Pre-MPC Meeting: Is devaluation really the issue?

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Tuesday, January 26, 2016 11:23 AM / ARM Research

Today, the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN) wraps up its first two-day meeting for 2016 with global and domestic macro landscape largely unchanged since the last meeting in November. On the external front, monetary policy is set to remain divergent as the ECB at its January 2016 meeting, noted that its monetary stimulus had no bounds even as the US Federal Reserve’s rate normalization is expected to persist. At home, extended decline in oil prices which plumbed to 12 year lows of $28/bbl recently, continues to bruise domestic economic variables. With Iranian oil exports expected to hit the markets in the coming months, the outlook for oil prices remains bearish.  The foregoing point to further deterioration in domestic macroeconomic indicators—internal and external – in the coming months. This bleak outlook buoys the case for an extension of current accommodative stance. Whilst inflationary pressures persist, with headline reading of 9.6% in December – the highest in 34 months—we think, given economic realities, that the MPC will favour output growth with inflation, over the alternative: no growth and benign inflation.

 

Consequently, we expect monetary policy environment to remain accommodative, though we see little scope for any adjustment of key metrics at this meeting. Given relatively weak transmission mechanism, we think the MPC will rather hold to better assess the impact of the easing at the November meeting on the credit markets. 

 

CBN forex policy at the front burner?  

 

 

That said, this meeting is likely to be dominated by currency concerns, given recent

developments in the foreign exchange market where parallel market rates have climbed to record peaks of N300/$ (vs. N250/$ at the November MPC) pushing parallel market premiums to record levels of 50%. Importantly, the sizable deviation of parallel market rates is a direct consequence of a series of demand curbing measures instituted by the CBN, particularly the halt of forex sales to BDCs. These measures, primarily aimed at conserving forex reserves, which hit a decade low of $28.3 billion (-6% since the last meeting) reinforces the worsening fundamental picture. Indeed, Nigeria is on course for the first current account (CA) deficit in 13 years even as financial account remains frail on softer FPIs and FDIs.

 

Crucially, current oil prices of $30/bbl, ~40% lower than 2015 average, points to even more balance of payment pressures in the coming months, with potential pass through on forex reserves. Our prognosis for Nigeria’s external position, buoys the case for some adjustment to the naira peg at this meeting and market appears to have priced-in same with the NDF curve currently inverted. 

 

Figure 1: Implied yield on NGN NDFs (%) 



Change the market, not the price

 

Given current level of oil prices, parallel market premiums and NDF yields, we believe any devaluation will have to be sizable to have meaningful impact.

 

However, fiscal resistance to such a move blurs this prognosis in the near-term.

 

Specifically, the President effectively ruled out a shift in naira peg at a media chat days after reading the 2016 budget speech where he had guided to some exchange flexibility. This fiscal posture despite the fundamentals pointing towards a need to devalue should see the monetary authorities reluctant towards adjusting the current naira peg. In many ways, it seems that reluctance is rooted in a fear of the unknown, specifically the risk that devaluation now will only trigger an unending cycle that could take the USDNGN to regions out of the apex bank’s control.

 

Given the spectacularly weak fundamentals, the fear is not without foundation. Thus, for us, the question is not whether there should be devaluation1 or not, but how the foreign exchange market should operate going forward to ensure efficient allocation of forex.

 

Specifically, we think devaluation—regardless of quantum—without addressing structural issues around forex allocation, is tantamount to chasing the very volatile parallel market and will, ultimately, be a short-term fix. The issues around forex allocation become apparent considering that currency pressures have subsisted, despite elevated net autonomous forex inflow which averaged $70 billion annually in the last five years.

 

We see the arbitrarily determined forex clearing rate of the CBN, regardless of market fundamentals, as a key driver of the inefficiency in forex allocation.

 

Indeed, where autonomous flows perceive pricing in the foreign exchange market to be misaligned with fundamentals, rather than aid liquidity, those same flows become keen to exploit the arbitrage opportunities. To engender improvement in forex allocation, we still think our long held view that the CBN would need to ease forex restrictions and allow market forces take a greater foothold remains the way forward. Admittedly, this could result in a spike, as prices adjust to fundamentals, but we think such volatility will eventually settle as strong net-flows from autonomous sources gradually assert their influence on the forex market. Crucially, under this structure, the CBN can ‘intelligently’ use its reserves to influence prices.    

 

Figure 2: Trends in autonomous flows, CBN inflows and USDNGN

 



Executive Summary

 

On the external front, monetary policy is set to remain divergent as the ECB at its January 2016 meeting, noted that its monetary stimulus had no bounds even as the US Federal Reserve’s rate normalisation is expected to persist. At home, extended decline in oil prices which plumbed to 12 year lows of $28/bbl recently, continues to bruise domestic economic variables. Consequently, we expect monetary policy environment to remain accommodative.  That said, this meeting is likely to be dominated by currency concerns, given recent developments in the foreign exchange market where parallel market rates have climbed to record peaks of N300/$ (vs. N250/$ at the November MPC). However, the question is not whether there should be devaluation or not, but how the foreign exchange market should operate going forward to ensure efficient allocation of forex. To engender improvement in forex allocation, we still think our long held view that the CBN would need to ease forex restrictions and allow market forces take a greater foothold remains the way forward.

 

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