Monetary Policy: Rewriting the Past

Proshare

Friday, January 29, 2016 11:42 AM / ARM Research

In today’s cut-out from our core strategy document – The Nigeria Strategy Report, we conclude the review of major macroeconomic indices by examining trends in monetary aggregates and policy over 2015 and delineating our outlook for 2016.

 

In a bid to tackle the sluggish pace of monetary aggregate growth and stimulate output, after GDP softened to lowest in more than 5 years, the apex bank switched monetary policy in H2 15 to a dovish tone from the hawkishness of the last 5 years.

 

Retracing the roots of the tightening we note that following the rebound in oil prices in 2010 and expansionary fiscal stance, financial system liquidity tripled YoY to monthly average of ~N400 billion in 2011. However, despite relatively low MPR (6%) and CRR (2%) at the time, there was minimal impact on credit to the “core” private sector (2010: -13% and 2011: -4%) and intermediation spreads in credit markets widened in excess of 20 pps.

 

 

Added to this, the excess liquidity threatened price stability, as banks “speculated” in forex market which eventually resulted in devaluation late in 2011. Whilst the era of tightening was indeed possible because of robust macro conditions (GDP growth averaged 6% and external and fiscal balances were relatively comfortable), the deterioration in external balances, triggered by the precipitous drop in oil price since Q4 2014, and spectacularly weak growth in 2015, are giving cause for pause. This dire prognosis—particularly for output growth—favours an extension of the current monetary policy thrust especially as focus has shifted away from forex and attracting FPl to more fundamental domestic considerations.

  

Going forward, we see current OMO maturity profile over 2016 (N2.2 trillion) and still high CRR (20%) as leaving enough headroom for the CBN to sustain its accommodative policy. In addition to these tools, given the signaling effect of MPR adjustments, we think the odds for further cuts to single digit territory, possible over the H1 16, are relatively high. This could mirror the rapid cuts in MPR (from 10.25% to 6%) over about 6 meetings, following the 2008 financial crises.

 

 

Extended contraction in net foreign assets crimp money supply in H2

 

After the brisk pace of growth in the first half of 2015 (+11.8%), broad money supply (M2) contracted 3.2% to through October 2015. Unlike H1 15, where the upswing in net domestic credit (+33%) and other net assets (+29%) offset the contraction (-19%) in net foreign assets (NFA), each of these three major components sank over H2 15. The continued deterioration in net foreign assets (H2 15: -22%) primarily reflects the contraction in the CBN's net foreign position (stabilise the naira in the face of dwindling oil receipts and also underpinned the negative growth of M2 in the second half.

 

Indeed, without certain currency restrictions imposed by the CBN the decline would possibly have been worse. However, the consequence of the currency measures heightened the already elevated, oil-induced credit risk and weighed on domestic credit.

 

In H2 15 net domestic credit (NDC) contracted 0.3% to trillion as credit to private sector (CPS) slowed to 1% (H1 15: +4%) due to a cut back in bank loans to the core private sector (3.7% to N11.7 trillion) and contraction in net credit to government (-10%). Notably, the contraction in the latter reflects the implementation of the Treasury Single Account (TSA) in September, with the sharpest MoM contraction in October (19%), the month after implementation of the TSA. 

 





 

The outcome of the interaction of these aggregates was more visible on quasi money (QM)—time, savings and foreign currency deposits—which contracted 6% over H2 15. Unsurprisingly, the key pressure point for quasi-money was foreign deposits which fell 13% in H2 15 (accounting for nearly a third of the decline) as banks rejected forex deposits and cutback on forex exposure in response to CBN forex controls. Growth in narrow money (M1) slowed to 2.3% in H2 15 (vs. 4.4% H1 15) on back of slowdown in demand deposits (+2.4%; H1 15: +9.4%) while base money (M0) shrank 7% (H1 15: -0.3%), transmitted by a decline in bank reserves (-9.1%), despite sizeable monetary easing over the period. Overall, annualised M2 growth of 9.8% is about half of the apex bank’s FY target of 15.4%, but tracks ahead of 2014 (+7.4%). Perhaps, more worrying, is the sharp slowdown in CPS underpinned by the pullback in credit to the core private sector.    

