MPC likely to devalue the Naira?…as oil price shocks test CBN’s resolve


Wednesday, November 19, 2014 4:15 PM / Meristem Research


Ahead of MPC Meeting

The Monetary Policy Committee (MPC) will be meeting on the 24th - 25st November, 2014 to determine policies directions on key monetary variables. In our view, key considerations for the committee will include amongst others; declining oil prices and the pass through effect on FX rate, external reserves and general price level.


Other items expected on the agenda will include, the current level of liquidity in the system and political spending. In the light of these, we review events in the global economy, most especially as it relates to the faltering global growth, weak recovery in the Euro-area, global oil price shocks and crisis in the Middle-East and Ukraine.  


We went ahead to re-assess economic indicators in the domestic economy, paying special attention to the pressure on FX rate, dwindling reserves and CBN's resolve to defend the Naira, in the face of marked sell-offs noticed in the Equities and Fixed income markets.


Constrained to reason in the above realities, we see the committee waylaid to play out one of three scenario as highlighted in the report reproduced below.


Kindly click DOWNLOAD to view full report. 


International Economics & Developments

Soft Global Growth, Falling Oil prices and Other News

By IMF latest projection, global growth slowed from an annualized rate of 3.9% in H1:2013 to 2.7% as at H1:2014. Growth in the Euro area appears to be weakening (+0.2% in Q3:2014), while recently released results showed a 1.6% contraction in the Japanese economy within the same period despite huge monetary stimulus package.


China on the other hand, though growing at its slowest pace since 2009, recorded slightly higher than expected growth as GDP expanded by 7.3% in the third quarter of 2014. IMF projection pegged global growth at 3.3% by year end 2014, expected to stay tempered, uneven and fragile.


To fast track growth, the European central bank (ECB) says its stimulus measures (Asset purchase) are starting to have effect, but it is ready to do more given sustained bleak outlook. Growth in the US however strengthened as the FED officially ended its asset purchase program in October whilst leaving interest rate low.

Global oil prices continued on a free fall in November (Brent crude down -26.72% YtD) as the global supply glut persists, with dim indication of respite in the near term. Going into the 27th November OPEC meeting, Saudi Arabia has restated its stance not to cut its production; a move it says is to keep its share in the US market. This reluctance to cut production, and tumultuous drop in prices has resulted in depletion in foreign reserves of selected OPEC members (Nigeria and Venezuela), as they struggled to strengthen local currencies against the dollar.


Other downside risks to global growth include, the Russia-Ukraine tension and ISIS insurrection. Growth forecasts for Sub-Saharan Africa (SSA) however remains strong at 5.4% in 2014 (unchanged from earlier projections in April).


With Nigerian foreign reserves presently at about USD37.55bn, we expect the MPC to put policies in place that will help conserve the reserve given pressure on the Naira. In this light, whilst we think devaluation of the naira may be considered, the downside impact in that it makes imported products more expensive plus the previous assurances by the CBN that the naira won't be devalued makes this move somewhat unlikely. However, we envisage other creative monetary policy measures to containing it.



Domestic Macros

Output: Q3 GDP Number stays strong, softens compared to Q2

Nigeria released its Q3:2014 result reporting a real GDP growth of 6.23% Y-o-Y (vs. 5.17% in same period 2013). Although, a relative Y-o-Y increase, a Q-o-Q decline of 0.31% when compared to real GDP growth of 6.54% in Q2:2014. The non-oil sector remained the driver of growth contributing 7.51% in Q3:2014, albeit 0.95% lower relative to 8.46% in Q3:2013, but 0.80% higher than what was obtained in Q2 2014.


The increased growth in non-oil GDP was traced to appreciation in agricultural, industrial and services sector relative to Q2:2014. Q-o-Q non-oil GDP growth was measured at 8.67%, and the agricultural sector grew the most with 38.53% in Q3:2014 (vs. 10.76% in Q2:2014). The growth in the agricultural sector is based on the numerous policies put in place to boost rural agricultural development and growth in recent times.


The oil sector on the other hand remained challenged, as average daily crude production in Q3:2014 was 2.15mbpd (vs. 2.26mbpd in same period 2013 and 2.21mbpd in Q2:2014). The overall impact of drop in crude production resulted in 3.6% decline in oil GDP in Q3:2014.


We are of the opinion that, although the committee would be satisfied with the recent development in the agricultural sector, as the country retraces its ancient path to revenue and employment generation, recent steady decline in crude oil price since Oct-2014 will be a source of major concern for the MPC in the face of dwindling fiscal and monetary buffers.

Price Level: Inflation at 8.1% against all odds

Inflation stays relatively stable in 2014 at an average of 8.08%, peaked in August (8.5%) and lowest in February (7.7%). Inflation rate has declined from 8.3% to 8.1% since the last MPC meeting in September despite the pressure imposed on FX rate due to oil price shocks. This drop is synonymous with the decline in food inflation from 10.00% in August to 9.3% in October. This may however be slightly connected to reduced importation of food (especially rice which is most consumed) and investing in local production through partnership with investors like Dangote who injected USD1bn in rice production.

As against the above, outlook on general price level is bleak given the pressure on FX rate (on the back of global price shocks) and the country’s dependence on imported goods. Also, expected increased election spending and worsening insurrection in the North also call for concern. With this in mind, we see further tightening as the way to go for the MPC.



Fiscal Policy: Government set to check spending

2015 budget proposal remains based on the MTEF assumptions, but this has been reviewed recently to reflect current realities. Revenue estimates for the 2014 budget may however be unattainable given events in the oil and gas space.


