Thursday, March 09, 2017 05.45PM / Renaissance Capital (Release Date: February 24, 2017)
GDP, FX reserves, trade and the current account are all looking better
There are chinks of light in Nigeria’s outlook. Headline GDP may have risen in 4Q16 and the IMF expects full-year GDP to turn from -1% in full-year 2016 to 1% growth in 2017.
The fall in exports slowed to just -7% by December, the trade deficit halved in 2H16 and the current account is on course to return to a surplus. Rising oil prices and a deal with the Delta militants have addressed both the oil price and volume challenges that hurt so much in mid-2016.
FX reserves have risen over 20% to $29bn and a more comfortable Central Bank of Nigeria (CBN) has this week announced changes to its FX policy and injected more dollars into the local market. Since Monday (20 February), the parallel market FX rate has strengthened 4% from NGN520/$ to NGN500/$.
We think NGN450-500/$ would attract investors even without $20bn of cheap IMF-led financing
One of our Real Effective Exchange Rate (REER) models – the 22-year model which corresponds to a period when oil averaged $55/bl – implies fair value for the naira at NGN370/$, which via inflation should become NGN400/$ by end-2017.
At the parallel rate of NGN500/$, Nigeria has the cheapest currency in Africa, and even at NGN450/$ it would still rival Egypt at EGP15.8/$ (the third cheapest in Africa). Given this, a full float of the currency would likely attract billions of dollars to Nigeria, similar to how Egypt has attracted $9bn since its float in November.
This would be even more likely if the authorities were prepared to seek a maximum World Bank and IMF support package of $20bn at very low interest rates. But we were literally laughed at in one meeting (in a kind way) for suggesting there was a 10% chance of this happening.
Nigeria still blames the IMF, rather than the collapsing oil price, for the pain of the 1980s, and at best a $2.5bn package of World Bank and African Development Bank (AfDB) funding is realistically on the table. That does require a narrowing in the spread of the official and unofficial currency rates.
Our Africa economist Yvonne Mhango forecasts that we will see the interbank rate averaging NGN381/$ and the end-year rate at NGN447/$ – levels which may attract some investment, if Nigeria wants these flows. Without a more realistic interbank exchange rate (or a surge in oil prices), we believe Nigeria will remain un-investable for most.
At present we doubt cross-over EM investors will put money into Nigeria, but some frontier investors may be prepared to invest for the long term at the exchange rates Yvonne Mhango is assuming.
Nigeria has acute reform needs but has successfully beaten back Boko Haram
While many criticise Nigeria for not following the reformist path of Russia, Argentina or Egypt, at a headline level, volatility has been reduced, and Nigeria has also avoided following the destructive policies of Venezuela, Angola and Zimbabwe.
Nonetheless, the fall in commodity prices will have nearly halved per capita GDP between 2013 (when oil was high) and 2017. There is an acute need to cut the cost of interest payments, and increase budget revenues, while improving electricity supply and infrastructure (helped by China).
On the positive side, there has been very important progress in addressing the existential threat from Boko Haram. And we still believe that many talented individuals in government would be a credit to any government, and will be able to demonstrate improvements by late 2017, for example in the Ease of Doing Business.
Opportunities emerging due to the rising oil price and doubling of production from 2016 lows
The vast majority of Nigerian and foreign potential investors ignored Nigeria in 2016 due to exchange rate difficulties, but rising oil prices and production (double the 0.9mbpd 2016 lows) suggest some opportunities may emerge in 2017.
A best-case scenario is very unlikely, but some frontier investors may well be able to find value in the country at an oil price of $55/bl and an exchange rate of NGN450-500/$.
President Muhammad Buhari deserves our sympathy, first for his current medical condition (we wish him all the best of course). Second, because after waiting 30 years to return to power by democratic means, he succeeded only when the oil price had begun to collapse just as it did in the mid-1980s when he last lost power.
GDP has been hit as a result. Using IMF estimates from October, Yvonne Mhango’s Nigeria currency forecasts for 2017-2018 and my estimates for Egypt, we think that by end-2017, per capita GDP will have fallen to a little over half of where it stood in 2013.
This is primarily because of the fall in commodity prices. We have seen the same in Kazakhstan (the figure may be identical to Nigeria by end-2017), and Russia (already at this level in 2016), while Brazil too has taken a beating.
