Wednesday, September 27, 2017 /2:15 PM /FBNQuest Research
All options considered, compelling reasons to hold
The seven members of the monetary policy committee (MPC) at this week’s meeting decided by six votes to one to hold the policy rate of 14.00%. (The member in isolation supported easing.) The other policy parameters are also unchanged. Our call was no change on a majority vote. We were not alone. The committee looked at the options available to it (including tightening) and concluded that the fiscal and monetary policies in place require time to have their intended impact. It also warned of the inflationary risk of easing.
Robust confidence in fx policy
The committee noted the stability in its various fx windows and the continuing increase in gross reserves. Given this confidence, the emergence of the economy from recession and the growth of turnover on NAFEX, we no longer expect a formal adjustment to the official/interbank rate this year or next. This debate is somewhat academic, given the many fx windows in operation.
Economic recovery secure if fragile
The communique accepted that the recovery in Q2 was fragile yet identified grounds for it to continue. It felt that we will have to wait until Q1 2018 before a marked pick-up in growth and easing of inflationary pressures. In our view the MPC has overstated the impact of the fiscal stimulus.
Caution over a slowdown in inflation
The committee is no longer talking of good harvests and falling food price inflation this year.
Finally a prospect of narrower yields
The return of the offshore investor and the CBN’s strategy at OMOs together point to a narrowing of bond yields in the weeks ahead. We struggle to identify a trigger to drive yields down substantially at this stage, and feel that 15.75% would be a realistic target for the middle of the curve over the next two months. A level of 15.50% would be ambitious.
Inflation: pressures to ease in early 2018
From its communique, we can see that the committee was cheered by the continuing downward trend in y/y headline inflation, to 16.0% y/y in August. It argued reasonably that exchange-rate stability had played its part. We would add soft demand as another factor. The majority case for no change was bolstered by the fear that easing would encourage a resurgence in inflation and push real interest rates (at least its own) further into negative territory. There was no mention in the communique of the policy reference band of between 6% and 9% y/y.
Food price inflation has been sticky, virtually unchanged at 20.3% y/y in August. Two months ago, the committee anticipated some relief in Q3 2017 from the forthcoming harvest. Now it listed several explanations for stubbornly high food price inflation including rising prices of inputs, supply shortages, disruptive attacks by herdsmen on farmers, flooding in some areas and signals of a weak harvest. It has pushed back the point of turnaround to Q1 2018, when inflationary pressures are set to ease and growth strengthen.
The committee’s view over many months has been that legacy and structural factors such as the poor infrastructure are largely responsible for inflationary pressures. We accept that these factors are mostly beyond its control. The latest credit and money data are supportive over time of easing inflation. While the numbers are subject to sharp fluctuations, the communique noted that money supply (M1 and M2) and net domestic credit all contracted in August on an annualized basis.
Sadly, it no longer shares the CBN’s latest staff forecasts for inflation although the communique did warn that the positive base effects are set to wane from August. We project headline inflation of 16.2% y/y at end-year.
Fiscal policy: limited support for growth
Not for the first time, the communique looked to the rapid implementation of both the 2017 budget and the Economic Recovery and Growth Plan 2017-20 (ERGP) to support growth and job creation. It applauded what it termed the steady implementation of the budget, notably the capital component.
We have no evidence to support this praise and have the impression, in the absence of data to the contrary from the federal finance ministry, that implementation has been patchy. We have a deeper issue with the claim. Two months ago the committee cited a provisional deficit in H1 2017 of N2.5trn. If this remains the figure and since the committee supports fiscal responsibility, then we struggle to see how the FGN can provide much of a fiscal boost to the economy in H2. Like any sensible organization, it is paying the salaries of its employees but we query how much further it can go.
The approved 2017 budget set FGN aggregate spending at N7.44trn, compared with N6.06trn in last year’s approved budget. This is expansionary in that the increase is above annual average inflation. In reality, the projected increase is substantially higher since actual spending in 2016 was well below target.
The budget has a target for FGN capital spending of 30% of total spending. The CBN data for the month of May, still the latest available, show that capital items had a 34.3% share, recurrent spending including debt service a 61.0% share and statutory transfers a 4.7% share. We have to be careful and distinguish between capital releases as announced by the federal finance ministry and capital spending by the ministries, departments and agencies (MDAs).
The budget has capital spending at N2.24trn. This is not attainable in our view because we see the total revenue projection of N5.08trn as overly ambitious. (For the 12 months to May 2017, the CBN shows a total of N3.24trn.) We see an unspectacular increase in capital spending this budget year, with some benefits for the infrastructure, the ease of doing business and employment.
