Nigeria: Economic Strategic Report – Q4 2016 Highlights and Outlook 2017




Monday, January 2, 2017  2.48PM / Ecobank Research  

1.Short Term Outlook

· Economic activity continues to be constrained by acute FX illiquidity in the market.

· CBN’s decision in June to move to a flexible exchange rate has set the economy on the right path to recovery, but lack of robustness in market policies continue to undermine investor confidence and hence foreign investment prospect.

· Although a rebound in average oil prices (above USD50/b) will provide some respite for government finances and the oil sector, the likelihood of further militant attacks against onshore oil Terminals will bode ill for oil export receipts.

· Remittances remain strong and portfolio inflows have picked up slightly; however, the latter remains well below an annual USD10+bn seen in recent years.

· FX liquidity risk will remain high due to weak FDI inflows, low oil prices (sub-USD100/b), ongoing ban on importers of 41 goods and services, robust import demand, and tightening global financing conditions.

· This will ensure continuation of multiple interbank exchange rates by end - Q4 2016 and into Q1 2017, indicating significant structural imbalances between USD supply and demand.

· The spread between the official and parallel exchange has widened and will remain large, raising the scope for further currency devaluation in the near term.

· Inflation is likely to remain elevated amid exchange rate pass - through effect arising from imported goods, higher fiscal spending, increases in electricity tariff and fuel prices, higher input costs and weak product markets.

· The Monetary Policy Rate will remain elevated at 14% and the scope of further rate hikes is high, given growing global economic uncertainties and rising NGN pressures.

· Yields are likely to rise in line with further policy tightening and investor concerns over NGN.

· Short term primary market T-bill yields will rise to around 15-25% as investors take active positions at the short end of the curve amid rising inflation and expectation of further policy tightening.

· The effect of US Federal Reserve monetary normalisation will continue to draw some investors into US Treasuries, thereby maintaining upwards pressures on Nigerian rates. 


2. Key Risks, Triggers & Pressure Points

· Failure by OPEC members and others to commit to the agreed production cut will further undermine the NGN.

· Increased liquidity arising from higher spending will add to NGN pressures.

· Further hikes in US interest rates could increase capital outflows, raising exchange rate risk.

· European politics, US’ trade policy uncertainty, weak activity in China, and higher refined oil prices all pose challenges 


1. Economic Review

· The Nigerian economy continues to be dominated by a range of structural problems, specifically volatile oil production, lack of optimal FX liquidity, weak fiscal policy and governance issues.

· At the time of writing, oil production has stabilized somewhat at around 1.7mn b/d, having dropped significantly to 1.4mn b/d mid-year, from an estimated 2.17mn b/d in February 2016.

· At current level, oil production remains below the 2016 budget projection of 2.2mn b/d (Table 1) owing to a recent spate of attacks by militants (Niger Delta Avengers) after initial talks for a ceasefire failed. Two

major crude oil loading terminals have experienced attacks and are currently under ‘force majeure’ Brass River and Forcados, weakening their production capacity. 


Table 1: Key Economic and Financial Indicators


· Brent oil prices have rebounded above USD50/b, thanks to recent decision by OPEC to cut oil production by 1.2mnb/d, effective from 1 January 2017 and strengthening recovery in the US (a key export market, which rose by an annualised 3.2% in Q3, up from 1.4% in Q2) and some emerging markets.

· However, oil prices remain well below historical highs of USD100+/b seen in H1 2014 undermining much needed FX inflows into the country.

This along with CBN’s high levels of USD supplied to the interbank market has depleted FX reserves (down 16% to USD25bn from a year ago).

· NGN interbank pressures remain amplified following the sharp fall in global oil prices, dwindling FDI inflows and ongoing ban on importers of 41 goods and services from accessing interbank.

· Significant demand pressures prompted monetary authorities to switch to a flexible exchange rate policy on 20 June 2016 (following a second devaluation on 18 February 2015 to NGN199:USD1 and an 8.4% devaluation on 25 November 2014), underlining the impact of the fall in global oil prices on the economy.

· Since then, the official exchange rate has depreciated by close to 40%, while the parallel exchange rate has weakened significantly in recent months (trading around NGN500:1USD), reflecting the acute shortage of FX amid the plunge in oil prices, high import demand and increased speculative demand for FX.

· The move to a flexible exchange rate policy has helped to increase FX liquidity, but current levels remain very low compared to four years ago; this is owing to strong import demand against a backdrop of weak FX inflows.

1.      As a result, the spread between the official and the parallel rates remains large, even larger than it was under the pegged exchange rate system: 120 points compared with 185points currently reflecting major structural imbalance between USD supply and demand.

· Monetary policy has been held tight, with the Monetary Policy Rate standing at 14.00% since July 2016 when the CBN decided to hike interest rates by 200bp in response to rising inflation. This policy move follows a 100bp hike to 12% in March 2016 and an unorthodox rate cut of 200 bp to 11% on 24 November.

