically. This occurs because sellers pre-emptively increase prices, assuming that higher exchange rates signal broader economic instability or rising costs. This psychological inflation creates a ripple effect, eroding purchasing power and exacerbating poverty.

Distorted Trade Dynamics
Currency alignment can lead to overvalued currencies, making exports less competitive while encouraging imports. In Nigeria, where oil is the primary export, efforts to maintain a favourable Dollar exchange rate for oil revenues have overshadowed the need to diversify the economy. As a result, non-oil exports struggle to compete globally due to high costs, deepening dependency on imported goods and external financing.
Speculative behaviour further exacerbates the problem. In Nigeria, for example, the black market exchange rate often diverges sharply from the official rate. Businesses and individuals hoard foreign currency, anticipating further devaluation, which accelerates the Naira’s depreciation and fuels economic instability.

Case Studies: Lessons from Zimbabwe and Argentina
Zimbabwe: A Cautionary Tale of Dollarization
In 2009, Zimbabwe adopted the US Dollar as its de facto currency to combat hyperinflation. While this temporarily stabilized inflation, it made Zimbabwe’s goods more expensive compared to those in neighbouring countries with weaker currencies. Local industries, such as textiles and food processing, struggled to compete with cheaper imports, leading to widespread factory closures and job losses.
The reliance on dollarization also drained foreign currency reserves, as the economy depended heavily on imported goods. Instead of boosting local production, authorities implemented measures such as bond notes and currency controls, eroding trust in the monetary system and deterring foreign investors.

Argentina: The Fallout of Currency Pegging
Argentina’s history of currency pegging during the 1990s highlights the risks of aligning with a major currency. By pegging the peso to the US Dollar at a one-to-one rate, Argentina initially stabilized prices. However, the fixed exchange rate overvalued the peso, making exports expensive and imports cheaper. This devastated local manufacturing, leading to factory closures, unemployment, and a dependence on foreign goods.
When the system became unsustainable, Argentina abandoned the peg in 2001, triggering a debt crisis, capital flight, and a collapse in investor confidence. Throughout the peg, the central bank prioritized exchange rate stability over structural economic reforms, ultimately deepening the crisis.

Broader Impacts of Currency Alignment
The experiences of Nigeria, Zimbabwe, and Argentina reveal several common consequences of currency alignment:
Inflationary Pressures: Local goods experience price hikes due to perceived economic instability, even when production costs remain unaffected.
Stifled Innovation: Overvalued currencies make imports cheaper, discouraging local industries from innovating and competing.
Monetary Policy Constraints: Central banks focus disproportionately on maintaining exchange rate stability, neglecting pressing domestic needs such as unemployment reduction and infrastructure investment.
FDI Deterrents: While currency alignment may attract foreign direct investment initially, long-term instability and unpredictable devaluations deter investors.

Alternatives to Currency Alignment
Developing countries can adopt several strategies to mitigate the risks associated with currency alignment:

1. Strengthening Local Economies: Investing in infrastructure, agriculture, and technology can reduce reliance on imports and build economic resilience.
2. Diversifying Reserves: Holding reserves in a basket of currencies and commodities like gold can minimize exposure to any single currency.
3. Floating Exchange Rates: Allowing market forces to determine currency values ensures better reflection of domestic economic conditions.
4. Regional Economic Collaboration: Establishing regional currency unions or trade agreements can provide stability without over-reliance on major international currencies. For instance, the proposed West African Eco offers a potential model.
5. Attracting Sustainable FDI: Creating a stable, predictable business environment through transparent governance and infrastructure development can attract investors without relying on currency alignment.

Overall, it may be said, while currency alignment may offer short-term benefits, such as stabilizing inflation or attracting FDI, the experiences of Nigeria, Zimbabwe, and Argentina highlight its long-term consequences. These include the erosion of local industries, imported inflation, loss of monetary sovereignty, and economic instability. To ensure resilience in the face of global economic uncertainties, underdeveloped and developing countries must prioritize policies that strengthen their domestic economies, enhance competitiveness, and promote sustainable growth.

• Dr. Okoroafor has worked 33 years in academia and industry in Nigeria and Overseas. He is the Managing Director/CEO of Hobark Consultant Management Services Ltd, a business with primary focus on the full-suite of Human Capital Management, a director in RUTA E&P Ltd and FACEATO E&P Ltd. Founder of MEPON Ltd, a company that provides online platforms for “Global Equipment and Facilities Rentals” , Founder of Frempi Spring Water Company Ltd and IExport Afrique Ltd, a company that specializes in providing and exporting locally sourced food products from regions around Nigeria and the entire African Continent

He is a UK Engineering Council registered Chartered Engineer-CEng, FEANI registered Engineer – Eur-Ing, Fellow of the Institute of Materials, Minerals & Mines – FIMMM. He Possesses a BSc (Hons) Physics, University of Ife, Nigeria, Dip d’Ing Nuclear Engineering, Institut National des Sciences et Techniques Nucleaires, Grenoble, France, PhD Materials Science, Universite Denis Diderot, Paris VII, Paris, France.

He writes in from Southampton