We reiterate our view that the FGN is fiscally responsible. If revenue falls short of the ambitious proposals for the year, as seems clear, we are confident that the FGN would adjust its spending. Capital items would be the loser. We do not think that the threshold of 3% of GDP for the deficit set in the Fiscal Responsibility Act 2007 is under threat.
The debt stock ratio of the FGN is very strong, with a burden in June 2017 (external and domestic combined) of 15.7% of 2016 GDP. This excludes the bonds issued by state governments, their bank borrowings, those of AMCON and the liabilities of the NNPC. We also understand that the 10-year pro-notes to be issued to meet contractor and other claims on government of N3.4trn will be treated as sovereign but not FGN debt.
These extras would raise the burden to around 25% of nominal GDP, which would still be very healthy in an EM context. In contrast, the debt service burden of the FGN is rapidly mounting. Payments have soared from N354bn in 2010 to N1.23trn last year, and have become the principal weakness of the public finances. As a proportion of FGN revenues, they are projected to reach 35.4% this year although the first months of the year suggested a ratio closer to 40%. This would naturally worsen in the likely event of continuing underperformance on revenue collection. More than 90% of the burden is due on domestic debt.
We endorse the expansionary stance because of the FGN’s diversification agenda: however, in order to lighten the burden over time, the authorities have to boost revenue generation, make better use of monies borrowed and continue the shift from costly domestic borrowing to mostly concessional, external finance. The shift would be cemented by the FGN’s proposal in mid-August to convert maturing NTBs into short-term external obligations up to a ceiling of US$3bn.
Exchange rate: just carry on as is
The committee noted the stability of its exchange rates and their continuing convergence. To recap, the authorities have adopted unfashionable multiple currency practices (MCP). These include: spot and forward sales to banks for the use of importers; further sales to banks at N357 per US dollar for the use of the retail segment for travel, medical and educational bills; sales to the bureaux de change; sales to SMEs; and the investors and exporters’ window (NAFEX). (The interbank/official rate is currently N305.8.).
MCP are frowned upon by the IMF but have had some success. The naira exchange rate on the parallel market has appreciated from about N520 per US dollar before the interventions to N365. Manufacturers are enjoying much improved access to raw materials, which is evident from the national accounts and our own PMI readings. A feelgood factor is discernible in the retail segment because of the availability of fx for invisible payments. Offshore portfolio players have brought new money into Nigeria through NAFEX. Official reserves (gross) have risen to above US$32bn despite the rise in fx made available by the CBN.
The communique mentioned inflows through NAFEX of US$7bn over five months (ie since its launch in late April). This is roughly consistent with the data from FMDQ for turnover (both sides of trades) over the period. That turnover has picked up from about US$400m per week in its early days, supported by dedicated Africa/frontier market equity investors, to US$1.3bn last week, which is explained by large offshore investment in NTBs and short-term FGN bonds by fixed income players. If this turnover is sustained, then MCP in Nigeria could become a successful case study. The higher the turnover, the less the CBN has to draw on its reserves to supply its various windows. Our understanding is that CBN’s supply of NAFEX is currently negligible.
The communique commented that the sharp rise in inflows on NAFEX is due not only to offshore portfolio investors but also to Nigerian exporters. We have no evidence to support this observation. We should also note that some of the bid at NAFEX will have come from other fx windows, notably sales to banks for importers. An additional sizeable boost to fx supply could come from several sources. If we wait long enough, a recovery in the oil price will deliver. FDI will pick up over time. The FGN, however, will not accept the IMF loans reportedly on offer and is opposed to substantial asset sales because they would be made from a position of weakness.
We no longer see an adjustment to the interbank rate (devaluation) this year or next. The CBN has stabilised gross reserves for now, and can watch NAFEX develop with some fine-tuning if necessary. The system ain’t broken so the CBN is in no hurry to fix it, not least because it is uncomfortable with the free-market alternatives. In any event, there] is a strong case for arguing on the basis of the principal windows (other than the interbank rate) that it has already come.
Growth: a little more confidence
The committee celebrated the economy’s emergence from recession in Q2 to growth of 0.6% y/y after five quarters’ contraction while noting that the process was fragile. It has become a little more confident about the short to medium term GDP outlook, pinning its hopes above all on agriculture and construction. The drivers of growth in its view include the ERGP and the 2017 budget (overstated per our analysis), the revenue boost from firmer crude prices, exchange-rate stability, some policy initiatives from the FGN and even the CBN’s role in development finance as the provider of credit lines.
On the demand side, the communique pointed to the boost to consumption arising from the FGN’s settlement of several trade disputes with groups like university lecturers, its payment of arrears to former employees of Nigeria Airways and its efforts to bolster state government finances.