· Inflation continues to rise driven by exchange rate pass-through effect arising from imported goods, limited product markets, increases in electricity tariff and fuel prices and higher input costs resulting from the shortage of FX and security challenges. CPI inflation rose to 18.5% y/y in November, up from 18.3% y/y in October.

1.    Core inflation has also been rising; in October, it rose to 18.1% y/y, up from 8.7% y/y in December 2015, but in November it grew at a slower rate to 14.5% y/y, in line with recent decline in production.

· Money market and T-bill rates have risen sharply since Q1 2016, in line with the CBN’s interest rate hikes in March and July 2016 and increased domestic borrowing amid lower FX inflows.

· Longer term MM rates have also increased, reaching the 16+% level seen in Q1 2015.

· Investor concerns over FX market uncertainties and still tight FX liquidity conditions continue to sustain high yields, but given higher inflation, real returns are generally in negative territory.

· Overall, Q3 16 has seen sustained market skepticism over the ability of the authorities to boost price transparency and restore confidence in the NGN, given continued erosion of FX reserves, which has sustained FX restrictions. 


2. Key Risks to the Outlook & Triggers/Pressure Points

· Although oil prices are recovering, a renewed fall is possible, especially if OPEC fails to implement the production cut of 1.2mnb/d agreed at the November 2016 meeting, and if US Shale oil producers and non-OPEC members ramp up production in light of rising prices; this would add further pressure on FX reserves, which in turn would undermine NGN.

· A further dip in oil production (hydrocarbons export revenues account for 98% of total export revenues and 75% of fiscal revenues) is also likely.

1.   So far, prospect of oil production reaching the government’s 2016 budget benchmark (covering the period 1 June 2016 -30 May 2017) of 2.2mb/d (same as the 2017 budget benchmark)remains weak; this is owing to declining output from maturing fields, lack of funding required for major drilling in new oilfields and the possibility of further militant attacks: the government is unlikely to yield to demands by militant in the Niger Delta , who are demanding to take over control of oil production in the region.

· Exchange rate risk will be driven by effect of still low oil prices, weak FDI levels and US’ rate hike in December 2016.

1.       The likelihood of further US rate hikes in 2017 remains high – the US Federal Reserve Bank has signalled three more rate hikes during the year; this will lead to further strengthening of the US dollar, which in turn will result in a weakening in global commodity prices and a depreciation of the NGN.


European politics, uncertainty over US’ trade policy under president-elect Donald Trump, subdued eurozone growth, weak activity in China, and rebound in refined oil prices all pose potential challenges.

1.    In the eurozone, many countries are still dealing with political issues, large fiscal deficits, high debt stocks and widespread unemployment. Subdued demand in the bloc (accounting for 41% of Nigeria’s exports) will continue to undermine trade prospects for Nigeria. Encouragingly, the ECB has expanded its QE / asset buying programme to December 2017 to boost demand.

2.   China remains a concern for Nigeria given that growth has remained weak: the economy grew by 6.7% y/y in Q3 2016, same as in the two previous quarters, and although the official manufacturing PMI has been steadily above the 50-point benchmark (which separates economic expansion from contraction) since September 2016, China’s economy remains structurally weak. 

Policy easing in China aims to stimulate domestic demand and boost growth, but we expect stimulus measures to fade away by Q2 2017, boding ill for African countries. 

This will continue to undermine the outlook for Nigeria and many other African economies that have come to rely on increased levels of capital/investment inflows along with greater

levels of trade. This is especially given Nigeria’s decline in its export share in the US market (from 34% of total exports in 2010 to 4% currently) amid US’ oil self-sufficiency policy.

1.  Specifically, another global commodity price shock, particularly a sharp and sustained rise in oil prices would widen the current account deficit (given Nigeria’s status as a net importer of refined oil), which in turn would need to be financed by FX reserve draw-downs, higher portfolio and FDI inflows and import demand suppression. 


3. Short Term Outlook

· We are more upbeat about prospects for Q4 and into Q1 2017. The Federal government’s recently released budget provides some positive developments that should help to kick-start the economy, pull it out of a recession and back unto a growth trajectory.

· Fiscal policy is likely to be expansionary, boosting prospects for private companies reliant on state procurement, while stimulating economic activity.

1.   The 2017 budget proposes a 20.4% rise in expenditure to NGN7.298trn (about USD23bn), of which 31% will be geared towards infrastructure development (up from 26% of total expenditure in 2016) – a move that will help to boost the country’s competitiveness and attract much-needed foreign investment flows.

2.    In view of this, the share of recurrent expenditure to total expenditure is projected to decline from 44% to 41%, signaling government’s intention to apply greater fiscal prudence over 2017 - reducing outlays on non-essentials and reducing corruption.