 

As macro-concerns force policy to unwind the past

 

To tackle the sluggish pace of monetary aggregate growth, but also stimulate output, after GDP softened to lowest in more than 5 years, the apex bank switched monetary policy in H2 15 to a dovish tone from the hawkishness of the last 5 years.

 

However, we think a good grasp of recent events is unlikely without a quick review of the just-ended tightening cycle, and motivation for same. After the sharp rebound in oil prices that started in 2010 and with a very expansionary fiscal budget being operated, system liquidity tripled YoY to monthly average of ~N400 billion in 2011. However, despite relatively low MPR (6%) and CRR (2%) at the time, there was minimal impact on credit to the “core” private sector (2010: -13% and 2011: -4%) and intermediation spreads in credit markets widened in excess of 20 pps. Added to this, the excess liquidity threatened price stability, as banks “speculated” in forex market which eventually resulted in devaluation late in 2011 and partly aided the jump in inflation to 12% in 2012.  

 

To combat the effects, the CBN effected tight monetary policy to limit available liquidity and raise the cost of funds for currency speculators on the one hand, but more importantly, to attract foreign portfolio investors (FPIs) as the 1 year minimum investment horizon for FPIs was jettisoned. By 2014, CRR had risen to 31%1 from 1% in December 2010 while MPR had more than doubled to 13%.

 

The higher yields that came about as a result of this tighter environment was aided by the subsequent inclusion of some FGN bonds in JP Morgan Bond Index in 2012 in driving the jump in FPI into fixed income market to ~$3.5 billion by 2014, from under $1 billion in 2011. Concomitantly, money market rates climbed into double digits with the SDF—at at 10% for nearly 4 years—as the effective floor. Although the naira enjoyed some stability, the opportunity costs of these outcomes were quite evident.  The high FI yields saw banks increase their share of outstanding treasury bills to over 80% by 2015 (2012: <40%). Concomitantly, already elevated sub-prime borrowing costs increased further to highs of 28% on average in 2015 (December 2009: 23%) weighing on growth of credit to private sector; 8.6% CAGR in the last five years, relative to CBN’s average annual target (30%).

 

Interestingly, prime interest costs contracted 200bps on average over the period. In essence, going by the foregoing combination of events, the high yield opportunities created by the tightening regime, that saw ~N5 trillion mopped up between Jan 2010 and August 2015 excluding impact of CRR hikes, resulted in even more severe disintermediation, with only government and the most credit worthy private sector being serviced. Indeed, considering that a germane but less publicised motive of the tightening was to dis-incentivise government borrowing which was perceived to be crowding out the private sector and disrupting the financial markets, the fact that banks raised exposure to government was counter-productive at best

 






CBN shuns FPIs to stimulate growth as money market rate hit multi-year lows

 

However, against the backdrop of unintended effects (private sector crowd-out), and mixed success with the main aims (FPI attraction, currency stability, government borrowing) of the tightening, recent events appear to be forcing a rethink of monetary policy tools and methods. Whilst the era of tightening was indeed possible because of robust macro conditions (GDP growth averaged 6% and external and fiscal balances were relatively comfortable), the deterioration in external balances, triggered by the precipitous drop in oil price since Q4 2014, and spectacularly weak growth in 2015, are giving cause for pause. Interestingly, the apex bank initially tried to give more of the same medicine by stepping-up its monetary tightening to stem the impact of the unwinding FPI positions on price stability via rapid depreciation of the exchange rate. MPR was hiked 100bps in late 2014 with~N1.2 trillion net OMO sales in H1 15 (vs. N800 billion repayments in H2 14) even as additional forex controls were imposed by the CBN to slow the rate of forex reserves attrition.  

