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Nigeria Strategy Report H1 2017 (13) - Base Effects Set High Hurdle For Inflation

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Wednesday, January 25, 2017 06:18 PM / ARM Research 

In today’s cut-out of our core strategy document – The Nigeria Strategy Report, we continue with the review of Nigerian macroeconomic environment by examining movements in inflation over H2 2016 and delineating our expectations for same over 2017.   

In our H1 2016 Nigeria Strategy Report, we identified a tripod of shocks (fuel prices, electricity tariffs, and currency) as central to CPI trajectory in the second half of the year. Specifically, we noted that the upward adjustments in electricity and fuel prices, which moved the CPI index to a new level, would decelerate in monthly releases in H2 16 as impact of the one-off hikes dissipate.  

Accordingly, core inflation rose 183bps over H2 16 relative to 737bps to 16.2% YoY over H1 16. On food inflation, we noted that persisting naira weaknesses and increased flooding along agricultural plains posed upside risks to food inflation. In view of this, food inflation tracked higher over H2 16 (+208bps to 17.4% YoY) largely reflecting upsurge in farm produce prices (2016: +244bps to 19.2% YoY). Consequently, on the back of the said shocks,  pressures across food and core CPI drove upswing in headline inflation (H2 16: +211bps to 18.6% YoY) to eleven year highs.

In setting out our view on inflation over 2017, we note that of the three factors on which 2016’s inflationary spiral was hinged upon, the impact of currency though indirect, was central. Consistent with our expectation for further naira downside over 2017, within a range of N400/$ to N450/$, we see scope for enforced adjustments to key prices in the coming year. That said, fresh inflationary pressures would have to surmount the sharp jumps in our identified tripod in 2016 to leave inflation close to currently elevated levels over 2017. 

Starting off with core inflation, we note that the second order impact of lingering naira depreciation makes a compelling case for another adjustment to the current electricity tariff template which assumes an exchange rate of N197/$. However, in contrast to the 2016 price hike which drew limited reaction from the populace and threatened agitations by labour unions, broad deterioration in consumer purchasing power (real wages -14% YoY) and continued rise in unemployment creates sufficient grounds for even more vehement demonstrations should electricity tariff be tampered with for a second consecutive year. Also, with lingering currency pressures and insights from within the oil and gas space suggesting that PPPRA may yet yield to pressures in 2017 we have adopted a base case scenario of mean exchange rate of N400/$ and crude oil price of $55/bbl. Our assumptions translate to PMS price of N198.10/litre (+37% from current levels) assuming food inflation is unchanged from trend levels. 

In delineating our outlook on food inflation, we have also re-applied our regression framework on grain price and food inflation which indicate that a N1 devaluation of the USDNGN would translate to an 11kobo rise in monthly cereal prices, with a 1% increase in the latter also resulting in 10bps and 14bps acceleration in farm produce and food inflation respectively. Aligning these results with outcome from our scenario study, our analysis along the core and food components indicate that while base effects stoke CPI downside, likely FX-induced hikes in PMS prices and food price pressures will limit scale of price downside. Accordingly, we forecast 2017 mean CPI inflation 163 bps lower YoY at 13.9%. 

Energy and currency pressures trigger inflationary spike to eleven-year peak

In our H1 2016 Nigeria Strategy Report, we identified a tripod of shocks—fuel prices (+66%), electricity tariffs (+50%-+70% YoY), and currency (-53% YTD)—as central to CPI trajectory in the second half of the year. Specifically, we noted that the upward adjustments in electricity and fuel prices, which moved the CPI index to a new level, would decelerate in monthly releases in H2 ’16 as impact of the one-off hikes dissipate.   

Accordingly, core inflation rose 183bps over H2 16 relative to 737bps to 16.2% YoY over H1 ‘16. On food inflation, we noted that persisting naira weaknesses and increased flooding along agricultural plains posed upside risks to food inflation. Though our concerns over the flooding impact proved to be overstated as rainfall patterns normalized in subsequent months, our views on currency largely played out as increased competitiveness of Nigerian grains on account of a weaker naira resulted in sizable cross-border exports, inducing rising momentum in domestic food prices. In view of this, food inflation tracked higher over H2 16 (+208bps to 17.4% YoY) largely reflecting upsurge in farm produce inflation (2016: +244bps to 19.2% YoY). Consequently, pressures across food and core CPI, on the back of the said shocks, drove upswing in headline inflation (H2 16: +211bps to 18.6% YoY) to eleven year highs1. Excluding direct pressures along these volatile items (using NBS measure which strips out food and energy prices), period end inflation is 387 bps lower than current headline with average over 2016 at 12.6% YoY (2015: 8.2% YoY)2. In sum, one-off supply side shocks had a bigger say on inflation in 2016.  