In nominal terms, while in 2014, Nigeria’s per capita GDP rivalled Bolivia or Cape Verde, by 2016 the IMF estimates it was closer to Vietnam. For 2017, using the 2017 budget estimate for GDP, and various exchange rates, Nigeria is on course to rival India, Pakistan or Zambia.
In terms of a spot visual check, these 2017 comparisons do not look too far off. For 2017, Yvonne Mhango assumes a higher nominal GDP figure, but with an exchange rate that puts per capita GDP at $1,740, between India and Pakistan.
This does push up Nigeria political risk. We have shown that fundamental political risk (i.e., whether a country sustains democracy) is determined by wealth levels.
The chance of Nigeria’s democracy weakening has been just 3.3%, which is the sum chance of Nigeria becoming an autocracy, or a closed anocracy or an open anocracy, relative to its current “democracy” rating by Polity IV. At NGN350/$ or weaker, that risk is higher, at 5.3% annually. This is still low, but shows the potential cost from the weaker economy.
Per capita GDP is a good reflection of human capital, and tell us to expect that economic policy will be different in Nigeria than in countries that are 4-6 times richer like Argentina, Kazakhstan or Russia.
Each of these three floated their currencies over 2014-2015, took the commodity shock on the chin and already in 2017-2018 should be seeing a significant rise in per capita GDP in dollar terms.
What Egypt has done is more surprising. Its per capita GDP may be just $2,600 in 2016/2017, yet it too has gone down the route of a full free float of the currency. Many, including us, saw a risk that it would attempt a managed float of some kind, with a crawling peg monthly devaluation.
Instead it chose a policy more typical among higher income countries. We see its policy choice as likely to work out very well for Egypt in the medium term. Reports suggest it has already received $9bn of foreign exchange inflows since the float, which might include its $4bn of eurobond issue.
We are forecasting 6% growth next year in Egypt, but just 2% in Nigeria thanks to differing currency policies.
As Yvonne Mhango published on 17 February 20172, a full float of the naira is unlikely in Nigeria. The investor’s ideal scenario that Nigeria would follow Russia, Kazakhstan, Argentina and Egypt in this regard is improbable.
But even without a full float (and many frontier countries do not have such a currency policy) we know that some longer-term investors are looking to invest significantly.
They recognise that in some regards, Nigeria is past the worst. This is most obvious on the external side. The latest export figure for December is the smallest fall YoY since 2014.
Meanwhile, as currency demand and supply has not been balanced via the exchange rate, it had to be balanced via rationing. This has squeezed domestic demand and imports are still falling by over 30% YoY.
Admittedly, even if the currency was freely floating, we would also have seen a squeeze in domestic demand.
The rolling 12-month trade deficit halved from $10bn in June 2016 to $4bn by December.
Meanwhile remittance inflows have held up well. This makes a lot of sense for Nigerians able to put dollars into the country at the unofficial rate of NGN500/$.
Taken together, these trends put the current account on course to return a surplus, after recording a deficit of 3% of GDP in 2015.
The improving current account trends would appear to explain the $6bn (21%) rise in foreign exchange reserves since the bottom in October.
Evidently reserves growth was the priority for the authorities on the back of the rise in oil prices to around $55/bl, and a deal with the Delta militants expected to secure oil production around 2mbpd. As yet, higher production has not fully translated into higher exports, due to pipeline disruptions since late 2016.
With FX reserves expected to imminently top $30bn, back to the levels of 2Q15 when Buhari took office, this has given Nigeria more options. This week, instead of only pushing up FX reserves, we have seen the CBN prioritise the supply of greater dollar liquidity to the local market.
We think this echoes what we have also seen in Egypt in February. Until last month, Egypt was determined to push up FX reserves. But in February, it has allowed more dollars to enter the FX market which has pushed the Egyptian pound stronger.
As Nigeria’s official exchange rate was strong, while Egypt had the cheapest currency in Africa in January3, the response to greater dollar supply is of course different. In Egypt the currency moved 16% stronger in 16 working days during recent weeks.
In Nigeria, we have (so far) seen no move in the official exchange rate, but the unofficial parallel exchange rate has strengthened by 4% from NGN520/$ to NGN500/$ between 20 and 22 February.
