Saturday, 18 June 2016 11.52 AM / Afrinvest
Three weeks after the Monetary Policy Committee’s (MPC) consensus decision to adopt a flexible exchange rate system, the Governor of the Central Bank of Nigeria (CBN) - Godwin Emefiele - at a press briefing on Wednesday, 15th June, 2016 announced the re-introduction of a market driven two-way quote single Interbank Foreign Exchange (FX) Market. Though ultimately inevitable, reneging of the CBN represents a policy backflip against the long-held stance of maintaining NGN/USD peg at N197.00/US$1.00.
Afrinvest Research has in recent reports - notably “Price Modulation” of the Downstream Sector …Taking the Bull by the Legs” of 17/05/2016 and “A Change in Market Sentiments... 5 Signs to Watch!” of 08/12/2015 - consistently noted that the erstwhile pegged exchange rate regime adopted by the CBN had a debilitating effect on major sectors of the economy, was unsustainable and was growth inhibiting. We had also argued that a flexible exchange rate regime, together with a devaluation of the currency or the introduction of a Two-Tiered market would bode well for the capital market and the economy.
The CBN surpassed our expectations by not only adopting a single FX market structure without trading limits but also introducing derivative hedging products – Forwards, Futures, Swaps and Options – to ensure orderly transition to a market-based mechanism. Whilst we laud the bold move by the CBN in instituting a flexible FX market structure, we reiterate our position on the restricted 41 items that are still termed “inadmissible” in the new market framework.
We think that perhaps the CBN should not use monetary policy tools to tackle issues that are better dealt with using fiscal policy tools. We believe as the system becomes more sophisticated through the depth and breadth introduced, market efficiency might convince the CBN to free the excluded items.
Given the above, we expect the financial market to pick up on the back of increased global funds inflow into the system and as investor sentiments favour investible assets in the money and capital market.
As part of the new guidelines for the workings of the new interbank FX market, the CBN is introducing Foreign Exchange Primary Dealers (FXPDs) who will serve as the bulk traders dealing directly with the CBN. The somewhat stringent conditions (40.0% liquidity ratio, N200.0bn shareholders’ funds and N400.0bn foreign currency assets) for qualification as an FXPD will establish a new category in the banking industry.
Based on FY: 2015 and Q1:2016 data, only the Systematically Important Banks (SIBs) excluding Skye Bank would qualify. This imposes a new element to banking industry’s fundamental competitiveness.
In the subsequent sections, we present our thoughts on the new arrangement while reviewing the major highlights of the policy and how the system could work. We then conclude with the potential impact of this new FX paradigm on the economy and financial markets.
Major Highlights of the New Nigerian Inter-Bank Foreign Exchange Market (NIFEX) Guidelines
1. Minimum shareholders fund unimpaired by losses of at least N200.00bn
2. Minimum of N400.00bn in total foreign currency assets and
3. Minimum liquidity ratio of 40%
We have analysed these criteria for listed Banks as at FY: 2015 audited accounts filing as shown in the Table below.
We believe the CBN’s decision to introduce FXPD will have further impact on the competitive dynamics of the banking industry with Tier-1 banks - which overwhelmingly dominate the list of qualified institutions - gaining more competitive advantage. The CBN is the single-largest supplier of FX in Nigeria.
By providing FXPDs exclusive access to deal with the CBN for large-volume transactions (with no capped spread on resale of the FX sold to other authorised dealers and retail clients), corporate clients with huge demand for FX could shift deposits to designated FXPDs, further widening the Cost of Funding gap between Tier-1 and Tier-2 banks.
This will all inevitably filter into bottom-line performance which will further segregate the profitability of FXPDs and other banks. Yet, we believe the decision of the CBN is justified, given the need for FXPDs to have sufficient liquidity, capital base and assets to independently source for FX.
How the System is expected to Work
The new system is expected to be broadly market driven through the interbank market with the CBN as a participant through special interventions. The anticipated operating mechanism of the system is broken down in charts 2 and 3.
Source: FMDQ, Afrinvest Research
Implications on the Economy and Financial Market
Impact on Funds Flow… Rain before Sunshine
The distortions in the FX market alongside deterioration in macroeconomic fundamentals have deterred capital importation into Nigeria and led to massive exodus of capital. Total Capital Importation declined from N4.1tn (US$26.0bn) in 2014 to N1.9tn (US$9.5bn) in 2015.
This worsened in H1:2016 as capital control measures lingered, with Q1:2016 capital importation down 73.4% to N140.1bn (US$710.0m) from N526.3bn (US$2.7bn) in Q1:2015. Although funds outflow (by investors who had previously been unable to repatriate profits prior to the review of the policy) is expected in the interim as the market transitions, this new move is anticipated to restore confidence given that the value of the domestic currency will be viewed as appropriately priced. To this extent, we expect increased portfolio and direct capital inflows, including government foreign currency borrowings.
Impact on External Trade… Deficit to Remain but More Autonomous Capital Inflow
Nigeria has recorded trade deficit every quarter since Q4:2014 as a result of the over 50.0% dip in oil prices. The CBN’s reduced supply of FX, restriction on 41 items from the interbank market as well as massive currency depreciation in the parallel market constrained import bills by 38.0% (between Q1:2016 and Q1:2014) to a monthly average of US$3.2bn, although at a great cost to domestic growth, but not enough to offset the decline in exports.
Hence, the country reported US$2.5bn in trade deficit in Q1:2016, higher than US$1.3bn in Q1:2015. Theoretically speaking, a significant exchange rate adjustment should result into narrowing of the trade deficit as imports become more expensive. We expect this to happen, with the impact flowing majorly from lower import bills given the uptick in the cost of importation.