Federal ministry of finance has given indication for likely austerity measures to check government spending, taxes on luxury good (such as champagne, private jets and yachts) are to increase to improve IGR whilst government spending on travels will be reduced, according to the minister of finance.


In all, we imagine a fiscal policy tightening going forward with fringe reduction in recurrent expenditure and restricted capital expenditure, Increase in tax revenue to gear up non-oil revenue generation is also expected. However, we expect the MPC to be wary of election spending bulk of which may not be separated from government finances.


Security and Insurgency: North East remains a major security concern

The end to security challenges across the country particularly in the North East does not seem near despite the much of resources committed to ending the insurgency. We do not see the current security challenge abating in the short term as we are of the opinion that the general elections in 2015 may further heighten the insecurity challenges. For the MPC, this has a link to food prices and inflationary tendencies as the bulk of our food supplies come from the north.


As the election year leans closer and political activities gather momentum, we expect increased political spending as the major parties jostle for supremacy. Uncertainties around elections usually induce investors’ flight to safety. We are of the view that the committee would be concerned about how to manage capital flight arising from perceived instability in the country.


FX Rates and Reserves Position: Devaluation, how plausible?

FX rate has weakened 5.48% against the greenback since the last MPC and 7.80% year to date (YtD) closing at NGN/USD173.3 as at 18th November 2014, severely pressured by events in the domestic and global space, particularly the continuous drop in the global oil price. To salvage the situation, the CBN stayed resolute to its resolve to defend the currency, selling billions of dollars in its RDAS auction to stabilize FX rate.


The unavoidable cost of this resolve remained the depleting FX Reserves which continued on a downward trend (USD43.6bn in January vs.USD37.6) as accretion diminishes on the back of lower oil prices. Pressure on the reserves was most obvious over the last three weeks dipping by 7.53% compared to 13.83% YtD. Estimated month of import cover reduced to 7months (vs. 8 months average for the year).


In bid to conserve the reserve in the light of the above, the apex bank has already removed some items from its official windows. This however has resulted in massive pressure across FX market segment as the Naira tumbled following the announcement, peaked at NGN/USD173.3 (vs. NGN/USD165.5 prior to the pronouncement) in the interbank market, whilst BDC and Parallel market premium peaked at 11% and 12% respectively so far in the year.

In our opinion, defending the Naira with reserves appears unsustainable given the expectation for sustained pressure on the Naira and the aforementioned catalysts.



Hence, the need for the CBN to consider other plausible measures, most likely devaluation in lieu of the tumbling reserves. Although devaluation may trigger a short term inflationary pressure (J-curve effect), but moderation is expected in the medium to longer term.



Financial Markets

Fixed Income: …heightened risk factors

The fixed income space from the last MPC meeting-to-date has witnessed a substantial amount of gyration due to recent headwinds encountered in the country resulting in divestments by major foreign investors from the Nigerian market.


Average NIBOR and OBB/OVN rates dipped by 36bps and 70bps respectively between the last MPC till date as compared to the July-September period. The Treasury Bills market however increased average yield by 33bps, increasing to 11.15% September-till date compared to 10.82% in the prior period further buttressing the earlier stated sell out in the fixed income space by foreign investors amidst fears that the country might not be able to meet its debt obligations as a result of declining revenue from oil.


There was also reduced activity in the bond market, as average yield in the current period increased to 12.07% from 10.93% as the weakening economic fundamentals of the country increases the risk profile of exposure to the long end of the curve.


Whilst we think investors will continue to seek a safer haven for their funds in fixed income instruments due to the underperforming equities market, we expect yields to continue to trend upwards (due to supply overweight on demand) as risk premiums widen due to the headwinds from declining oil prices and the upcoming elections.


Equities Market: Headwinds drag performance

The performance of the equities market has been generally downtrodden of late as various headwinds have caused performance to drag considerably. Besides the political pressures due to build-up to 2015 elections, the marked decline in oil prices witnessed in the global market have had a transmission effect which has caused striking depreciation in the Naira. This has caused foreign investors to re-assess their exposure to the country by reducing their holding, particularly in equities, a view supported by the sell-off witnessed from the 27th Oct-7th Nov, 2014. Equities YtD return currently pegs at -17.38%.

In our view, the sell-offs experienced in the financial market have mounted more pressures on the Naira as huge demand for dollar is also crystalizing as foreign investors exit for safety. Whilst we think the situation in both fixed income and equities market may subsist, we opine that the MPC will likely explore practicable alternatives that will help external reserves conservation than currency devaluation.



Possible Decision Rule

We are constrained to reason that amongst other considerations of the MPC, the need to salvage the declining currency as well as defend the reserves against further diminution will be pivotal. Hence, further tightening measures are expected. The committee in our view would be left with few options which can be played out on a scenario basis as highlighted below.


a)    Retain all rates (MPR at 12%, Private and Public Sector deposit at 15% and 75% respectively) at their current levels while further exploring other measures of containing the demand pressure for Dollar at the official window. We think this has a 22% probability.

b)    The second option (with a probability of 13%) is to devalue the Naira officially by shifting the band from the current NGN/USD 155±3% to reduce the pressure on the reserves.

c)    Increase the CRR on private sector deposit from the current 15% while retaining that of public sector at 75% to reduce the speculative activities of the banks with dollar. This, we attach a probability of 65%.


Kindly click DOWNLOAD to view full report.


Related News