Tuesday, April 04, 2017 3:52 PM / CardinalStone Research
Following the new foreign exchange (FX) policy of the Central Bank of Nigeria (CBN), we discuss our views on impact & sustainability of the policy as well as our outlook for FX demand/supply in the short to medium term.
The CBN’s New FX Policy & the Naira
Since February 20, the Central Bank of Nigeria (CBN) has maintained a heavy & steady supply of dollars at both the interbank and parallel FX markets. The Bank has supplied over $2.6 billion in both spot and forward sales at the interbank market, and Bureau de Change operators receive $8000 (FX sales to BDCs have been increased to $10,000 weekly. Sales are yet to commence) on a weekly basis through International Monetary Transfer Operators (IMTOs). Heavy sales have also been directed to the retail end of the market, specifically for invisibles such school fees, medical bills, personal & business travel allowances (PTA & BTA).
This has resulted in a remarkable turnaround for the Naira which currently trades at N395/USD at the parallel market compared to all-time low trades at N520/USD just before February 20. The new FX policy has been strongly supported by the accretion in FX reserves as a result of higher oil prices & oil production levels, the successful $1 billion Eurobond issue and various inflows from multilateral agencies including the World Bank. Also, the high interest rate environment for fixed income instruments as well as aggressive open market operations (OMOs) by the CBN has helped to put a tight lid on liquidity & reduce the volume of money available at FX auctions. The sale of forwards served to shift most spot demands into the future. Nigeria’s FX reserves have risen to $30 billion from as low as $24 billion about 3 months ago.
Figure 1: FX Reserves & the exchange rate
Background - The naira’s huge loss was mostly speculation driven
The drastic loss in value of the naira at the parallel market was the direct result of speculation and round tripping. Despite the fall in international crude oil prices, the CBN held tightly to an official peg of N197/USD for at least 15 months until it announced a floating rate policy in June 2016. Even after a float to around N300/USD officially, the FX market remained largely illiquid because of the low level of market confidence in the CBN’s FX management process.
Market participants alluded to a lack of transparency and lack of credible price formation. The market became very fragmented with trades even at the official interbank market swinging between N305- N360/USD.
With the firm control and management of the official interbank market, the parallel market, which seemed more transparent & responsive to demand-supply fundamentals, became a more popular reference point for the value of the Naira. Trades occurred at all-time lows of N520/USD and a further depreciation was anticipated towards N600/USD levels. Both genuine and speculative demand filtered into the parallel market.
The facts were that the greenback was scarce (or appeared to be scarce) and BDC operators had resorted to getting dollars from private sources and reselling at very high margins.
The Central Bank had hitherto focused on FX sales at the wholesale end of the market, directing that 60 per cent of all FX receipts by DMBs be sold strictly for the importation of raw materials, plant and machinery. The balance of 40 per cent was to be used to settle trade obligations, visible and invisible items. However, dollar demand for invisibles as well as for the 41 items banned from accessing FX at the interbank market, filtered to the black market and drove rates to all—time lows.
Demand/supply outlook – supply will be higher in the near term
At the moment, it seems almost all legitimate demand for FX is being met implying minimal, if any, backlogs. Most bank treasurers state that they have successfully cleared all pending requests for FX. With the CBN’s interventions at both the wholesale and retail ends of the market, supply currently outweighs demand and as a result the naira has witnessed a significant appreciation. We however think that an increase in FX demand, above current levels, is likely in the coming months as capital repatriation by portfolio investors hold sway following recently announced 2016 corporate actions.
On the supply side, the direction of international crude oil prices will determine the extent the CBN can go with its interventions. So far, rising U.S. drilling activity and shale production seem to have eroded the OPEC output cut and the current outlook for oil price is hinged on the extension (or not) of OPEC production cuts beyond the initial deadline of mid-2017. Oil production has however recovered to an average of 2.0mbpd and is expected to remain stable in the near term following successful negotiations with the Niger Delta militants.
We therefore expect that dollar revenues will be sustained at least in the short term (next 3 to 6 months). Other sources such as inflows from multi-lateral agencies & external debt issuances will help shore up FX reserves.
Figure 2: Brent crude price trend
Already, the government has concluded an additional $500 million raise through a Eurobond issue and the World Bank has approved a loan of $200 million to support Nigeria’s agriculture sector. The balance of the $400 million budget support facility from the African Development Bank (AfDB) is still anticipated and we are optimistic that with the release of the Economic Recovery and Growth Plan (ERGP), other multilateral donors will be favourably disposed to extending facilities to Nigeria.
The naira’s appreciation in the parallel market speaks to a possible convergence/harmonization in rates which will be a positive development for foreign investors. The CBN has maintained that it anticipates an alignment in FX rates in the coming months.
We however think that in addition to a possible harmonization of the rates, the CBN must allow for increased transparency and confidence by restoring the two-way quote trading system in the interbank market. Asides oil earnings and external credit, the next biggest source of dollars are offshore inflows for investment and to the extent that the operation of the market is still opaque, foreign investors will remain on the sidelines.
Table 1: Nigeria’s multiple FX rates 2