Tuesday, September 06, 2016 7.43pm/ HSBC Global Research
· The naira has devalued by 30% and is set to cause near-term pain for an economy already facing stagflation
· We now see higher inflation, more rate hikes and a deep contraction in 2016
· FX flexibility and other macro policy adjustments are needed to attract capital inflows, ease FX scarcity and rekindle growth
A long-overdue devaluation
The naira has fallen by 30% following the Central Bank of Nigeria's (CBN) decision to move from a fixed FX policy to a market-determined exchange rate. The adjustment was long overdue, with the preceding 15 months of NGN stability against the dollar glaringly out of step with fundamentals. As oil prices collapsed from mid-2014, export earnings have fallen by USD50bn leaving the economy starved of foreign exchange and with widening macro imbalances.
The FX move has helped reduce the overvaluation of the naira, lessen the backlog of pent-up USD demand, and should trigger some rebalancing of the external position, creating conditions in which import demand moderates, and crucially, capital inflows pick up. But it will only be if the CBN builds on the initial devaluation and works toward full liberalization that FX reform will ease the scarcity of foreign exchange and reinvigorate growth. We expect the NGN to end the year at 300 against the USD.
Stagflation - revising our forecasts
Assuming the CBN pushes ahead with a more flexible currency; the economy is likely to endure a painful adjustment process as FX devaluation adds to already-elevated inflation pressures and pushes the CBN into more aggressive policy tightening. We now expect inflation to average 15.3% in 2016 (up from 13.8% previously) with the CBN delivering 300bp of hikes during H2 (up from 200bp).
We have also made deep cuts to our growth forecasts, following the surprise contraction in the first quarter, and the sharp fall in oil output as militant attacks on oil infrastructure severely disrupted production during Q2. We now see the economy contracting by 1.7% this year (2.2% expansion previously) before expanding by 2.6% in 2017 (3.0% previously).
More policy adjustment needed
Nigeria needs broad-based policy action to respond to the current economic landscape, re-establish macro stability, and provide a solid foundation for future growth. Beyond a flexible NGN and more aggressive rate hikes, we continue to argue that higher non-oil taxes have to be part of this macro policy package, reducing the reliance on oil revenues and diversifying the tax base.
After the devaluation
• Naira devaluation is set to cause near-term pain for an economy already facing stagflation …
• …but it is greater exchange rate flexibility and other macro policy adjustments that are needed…
• …to attract capital inflows, ease FX scarcity, re-invigorate growth prospects and help correct the country's macro imbalances
A long overdue adjustment
The Central Bank of Nigeria (CBN) announced the implementation of a new FX regime in mid-June, stating that it would move away from its fixed FX policy to a market-determined exchange rate (see Moving to a flexible naira, 16 June 2016).
After relying on a range of restrictions to hold the naira stable at 197-199 against the dollar over the preceding 15 months, the NGN dropped almost 30% against the USD on 20 June, when the new regime was introduced (Chart 1).
The drop was widely anticipated and, in our view, long overdue. Other oil producers had let their currencies fall in response to the slump in oil prices (see Chart 2), and NGN’s stability against the dollar was glaringly out of step with fundamentals. As Chart 4 highlights, oil and gas exports had fallen by USD50bn from their peak in 2011, as prices and production fell away, dropping even lower at the start of this year (Chart 6).
The marked drop in export receipts has been compounded by the slowdown in inward FDI and marked decrease in portfolio inflows (Chart 5), with FX restrictions and Nigeria's exclusion from emerging market bond indices in the second half of last year, among the factors that have deterred foreign investors.
Rather than adjusting to the terms of trade shock, the CBN’s decision to hold the naira flat against the dollar in nominal terms meant that the currency continued to gain in real terms, ending 2015 up some 25% since the end of 2011.
Unsurprisingly in this environment, Nigeria’s external account position became increasingly unbalanced, with the country recording a current account deficit of 3.3% of GDP last year – the first shortfall in 13 years as exports dropped by USD37bn but imports of goods and services remained relatively robust (Chart 7).
The trade balance slumped to its first deficit for more than 30 years. As a result of this dynamic, FX reserves have shrunk by about a third over the past 18 months to below USD26.5bn, (six months of import cover), eroding Nigeria’s external buffers.
The devaluation should trigger some rebalancing of the external position, creating conditions in which import demand moderates, non-oil exports can rise and, crucially, capital inflows pick up.
