September 27, 2019 / 09:43PM / CardinalStone Research// Header Image
Emerging risks provoke another devaluation enquiry
The naira has witnessed relative stability, moving within a narrow band of N359-N370/$ since mid-2017. This period of naira stability was preceded by the introduction of the Investors and Exporters FX window in April 2017 and supported by a notable recovery in global oil price (2017 Brent price: +16.0% YoY to $54.77/barrel), following the collapse of the latter in 2016.
In view of the decline in reserves over the last two months ($2.2 billion) and the emergence of pertinent risks, such as the $9.6 billion judgement granted against Nigeria in favour of Process and Industrial Developments Limited (P&ID), we revisit the case for an adjustment to the current currency regime in this report. Specifically, we discuss the likelihood of devaluation in the near term, partly by juxtaposing current realities with conditions prevalent in 2016, when the Central Bank of Nigeria (CBN) was compelled to devalue the currency after months of applying ad hoc administrative measures.
Will the CBN need to devalue soon?
CBN's ability to sustain its currency defense is a function of the strength of the nation's FX reserves. The reservelevel, in turn, is influenced by factors such as crude oil revenue, foreign capital flows, current account flows, changes in dollar-denominated obligations, and other foreign currency denominated arrangements. Nigeria's external reservesis currently at c. $42.3 billion, which, by our estimate, translates to a worst-case scenario position of c. $15.0 billion (equivalent to 3.5x import cover) after adjusting for the riskier portions of the reserve, as well as the FGN and federation portions. For clarity, our worst-case (adjusted)scenario level of foreign reserves strips out the portion of the reserves subject to claims by third parties and, as such, already accounts for possible impact of capital flights-a typical trigger for currency repricing. However, we note that an increased supply of the local currency, precipitated by capital flights, could, nonetheless lead to heighten pressure on naira and force a stronger draw-down on the relatively "less-vulnerable" portion of reserves to defend the currency.
While the CBN would prefer a much higher adjusted reserve level, we highlight that our estimate for the current period, at $15 billion, is c. $2.8 billion higher than the corresponding adjusted level in 2016, when the CBN succumbed to currency pressures. This exercise suggests that the CBN is likely to face increasing pressure to devalue the currency in the coming months if the current rate of reserve depletion ($1.1 billion per month) persists.
However, our base case, and more likely scenario, is that the CBN will focus on what is currently available to defend the currency ($34.9 billion) and bet that its efforts to keep Nigeria's carry trade opportunity attractive will motivate foreign portfolio investors to roll-over their positions. This position is largely consistent with the CBN Governor's recent declaration that the Monetary Policy Committee would only reduce rates when inflation hits single digit- a development that is largely doubtful in the near term in view of imminent increases in electricity tariff and minimum wage, as well as the ongoing stiffer border enforcements. On this wise, the risks of significant capital flight and devaluation is likely to be muted in the near term.
In addition to the above exercise, we look at relative changes to medium-to-long term determinants of our adjusted reserves, including crude oil revenue and current & financial accounts movements. Leading up to the last devaluation in 2016, crude oil revenue was on the downtrend as oil price plummeted below $28/barrel levels (and averaged $40.9 in H1'16). Similarly, oil production plunged to a decade low of 1.5mbpd. We hold the view that the decline in oil price and production in 2016 occasioned foreign capital flight, which was heightened by CBN's slow policy adjustments and recourse to dollar rationing. By contrast, crude oil prices have so far averaged $64.8/barrel in 2019, while mean oil production (c.2.0mbpd) is c. 25.0% higher than the levels seen in the build up to 2016 devaluation.
That said, Nigeria's services-induced surge in current account deficit to $5.6 billion in H1'19 (H1'16: $576 million) has done the NGN no good from a medium-to-long term fundamental standpoint. This case becomes more worrying when viewed against the backdrop of the negative balance in financial accounts in H1'19. To our minds, weaknesses in Balance of Payments (BoP) could pressure the CBN to "bite the bullet" on the currency management front at some point in the future. However, with CBN's portion of reserves still relatively comfortable at c.$34.9 billion (vs. $17.3 billion in 2016), and amid its resolute inclination to hold the peg, it is more likely to consider this "future" a more distant one.
$9.6 billion judgment debt could lead to a material repricing of naira yields
The recent judgement debt of $9.6 billion awarded to P&ID, however, swiftly takes the FGN from a position of comfort to one of unease. The judgement debt,if fully enforced, could lead to a decline in CBN's portion of reserves to $25.3 billion (46.0% higher than the 2016 levels). Assuming this worst-case scenario, the 'adjusted reserveâ€™'level, however, could plummetto $6.5 billion (50% lower than the devaluation levelin 2016). This could potentially trigger foreign capital flight and intensify levels of CBN intervention, hence, deteriorating the foreign reserves position and leading to an upward repricing of naira. In a more likely scenario of an out of courtsettlementto the speculative range of $1-3 billion. We expect the CBN to withstand the negative shock and avoid a devaluation as the reserves level remains above that of 2016, and crude oil revenue remain supportive.
How much longer can the CBN defend the currency?
In view of Nigeria's weak current account position, and the sustainability implications of the currency defense, we believe the CBN will have to weigh the monetary and opportunity costs of defending the currency at some point. We see the main costs of defending the currency as the following; the cost of issuing CBN treasuries at attractive yields, the direct cost of interventions in secondary markets, and the opportunity cost of defending the currency. To defend the currency following the devaluation in mid2016, the CBN increased its issuances of OMO bills from N4.2 trillion in 2016 to N7.7trillion in 2017 and N17.0 trillion in 2018. Between 2017-2019, the CBN issued N35.8 trillion at an average stop rate of 15.1%, which translates to an associated interest expense of c. N5.4 trillion in the period. Our interest expense estimate is corroborated by total interest expense of N4.2 trillion reported in CBN's financial statements of 2017 and 2018 combined (2017: N1.3 trillion; 2018: N2.9 trillion).
In addition, the CBN also raised the frequency of OMO auctions and its issuance of long-dated securities (300 days and above),thus directly competing with FGN bond issuances and raising the cost of debt of the FGN. Clearly, there is significant cost involved in defending the currency and the costs can manifest in monetary and opportunity cost terms. For context, the interest expense incurred by the CBN in 2018 alone is over 6x the average interest expense recorded in the 4 years leading to 2017. CBNâ€™s 2018 interest expense is also c.75.0% of Federal Government's actual retained revenue and 1.6x the amount spent on capital expenditure in the same year.
Against the backdrop of weakGDP growth and poor FGN revenue mobilization, the CBN may begin to ponder the opportunity cost of its currency defense on long term growth objectives of the country and the sustainability of these interventions. Evidently, in order to avoid reserve depletion, the CBN is likely to incentivize foreign portfolio managers to roll over existing investments with higher rates at the detriment of the real sector. Furthermore, interest rates are likely to increase even further in coming years, when developed economies reach an inflection point in their economic cycles and begin to experience robust growth, leading to a normalization of interest rates.
Lastly, the sustenance of this regime will not only leave the foreign reserves more vulnerable to foreign capital flight, but also imply that a devaluation at a later date would be of a higher magnitude given consensus expectations of double-digit inflation in the next two years. Thus, while the CBN is not under immense pressure to devalue in the next 6 months given the current level of its foreign reserves, the risks in favour of naira repricing are now materially higher. The recent constitution of a pro-market economic advisory council by President Buhari may also leave the devaluation discourse on the table in the near-to-medium term.
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