Wednesday, January 27, 2016 10:11 PM / ARM Research
In today’s serialisation, we assess the drivers of currency performance in the second half of 2015 with a view to providing insights on likely naira trajectory over H1 2016.
Over H2 15, the interbank USDNGN continued to trade within the narrow trading range established post the commencement of the order-based 2-way quote (OB2WQ) system in February 2015.
Coming after a topsy-turvy 2014, when a 44% drop in oil prices culminated in a 14% weakening in the USDNGN over the year, the ‘stable’ trend in the naira since the 8% de-facto devaluation in February 2015 contrasts with continued deterioration in the fundamental picture.
Retracing the roots of the stability, the (February commencement of) OB2WQ imposed FX trading curbs, switched market architecture from a quote driven market to an order based one and mandatorily pegged daily interbank pricing to CBN’s daily clearing rate. The impact of the demand curtailment measures was felt at the parallel market where premium over the official rate widened 9pps from H1 15 average to 20% in July (2014: 4%). Events came to a head in December 2015 following CBN’s suspension of 56% of registered BDC operators in December which underpinned a depreciation of the USDNGN at the segment to record lows of
N280/$ with mean premium over the month climbing to 31%.
Looking through the current account, whilst dollar scarcity and CBN demand management measures should continue to drive tamer imports, our bearish prognosis for oil prices in 2016, which implies a tepid export outlook should drive an extension of the weak trends in the goods account.
Set against this backdrop, and observing recent devaluation episodes of USDNGN devaluation, we note that CA pressures and widening parallel market premiums typically coincide with eventual CBN capitulation. Calibrating current parallel market premiums to past episode of devaluation and factoring in prospects for extended CA deficit trends into H1 2016, we see fundamental driven concerns underpinning scope for 20-25% USDNGN devaluation from current level.
Nevertheless, despite the fundamentals pointing towards a need to devalue in 2016, as in 2015, the monetary authorities should continue to remain reluctant towards releasing current naira peg without affirmative signals from the fiscal side on the matter.
Naira performance at odds with weakening fundamental picture
Over H2 15, the interbank USDNGN continued to trade within the narrow trading range (~N199-199/$) established post the commencement of the order-based 2-way quote (OB2WQ) system in February 2015. Coming after a topsy=turvy 2014, when a 44% drop in oil prices culminated in a 14% weakening in the USDNGN over the year, the ‘stable’ trend in the naira since the 8% de-facto devaluation in February 2015 contrasts with continued deterioration in the fundamental picture. Specifically, Brent crude prices have declined a further 38% from February end with profound implications on Nigeria’s balance of payments.
Amid largely unchanged production levels, feed-through from the sustained oil price drop resulted in a 44% YoY decline in exports over 9M 15 to $36billion. The export cutback overrode impact of a 10% YoY contraction in imports to $37.8 billion and underpinned the emergence of a deficit in the goods sub-component (9M 15: $1.7 billion – 0.5% of GDP) – an infrequent event in Nigeria’s economic history1 and putting it/the nation on track to report the first negative CA balance since 2002. (9M 15: $11.5 billion – 3.3% of GDP).
Figure 1: Trends in Nigeria's current account and oil price
Exacerbating the weakening fundamental picture are developments in the financial account where mean monthly FPI flows shrank 55% to $301 million from H1 15 mean (2014 avg: $1.2 billion) while mean monthly FDI flows were 26% lower at $140 million. On the former, compressed reading in part reflects FPI anxiety over impact of less accommodative US monetary policy on EM countries and impact of oil price shocks on economies of oil exporting countries. On the latter, FDI pull back (in historically larger) reflects subsisting uncertainty over policy environment and surrounding the PIB, in particular. Thus, on the heels of an 82% YoY plunge in net FPI inflows over 2014 to $1.84 billion, 9M 15 reading of a $74 million net outflow places Nigeria on track for the first negative FPI flow since 2009 whilst FDI net flows are at multi-year lows (-12% YoY to $2.2billion).
