January 24, 2018 /1:35 PM /ARM Research
Acknowledging the downtrend in Nigeria’s imports and lower incentives for round tripping in the FX market, we believe the decline in autonomous flows will pressure the apex bank to bridge the short-term demand-supply overlap over 2018. Imputing our inflation and interest rates forecasts on the PPP model, we see fundamental driven pressures underpinning the scope for down-leg in the USDNGN (8-10% from current levels) over 2018 – which implies average exchange rate of N401.55/$ to N403.54/$ over 2018.
CBN slows its tap as Hot money fires up
Over the second half, FX flows were more significant than anticipated in our H2 17 Nigerian Strategy Report. Basically, we had projected a moderate decline in monthly dollar sales by the CBN, from average of $2.9 billion in May/June to $2.0 billion in the review period, underpinned by a reduction in pent-up demand. Much of the cutback was expected to emanate from the special intervention forward contracts which contributed 38% of CBN’s monthly dollar sales in the first half of 2017.
To add, we firmed up our upbeat outlook on portfolio flows which should combine with CBN sales to leave the IEW relatively greased with dollar supply. Consequently, our postulation implied a $2.5 billion decline iFX reserves to $27.8 billion by year end (H1 17: $30.3 billion).
The variance in our expectation compared with actual figures emanated from a combination of robust portfolio inflows and higher oil receipts. For context, CBN average monthly dollar sales over Q3 17 declined by 14% to $2.1 billion relative to $2.5 billion in Q2 17 with September sales printing at $1.5 billion. Notwithstanding the cutback in dollar sales, which largely reflected lower sales at the interbank and parallel market, the naira remained stable over Q3 largely due to higher than expected portfolio flows over the period (average Q3: $1.4 billion, H1 17: $470 million).
Against this backdrop, the CBN reduced its supply at the IEW from $845 million in June 2017 to $101 million in September 2017 while also intervening in other segments of the market, particularly the Secondary Market Intervention Sales (SMIS). Furthermore, despite strong (but moderating) dollar sales by the apex bank, external reserves firmed up by 28% over H2 17 to $39 billion on the back of higher oil inflows. Consequently, the premium between the parallel and official market contracted to a 27-month low of 17.0% at the end of December - the naira also gained grounds over the period at the NAFEX and BDC segment, appreciating by 2.8% and 2.3% respectively.
Interbank garners support from fundamentals and carry flows
Tracking the performance in H1 17, sturdy accretion to reserves (+718% QoQ to ~$2.8 billion) improved Nigeria’s financial account, with the widening CA surplus further tapering concerns over naira resilience in H2 17. Notwithstanding the decline in CBN sales by 81% QoQ to $688 million in Q3 17 (Q2 17: $3.6 billion) at the NAFEX end, the naira appreciated further (+3.7% QoQ to mean of N362.92/$) with daily average market turnover rising 101% QoQ to $157 million. The strength of the naira amidst sturdy turnover during the period, is not unconnected with the regulatory move to fast-track the synchronization of FX rates in Nigeria.
In July, the FMDQ selected Bloomberg as a partner saddled with the responsibility to report transactions in the IEW electronically and enhance price discovery and transparency. Consequently, Bloomberg’s USDNGN reporting became based on the IEW as opposed to the CBN-determined Wholesale Secondary Market Intervention Sales (SMIS) interbank rate. Furthermore, in August, the apex bank directed banks to quote the floating IEW rate rather than a fixed exchange rate, a move perceived as moving towards a unified, floating exchange rate.
In Q4 17, the sustained ascent in FX turnover (+29% QoQ to $204 million) reflected improved confidence and transparency on the back of the regulatory move at unifying the exchange rates at various ends of the market. Consequently, the naira extended gains at the NAFEX closing at N360.31/$ (+0.8% QoQ) in Q4 while the parallel rates and BDC also appreciated (+1.22% and 0.8% respectively). In our view, the lower intervention by the apex bank in the IEW provided scope for increased dollar sales in the BDC and SMIS.
NGN optimism: Unfaltering or a damp squib?
Against the backdrop of general improvement in the external sector, one could argue that the naira stability looks set for a sweet sail over 2018. However, despite improving fundamentals, we anticipate greater uncertainty in H2 2018 as politicking enters full gear.
