Tuesday, August 11 2020 / 12:40
PM / by NOVA Merchant Bank / Header Image Credit: Business AM Live
Social Distancing Persists at the IEW and BDC Segments
Following the lockdown initiated by the government in a bid to slow the spread of COVID- 19, the apex bank implemented a similar suspension of sales at the IEW and even to Bureau de Change operators. While the restriction has been largely relaxed, the lockdown on FX sales at the IEW and BDC segments still persists, even with sales across other segments at historic lows. Reflecting the absence of dollar supply amidst present risk-off sentiments, the BDC-Interbank premium remained above 20% at the end of July with the parallel market exchange rate rising to N465/$.
With the absence of sales at the IEW since April, we believe the portion of offshore holdings of maturing fixed income, estimated at $3.65 billion, is yet to be repatriated and could be rolled over to the rest of the year. Also, the suspension of BDC sales since April by our estimate conserved about $4.0 billion between April and July as sales are expected to only resume when international airports are opened.
Notwithstanding the minimal sales at other segments, the lower inflow from oil and paucity of FPI flows continues to put pressure on the gross external reserves. By our estimate, excluding the one-off inflow of the foreign borrowings and other official receipts, the gross external reserves will currently hover around $31.9 billion despite the absence of sales at the IEW and to BDCs.
In the month of July, CBN sales to the SMEs, Invisibles and SMIS (retail and wholesale) segments totalled $549 million compared to $445 million in June. Non-auction sales increased to just $215 million compared to $122 million in June, while no sale was recorded for BDCs as the apex bank is yet to resume sales. Notwithstanding the gradual reopening of the economy amidst moderating fixed income yields, foreign inflows totalled $117 million compared to $98 million in June, dominated largely by foreign portfolio flows. Also, local supplies (ex-CBN) increased to $458 million (June: $360 million), following higher dollar sales by non-bank financial institutions. DMBs sold a total of $394 million during the month compared to purchases from clients of $554 million. With the gradually increasing sales compared to the level of inflow, the gross external reserves depleted by $321 million (June depletion $396 million) in the month of July to adjusted level of $35.77 billion.
OTC FX futures market activity slowed in the month of July, with total value traded declining to $891 million compared to $1.13 billion in April. Futures contract worth $1.37 billion matured on July 29. Compared to the rate at initiation of N362.5/$, the NAFEX rate on the settlement date averaged N391.1/$, indicating a loss position of N39.1 billion compared to N53.3 billion loss on the June settlement.
In modelling the reserve position over the rest of the year, while we have adjusted expected oil inflows to reflect the modestly improving oil price and expected foreign borrowings, we expect paucity of FPI inflows over the rest of the year. On oil inflows, on our modelled benchmark oil price of $44.96 /barrel and average production of 1.85mbpd, we estimate oil inflows to the apex bank to average $790 million over H2 20, compared to average in H1 20 of $1.1 billion. Also, with the fall in fixed income yields amidst fragile external position, we see limited inflows of hot money into the economy. As such, we estimate that the non-oil inflows will be dominated by inflows of FCY borrowings. In all, we believe the apex bank will run on lower flows over 2020 with average monthly inflow of $2.7 billion over H2 20, compared to H1 20 average of $3.8 billion.
With the likely resumption of international flights in September by our estimate, demand for services (especially Business and Personal travel allowances), even below Q1 levels could further trigger a depletion in the reserve. Also, we model resumption in BDC sales over same period, with average monthly sales of $550 million compared to average over Q1 2020 of $1.2 billion. As mentioned above, the yet to be repatriated offshore holdings of maturing fixed income securities estimated at $3.65 billion and other maturities prior to Covid-19 are yet to be repatriated and could be rolled over for possible exit starting September if the CBN resume sales at the IEW.
Assuming 25% repatriation of backlog and maturing offshore holdings between September and December, even with lower imports and services demand, the gross reserve could close the year at $33.5 billion on our best case scenario. Our base scenario assumes that if 50% of the backlog and maturing offshore holdings are repatriated between August and December, the gross external reserves could end the year at $30.5 billion. With limited inflows and reduced avenues to control outflows, recent unification of rates (with the adjustment of the official rate to N379/$ on August 8) will have limited impact on the reserves. We believe an outright floating of the exchange rate with intermittent intervention to avoid unnecessary speculative attacks will have more meaningful impact. Based on our purchasing power parity model (PPP), the fundamental value of naira lies between N427/$ and $430/$ (~10% overvaluation from current NAFEX rate of N386.0/$ and ~10% undervaluation from current parallel market rate of N472.5/$).