As drivers of growth in Q3 2017 and beyond, we would add: the improved access to raw materials for manufacturing due to greater-than-expected turnover on NAFEX; a pick- up in investment by the private sector in selected segments of the economy such as petrochemicals and agriculture; particularly low oil output in 2016; and the FGN’s use of diplomacy rather than military resources to keep the peace in the Niger Delta (although its efforts may need to be reinforced).
As with inflation (see above), so with GDP does the committee now see improvements from Q1 2018. It did not provide a numerical forecast. Our own expectation remains growth of 1.6% y/y this year and 2.5% for 2018. We should add that the population is said to be growing by 2.8% annually.
Bond market: a leg downwards in rates
Dramatic changes in monetary policy such as banks’ cash reserve requirements, adjustments to exchange-rate policy and the market liquidity position are the largest determinants of short-term rates (NIBOR and short tenor NTBs). These can sometimes make for sharp fluctuations.
There is one captive investor category for FGN paper (the local institutions). The banks can earn 9% on the CBN’s standing deposit facility but up to a ceiling: once this is exhausted, they buy short-term paper. Alongside the banks, the other core domestic institutional investors are the PFAs. The pension funds are steadier investors in FGN bonds although their monthly inflows have softened a little due to payment arrears by the contributing state governments and federal agencies. The latest data from their regulator (PenCom) show total assets under management (AUM) at end-May at N6.73trn (US$22.0bn).
FGN bonds accounted for N3.80trn (56.5% of AUM) and NTBs a further N1.12trn (16.7%). In contrast, their holdings of domestic equities amounted to N0.54trn (8.0%). The PFAs have played their part in the surge on the NSE since mid-May, which will be reflected in subsequent data releases from PenCom. We can all make different valuations of local currency FGN paper. In other markets we might be tracking inflation but in Nigeria’s case we focus on fiscal factors, supply and demand considerations, and, for the offshore investor, exchange-rate risk. On the fiscal side, the FGN has borrowed heavily in H1 2017, which was apparent from the provisional deficit figure of N2.5trn and so above the projection of N2.36trn for the full year. The DMO has achieved sales (gross) of FGN bonds totaling N1.01trn in just eight months towards net domestic borrowing of N1.25trn for the year per the budget.
This exemplary front-loading of issuance by the DMO has been supplemented by external borrowing and, it would appear, CBN financing. Its good work will only be rewarded if in H2 the FGN succeeds in pushing up revenue collection substantially and returns to the international capital markets on a decent scale. We assume that the FGN will remain fiscally responsible and show spending restraint in the face of the likely shortfalls on revenue collection later this year.
We do therefore see the supply of new paper easing. We also note that the offshore investor did return to the FGN bond auctions in July and August, attracted by the nominal yields on offer in the market and by the workings of NAFEX.
Our chart shows a welcome dip in yields over the past two weeks. This was driven by the CBN’s market strategy: it has not offered longer tenor NTBs at its open market operations since 24 August, creating a surge in the bid for the 364-day bills to more than N330bn at the primary auction of 13 September. The unmet bid at auction fed into demand for FGN bonds, initially at the short end of the curve and then for all liquid instruments. (Our chart shows broken lines for the 182 and 364 day T-bills because they are not sold at every CBN auction.)
Taken together, we have a number of factors that could drive down yields. Such a move would be popular with the FGN for the easing of debt servicing costs. Our hunch is that a trigger is required if we are to see a pronounced downwards move. Nigeria’s re-inclusion in the JP Morgan indices would qualify but is not forthcoming. We conclude that 15.50% would be an ambitious target for the middle of the bond curve at the time of the next MPC meeting, and 15.75% more realistic.
1. MPC Holds Rates in Nod to Sticky Inflation
2. CBN Holds Again – Better Safe than Sorry
3. CBN Communiqué No. 115 of the MPC Meeting – Sep 25-26, 2017
4. MPC Leaves Policy Rates Unchanged
5. Pre-MPC Commentary - Inflation, FX Considerations Should Stay MPC Hand
6. MPC Preview: Policy Trade-Off Still Favours No Change
7. On hold on a Majority Vote Expected
8. MPC: Advocacy and The Total Eclipse of Analysis
9. Likely Split Decision At MPC, Status Quo To Be Maintained
10. Some Cracks Emerging In The Group of Eight
11. After Recession : A Need for Policy Change?
12. MPC to Hold Rate Steady as Green Shoots of Recovery Emerge
13. Personal Statement by the MPC Members at the 114 MPC Meeting of July 24-25, 2017
14. Growth in Money Supply Falls below Targets
15. Pre MPC Note: Tightening Argument Overriding Despite Strengthening Case for Easing
16. South Africa – Cautious Rate Cuts Ahead, But Risks Finely Balanced