Thursday, January 28, 2016 10:12 AM / ARM Research
Today, we assess the drivers of inflation in 2015 and provide our outlook for 2016.
Over 2015, headline inflation rates trended upward, rising from 8.2% in January to 9.6% in December, as supply-side pressures saw increases in general price level exceed 9% upper band of CBN’s inflation target as early as mid-year, even as average core and food inflation expanded 125bps and 31bps YoY to 8.2% and 9.8% respectively.
NBS attributes core pressures to sharp price increases in Housing Water, Electricity, Gas and Other Fuels (HWEGF); Transport; Clothing and Footwear; and Furnishings and Household Equipment Maintenance divisions of the sub-index. On the other hand, food inflationary pressures were driven by 48bps YoY acceleration in mean farm produce prices to 9.9% over the first 11 months of 2015.
Going forward, we believe hike in electricity tariff (residential: 70%, commercial: 52%) which comes into effect in February should induce inflationary pressure over 2016. Meanwhile, Naira weakness remains a pivotal inflation risk in the current year whether or not CBN’s dogged currency support eventually gives way as spike at the parallel market. Hence, our forecast for mean inflation of 10.1% YoY +/-0.5% over H1 16 (vs. 8.7% YoY in H1 15), with FY 16 average at 9.9%, largely reflects anticipated pressures from higher electricity tariff and parallel market currency depreciation.
Movements in core components drive focal pressures on headline
Over the first 11 months of 2015, headline inflation rates maintained an upward trend as supply-side pressures saw increases in general price level exceed 9% upper band of CBN’s inflation target as early as mid-year. Precisely, from 8.2% in January, headline inflation accelerated to 9.4% in November 2015 implying 89bps YoY rise in mean headline reading to 9.0% over the period.1 Nonetheless, this inflation level lags our revised FY-2015 inflation forecast of 9.4% as pace of MoM readings in H2 15 stayed relatively contained. Disaggregating the components, average core and food inflation respectively expanded 125bps and 31bps YoY to 8.2% and 9.8%.
NBS attributes core pressures to sharp price increases in Housing, Water, Electricity, Gas and Other Fuels (HWEGF); Transport; Clothing and Footwear; and Furnishings and Household Equipment Maintenance divisions of the sub-index. Together, these segments have accounted for ~60% of core inflationary pressures in 2015. On the other hand, food inflationary pressures were driven by 48bps YoY acceleration in mean farm produce prices to 9.9% over the first 11 months of 2015. Importantly, movements in food readings were firmly in line with our expectations for the lean season as carryover stocks from previous harvest depleted and underpinned the resurgent farm produce pressures (see NSR H2 2015).
However, despite the commencement of main season harvest in October, food inflation tapered only a mild 3bps from September to 10.1%, vs. 34bps MoM moderation in October 2014. Whilst we believe that low base limited the moderating impact of the current harvest on food prices, it also seems transport costs played a role.
Nonetheless, core portion of the basket was the primary source of pressure on headline inflation with lingering fuel shortages across the country particularly in May/June and November/December contributing to the overall uptick.
Figure 1: Headline, Core and Food Inflation
Figure 2: Growth attribution for components of core inflation (July – November 2015)
Fluid PMS supply dictates H2 15 CPI trajectory
Coming into the second half of the year, improved PMS supply drove a moderation in PMS prices from June peak (See Figure 4) and slowed down inflation momentum over Q3 15. Calm on this front worked with improved food supplies on commencement of main harvest in September to drive even more benign outcome in October. Though FEWSNET noted that heavy flooding and military engagements resulted in below average harvest in the north, benign outputs from southern states have made up for the shortfall. Largely premised on this offset, FEWSNET projected temperance in food prices in November and December as well as in Q1 2016. Though these expectations would ordinarily be positive for inflation, fresh PMS shocks emerged in November following scarcity issues which drove gasoline prices higher (+24% MoM to N116/litre) and underpinned 60bps quickening of transportation CPI to a 34 month high of 9.8% in November. Subsequent feed-through to food prices drove 20bps acceleration in food inflation to a three year high of 10.4% in November. The PMS supply issues also tilts risk to food inflation firmly to the upside for the remainder of 2015, in our view. Thus, with fuel shortage still endemic over December and given the sheer weight of food in overall CPI basket, we expect PMS to remain an accelerant for headline inflation (Dec 2015F: +10bps) despite ongoing harvesting.
Table 1a: Typical year seasonal calendar (North)
Table 1a: Typical year seasonal calendar (North)
Figure 3: Average PMS prices
Tripod of concerns to tow inflation northward
Indeed, PMS issues could remain a stoking influence on inflation for longer. To buttress, despite Senate’s December 2015 ratification of ~N407 billion for payment of backlog of oil subsidy claims and the proactive inclusion of a further N110 billion to cover claims through year-end, fuel scarcity in major cities has subsisted.