Figure 2: Trends across the financial account
Naira’s strength is also at variance with a broad weakening trend across currencies of oil exporting countries over H2 2015. Relative to a basket of 15 currencies for oil exporting countries, USDNGN’s performance places Nigeria in the top quartile of the group, in company of the likes of Saudi Arabia, Qatar and Kuwait whose currencies remained largely unchanged over the period. However, ranking these countries by reserves’ firepower, using a reserves-to-import cover ratio, Nigeria is closer towards the middle of the group. Furthermore, using CA balances to GDP, the 3.3% current account deficit over 2015 situates Nigeria near the lower rungs of the basket. In sum, USDNGN performance over H2 15 is dislocated from deterioration in Nigeria’s own fundamentals, sustained down leg in oil prices and relative movements in oil exporting peers.
Figure 3: Trends across currencies of select oil exporters
Figure 4: Reserves to import cover (months)
Figure 5: Trends across current account balances of select oil exporters (% of GDP)
But widening parallel and offshore market premiums casts doubts over NGN ‘strength
Retracing the roots of the stability, the (Feb commencement of) OB2WQ imposed FX trading curbs, switched market architecture from a quote driven market to an order based one and mandatorily pegged daily interbank pricing to CBN’s daily clearing rate. Having effectively anchored market price to itself, the apex bank then set about trying to regulate ‘quantity’ of dollar demand through imposition of several administrative measures. These measures were wide-ranging, starting with April 2015’s reduction in overseas cash withdrawal limits on naira cards2 to June 2015’s proscription of a list of 41 items from accessing the official foreign exchange market. The impact of the demand curtailment measures was felt at the parallel market where premium over the official rate widened 9pps from H1 15 average to 20% in July (2014: 4%)
Following the spike, the apex bank, officially citing the fight against money laundering, stopped granting export approvals to banks for changing dollar cash into telex format abroad. In response to the move, banks stopped accepting dollar deposits and commenced BTA/PTA sales to get rid of dollar cash in their vaults resulting in the USDNGN appreciating in the parallel market over August (+16% MoM to N207/$) with parallel market premium to interbank declining 10pps over the month. Though the move helped calm scarcity at that segment of the market, implementation of a CBN circular mandating linking of BVN numbers to FX transactions to track annual dollar limits3 stoked a jump in parallel market premiums to 18% in November. Events came to a head in December 2015 following CBN’s suspension of 56% of registered BDC operators in December which underpinned a depreciation of the USDNGN at the segment to record lows of N280/$ with mean premium over the month climbing to 31%.
Akin to onshore markets, sentiment over tightening dollar liquidity in domestic markets drove expansion in the implied NGN yields on non-deliverable forward (NDF) contracts widened in December to 50% for short dated contracts (+7pps higher than the June average). The elevated yields on the short end of the NDF curve imply that foreign investors are less optimistic over current naira stability.
Figure 6: Trends in Interbank USDNGN and BDC premium
Figure 7: Implied yield on NDF forwards (%)
Does CBN need be so fearful of true reform of market architecture
Despite the broadly weak trends in the fundamental picture, a look at CBN cash flow data on FX flows through the economy highlights shortcomings of the CBN reforms of FX market architecture. In particular, at $57.3 billion thus far in 2015, autonomous flows into the economy are nearly double inflows through the CBN reserves ($29.2billion) – extending a trend since 2008--with the source now accounting for 69% of total FX flows into Nigeria over the last three years. (2008: 55%). Nonetheless, on the outward side, these autonomous flows do not show up either implying they remain onshore or they exit unnoticed via the parallel market. For evidence, autonomous inflows into the economy over 2015, only $2.4 billion has left officially with the remnant still sizable to handle CBN outflows thus far estimated at $33 billion without resorting to reserves. In consequence, Nigeria has consistently reported positive dollar net-flows averaging 18% of GDP since 2008 which singularly should serve as a veritable source of dousing CA induced pressures on the currency.