Figure 1: Historical average headline, food, and core inflation readings

 

On a MoM basis, our conclusion about the role of supply shocks was even more evident as average readings over the last 12 months printed at 1.4%—a level synonymous with years of hikes in PMS prices (i.e. ~1% in 2008, 2009, and 2012). Absent sizable gyrations in PMS prices and spikes in other inflationary accelerants (i.e. higher electricity tariff), MoM headline readings has hovered around a mean of 0.7% in Nigeria. 

Figure 2: Historical MoM Headline Inflation Readings

 

Core pressures recede in H2 on improved PMS availability

Focusing on the core basket, after rising sharply over the first half of 2016, core inflation momentum slowed over H2 16 with MoM readings averaging 0.78% (vs. 1.94% in H1 16) as underlying drivers of the upward spiral receded. Disaggregating core by its sub-components, the Housing, Water, Electricity and other Gases and Fuel (HWEGF) component, which accounts for 31% of the basket, rose more modestly over H2 16 (+0.87% MoM) relative to +3.21% MoM in H1 16. The tamer expansion reflects convergence of national PMS price to average retail price over H2 16 as fuel supply improved across the country following May’s price hike. Specifically, mean PMS prices declined 10% from May levels to N146.70 per litre in December (vs. +61% acceleration to N150.90 over the first five months of 2016). 

Figure 3: MoM Core CPI readings

 

Expectedly, as growth in fuel prices tapered, pressures on annualized core inflation also moderated in the review period with NBS reporting only a cumulative 183bps rise from June levels to 18.1% in December. Needless to mention, this ran in stark contrast to the 737bps surge in core inflation experienced over the first five months of 2016. Beyond the fuel and electricity issues, pass-through from NGN depreciation stoked pressures on other segments of the core basket: Clothing and Footwear (+230bps to 17.8% YoY), Furniture and Fittings (+127% to 13.6% YoY), alcoholic beverages, education (+93bps to 14.8% YoY). 

Figure 4: Attribution analysis of components of core inflation

 

High cross border grain demand fuels upswing in food inflation

In a departure from trend, food inflationary pressures re-emerged over H2 16 with average MoM food inflation over harvest months (+0.97%) at its highest level since the flood-induced jump in food prices in 2012. Pressures emanated from farm produce, whose MoM readings averaged 0.86% (263bps higher than the average over the last three years). Importantly, the price pressures emerged despite above average harvests with FEWSNET linking the jump in food prices to higher domestic cereal prices following increased cross border purchases – a fall-out of naira softness relative to the CFA franc in 2016. Corroborating FEWSNET reports, the Federal Ministry of Agriculture (FMARD) raised an alarm in October with its statements suggesting that weekly exports to West African countries were key drivers of higher cereal prices. 

Subsequently, the Nigerian Customs Services included maize on its list of prohibited export items in November. 

Figure 5: Average MoM food inflation over main harvests

 

High 2016 base presents hurdle to major price increases

In setting out our view on inflation over 2017, we note that of the three factors on which 2016’s inflationary spiral was hinged upon, currency, though indirect, was central. Consistent with our expectation for further naira downside over 2017—within a range of N400/$ to N450/$, we see scope for enforced adjustments to key prices in the coming year. That said, fresh inflationary pressures would have to surmount the sharp jumps in our identified tripod in 2016 to leave inflation close to currently elevated levels over 2017. Starting off with core inflation, we note that the second order impact of lingering naira depreciation makes a compelling case for another adjustment to the current electricity tariff template which assumes an exchange rate of N197/$. 

However, in contrast to the 2016 price hike which drew limited reaction from the populace and threatened agitations by labour unions, broad deterioration in consumer purchasing power (real wages -14% YoY) and continued rise in unemployment creates sufficient grounds for even more vehement demonstrations should electricity tariff be tampered with for a second consecutive year. Besides, plans of electricity tariff adjustments have traditionally been met with stiff opposition from the populace, which, to a degree, accounted for the 7-year delay before the implementation of the MYTO 2 tariff arrangements that underpinned the last increase.  

