Flexible Exchange Rate: The Bitter Pill

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Friday, June 17, 2016 1:35PM /FSDH

Taking the Bold Step
The Central Bank of Nigeria (CBN) has announced the long awaited flexible exchange rate. We believe the foreign exchange (FX) policy is a bold step to align the foreign exchange rate management in Nigeria with the current economic realities.

Although the policy may increase the prices of some imported items in the short-term, it will inspire confidence in the Nigerian economy and financial system. We expect a sharp drop in the value of the Naira against the U.S Dollar when the interbank market opens on Monday, June 20, 2016.

However, we believe as the internal adjustments regarding consumption patterns and productions within the Nigerian economy continue, the exchange rate should appreciate.

The Key Components of the Policy
The market to operate as a single market structure through the inter-bank/autonomous window. The exchange rate would be market driven. The CBN would participate in the market through periodic interventions to either buy or sell foreign exchange. The Foreign Exchange Primary Dealers (FXPD) introduced.

There shall be no predetermined spread on spot transactions executed through the CBN intervention with Primary Dealers, while all FX spot purchased by Authorized Dealers are transferable in the inter-bank FX Market. The 41 items classified as “Not Valid for Foreign Exchange” as detailed in a previous CBN Circular shall remain inadmissible in the Nigerian FX market.

The CBN may also offer long-tenored FX Forwards of 6 to 12 months or any tenor to Authorized Dealers to improve liquidity. Sale of FX Forwards by Authorized Dealers to end-users must be trade-backed, with no pre-determined spreads. The CBN shall introduce non-deliverable over the- counter (OTC) Naira-settled Futures to moderate liquidity.

Proceeds of foreign investment inflows and international money transfers shall be purchased by authorized dealers at the daily inter-bank rate. Non-oil exporters are now allowed unfettered access to their FX proceeds, which shall be sold in the inter-bank market.

Impacts on Demand and Supply for FX
The introduction of the FX Futures market should reduce the frontloading of FX and consequently in the spot market. In addition, we believe the market structure that the CBN announced was well thought out and investors will have confidence in the system to manage their exchange rate risks. On the supply side, we note that it would increase the supply of FX from Foreign Portfolio Investors (FPIs) and Foreign Direct Investors (FDIs).

The data from the CBN and the National Bureau of Statistics (NBS) shows that the total capital inflows in 2015 dropped significantly partly on account of the unacceptable foreign exchange rate regime.

We expect foreign capital to flow in. In addition, the policy will encourage the non-oil exporters to bring in their export proceeds. It should also encourage the development of the non-oil export sector in Nigeria in order to boost exports.

The fact that there will be only one exchange rate in the market means that no product will source U.S Dollar from a special exchange rate that is lower than the inter-bank market rate.

We expect this to further alter consumption pattern in the economy towards locally produced commodities where such opportunity exists. Only the machines, spare parts and other important imports inputs that will enjoy import patronage. The implication of all these is that the demand for FX may reduce. Table 2 below shows the leading important imports in Nigeria.

External Reserve – Drop and Increase
Market estimate shows that there are about US$3bn overdue foreign exchange obligations which Nigerian institutions need to meet. The CBN may take a hit on the external reserves to meet this, leading to a drastic drop in the external reserves. As demand on FX reduces and supply increases as we envisage, the external reserves should receive a boost.

The data from the CBN shows that the external reserves have been recovering in the last few weeks. This may be linked to the removal of subsidy on the pump price of petrol.

More Spending Power for the Government
The policy will make more money available to the government at this time when it needs to reflate the economy. We expect more money from both the oil and non-oil sources in addition to the proceeds from the Naira conversion of the external borrowing.

This is because of the expected higher exchange rate going forward. This will better position the government to fund the 2016 budget. Table 3 below shows our estimates of the impact of an exchange rate of US$/N260 on the revenue of the Federal Government of Nigeria (FGN).

We expect currency adjustment to US$/N260 to increase the FGN retained revenue for 2016 to about N3,522bn.

Impacts on Corporate Earnings
We expect companies with U.S Dollar receivables to benefit from this development. Meanwhile, companies with Naira receivables but with dollar denominated financial obligations without any hedging strategy in place will record exchange rate losses. Some of the companies operating in the power sector may fall into this category.

They may require additional bailout very soon if they have to improve power generation and distribution in the country. In addition, the impact of this may be transferred to the banking sector in the form of increase in the non-performing loans. The CBN had earlier warned Nigerian banks about Dollar – Naira mismatch.

However, banks may require higher earnings retention to boost their Capital Adequacy Ratio (CAR). The table 4 below shows the sectoral distribution of banks credits as at December 2015.

The opening of the foreign exchange inter-bank market and the futures market will create additional activities in the inter-bank market, with banks earning additional income. This will also promote trade finance businesses.

Impact on Inflation
We expect increase in the prices of some items particularly those that enjoyed special allocation from the CBN at N197 before now. Nevertheless we do not expect a major spike as we had in May 2016.

The FGN announced a new pump price for petrol on May 11, 2016 and that impacted the prices of nearly all the items in the Consumer Price Index (CPI). We believe the CPI is more sensitive to a change in the petrol price than a change in the exchange rate. The prices of items like raw sugar and wheat will increase.

We have observed that some manufacturers are absorbing a larger part of the increase in the cost of sales. This is because of the current weak purchasing power in the country. We note that inflation rate would remain in the double digit in 2016.

However, we believe the flexible exchange rate is a more credible policy option to pursue under the current economic situation in Nigeria than inflation. When the FX market settles, we see an appreciation in the currency in the medium-term and this will help to lower the costs of major manufacturing inputs.

Short-Term Outlook for Exchange Rate
The wide disparity between the official market exchange rate of US$/N197-N199 and US$/365 at the parallel market was majorly because of the ‘pegged’ policy of the CBN. As mentioned earlier, the foreign capital inflows had reduced significantly, partly on account of the unfavourable exchange rate regime.

With the acceptance of this policy and the structure in place, we expect an initial spike in the exchange rate in the region of US$260-N270 in the short-term. We expect the rate at the parallel market to crash and the inter-bank exchange rate to settle in the region of N220 within the next one year. This will be driven by the changing consumption pattern of Nigerians in favour of goods with local contents.

The local manufacturers are already taking advantage of the import substitution strategies of the government. The imports bills will also drop considerably when Nigeria becomes self-sufficient in refined petroleum products and rice production.

With the bold step from the monetary authority, we expect the fiscal authorities to implement policies that will drive massive infrastructure developments in the country. This will make made-in-Nigeria goods competitive and boost the non-oil export earnings.

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