Recent Price Adjustment Will Have Limited Impact on Revenue
One month after the quoting of the official rate on the FMDQ platform at N381/$, the CBN officially reflected an adjustment of the official exchange rate to N379/$ from N360/$ on its website on August 7. The official rate is used for special government transactions including importation of premium motor spirit and other subsidized imported items. While the move suggests a gradual unification of rates, the movement is still at a discount to the NAFEX rate. For us, this reflects the need to generate higher oil revenue by translating at a much higher rate following the cap placed on production by OPEC+ agreement and the still low crude oil price. We see limited impact of the adjustment on the FGN revenue, it however supports the deregulation of the downstream oil and gas sector. On FGN revenue, overlaying the higher exchange rate on our modelled FGN revenue, it translates to an increase of N108 billion and N53 billion for net oil revenue after 13% derivation and FGN share of oil revenue, respectively. The increase in our view is a drop in the ocean with limited impact on our modelled fiscal deficit. However, the gains from complete removal of PMS subsidy could unlock additional revenue of ~N250 billion for the federation account.
On the other hand, the increase in average oil price to $40.8/barrel in June and $43.30/barrel in July, suggests the NNPC still subsidized PMS in June and July, which by our estimate amounts to ~N51 billion. However, given the lower consumption in April and May due to lockdown, we believe the level of import could have been minimal in June and July. With oil prices currently above $44.5/barrel, coupled with the adjustment of the official rate to N379/$, we estimate PMS average expected market price of N165.9/litre. With ex-depot price now fixed at N138.62/litre by the Pipelines and Products Marketing Company (PPMC), we estimate actual pump price of PMS in August of N156/litre, which is still below our expected market price of N165.9/litre.
Consumer Prices to Succumb to Pull and Drag Factors
The decline in market supplies occasioned by the restriction of movement and disruption to farming activities resulted in a spike in prices of staple foods and farm produce in the month of June. Food inflation expanded month-on-month by 1.46% - the highest MoM increase in about 24 months. Largely, most of the increase in the food index emanated from higher prices of farm produce. For context, while the headline index expanded 5bps to 1.21% MoM in June, the headline index excluding farm produce contracted 2bps to 0.86% MoM and when further adjusted for energy related cost, the headline index fell 4bps in June. Surprisingly, while imported food increased by 2bps to 1.29% MoM, processed food prices contracted during the month. The decline in the core index by 2bps to 0.86% MoM is however surprising given modest increases in most constituents - HWEGF (+2bps to 0.74% MoM), clothing and footwear (+3bps to 0.90% MoM) and furnishings (+3bps to 0.84% MoM) - expanding during the month.
According to FEWSNET, livestock prices have increased by between 20% to 30% during the lockdown relative to the pre-COVID-19 period across most markets. Also, prices of staple foods (including maize, rice, millet, sorghum, and yams) are above the level in 2019 and the five-year average, as prices increased 65% to 120% between January and May. Relative to the same period in the prior year, the food index is 162bps higher than the June 2019 level of 13.56% YoY while the core index increased by 129bps from 8.84% YoY in June 2019. As a result, the food index surged 13bps to 15.18% YoY, pushing the headline index to 12.56% YoY in June, despite a flat movement in the core index at 10.13% YoY. Relative to the same period in the prior year, the food index is 162bps higher than the June 2019 level of 13.56% YoY while the core index increased by 129bps from 8.84% YoY in June 2019.
We see the trend in inflation in the month of June, mirroring similar patterns in July. While the impact of the border closure is expected to largely fade off in August, the combined effect of the breakup in supply chains, social distancing measures in transportation, Naira depreciation, supply shortages and expected volatility occasioned by the market reflective PMS price will further add to the pressure on the core index over the rest of the year. Despite the decline in diesel and PMS prices YoY by 0.14% and 11.3% respectively, average fare paid by commuters for bus journey within the city and intercity increased by 25.6% YoY and 13.5% respectively in June. With the gradual upward movement in crude oil prices, and a translation to higher diesel and PMS prices, we see increasing pressure on transportation prices with consequent impact on food prices especially farm produce. Adjusting our model for the above-mentioned pressures, we arrived at a base average inflation rate of 12.5% in 2020, compared to average of 11.41% in 2019. For the month of July, we expect the consumer price index to expand by 1.18% MoM, with headline YoY expanding to 12.75% YoY.
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