3.    The budget also focuses on greater import substitution, which should help to reduce import demand and support the value of the NGN.

· However, the 2017 budget scenario is fraught with risks. The key risk is the government’s ability to generate budgeted revenue to finance such expenses – the budget proposes a 28% rise in government revenue to NGN4.94trn (around USD15bn) with oil revenue contributing around 40% to this amount.

· While proceeds from the planned USD1bn Eurobond and a planned rise in domestic borrowing should go some way towards financing government expenses, revenue challenges will persist.

· The Federal government’s 2017 budget is based on an oil price benchmark of USD42.5/b, with an oil production of 2.2mn b/d and an average exchange rate of NGN305:1USD.

1.   While our 2017 oil price projection is above the Federal government’s oil price benchmark (above USD50 b/d), potentially increasing oil savings, we expect oil production to remain below 2.0mn b/d in 2017 owing to our expectation of further disruption in oil production in the Niger Delta.

2.    This will limit prospects for overall FX liquidity and government tax revenue. As a result, we expect a higher-than-expected budget deficit (as opposed to the 2.18% of GDP proposed under the budget) which will sustain strong FX demand.

· Similarly, we are pessimistic about the government’s assumption of the exchange rate in the budget . The 2017 budget is based on an exchange rate of NGN305:1USD.

1.   While the NGN will be supported by higher oil prices, modest capital inflows, content localisation and an anticipated issuance of a USD1bn Eurobond in Q1 2017 (possibly resulting in a strengthening of the currency from its current low of NGN410:1USD in the interbank market), strong import demand and still weak liquidity will limit currency gains.

2.      This is given problems in the oil sector alluded to above, and our expectation that the reform process will be subjected to delays and that implementation of policies will remain weak, specifically the economic diversification policy.

· CBN’s recent decision to move to a flexible exchange rate has set the economy on the right path to recovery, but exchange rate pressures will persist due to expectation of continued low oil prices, still low FDI inflows, FX reserves depletion, robust import demand, and tightening global financing conditions. Amid these factors, we anticipate further devaluation of the NGN in the short term. This should help the NGN to converge, providing greater price transparency which will help to attract more investment inflows, reduce the rate of depletion in FX reserves, boost FX liquidity and revive trading activity.

· We expect the official interbank exchange rate to depreciate over Q4 and into Q1 2017, reaching NGN320:1USD in the coming months.

· FX restrictions are likely to remain in place given the weak oil price outlook. We expect only a moderate rise in oil prices, and as government spending is set to rise, significant import demand in an environment of depleting FX reserves suggests further import demand suppression in the near term.

· We advise remaining USD long due to: (i) oil price and production concerns; (ii) volatile interbank liquidity; (iii) structural imbalance between USD supply and demand; and (iv) fundamental strength of USD.

· CBN’s recently adopted exchange rate policy will relieve some pressure on FX reserves, which have declined 16% to USD25bn from a year ago to defend the NGN peg to the dollar.

1.   At present, CBN’s intervention in the interbank FX market appears to be less aggressive compared with immediate weeks following the adoption of the new exchange rate policy.

2.      However, ongoing weak oil receipts and low investment inflows, which account for the country’s main sources of FX, suggest that the CBN will remain the main supplier of liquidity in the market undermining any prospect for a significant build-up in FX reserves to pre-crisis levels.

· Headline inflation is likely to ease slightly in the coming months but will remain elevated. The recent slowdown in core inflation points to lower price pressures in the coming months–price pressures will ease slightly on the back of higher base effects but ongoing tight FX liquidity, production constraints, higher utility and transport and food prices will keep inflation elevated (above CBN’s inflation target range of 6-9%).

· The Monetary Policy Rate will likely remain high at 14%, and given ongoing market uncertainties, specifically concerns over inflation and exchange rate in a low oil price environment, and the need to ensure positive real returns on assets, the scope of further hike is high. As a result, we expect a further 100-200bp rise in the near term.

· 91-day T-bill secondary market rates will continue to be strongly influenced by monetary and exchange rate developments and CBN liquidity management efforts.

1.     CBN’s policy hikes in March and July 2016 have led to an upward shift in short term primary market yields, ranging between 14.5-23.0%, and this is set to continue as investors take positions in short term securities in expectation of further monetary policy tightening given higher inflation expectations; with inflation at around 18%, this has already led to negative real returns for investors.

· The yield curve is likely to shift further upwards in the coming months. After dropping significantly in Q4 15 (amid the policy cut in November), primary bond yields have risen since, reflecting Growing investor concern over the short-to medium-term outlook.

· Yields are likely to rise further and the effect of US Federal Reserve monetary normalization will continue to draw some investors into US Treasuries, thereby maintaining upwards pressures on Nigerian rates. 

4. Economic and Financial Indicator Performance

See more charts here

Nigeria Economic Strategic Report, Q4, 2016 Ecobank  – Dec 20, 2016 


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