Our base case is that Nigeria will continue to see a range of exchange rates, but with less official interference. For example, on 20 February, the CBN announced it would no longer impose the 60% rule on allocation of dollars to the manufacturing sector. We assume Nigeria will maintain an exchange rate allocation for the petrol importers, perhaps around NGN305/$, because so many households in Nigeria power their houses with petrol generators.
Yet, via all the market distortions, Nigeria has succeeded (at a headline level anyway) in smoothing volatility. The currency never went as extremely weak as it did in Egypt, and now it may not need to. The fortuitous rise in oil prices has helped improve the balance of payments, and Nigeria has in the meantime avoided some of the extreme currency and inflation moves that we have seen elsewhere.
The downside is that for two years, foreign currency allocations have been largely determined by the public sector, which was also true of Egypt until November, but has not been the case in Argentina or Russia for example.
Many believe this has increased corruption in Nigeria and undermined some of the gains that Buhari had achieved by clamping down on corruption in the oil sector. The latest 2017 Corruption Perceptions Index from Transparency International saw Nigeria’s score improve from 26/100 to 28/100 – but its rank was unchanged at 136th.
In addition, while private sector investors have now returned to Argentina, Russia and Egypt, this is not the case in Nigeria, where a very wide spread in exchange rates still exists. Trends may have begun to improve this week, but these are very early days, and investors will be sceptical about whether it can be sustained.
As there is no faith in an official commitment to a fully floated currency, investors will remain concerned that they will be unable to withdraw money from Nigeria, if oil prices fell again. By contrast, while investors know they would carry a currency loss in Russia or Kazakhstan if oil prices fell, at least they also know they can withdraw their capital if their own end-investors demand it.
So as dollar liquidity improves in Nigeria, one response may be more capital flight from Nigeria until asset price valuations, and the exchange rate, reach levels that investors find tempting.
Where is that level? On the currency, our December 2016 update of our long-dated REER model suggests that since January 1995, in today’s money, the naira has averaged NGN364/$ in today’s money. Coincidentally, over the same period, Brent oil has averaged $54.8/bl, which is very close to current oil prices.
This average rate in today’s money moves because of inflation. With January inflation of 1% MoM, that fair value should have moved to NGN367/$ and assuming another MoM inflation print of 1% in February, we might estimate fair value today at NGN370/$.
If we see another 10% inflation by year-end, this might put fair value at NGN400/$ by December 2017, and with another 10% inflation in both 2018 and 2019 would put fair value at around NGN490/$ by end-20195.
For those able to invest in Nigeria at NGN500/$, Nigeria already looks attractive. As investors said on our Abuja/Lagos trip, after exchanging money at that rate, Nigeria felt cheap for the first time they could remember. A drink in the mini-bar was just $2.
At NGN500/$ the currency is 26% cheap to the fair value of NGN370/$, compared to Ghana which is 23% cheap or Egypt which is 18% cheap to their December 2016 fair values (note Egypt was 32% cheap in January though).
At NGN450/$, the naira is similar to Egypt at EGP15.8/$ – roughly 18% cheap, and still offering value.
At NGN390/$, the currency is equivalent to 5% cheap to fair value, similar to the rand at ZAR12.9/$. This is probably insufficient compensation for perceived liquidity risk.
So for those in Nigeria who fear that a full float of the currency might send the naira to NGN600/$ or even NGN1,000/$, our model should be reassuring. A currency rate of NGN600/$ would be an extreme undervaluation, such as we saw in Egypt in January, and very unlikely to be sustained unless inflation soared towards 40-50%.
If officials are right that many prices in Nigeria already reflect the unofficial exchange rate, that is not a serious threat (note however, Egyptians also believed inflation might not rise much above 20% after their devaluation, for the same reason, but the latest urban January inflation figure hit 28%).
This tells us then that investors should be looking to add exposure to Nigeria if they can put money into the country at NGN450-500/$. The problem is they cannot. Unlike Nigeria, both Ghana and Egypt have IMF programmes and floating currencies that investors can access, so both should attract more interest than Nigeria at present.
So unless oil prices rise significantly from here, or the official currency rate becomes much more liquid and weakens to NGN450-500/$, we assume most investors will continue to avoid Nigeria.
The currency is of course only part of the equation for equity investors. Share price is the other part, and for half the equity market this means looking at the banks. We generally heard less concern in Abuja and Lagos about the banking system than we feared.