To our long held views, this irrational behavior reflects the moral hazard problem associated with CBN’s positioning of itself as the centre-piece of USDNGN determination, in place of a properly functioning market system. A derivative effect of the ensuing price distortion is that the allocative efficiency of the FX market is impaired on occasions when the arbitrarily determined price is perceived by autonomous flows to be misaligned with fundamentals, creating a hesitation on their part to bridge widening dollar scarcity at the going rate. Indeed, rather than encourage these autonomous flows to aid liquidity, the misalignment creates arbitrage opportunities that some of these same flows become keen to exploit.
Under a functioning free market system, these sizable autonomous flows could easily offset demand side pressures as prices would determine allocation leaving the apex bank on the sidelines, with no commitments to a set price, free to intervene as a market participant in the event of supply shortfalls. In contrast, whilst on the implementation of the OB2WQ the CBN guided to no set commitment to any fixed rate, the apex bank went ahead to anchor the interbank USDNGN to its largely unchanged clearing rate which retained the moral hazard problem of the old two-tier system. Whilst the CBN reluctance on naira floatation likely stems from political disapproval to wider NGN volatility, deteriorating oil price outlook, growing integration with global financial markets and sizable domestic demand for foreign goods and services ultimately render its ability to maintain the peg unsustainable. More importantly, as developments across the parallel market over H2 15 showed, the administrative measures only raise the returns available to speculative demand. In particular, the widening spread showed that BVN implementation diverts demand away from the official market to the less visible parallel segment. Thus, despite the longer term benefits (principally forex flow tracking and less speculation), the short term impact is that the BVN system’s aid in demand management is limited to the formal market and does not help curb the fundamental supply–demand mismatch of the current system.
To improve the FX markets, we reiterate our long held view that the CBN would need to relax its stranglehold and allow the demand and supply interplay set prices. Granted that the initial phase might result in a sizable NGN depreciation, this would be in tune with the underlying fundamental picture which warrant a weakening. Nonetheless, such volatility should be short-lived as the strong net flows from autonomous sources, no longer distorted by multiple prices, gradually assert their influence on FX markets. Importantly, this allows the CBN to use reserves intelligently as a market participant with sizable influence.
Figure 8: Trends in autonomous and CBN inflows
Resilience in foreign reserves: Evidence of leakages being blocked?
Despite the tamer oil prices, mean monthly oil inflows into CBN reserves at $1.9 billion in H2 154 were 16% higher than H1 15 levels, reflecting the impact of a $2.1 billion dividend payment by NLNG in July 2015. Assisted by 67% increase in average monthly non-oil inflows to $1.7 billion from H1 15 levels and a 16% drop in average monthly outflows from reserves to $2.9 billion relative to H1 15, foreign reserves are on track to close H2 2015 2% above levels at the June 2015.
The resilience in foreign reserves in the second half of 2015 (H1 15: -16%) despite the tamer oil price bears further questioning given the source of the gains in non-oil. Parsing through breakdowns provided by the CBN isolates ‘other official receipts’ as the key driver with the H2 15 reading of $5.1 billion accounting for 75% of the jump in non-oil inflows into CBN reserves. Indeed the cumulative H2 15 ‘other official receipts’ number, which covers only four months, is the highest on record using available data from 2005. Whilst CBN provides no further definition, we draw interpretation on the line item using breakdowns provided on the corresponding items under reserve outflows (other official payments) where the apex bank lists: FGN estacode payments, foreign embassies etc.