We also believe that the reform is an essential first step toward rekindling growth. The use of administrative restrictions to peg the official NGN exchange rate over the preceding 15 months had also hampered the functioning of the economy, and alongside low oil prices and fuel shortages, contributed to a sharp fall in activity. This saw the economy contract by 0.4% y-o-y in Q1 2016, and the jobless rate increase to 12.1%.
In our view, naira devaluation will be positive for investment and growth, boosting competitiveness, supporting a better allocation of scarce foreign exchange, and signalling to the market that Nigeria has a strategy that will support growth and development over the medium term.
With oil prices currently around USD50/bbl, we expect the naira to trade anywhere within a broad range of 280 to 320 against the USD, once the market has fully digested the change to a market-determined exchange rate, and end the year at 300 against the USD.
Adjustment takes time, and flexibility is missing
While we are encouraged by the devaluation and promises of a shift to a more flexible FX regime, we remain cautious on the scale of the gains that will be delivered and the pace at which they will be realised. To an extent, this reflects the time it will take for the domestic economy to adjust to the new FX system, and for international investors to regain confidence that the naira is once again a fully convertible currency.
Critical to this, though, are the doubts that persist over the nature of the new NGN regime that has been brought into effect. While CBN has committed to a market based FX system, the naira’s value on the formal market continues to be set by the authorities and has been flat against the USD since 21 June, the second day of inter-bank trading.
Although the initial adjustment was large, there are clear grounds to believe that it has not taken the currency to a level at which demand for dollars actually clears. So far, for example, there are few signs that the private sector is offering FX at the new rate, with liquidity thin and the supply of USD largely coming only from the central bank.
Moreover, the FX backlog appears to have been “resolved” largely by pledging USD forward, not by supplying currency in the spot market. While NDF rates have declined since the inter-bank market began trading, the market clearly believes that further adjustment is required – 12m contracts priced at 330 in late June, about 15% wide of spot (Chart 9).
We hope that the naira’s recent stability is part of a strategy that will see CBN move step-by-step toward a flexible FX regime. Our concern, however, is that having seen the market fail to settle after the initial large devaluation, the authorities might have become reluctant to follow through, fearing the inflationary consequences of a larger adjustment. If this proves to be the case, then an artificially strong NGN would mean
Nigeria’s FX shortage would likely persist, as the trade account fails to rebalance, capital inflows struggle to recover and the private sector continues to hold what dollars they have. In such an environment, the recent devaluation would do little to boost growth, and the likely re-emergence of a black-market would keep inflation under upward pressure.
Following through on the reform process is all the more important given the challenging environment Nigeria faces. Oil production may rise over the coming 18 months, but gains will be vulnerable to reverse given the ongoing security threats. The global backdrop itself makes this more challenging, particularly in the near term, following the United Kingdom's vote to leave the European Union.
While export ties are relatively limited (and oil production disruptions are a far greater constraint), Nigeria is particularly exposed to the UK in terms of capital flows, with CBN data showing that the UK has accounted for about half of all capital inflows since 2010.
Assuming the CBN forges ahead with the adjustment, the economy is likely to endure a painful transition, as the devaluation pushes up import costs and adds to already-elevated inflation pressures.
Headline consumer inflation has surged this year, rising by 6pp to a six-year high of 15.6% y-o-y in May. This is far higher than the CBN's 6-9% inflation target range. Core inflation has also increased rapidly, to 15.1% y-o-y, highlighting the broad-based nature of price pressures, with 98% of the consumption basket suffering double-digit inflation.
Some of this reflects fuel and power shortages, while there were substantial electricity tariff increases in February. Seasonal effects from the planting season have also contributed to higher food inflation. Together, food and housing and utilities account for almost 80% of the increase in inflation since the end of 2015 (Chart 12).
But the exchange rate has also had an important impact, as the shortage of FX supply and the associated increase in the spread between the interbank rate and the rates on the BDC and parallel markets (the parallel market rate hit NGN370 against the USD in mid-June and is currently at 350) fed into higher prices in the Nigerian economy.
A substantially weaker NGN risks inflation moving even higher, with a CBN paper estimating a long-run pass-through coefficient of 0.26 with much of this taking place within four quarters.1
We have adjusted our CPI forecast, and now expect inflation to average 15.3% y-o-y in 2016 and 13.3% in 2017, peaking at an average of 17.8% in Q4 2016 and spending the entire forecast period above the CBN's inflation target range (Chart 13). The weaker naira will underpin much of Nigeria's elevated inflation pressure.