Beyond these, following a defeat in court, which the government subsequently appealed, the 2016 electricity price hike cannot even be assumed to be cast in stone. Thus, faced with the prospect of greater opposition from the populace, we think the government is unlikely to re-open the already heated issue with a proposition for another hike in electricity tariff – especially when the FGN might still have to contemplate the possibility of addition fuel tariff hikes following recent rally in crude oil prices.  

For us, the latter prospect seems a more likely battle for the FGN to countenance in 2017 as persisting unease of the naira and recent rally in crude oil prices could yet force adjustments to the PMS price template. As in 2016, any upward price increase, given strong relationship between PMS and core CPI, could fuel fresh inflationary pressures in 2017. Thus, we believe expected movements in PMS prices will give a more accurate indication of the strength and direction of MoM inflation going forward. We have therefore focused our analysis on it appropriately, drawing insights from historical precedence. In doing this, we adopted several scenarios of PMS pricing for 2017, with each case corresponding to assumptions regarding average crude oil prices and exchange rates. (See chart below). 

 

Figure 6: Changes in PMS prices for different crude price and USDNGN assumptions

 

With lingering currency pressures and insights from within the oil and gas space suggesting that PPPRA may yet yield to pressures in 2017 we have adopted a base case scenario of mean exchange rate of N400/$ and crude oil price of $55/bbl. Our assumptions translate to PMS price of N198.10/litre (+37% from current levels) assuming food inflation is unchanged from trend levels. On the basis of this scenario, average MoM headline inflation should come in at 0.93% over 2017 with corresponding annualized headline reading printing at 12.9% YoY (2016E: 15.6% YoY). Overall, the results from our scenario exercises points to sizable moderation in inflation in the coming year barring any sizable unforeseen shock. 

Figure 7: Scenario results

 

Switching to food inflation, although the FGN imposed a ban on grain exports, Nigeria’s largely porous borders has historically limited success with trade restrictions relating to neighbouring countries. On a positive note though, FEWSNET reports suggest that domestic farm producers are favorably responding to the elevated domestic prices and the allure of earning forex, which raises prospect for stronger harvests in 2017. That said, currency-induced price elevation on the low base of H1 16 suggest that food pressures would persist up until H2 17, when harvests from increased cultivation stokes moderation. In delineating our outlook on food inflation, we have also re-applied our regression framework on grain price and food inflation, whose results indicate that a N1 devaluation of the USDNGN would translate to an 11kobo rise in monthly cereal prices, with a 1% increase in the latter also resulting in 10bps and 9.14bps acceleration in farm produce and food inflation respectively. 

Bringing these results together with outcome from our scenario study, our analysis along the core and food components indicate that while base effects stoke CPI downside, likely FX-induced hikes in PMS prices and food price pressures limit scale of price downside. Accordingly, we forecast 2017 mean CPI inflation 163 bps lower YoY at 13.9%. 

Figure 8: Sensitivity to varying fuel price scenarios

 

Related News from ARM’s H1 2017 Nigeria Strategy Report

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3.      Nigeria Strategy Report H1 2017 (10) - Feeble Steps Out Of Recession

4.      Nigeria Strategy Report H1 2017 (9) - Pension Reforms Set Sights On Infrastructure Investing

5.      Nigeria Strategy Report H1 2017 (8) - FG Fiscal Expansion: Once Bitten, But Not Shy

6.      Nigeria Strategy Report H1 2017 (7) - Energy Sector Reforms: An Unbalanced Score Card

7.      Nigeria Strategy Report H1 2017 (6) - Back and Forth on a Political Tight-Rope

8.     Nigeria Strategy Report H1 2017 (5) - Broadly Bearish Twist For Soft Commodities

9.      Nigeria Strategy Report H1 2017 (4) - Crude Oil Prices On Verge Of A Breakout?

10.  Nigeria Strategy Report H1 2017 (3)-Tightening US Monetary Policy Stokes Prospect For Portfolio Flow

11.   Nigeria Strategy Report H1 2017 (2) - Commodity Price Shocks Dim Growth Lights Across Africa

12.  Nigeria Strategy Report H1 2017 (1) - Optimism on US GDP Buoys Global Growth Prospects 

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