In framing our currency outlook, we examine developments in the BoP with more emphasis on the fundamental picture. Starting with the exports, we expect the higher crude offtake to persist especially over H1 18 stemming from higher crude oil prices and production.
Assuming mean crude price of $60/bbl. and oil production of 2.0mbpd in 2018, we project a 10% YoY increase in goods exports to $47.3 billion. On imports, we estimate a 15% YoY growth to $37.3 billion, as we expect sustained FX liquidity to encourage increased importation of manufacturing products, with sustained reduction in the importation of petroleum products and raw materials should moderate the impact.
Overlaying the implied goods trade surplus of $10.2 billion with service and income deficit on our target net current transfers, we estimate the current account to print at $6.3 billion (FY 17E: $8.1 billion). On the financial account, we expect a combination of the gradual unwinding of QE in developed economies – especially rising US interest rates – and bullish economic picture in developed economies to induce net FPI outflows from emerging markets. As a result, we expect a further drawdown in FX reserve as the apex bank intervenes to bridge the lower FPI flows. On balance, we expect the financial account to print at a lower level relative to prior year.
Having resolved the BoP considerations, we then look to evaluate the potential liquidity picture across the FX markets. While we note the resilience of capital flows into Nigeria from the flexible exchange rate system, which buoyed demand for naira-denominated assets over H2 17, we believe the political related risks ahead of the 2019 election and our expectation of a lower yield environment over 2018 will moderate inflows.
Acknowledging the ripple effect of turnover in the IEW on overall naira stability over H2 17, we expect a decline in FPI flows to weigh on overall autonomous flows and drive increased demand for CBN intervention at the window.
Adjusting current net reserve levels of $38.77 billion (excluding outstanding swap liabilities of $2 billion), with CBN having access to only 73% of total reserves, we estimate that import cover, using net reserves, should remain above 10 months by the end of H1 18. However, we expect a steeper drawdown in FX reserves over H2 18 as the political concerns – with electioneering activities expected to enter its prime – further dampens flows into the economy, with current flows taking a safe flight. While noting the healthy reserves at the disposal of the apex bank, our expectation for a decline in portfolio flows, speaks to more aggressive sales by the apex bank (even a stronger participation by the apex bank in the IEW) to keep the dollar within current band.
Overlaying the steep decline from May, when dollar sales was at a peak of $3.4 billion – to $1.5 billion in September on our monthly sales over 2018, we estimate a monthly sale of $2.0 billion (with overall average monthly outflow from the CBN estimated at $3.6 billion) stemming from the increased intervention at the IEW, with the cut back on special intervention forward contracts creating some cushion.
Acknowledging the lower incentives for round tripping in the FX market (with the narrowing gap between the Parallel-NAFEX and BDC-Interbank), we believe the decline in autonomous flows will pressure the apex bank to bridge the short-term demand-supply overlap over 2018. Imputing our inflation and interest rates forecasts on the PPP model, we see fundamental driven pressures as underpinning the scope for down-leg in the USDNGN (8-10% from current levels) over 2018 – which implies average exchange rate of N401.55/$ to N403.54/$ over 2018.
Is the Naira running ahead of valuation?
At the heart of the debate behind contraction in market premiums and stability at the NAFEX window, is that the NGN appreciation will be short-lived and near-term fundamentals suggest a possible weakness. To ascertain the extent of undervaluation or otherwise, we examine quarterly REER data from the IMF on the NGN over the last three decades to apply the Purchasing Power Parity (PPP) concept which holds that currencies gravitate towards their long run mean over time.
Looking at the data, recent NGN appreciation has driven the REER above its long run average (defined as the average over the period of the data). Extrapolating into equilibrium REER, the NGN REER deviates by a narrow range from its equilibrium values, potentially providing the likelihood of a downtrend to retrace its long run equilibrium, with the overvaluation estimated at 1.6%.
While we fully recognize many stipulations behind expecting mean reversion from REERs, we refrain from interpreting the results of our analysis as a viable trading signal, as currencies do not always trade in line over short term horizons due to current account trends.
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