May 12, 2020 / 01:36 PM / By Vetiva Research / Header Image Credit: Economic Confidential
Naira: The price of Nigeria's oil fortune
In many ways, 2020 has been a remarkable year - especially for oil-dependent countries - as the oil supercycle bear market persisted. The coronavirus pandemic led to the collapse in global oil demand, causing oil prices to nosedive amid heightened global uncertainty. For Nigeria, who relies on crude oil for about 90% of its foreign exchange (FX) earnings, the slump in oil prices means less FX into the government coffers and investors pulling out much needed foreign capital.
Managing the rocked boat
To stem the tide of dollar outflow and its attendant impact on the country's gross international reserves (GIR), which currently stands at $34.30 billion (- 11.13% YTD as at 11th May'20), the Central Bank of Nigeria (CBN) embraced - to a certain degree - some FX reforms while commercial banks also reduced their customers' international spending limits as the CBN tightened its grip on FX supply.
The major reform adopted by the apex bank is: allowing the naira exchange rate at the Investors and Exporters' (I&E) window adjust to reflect a deterioration of macroeconomic fundamentals. Consequently, the rate has weakened by 6% to â‚¦386.94/$. The CBN also narrowed the gap between the rates on the I&E window and the official market, allowing the official market rate to weaken by 18% to â‚¦361/$. As a result, the exchange rate gap has narrowed to an average of â‚¦23.97 from an average of â‚¦58.05 in Q1'20, prior to when the reforms took effect.
Post-currency adjustment, the naira has weakened continuously on the I&E window, as the foreign currency gap persists. Importers with due obligations continue to scramble for hard currency while most of the liquidity providers (foreign investors) have exited in favor of safe investment options.
The CBN also momentarily halted the sale of FX to Bureau de Change (BDC) operators as a measure to control the spread of the coronavirus. This move also provided the secondary benefit of conserving scarce dollar resources in the face of global risk aversion. Unfortunately, the resulting tight dollar liquidity in the parallel market caused currency speculation to run wild and the naira hit a three-year low of â‚¦460/$ on 28th April 2020. The bid-offer spread in the market also increased considerably, signifying low FX liquidity amid local demand for the dollar. Dollar demand has been swelling and piling up pressure on the naira.
Domino effect of oil's apocalypse
two-year down cycle in oil prices has resulted in a gradual depletion of GIRs.
As the shock in oil prices has been triggered by long-run structural
transformations in the supply side of the global oil market, the viability of
the naira peg is being tested and the naira exchange rate has come under
considerable pressure. Many oil exporters, particularly developing countries
seeking to build confidence in their economic policies, peg their local
currency to a foreign currency. However, this requires strong-enough firepower
to defend currency peg levels. But not all petro-pegs are alike as some lack
the deep pockets and abundant FX reserves the likes of Saudi Arabia or Kuwait
can boast of.
The Nigerian naira and Omani riyal are emerging market petro-currencies that have faced significant challenges since the oil price plunge episode. Currency pegs, with relatively low foreign reserves and sovereign wealth assets over a prolonged period, are undoubtedly vulnerable. This is the case of the naira, although the central bank has refuted plans to further devalue the naira in the coming months. The markets, however, tell a different tale. In a sign of rising pressure, Nigerian one-year non-deliverable currency forwards (NGN1YNDFOR) - contracts used to bet on future exchange rate moves - priced the naira at â‚¦513.68/$, after initially hitting its weakest level at â‚¦522.56/$. This implied that traders see another 33% devaluation over the next year.
The pegged regime still seems optimal because a floating regime could result in significantly high levels of imported inflation during economic downturns. However, the ability of policymakers to support the peg has weakened tremendously. The balance of payment (BoP) pressures caused by lower oil prices could generate peso problems in the FX market and increase the chances of dollar shortages, in the absence of adequate FX buffers. In view of the fact that the downbeat outlook for oil prices could persist over the medium term, sustained pressure on the naira peg - and the ensuing loss of reserves - make the existing FX arrangement untenable in the medium to long term.
Sailed the storm? Maybe not
Oil's plunge has stung currencies across emerging markets, and there's probably worse to come. Nigeria's derivative and black markets suggest the naira is still under plenty of strain, and the recent adjustment to the currency could be the first round of currency depreciation expected in the mediumterm. Experience from some other countries (e.g. Pakistan) has shown that ineffective devaluations often generate pressures for further devaluations, creating market disorder and financial instability.
Nigeria's currency adjustment may turn out to be ineffective because the protracted deficit in the current account is more structural in nature. The problem stems from the faulty composition of exports and a poor industrial structure, resulting in unfavourable terms of trade ex-oil. This limits the effectiveness of the currency adjustment to attracting portfolio flows at a lower cost, as a devaluation cannot solve the persistent structural problems.
While we do not think the naira's quasi-peg will be broken in this cycle, it is hard to see the pressure coming off the peg in the next few weeks because the currency adjustment is an ineffective tool to address Nigeria's persistent structural BoP imbalances. Rather, the country needs a coordinated structural transformation which will require the active role of the government along with the cooperation of private sector to achieve export diversification and sophistication in the long-term. The full implementation of exchange rate reforms will only come gradually as long-term economic reforms are delivered.
However, a favourable FX policy move by the CBN in the short term can be a gradual increase of the Yuan's currency composition of foreign exchange reserves (COFER) from 8% (as at Dec'19). Considering that China is Nigeria's largest import partner, increasing exposure to the Yuan leaves more room for cross currency transactions between both countries, eliminating the need to swap the naira into US dollars first before swapping again to Yuan, to complete an import transaction with China. This will bode well for the FX market as it could not only reduce the demand for the US dollar, but also make payments to China easier and cheaper because there will only be one transaction meaning only one spread is crossed.
In the short-term, there is room for more depreciation given extremely weak macroeconomic conditions. However concessional flows can provide some support for the naira, as the CBN will be better equipped to continue its interventionist policy in the FX market. Nigeria seeks to borrow about $6.9bn from multilaterals in 2020, to help counteract the impact of coronavirus on the economy. The IMF's $3.4bn tranche has been received and we expect flows from the World Bank ($2.5bn) and the AfDB ($1.0bn) to come in by Q3'20.
Also, as the spread of the coronavirus slows and more economies open up in H2'20, we expect an uptick in global oil demand to prop up crude prices. This could bode well for the country's FX earnings, liquidity and by extension support the firming of the naira, as the foreign currency gap narrows. The strengthening of the naira also, unequivocally, depends on the success of the import restriction policy by the central bank and a decline in aggregate demand - a fallout of growing coronavirus-recession fears.