NNPC reforms to provide interim offset for weak fundamentals


Friday, August 07, 2015 10:02 AM / ARM Research

In today’s serialisation of ARM’s core strategy document – The Nigeria Strategy Report, they assess the drivers of currency performance in the first half of the year with a view to providing insights on likely naira trajectory over the rest of the year.

Downdraft in oil prices extends bout of currency volatility   
On the heels of 12% depreciation in Q4 14, interbank USDNGN weakened 8.6% over Q1 15 to N199.28/$ largely on account of CBN termination of the RDAS market in February. The subsequent implementation of an order based 2-way quote (OB2WQ) system which effectively proscribed banks from trading on the naira helped steady the exchange rate over Q2 15 (+0.2% QTD). Dissecting performance on a monthly basis, fundamental concerns stemming from sustained moderation in oil prices (-7.6% MoM) in January underpinned 2.3% MoM depreciation in USDNGN to N187.60/$. During the month, market volatility hit fresh highs (See Figure 1) as CBN FX policy became fluid starting with 50bps increase in net open positions (NOP) to 0.5% of bank shareholder funds in response to J.P Morgan placing Nigeria’s status on its EMGBI on a negative watch. In addition, the apex bank proscribed interbank FX sales to BDCs, introduced a 72-hour holding period for utilization of proceeds from interbank FX purchases and increased frequency of rendition of bank NOP positions from monthly to daily. The net impact of the foregoing resulted in increased demand front-loading which spilled into the BDC segment resulting in a 620bps MoM expansion in the segment’s premium over interbank USDNGN rate to 10.6% in January—highest since June 2009.

Figure 1: Monthly USDNGN: Exchange rate, MoM performance and volatility

Surge in political risk premium triggers collapse of 3-tier exchange rate regime
Despite easing fundamental concerns in February as Brent crude prices rebounded 18% MoM, political uncertainty around the 2015 general elections scheduled for earlier that month continued to induce heightened USDNGN volatility. Events came to a head on the heels of an announcement of six-week deferment of 2015 general elections with FX markets joining other domestic financial markets in witnessing a sell-off. Post the announcement, heightened local and foreign investor uncertainty about political risk drove naira to a record low of N206.32/$ intraday, breaching the 2% circuit breaker agreed by FX traders and forcing two days of market shutdown. Faced with the prospects of depleting reserves—which, in the same month, fell at the quickest monthly pace ($3 billion) since April 2006 to a nine-year low ($31.5billion)—CBN collapsed the RDAS into the interbank market resulting in a second devaluation of the USDNGN in four months.

Figure 2: USDNGN and Foreign Reserves


CBN attempts to end currency skirmishes with OB2WQ  
Following the closure, the apex bank, in liaison with FMDQ OTC, introduced the OB2WQ under which banks were supposed to provide two way quotes, but unlike in their ‘currency dealers’ position in the previous interbank OTC were under no compulsion to do so; in the new system, quotes are to reflect client orders which effectively left banks as ‘currency brokers’. In the event of supply mismatch, the CBN intervenes to clear the market at the close of trading each day to eliminate uncertainty over guaranteed execution.

Thus, in contrast to the previous regime of a declared naira peg, the CBN would no longer provide forward guidance on the target range for the currency but intervene to clear market disequilibrium on its own terms. Aided by increase in frequency of CRR debits from monthly to bi-weekly and threats of prosecution to management of erring banks, introduction of the OB2WQ drove a cutback in USDNGN from record peak to N202.77/$ at the end of February. The Naira strengthened further in March (+2% MoM to N199.28/$) as, in addition to CBN support, a more-than-double MoM jump in FPI inflows to a 6-month high of $1.07billion helped temper pressures. In Q2 15, USDNGN stabilized at N198-199/$ whilst market volatility remained subdued, aided by tailwinds from peaceful conclusion to the 2015 general election and J.P Morgan’s stay of execution on Nigeria’s EMGBI status.

In sum, the OB2WQ system curtailed the risk of a disorderly breakdown in FX markets and, supported by admin measures the apex bank imposed on eligible transactions: daily NOP computation; 72-hour window for FX utilization; annual and daily USD withdrawal limits; 90-day repatriation of FX proceeds for exporters; stringent documentation requirement ; among others, helped keep currency markets stable.

Figure 3: FX and FX derivatives turnover

Figure 4: Interbank USDNGN and BDC spreads

But not yet uhuru for naira
Despite the ‘calm’ across FX markets post implementation of OB2WQ system, with FX market turnover shrinking to levels pre-November devaluation, trading in FX derivatives remains elevated which suggests continued unease over current naira levels among market participants. Furthermore, recent comments in the media and discussions with currency traders at banks hint at demand overhang in the interbank market, in part reflecting the ejection of BDC demand from interbank and CBN rationing of daily forex clearance sales.

This spillover from interbank market has resulted in persistence of the wider BDC-interbank spreads seen thus far in 2015. Subsequent demand curtailment measures by the apex bank (which includes a list of 41 items now barred from accessing FX and several admin measures) have pushed the spreads wider. In addition, similar to the build up to the last devaluation, increased frequency of circular revisions adds another layer of doubt to CBN’s ability to support the naira.