We think the combination of the devaluation and the deteriorating inflation outlook demands complementary monetary-policy tightening to try and anchor inflation expectations, and meet the central bank's price stability mandate.
The policy rate was increased by 100bp in March (see Surprise hike as CBN responds to inflation concerns, 22 March 2016), partially reversing the policy easing seen during the second half of 2015. We expect another 300bp of rate hikes in H2 2016, lifting the policy rate to 15.00% by the end of the year.
Given the inflation backdrop, the risks are tilted towards even more rate hikes. Currency devaluation may also aggravate corporate and financial sector vulnerabilities for those with FX exposure, although the government's external debt stock is low (2.3% of GDP at end-2015).
Growth has further to fall
This economic landscape has resulted in a sharp slowdown in GDP growth. Nigeria's economy slumped to a contraction in the first quarter of this year, as output fell 0.4% y-o-y (Chart 14). The non-oil economy, which accounts for about 90% of GDP and expanded by 3.8% last year, contracted as the manufacturing, construction and real estate sectors shrank.
Energy and fuel shortages, the scarcity of foreign exchange, rising inflation, depressed consumer demand, and delays in implementing the 2016 budget have all weighed on economic growth. FX and import restrictions, have exacerbated these problems, further hampering the functioning of the domestic economy and damaging growth.
Economic outcomes are likely to worsen in the near term. Repeated attacks by militants on oil infrastructure have disrupted and curtailed oil production in the Niger Delta, with output falling to less than 1.5mbpd in May - down more than 20% y-o-y and the lowest for more than 25 years
(Chart 15). Subdued global demand, higher import costs, rapidly rising inflation, and monetary policy tightening are all likely to add to Nigeria's growth headwinds. We expect the Nigerian economy to experience a deepening contraction with GDP falling by 1.7% in 2016.
The outlook should improve in 2017, contingent on increased oil production and a more favourable and flexible exchange rate system. As a result, real per capita incomes are likely to fall by about 4% over the next two years. In dollar terms, we think per capita incomes are likely to be almost 40% lower than in 2014.
After several months of delay, the 2016 budget was finally signed into law in May. The budget envisages government spending rising by about 20% y-o-y, with a focus on capital spending, however weak revenue collections are likely to result in worsening deficit and debt levels.
This is already evident in initial budget data. Federally collected revenue dropped sharply as both oil and non-oil revenues fell in the first quarter of the year, taking total income down to NGN1.27trillion, just half of what was estimated in the budget.
Spending at a federal level, meanwhile, was slightly above budget expectations, as capital spending gained (Chart 17). Together, these dynamics pushed the federal government deficit higher, rising to NGN725bn (USD3.6bn) in Q1, equal to 3.2% of GDP (Chart 16).
With severe production disruptions in Q2 likely to offset much of the recovery in oil prices during the quarter, we would expect the budget deficit to remain relatively large in the near term, before narrowing in the second half of 2016 as the currency devaluation boosts the NGN value of oil revenues.
Overall we think the budget deficit will be equal to 3.0% of GDP in 2016. While a weaker NGN provides some upside for fiscal dynamics, we continue to believe that sustainable public finances in Nigeria require deep-seated structural fiscal reforms that boost the non-oil tax take and diversify the tax base.
Non-oil revenues were less than 3.5% of GDP last year, despite the non-oil economy accounting for about 90% of GDP. In an earlier report, we highlighted that Nigeria's non-oil tax take pales when compared with other oil producers and that the VAT rate - at 5% - is substantially lower than peer economies in West Africa (see Failing to adjust, struggling to grow, 12 May 2016).
Nigeria needs broad-based policy action to respond to the current economic landscape, reestablish macro stability, and provide a solid foundation for future growth. Rapidly rising prices and large macro imbalances need to be addressed.
We think rate hikes and higher non-oil taxes have to be part of this macro policy package. The move to devalue the currency in June has helped reduce the overvaluation of the naira and reduce the backlog of pent-up USD demand, but it will only be if the CBN builds on the initial devaluation and works toward full liberalization that FX reform will ease the scarcity of foreign exchange and reinvigorate growth.
Improved oil production and a gradual rise in oil prices can help increase the supply of foreign exchange and support renewed economic expansion in 2017. Yet without the return of foreign capital flows we think the current account will have to adjust through a weakening in demand.
A more flexible exchange rate is desperately needed to generate the necessary incentives for investors to send capital, and much-needed foreign exchange, to Nigeria. Until this happens, we anticipate that Nigeria will continue to underperform.