This is in spite of a follow-up presidential order seeking to ensure immediate disbursement of the approved claims. According to reports, dollar-scarcity is impinging on marketers’ ability to import refined crude into the country. Worse still, local refineries have shown little aptitude for picking up the slack with average capacity utilization across state-owned refineries nose-diving to 2% as at last NNPC report (vs. ~15% in 2014). Thus, the legislative approval of subsidy payment in itself is unlikely to significantly curb PMS price and inflation pressures going into 2016.
Beyond this, recent hike in electricity tariff and naira depreciation at the parallel market look set to adversely impact inflation trajectory in the coming year. On the electricity front, despite resistance from Citizens Access to Electricity Initiatives (CATEIN) and National Association of Chambers of Commerce and Industry, Mines and Agriculture (NACCIMA), the power minster went ahead to raise electricity tariff by ~70% and 52% for residential and commercials respectively, with the FG hoping this will attract credible investors to support government’s plan to expand distribution and transmission capacities. Despite the positive connotations (margin, cash flow) for Discos and GENCOs, the tariff increment is likely to slightly aggravate price increases from virtually every segment of the CPI basket but particularly on key core components such as HWEGF. Importantly, we recount that the implementation of Multi Year Tariff Order 2 (MYTO 2) electricity tariff increase had corresponded with 521bps MoM jump in HWEGF reading to 20.48% in June 2012—albeit also reflective of fuel scarcity in some major cities and overall increase in energy prices (+447bps to 21.16%) in the period.
Furthermore, there are indications the FG may bow to devaluation pressures. In stark contrast to a firm opposition to devaluation in prior months, the president, in his budget discuss with law makers, declared that the apex bank is currently fine tuning the management of foreign exchange so as to introduce some flexibility and encourage additional inflows into the country. Whilst the actual timing of potential currency adjustments may be difficult to call, the inflationary effect of devaluation, though varied, is well documented in our prior reports.2 In any case, given government’s determination to keep PMS prices subdued in the near term, official currency adjustment is likely to take hold, at the earliest, in the latter part of H1 16 with knock-on effect on inflation spilling into the other half of 2016. Whilst more recent inflationary impact has been subdued due to a regime change, underpinned by better storage facilities and greater value chain integration, that restricted impact of devaluation outcomes on the inflation basket relative to prior episodes, we believe currency impact could still be significant. Indeed, going by the magnitude of the current BDC/Interbank spread—and the potential currency adjustment that may come with it—we feel that this could be one of the more impacting devaluations and thus estimate a cumulative 20bps impact on headline inflation as early as end of H1 16.
Figure 4: Historical BDC/Interbank FX Spread
Of the three key factors impinging on outlook, the PMS fire seems the more likely to be quickly doused but with the mooted options potentially creating more volatility in inflation readings.
The clamour for deregulation of downstream oil and gas appears to have gained more grounds in recent times owing to narrowing subsidy per litre payment and expectations, in some quarters, of minimal backlash from the populace in the event of complete removal. Amidst these agitations, FG has recently communicated a preference for the more scientific price modulation rather than an outright subsidy removal in 2016. To be clear, PMS prices are going to be structured to reflect global changes in crude oil prices with a proviso that will keep them within an upper band of N97 per litre. According to the minister of state for petroleum, with subsidy payment completely eroded by sharp declines in oil prices, the new pricing policy is unlikely to be a major concern going forward.
Importantly, whilst FG’s position on the ‘non-effect’ of the proposed pricing methodology on the populace comes across as plausible within the presently subdued oil price environment, it leaves Nigerians and businesses exposed to greater price instability.
Figure 5: Narrowing subsidy per litre, oil prices
In summary, largely owing to already highlighted pressures at the BDC market, naira weakness is likely to remain a pivotal inflation risk in the coming year whether or not CBN’s dogged currency support eventually gives way. However, although previous partial subsidy removal had coincided with near term headline pressures (+230bps to 12.6% in January 2012), the current congruence of non subsidized PMS price of ~N87 per litre with the current official rate makes an outright deregulation of downstream oil and gas less of a problem in the current period. In that sense FG’s clarification that an outright deregulation is not on the table holds little extra currency inducing concerns about potential push for inflation from this direction. Specifically, the apparent preference for PMS price ‘mark-to-market’ suggests direction is likely downward alongside oil prices.
However, that approach leaves room for greater volatility in transport cost and headline reading. Hence, our forecast for mean inflation of 10.1% YoY +/-0.5% over H1 16 (vs. 8.7% YoY in H1 15), with FY 16 average at 9.9%, largely reflects anticipated pressures from higher electricity tariff and parallel market currency depreciation.
2 Mean headline reading in the five months after respective 28% and 3.3% naira devaluations in November 2008 and November 2011 jumped 643bps and 11bps YoY. More recently, November 2014 and February 2015 devaluations (8% and 17% respectively) only cumulatively led to 46bps rise in headline reading as at April 2015.
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