Stimulating exports requires more structural reforms but liberalizing the FX market does allow both fiscal and monetary authorities the needed space and capacity to implement needed reforms. But we expect improvements in capital account to aid trading activities and fund the trade deficit until oil earnings rebound and non-oil exports grow.
Impact on Macroeconomic Variables… What is the Medium Term Value of the Naira?
Whilst acknowledging the sufficiency of the new FX system to stimulate capital inflows, it is important to note that the CBN would, at resumption of trading, be the major supplier of FX while pent-up demand seeking early exit would likely bid-down NGN-USD spot rate. This would heighten volatility pressure in the interim as the market goes through the process of price discovery – with the interbank rate likely overshooting the N300.00/US$1.00 mark.
The CBN Governor suggested that monthly FX inflows to the Bank has dropped to US$0.8bn which is far below pent-up demand, estimated to be in excess of N750.0bn or US$3.8bn at current interbank rate (N199.10/US$1.00).
Hence, the willingness of the CBN to utilize its external reserves to boost liquidity in the spot market will go a long way in moderating initial volatility. If the Naira depreciates to a mid-market rate of N281.05/US$1.00 and some current demands shift to the futures/forward markets, the CBN might not need more than US$2.0bn to intervene in the spot market.
We believe that some degree of intervention would be required and that the Naira might eventually settle in the region of N280.00-N300.00/US$1.00.
a. Inflation: The rate at which the Interbank market settles will be a major driver of inflation rate in the coming months. If the market settles within our forecast range, we expect the impact of the FX rate adjustment on inflation numbers to be moderate as retail consumer prices have more or less adjusted to parallel market pricing of the dollar.
b. Fiscal Policy: Translation of oil earnings at lower FX rate is expected to reduce the impact of decline in oil productions on federation revenue based on our estimates. We analysed that if equilibrium exchange rate settles at N280.00/US$1.00 (40.6% higher than budget benchmark of N199.10/US$1.00) and oil production remains at 1.4mbpd (36.5% lower than the budget benchmark of 2.2mbpd), with global oil prices up by an average of 26.3% to US$48.00/b, FAAC allocations will receive a boost thus strengthening fiscal revenue capacity of Federal and Sub-National governments. Also, restoration of foreign credit lines/capital market borrowings of Nigerian Sovereign and Municipals - subsequent to the implementation of the flexible system – will aid budget implementation and buoy aggregate demand.
c. Growth: With the easing of supply shortages, both in the Petrol and FX markets, alongside implementation of the 2016 budget, we believe the economy would return to a growth path in the second half of the year. However, much of this has already been considered in our projection for growth, hence we retain H2:2016 GDP growth forecast at 2.0% and FY: 2016 estimate at 0.4%.
Impact on Capital Market…Bullish Sentiment towards Equities; Yields to Moderate
The elimination of FX liquidity uncertainties especially in repatriating funds for foreign investors and expected devaluation of the naira due to market forces will serve as a signal to return of FPIs, especially into the local bond market. The derivatives hedging products will particularly be suitable for fixed income investors who could lock-in an exit FX rate at a pre-determined spread.
However, heightening inflationary pressures, speculations on exchange rate adjustments and renewed appetite for other asset classes might reduce the upside on gains in fixed income instruments. If implementation of the derivatives market goes as planned, we expect to see yields moderate from current average levels of 14.2% by at least 200bps. In addition, we believe that as the new FX market becomes more sophisticated and tested for depth and liquidity, Nigeria’s exclusion from JP Morgan’s Emerging Market Bonds Index in Q4:2015 could be reconsidered during H2:2017 which would further drive performance in the medium to long term.
We are of the opinion that the equities market will also witness increased activity from foreign players. Domestic investors are already positioning ahead of increased participation of foreign investors in the market. The benchmark index of the Nigerian equities market has risen 5.3% to 28,489.87 points (16/06/2016), since the release of the FX guidelines, driven by renewed bullish sentiments across two sectors – especially Banking and Consumer Goods.
Our equities market scenario analysis had in January 2016, projected the NSE ASI to settle at 28,980.55 (+1.2%) by year-end if
(1) a flexible exchange rate regime is adopted,
(2) there is more fiscal policy clarity and
(3) the budget is implemented speedily. All the conditions for a positive return of the index are being met now and we see the 2016 equities performance mirroring our best case scenario.
The Bigger Picture… Is Nigeria now a full-fledged market economy?
The recent move by the CBN does not only have monetary policy implications, but the larger picture that Nigeria is now embracing market-oriented policies in resource pricing and allocation. Coming to terms with this reality has taken a long learning curve with credibility of key public institutions undermined while also constituting a huge cost to public finances, external reserves and economic growth. Yet, we think credibility could be won back if reforms continue at current pace. Indeed, we are quite positive about this as four of the five signs we listed as signals for a rebound in the market and the economy have now been met, albeit with fiscal challenges still prevalent at the sub-national level.
It appears however that this is also being addressed with the “Fiscal Sustainability Plan” being driven by the Federal Ministry of Finance. The plan constitutes 22 stringent conditions aimed at restoring the fiscal health of States as a pre-condition for bailout fund. Indeed, the sub-nationals might now require much less bailout funds in the new FX market environment since their dollar based income from the Federal Government will now be adjusted to the new market determined FX rates.
We envisage that the traction in reforms implementation will smoothen the adjustment of the economy to a lower-oil price environment and thus maintain our long term investment thesis for Nigeria.