The table below excludes FX valuation gains which would be significant for some banks including GTB, RBNH, Access and UBA and Zenith to a lesser extent. So these banks would be in a better position than the table below suggests.
But even without these gains, it is notable that most of the banks would still have capital buffers even if the currency devalued by 50% from the official rate of around NGN350-315/$. It appears Nigeria’s regulators, and its banks, learnt a helpful lesson from the problems of 2008/2009.
Some in Nigeria think foreign banks may be prepared to take the opportunity to buy up those banks which are most at risk.
A few officials did hint that an IMF support package might be conceivable. The ideal scenario for the investor community is that the IMF grants a mega-package of around $18bn for Nigeria (the maximum we can imagine given Nigeria’s IMF quota), which combined with at least $2bn in World Bank support (it already has $8bn of programmes in the country) and a little from the African Development Bank, could provide $20bn of cheap financing for Nigeria, at interest rates far lower than the international markets offer.
We were laughed at for suggesting there may be as much as a 10% chance of this happening. Nigeria has not forgiven the IMF for the pain the country endured in the mid- 1980s, which is blamed on the fund and not on the fall of oil.
Only $2bn of World Bank and $400mn of African Development Bank support is plausible over the coming 12 months. The former does require a narrowing of the exchange spread (from the current NGN305-500/$ range). Nigeria aims to add to this by borrowing from the eurobond markets again.
We expect the IMF’s next Article IV to reiterate many of the recommendations it made in the last report, but to also draw attention to worrying trends, such as the rise of debt servicing costs as a proportion of revenues (now close to 67%). This is a highly negative ratio, which is not sustainable in the long term.
We do expect Nigeria to achieve gains in the World Bank’s Ease of Doing Business rankings in 20177. A team of former governing Georgian officials have been brought in to advise on how to achieve the gains that Georgia itself, and then Rwanda, achieved over the past decade.
One positive development is that a visitor we met in Abuja had just received a visa on arrival at the airport. It took two hours from landing to leave the airport (in Lao DPR, it took me less than 30 minutes and that included changing money8) but still this is progress.
Electricity is one of the most disappointing areas of (no) progress in Nigeria. Despite privatisation of the distribution and generating companies, output to the grid still often sits as low as 4,000 MW, while a few years ago, we were told by experts it should have doubled to 8,000-10,000 MW by now.
We expect the government to reach a deal with the electricity companies in which everyone takes a bit of a hit, but which provides time for companies to start addressing the investment needs in the sector. Until Nigeria addresses its power problems, it will lag East Africa and others with regard to industrialisation10.
A bounce-back to 5,000-6,000 MW will not surprise us, but does not come close to what Nigeria needs to be producing on the grid. Over the next year or two, the government is likely to focus on providing power for specific industrial parks, similar to what we have seen in Ethiopia.
Perhaps the most encouraging progress has been made in fighting Boko Haram. A few years ago, some feared that it represented an existential threat to Nigeria, that might tear the country apart.
But under the leadership of President Buhari, deaths caused by Boko Haram have plunged in the past two years. While upsurges of violence still exist elsewhere, these do not provoke the same existential concerns about Nigeria’s unity.
In reacting to the fall of commodity prices, Nigeria has chosen a less market-orientated path to reformers such as Russia, Argentina or Egypt. Exchange rate volatility has been lessened, but despite that, the impact on per capita GDP has in the end been similar.
On the positive side, Nigeria keeps making enough changes to avoid the mess we see in Venezuela, Zimbabwe or (to a lesser extent) Angola.
We expect investors to mostly stay away from Nigerian local assets when the interbank exchange rate is around NGN315/$, unless the oil price surges higher from here. We think assets look good value at an exchange rate of NGN450-500/$, but even at that rate larger cross-over EM investors are unlikely to invest in Nigeria unless there is clear evidence that the currency market is liquid (and likely to remain so).
Frontier investors with more of a buy-and-hold approach will likely move in first, providing the authorities do not take measures to deter portfolio flows.
We still believe Nigeria is blessed with a good number of high-quality personnel in government, but recognise that human capital is lacking at various levels of government which hamper implementation of policy. But there is a price for all obstacles, and at NGN450-500/$, we think investors would say this in the price.
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