August 13, 2020 / 01:43 PM / By Vetiva Research / Header Image Credit: The Africa Report
In line with how the COVID-19 pandemic is spurring a new normal in business and economy, the Central Bank of Nigeria (CBN) is gradually embracing agelong reforms in the country's foreign exchange (FX) market. For many years, international financial institutions, such as the International Monetary Fund (IMF), have expressed displeasure with the country's FX restrictions and multiple currency practices (MCPs).
One of such MCPs is the gap between the official exchange rate and the other unofficial rates, that exceeded the 2% divergence guideline. The large gap between the exchange rates in the FX market is predominantly fuelled by the CBN's limitation on the availability of foreign exchange, which results in international transactions being channelled to unofficial markets. This has made round-tripping or arbitrage in the FX market very lucrative as the returns are attractive.
Foreign exchange round-tripping or arbitrage refers to a process whereby funds are obtained from the official forex market (at lower rates) and diverted to other markets and sold at a higher rate by forex dealing banks and users. Currency speculators get FX from the interbank market under the guise of legitimate use (e.g. personal travel allowance (PTA)), and sell same on the parallel market, thereby taking advantage of the wide margin.
However, recent measures by the apex bank could help to drastically discourage rent-seeking in the FX market and have thrust the exchange rates in the interbank and parallel windows closer to convergence, after many years of defiance. Compelled by pressure on the gross international reserves (GIR) from fleeing investors amid a sharp decline in oil receipts, the CBN has devalued the naira. The official rate has been devalued twice in the year by a total of 24%, while the Nigerian Autonomous Foreign Exchange (NAFEX) Rate followed suit with a 6% depreciation.
Although the technical value of the naira is supposed to be N380/$ on the NAFEX window, the currency has traded within a band of N385-N390 to $1 since the NAFEX rate was adjusted in Mar'20. The currency adjustment in both the official and NAFEX windows has resulted in the narrowing of the gap between both rates to the 2% benchmark, from about 19% pre-currency adjustment in Mar'20.
Parallel market: Speculation gone wild
In the parallel market, however, speculation has run wild as the tight dollar liquidity position has forced importers with due obligations to scramble for hard currency in unofficial sources while most of the liquidity providers (foreign investors) have exited in favour of safe investment options. Based on data from the CBN statistical bulletin in Q1'20, the CBN has recorded a net outflow of foreign exchange flows since Jun'19, while inflows from autonomous sources are somewhat higher. This is suggestive of investors' preference for unofficial FX sources due to restrictions associated with sourcing for FX on the official window.
Investors' preference for unofficial FX sources has continued to put upward pressure on the naira exchange rate in the parallel market, where it currently trades above N470/$. Unfortunately, the increase in the naira exchange rate in the parallel market has resulted in the subsequent increase in the gap between the BDC and official exchange rates to 25%, from a gap of about 17% at the start of the year.
The pressure in the parallel market is also captured in the widening of the bidoffer spread from Mar'20, when the first devaluation took place. The widening of the bid-offer spread, similar to what was experienced during the 2016/17 FX liquidity crunch, is suggestive of an unfavourable gap between FX liquidity and the local demand for foreign currency.
Vulnerability indicators suggest reserves adequacy
While the unfavourable dynamics in the oil market has spelt doom for the Nigerian FX market, vulnerability indicators still suggest adequacy of the GIR. The imports cover serves as a current account-based measure of reserves adequacy, while the broad money ratio can be an indicator of the potential impact of capital flight. The CBN reported that the country's $35.16 billion in reserves as at Mar'20, could cover 7.31 months of imports. This exceeds the global minimum reserves requirements (3 months) and that of the West African Monetary Zone (6 months).
The broad-money ratio as at Mar'20 also reflected that the external reserves could cover 43% of money supply (M2) - global benchmark is typically set at 20%- if there were to be an increase in the demand for foreign assets from domestic sources or an aggressive reversal of foreign capital (assuming the entirety of money in circulation was foreign sourced). Fortunately, the accommodative outlook on global monetary policy will provide some respite from aggressive portfolio outflows and stem pressure on the external reserves.
Should investors ignore the latest currency woes?
Given the restrictions associated with the official window for FX, rates in the unofficial sources tend to reflect a true picture of the fundamentals in the FX market. As such, investors should keep a close eye on developments in the NAFEX window and parallel markets in the short-term. In the long term also, the NAFEX window is likely to be even more relevant because the CBN is not expected to remain the sole supplier of foreign exchange.
In the short-term, we believe the parallel market and NAFEX window premiums are likely to rise further (i.e. further weakening of the naira) before the end of the year, given extremely weak macroeconomic conditions. The continued delay of concessional flows from the World Bank and Africa Development Bank (AfDB) is likely to fuel upward pressure on the naira in both markets, even though the apex bank continues to implement restrictions in the FX market and ensure an orderly exit of foreign investors from the country.
In our base scenario, we expect the naira to depreciate to N394.31/$ and N486/$ at both the NAFEX and the parallel markets respectively. Our expectation is supported by continued recovery in oil prices that will be positive for both FX receipts and investors' flows, a total inflow of $1.5 billion in concessionary loans and the absence of a second wave of the COVID-19 pandemic.
Should we witness a second wave of the pandemic, oil prices are likely to nosedive and send jitters to inventors. The resulting unfavourable demandsupply dynamic in the FX market could cause the naira to trade at N396/$ on the NAFEX window increasing the gap from the current official rate to about 4%. The recent commitment from policymakers to rate convergence could spur a further adjustment of the official rate to N390/$, in a bid to bring the official and NAFEX spread within the permissible 2% gap.