Wednesday, May 25, 2016 3:47PM/ Vetiva
· MPC voted unanimously to adopt flexible exchange rate policy
· Establishment of a formal two-tier foreign exchange market
· Central Bank to unveil detailed framework in coming days
· Policy rates left unchanged as growth gets priority over price stability
· Markets to cheer development, stocks, bonds to rally
Finally a flexible exchange rate policy
At the third MPC meeting of 2016, the Monetary Policy Committee (MPC) unanimously decided to adopt a flexible exchange rate as widely speculated by markets. However, contrary to market expectation of a hike in the benchmark interest rate, the MPC decided to retain all policy rates - the MPR maintained at 12%, the asymmetric corridor retained at +2% and -5%, the Cash Reserve Requirement (CRR) of banks retained at 22.5% and Liquidity Ratio maintained at 30%.
In response to the challenges faced by the Nigerian economy (output contraction, rising inflation and high unemployment), the MPC appears to have favored growth over price stability with the CBN Governor noting that the balance of risk is now tilted against growth - reflecting a change in policy direction from the March meeting.
Establishment of a formal two-tier foreign exchange market
In his speech, the CBN Governor acknowledged that the illiquid foreign exchange market had created significant headwinds to the economy. Also, following the recent liberalization of the Downstream Petroleum market which allows for autonomous sourcing of FX, the Naira has continued to witness further pressure.
Thus, it had become clear that the current FX regime was no longer sustainable in the face of fast depleting FX reserves. We think this development, if successful, will move transactions from the informal parallel market to the formal interbank with likelihood of closing the gap between both markets in the medium term; first, we expect a knee-jerk reaction with the black market Naira rate further depreciating in the coming sessions.
The Governor further announced that the CBN will maintain a window for “critical” transactions in raw material and machinery imports targeted at boosting local production. We note that the establishment of the two-tier market creates room for arbitrage. Hence, we would expect the CBN to keep a tight noose on access to the “critical” window to curb such profiteering.
Whilst we await clarity on the new FX framework, we imagine that the NGN285/USD rate adopted in the setting of the N145/litre PMS price could serve as a pointer to where the interbank market would trade.
Inflation to spike further in the near term
It is clear that the MPC has chosen its battle carefully, deciding to loosen one of the key impediments to economic growth (the FX illiquidity). Following from this, we expect the inflation picture to worsen in the near term as a result of the pass through of a new exchange rate to consumer prices.
Like we had noted in our April inflation note, we expect inflation to recoil in 2017 from base effects. We believe this view could have further emboldened the MPC’s resolve to adopt the more flexible FX framework.
Markets to cheer development, stocks, bonds to rally
We recall that financial markets had rallied shortly after the announcement of the liberalization of the Downstream Petroleum market, partly in expectation of an official pronouncement on the FX framework.
Now that the news is official, we expect a knee-jerk reaction to push equity and fixed income markets higher in the coming sessions pending the unveiling of the new framework by the CBN.
Any sustainability thereafter would be determined by how markets assess the new framework and its prospects of improving FX liquidity. Overall, we view this development as positive for Nigeria.