Figure 9: Trends in Other Official Receipts
Whilst inflows from this line item has been constant over the years, the spike starting in July, which coincided with commencement of payment of NLNG dividends to the FGN, lends support to CBN Governor’s claim at the July MPC about measures by the Buhari administration aimed at blocking leakages resulting in positive accretion to foreign reserves. We draw attention to the fact that previously NLNG dividends were received on behalf of the FGN by the NNPC, before the new government’s insistence that the practice be discontinued. Thus, we believe a similar dynamic is at work with the ‘other official receipts item’ which largely accounts for the scale of the gains over the four month period.
Similar support to the reserves also emerged from CBN FX swap activities, which have considerably risen since June 2014 with the net swap position as at October 2015 standing at $5.6 billion. Relative to import cover, current foreign reserves are able to sustain ~7-months’ worth of imports using the 12-month rolling average of imports up to October 2015.
Figure 10: Foreign reserves to import cover
Deficit laden services account underpins extended BOP pressures on USDNGN
Regardless of the benefit of blocking leakages, our framing of naira outlook for 2016 still puts more stock on the fundamental picture as the impact of the oil price downturn on reserves offsets aforementioned gains on non-oil inflows. Looking through the current account, whilst dollar scarcity and CBN demand management measures should continue to drive tamer imports, our bearish prognosis for oil prices in 2016, which implies a tepid export outlook should drive an extension of the weak trends in the goods account.
Additional pressures to the current account should emanate from the historically deficit services sub-accounts which has recorded an average annual deficit of $20billion (5% of GDP) since 2008. Though, CBN administrative measures, drove a moderation in Services sub-segment over 2015, the sector should remain in deficit over 2015 owing to lack of competitive domestic alternatives to foreign services like transportation, travel, foreign insurance, education, etc. Absent a miraculous turnaround in crude oil prices, net imports of goods and services underpin scope for a current account deficit in 2016.
On the financial account, limited clarity over financing of the 2016 FGN budget, investor backlash to the fines on Telecommunications heavyweight MTN and lack of appreciable progress on two bills introduced to reform the oil sector, should dampen FDI prospects over 2016. On FPI, the combination of still depressed oil price outlook, global monetary policy divergence on the external front and commencement of an easing cycle on the domestic front drives scope for contraction in flows over 2016. In sum, both segments of Nigeria’s BoP point to fundamental weakness over 2016.
Set against this backdrop, and observing recent devaluation episodes of USDNGN devaluation, we note that CA pressures and widening parallel market premiums typically coincide with eventual CBN capitulation. From Figure 11 below, naira devaluation in H1 2009, occurred following oil price induced contraction in CA surplus (-400bps to 4.5%) from H1 2008. At the time, average parallel market premium to the interbank USDNGN widened 12.3pps to 13.7% from H2 2008 levels before the USDNGN was devalued by 22% over H1 2009. The pattern repeated itself in H2 2014 and H1 2015 with CBN’s intransigence preventing a more recent repeat in H2 2015 but perhaps that is just a delayed outcome and not yet an exception. Calibrating current parallel market premiums to past episode of devaluation and factoring in prospects for extended CA deficit trends into H1 2016, we see fundamental driven concerns underpinning scope for 20-25% USDNGN devaluation from current level.
Figure 11: Current Account balance, naira performance and parallel market premium
But presidential body language points towards wider divergence in FX rates
Nevertheless, despite the fundamentals pointing towards a need to devalue in 2016, as in 2015, the monetary authorities should continue to remain reluctant towards releasing current naira peg without affirmative signals from the fiscal side on the matter. On this wise, recent comments by President Buhari at the December 2015 media chat ruled out a near term NGN devaluation with the president electing to provide FX for target end-users. The statement corroborates media reports of CBN’s decision to ration FX with preference for matured LCs, refined petroleum products and raw material and equipment imports and an agnostic position to the rising parallel market premiums. Given this backdrop, the apex bank could deploy further administrative measures aimed at demand curtailments to stave off naira devaluation with the fall-out driving ‘devaluation’ in the parallel market FX rate while attempting to leave the official rate unchanged at ~N199/$.
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