Reinforcing the theme, after 17pps shrinkage to 19% post the elections, yields on USDNGN non-deliverable forward (NDF) contracts again began to rise at the end of June implying off-shore markets share domestic sentiments about vulnerable naira outlook. Placing these domestic and offshore expectations side-by-side with movement in the fundamental driver of USDNGN anchor (oil prices have declined ~40-45% from June 2014) and cumulative naira devaluation from November (28%), implied markets are pricing further currency down leg in the latter half of 2015.

Figure 5: FPI and Implied Naira Yields on NDF contracts

NNPC reforms to provide interim offset for weak fundamentals?
Going into the second half of 2015, bearish oil price outlook and difficulty selling Nigerian crude point to tempered scope for FX reserve inflows. Similarly, possible normalization of US monetary policy over the period which should result in stronger USD, dampens scope for autonomous portfolio flows to EM assets. Nonetheless, some reform initiatives highlighted by Buhari administration around the opaque nature of NNPC handling of export proceeds could in the interim hold potential for driving modest improvement in FX reserves. From the PwC report which covered January 2012 to July 2013; Nigeria suffered revenue under-reporting of $2.34billion and under-remittances to Federation account of $4.24billion on account of at-source deductions by the NNPC and its upstream subsidiary NPDC. Similarly, first line deductions for payments to JV operations, PMS/DPK subsidies, pipeline maintenance and NNPC operations accounted for ~46% of domestic crude oil lifting during the period ($67billion). Thus, reforms which block leakages and engender increased transparency around NNPC operations should hold expansionary benefits for FX reserves, possibly over the tail end of H2 2015. However, depressed oil prices progressively weaken scope for any gains from the NNPC reforms to provide anything beyond near term support for FX reserves as quantum of oil receipts are lower relative to the period of the PwC investigation. 

Set against a largely weak fundamental backdrop, market focus should remain on apex bank’s ability to interminably underwrite the OB2WQ status quo. On this wise, the CBN’s posture: refusal to loosen curbs on FX trading, recent flurry of circulars aimed at demand management and its recent spat with The Economist,  point to its reluctance to take a third bite at the devaluation pie. In its own defense, the CBN cites a need to stimulate local production as rationale for its decisions; however, aside the question of whether exchange rate is the best medium to achieve that long term, the potential import benefits from stable naira pale in comparison with scale of supply-side constraints facing domestic manufacturing: inadequate power supply, poor logistics and transport networks, access to low cost financing, to name a few. Constraints which, by the way, already ensure that locally produced goods are non-competitive relative to imported substitutes. In that wise, CBN’s apparent inflexibility over the naira (despite what would appear to be non-transitory changes to oil price regime) is at odds with the medium to long term time frame required to address the issues which drive strong domestic import demand.  Furthermore, examining recent experience in Japan, where BoJ aggressively weakened the yen exchange rate (56% since October 2012) in a bid to stimulate exports, and empirical work at the World Bank, where using a sample of 92 developing countries, sizable exchange rate depreciation was found to bolster manufacturing exports, CBN argument is in a minority.

Trends in balance of payments and weak market architecture point to softer naira outlook
Farther out, factors influencing import demand, in particular, progress on ramp-up in domestic refining capacity are pivotal to reining FX demand for fuel imports (~30% of imports) as are initiatives aimed at increasing local share in the consumption value chain; these should buoy trade balance anchor for USDNGN. Nonetheless, two developments in balance of payment (BoP) trends are worth noting. First, whilst much attention has been paid to resuscitating the local manufacturing in the aim to curtail import demand growth, foreign dominance of shipping and air transportation and increasing pursuit of educational pursuit overseas have resulted in Nigeria being a net services importer. Akin to slack fiscal effort to address the underlying issues with domestic manufacturing, sustained growth in service imports (~20% CAGR growth) could temper scope for gains from ongoing import substitution policy thrust. 

Secondly, the unabated pace of globalization which is driving increasing financial integration to major financial centres is resulting in greater FPI flows to EM. Aided by the lure of potential diversification of risk-adjusted returns and increased visibility of the Nigerian economy post rebasing, FPI flows have accounted for over half of total foreign inflows into Nigeria since 2010. The growing share of these FPI inflows increases the reserve requirements CBN would need to hold to temper possible capital account pressures in the future.

Figure 6: Trends in Capital account items

Beyond these long term macro-economic trends, the uncertain nature of current market structure and anchoring of interbank USDNGN to largely static CBN daily clearing rate has done little to inspire market confidence in naira in the presence of tempered outlook for crude oil receipts. In addition, constant fine tuning and re-editing of stream of FX circulars creates the impression of knee-jerk policy responses, further stoking market uncertainty. Furthermore, heavy reliance on CBN for supply and knowledge of CBN rate broadly ensure retention of moral hazard problems pervasive under old market system. Amid difficulty in diversifying export base, to cushion FX reserves from impact of shocks to crude oil prices, an inflexible exchange rate stance would only come at the expense of reserve growth. Pending full structural reforms to fully address demand side issues—deregulation of downstream oil industry and development of domestic manufacturing, the CBN would appear to only be playing for time. Indeed with the J.P Morgan review set for the end of H2 15 and the apex bank’s stated goal to keep Nigeria on the EMGBI, currency skirmishes should resume after four-month long hiatus. In all, we see enough risks on the horizon to expect the CBN to further raise daily clearing rate by 10-15% over H2 15.

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