MPC May Hold Policy Levers But FX Change Required


Monday, November 21, 2016 11:45 AM /Vetiva Research 

Monetary Policy Committee (MPC) meeting comes at a pivotal time. With fiscal policy in the throes of reflating the economy (N3.7 trillion or c.80% of pro-rated budget spending disbursed as at Q3), the two key policy paradigms of the Federal Government (FG) are able to work simultaneously – a privilege previously denied as a result of earlier budget delays.

The last monetary policy change (an increase in the monetary policy rate from 12% to 14%) was in July and economic conditions have largely been in stasis since then. In particular, the furor over the Foreign Exchange (FX) market has persisted despite CBN decision to officially float the local currency in June this year.

Next week, the MPC will have the opportunity to review their policy stance for the final time this year and perhaps, set a marker for 2017 as well. Here are a number of developments likely to be considered

Inflation reaches 18.3% y/y amidst slowing m/m pace
There are two key messages from recent inflation data. The first is that y/y inflation is perilously high at 18.3% and is likely to remain above 18% till the turn of the year (after which base effects kick in).

The second is that month-on-month inflation declined for four consecutive months from a high of 2.75% in May to 0.80% in September and although it inched up slightly in October (0.83%), the broad trend shows an easing of inflationary pressures. This is largely due to greater stability in the official exchange rates energy prices.

Whilst these two messages could give conflicting recommendations (the former – tighten, the latter – ease), we note that current inflation is cost-driven, so addressing cost pressures remain the most effective way of tackling it.

In this regard, there are two options: the first would be to cut MPR to reduce borrowing costs, and the second would be to maintain tight monetary policy in order to support the local currency.

That said, naira weakness remains the largest cost pressure on local firms and measures to alleviate this burden are likely to be the most fruitful.

Foreign investors respond positively to MPR hike
Capital imports in the third quarter exceeded total capital imports during the entire first half of the year as the new flexible exchange rate regime, as well as higher yields in the fixed income market, attracted improved foreign portfolio inflows (FPI).

In fact, bond inflows went from $0 to $370 million q/q as average yields on the benchmark bonds increased by c.170 bps q/q. The improvement in FPIs can be counted as one success of the July decision to hike MPR by 200 bps.

Despite this, capital inflows remain depressed (Q3 inflows still down 34% y/y) as a number of relevant conditions for foreign inflows remain unmet. Economic weakness and lower visibility (following expulsion from JP Morgan EM-BI) are likely to constrain capital inflows whilst confidence in policy-makers and stability in the FX regime will drive short-term investor interest.

FPI has been vaunted as a solution to dollar scarcity and this offers one justification of tight monetary policy. However, even considering recent modest inflows, the tactic of tightening monetary policy to attract inflows is hamstrung by the poverty of other necessary conditions, especially a stable and transparent FX market. Thus, we do not see much wisdom in escalating such a strategy in the meantime.

An economy crying out for monetary stimulus
Whilst we await official Q3 GDP figures, we expect economic malaise persisted in the last quarter (Vetiva Q3 forecast: -1.7%). All Purchasing Manager’s Index readings came in below the 50 threshold during the quarter, suggesting a perpetual deterioration in business activity during the review period.

Supporting this, listed companies’ Q3’16 earnings were generally disappointing, underscored by a 9% decline in NSE All-Share Index since the start of October. Tepid demand, as a result of squeezed consumer wallets, and FX-related cost increases have continued to dampen the economic climate.

Despite proactive fiscal policy in recent months, there is a need for coordinated policy action to address the current economic situation. At its September meeting, the MPC echoed doubts about the efficacy of monetary policy transmission to aggregate demand.

In doing so, it defended its focus on shoring up aggregate supply through FX market reforms as its contribution to economic recovery.

Whilst addressing the currency situation still offers the smoothest monetary route to economic recovery, the responsibility of monetary policy for supporting growth becomes weightier as the malaise persists.

Nigeria’s FX market evolving in rather bizarre fashion
The introduction of the much heralded flexible exchange rate system and removal of the CBN peg has been followed by a succession of “soft pegs” – NGN285/USD following devaluation, NGN315/USD in August, NGN310/USD in September, and NGN305/USD in October.

Accompanying this, ad hoc supply management ranging from regular late interventions in the Interbank market, to compelling BDCs to trade the currency within a strict band has defied the objective of a floating naira.

The consequences of this are possibly severe – further eroded investor confidence, created arbitrage opportunity through the superfluity of mini-markets, and restricted the flow of the dollar, an already-scarce commodity.

The danger is that this return to a peg-and-defend approach will unwind the progress made after the initial adoption of the flexible regime, and possibly undermine recent monetary policy moves to sustainably shore up dollar supply.

In this regard, FX policy currently stands as the bedrock of monetary policy as it remains the crucial variable for investors, businesses, and individuals alike. Tight monetary policy will only bear fruit with a robust FX market in support and absent this, the argument for keeping rates high becomes significantly weaker.

Thus, even as we do not expect the MPC to deviate from its recent tight stance, we do not expect much success in achieving its objectives until clarity, transparency, and flexibility is restored to the FX market.

Although the MPC meeting is ostensibly to review policy levers such as the monetary policy rate, cash reserve ratio, and liquidity ratio, the elephant in the room remains the most important variable.


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