  

However, with GDP growth plummeting to, then, multi-year lows in Q1 15 (+3.96%), and little success on the forex side, even after the double devaluation over Q4 14 (-8%) and Q1 15 (-19%), the monetary authorities were faced with the broadly two choices. One, tighten further in hopes of limiting FPI outflows, but risk further economic weakness or, two, ease and risk accelerating FPIs outflows while hoping to stimulate credit creation and ultimately output growth. The apex bank went with the latter, and the rest, as they say, is history. Since then, the apex has allowed N2.2 trillion into the system (via OMO maturities: N1.5 trillion and 600bps cut in CRR at the September MPC). Furthermore, by the November MPC, the CBN cut CRR by an additional 500bps2 but more importantly, delivered the first key rate cut in 7 years (-200bps to 11%). Unsurprisingly, system liquidity climbed to record ‘extended’ levels in Q4 15 pushing money market rates to multi-year lows as overnight and call rates dropped (and remained) below 1% with sharp compression in interbank placements. One month tenor placement tightened over 500bps into single digit territory (9.5%) for the first time in four years with the 3 and 6 months at 420bps lower on average to 11% and 13% respectively.  

 

Whilst, in abandoning the tightening, the apex bank may have felt it had achieved its forex aims, the expulsion of FGN bonds from the JP Morgan index in September clearly meant there was little reason to further pursue that line anyway.

 

Indeed, the apex bank appeared to have grown a whole new set of priorities by this time with weak growth being the most major. In that sense, in contrast to the era where tightening aimed to raise FG’s borrowing costs to discourage borrowing, any perceived support to the fiscal side from the ongoing monetary inducement of lower interest rates ultimately serves apex bank’s growth-stimulating objectives, especially now that FG budget seems to have more productive outcomes. For intermediation spreads, despite the initial widening that will likely accompany the automatic revision in MPR-pegged saving rates, we think the real benefit might be clearer with time and as data becomes available. 

 


 

 

Monetary easing to persist, but deterioration in credit quality could slow feed through to credit growth

 

Going forward, our bearish outlook for oil prices suggest that current internal and external imbalances will remain fragile, exerting negative pressure on already worrying output growth and foreign exchange market. This dire prognosis—particularly for output growth—favours an extension of the current monetary policy thrust especially as focus has shifted away from forex and attracting FPls to more fundamental domestic considerations. Furthermore, developments on the fiscal side also support an extension of easing. The FG plans to raise nearly N1 trillion from the domestic market in 2016 (vs. N500 billion in 2015) but at an implied interest rate of 14.2% (+40bps YoY), based on projected debt service, could be saddled with heavy borrowing costs. However, considering the budget priorities dovetail neatly with the CBN’s own aspirations for the economy, there seems to be a strong case for keeping the borrowing costs tame. Having maintained the easing stance through 2015, despite step-up in OMO at the tail end of 2015, system liquidity remained elevated at N800 billion. Current OMO maturity profile over 2016 (N2.2 trillion) and still high CRR (20%) leaves enough headroom for the CBN to sustain its accommodative policy. In addition to these tools, given the signaling effect of MPR adjustments, we think the odds for further cuts to single digit territory, possible over the H1 16, are relatively high. This could mirror the rapid cuts in MPR (from 10.25% to 6%) over about 6 meetings, following the 2008 financial crises.  

 

Indeed, our prognosis suggests money market rates will remain depressed in the near-term, but the outlook for credit creation is unlikely to become positive so quickly. On the latter, we expect interest costs for high credit quality borrower to track the decline in money market rates, as they renegotiate loan terms or refinance existing facilities. However, subprime interest costs are likely to be downward sticky given the challenges implied by the deterioration in the macro landscape. Indeed, this reality appears to partly inform the CBN’s latest approach to CRR credit, but the risks are self-evident. We note that at the same MPC meeting, where the MPC tied CRR rebates to certain criteria, banks were encouraged to employ more stringent criteria in evaluating their portfolio and business decisions. Thus, we are unconvinced that the CRR cash-carrots being dangled by CBN for lending will have the desired impact on banks’ lending appetite in the near-term, given heightened credit risk. However, given other encroachments on banks’ revenues, their recent touting of efforts to build credit writing capabilities and, indeed, questions surrounding the long-term viability of lenders that do not start to build a client base now, we think this is an area that banks have little choice but to address, even if it takes a while longer to feed through.  


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