Wednesday, September 06, 2017 11:55PM / BMI Research
BMI View: Nigeria's central bank will continue to tightly manage the naira through 2017 as the country's improving fundamentals indicate downside pressure on the currency is beginning to decline. The current multiple-rate FX regime is unsustainable beyond the short term and will likely be consolidated into a single – more flexible – rate in 2018.
Short-Term Outlook (three to six months)
Improving macroeconomic fundamentals and political pressure lead us to expect that Nigeria's central bank will not make any substantial devaluation to the peg on the naira's official exchange rate in 2017, leaving the rate around NGN324/USD at end-2017.
Both the central bank and the government have failed to provide investors with any degree of policy clarity on the country's exchange rate regime, leading to levels of uncertainty that have weighed on investor sentiment towards the oil-rich nation over the past two years. The introduction of multiple new exchange rates over 2017 has only exacerbated this uncertainty (see 'NGN: Official Rate Staying Put, But Spread With Parallel Market Will Remain', May 04, 2017).
However, with the country's fundamentals showing signs of recovery after its 2016 recession, we believe pressure to devalue or even float the naira is slowly beginning to decline. Although the recovery in crude prices after collapsing in H214 has been weak over H117, production increased dramatically in Q2 since declining in 2016, following a series of attacks on pipelines carried out by local militia groups. Increasing production this year has facilitated an uptick in crude exports, resulting in a much-needed boost to the supply of hard currency in the country.
This has been reflected in the uptick in foreign reserves recorded over 2017 and the strength of the NAFEX window (the most freefloating of Nigeria's various exchange rates). Finally, statements from various members of the central bank's monetary policy committee have not alluded to any desire to review the peg, and despite his questionable health, President Muhammadu Buhari holds enough power in government to continue defending what has become his most controversial policy.
Long-Term Outlook (six to 24 months)
Over a longer-term outlook, we believe it is unlikely Nigeria's exchange rate regime will continue to exist in its current form. Although we are confident that pressure to consolidate the various rates into a single, much weaker, exchange rate has dissipated in the last few months, the complexity and uncertainty surrounding the regime will pose a headwind to the country's economic recovery unless reformed.
The government's decision to peg the naira in response to the collapse in oil prices saw foreign investors flood out of Nigeria's capital markets in 2015 and 2016 for fear they would be unable to convert their investments back into hard currency.
The introduction of the more flexible NAFEX window in April has helped lure some investors back into local debt markets, but investor sentiment remains weak on suspicion of future changes and is unlikely to make any meaningful improvements until the government and central bank adopt a more sustainable exchange rate regime.
While we believe the current system is unsustainable over the long term, exactly when the government will reform the exchange rate is dependent on political will. So far, President Buhari has been the establishment's most ardent defender of the peg, but given he is in ill health and has been forced into prolonged absences from Nigeria as he seeks medical treatment in the UK, we see scope for more reformist voices coming to the fore over coming months.
Vice-President Yemi Osinbajo – who would succeed President Buhari should his illness force him to step down from office – is seen as a more technocratic breed of politician. It was during one of Buhari's medical visits to London that the naira was first devalued in 2016 under Osinbajo's oversight. Compared to Buhari, Osinbajo is seen by the wider population as a more proactive leader and has been touted as a potential successor to Buhari in the 2019 election, when the incumbent is widely expected to step down from office.
Osinbajo's political capital could provide the impetus needed to implement reforms to the exchange rate regime as Buhari's own influence in government is beginning to wane towards the latter stages of his current term.
Risks To Outlook
Given Nigeria's exchange rate is as much based on political motivations as it is on the country's economic fundamentals, our outlook for the naira comes with significant risks. We can never completely discount a change in the influence or mindset of either the reformist camp or among those defending the status quo. The gradual improvement in Nigeria's macroeconomic fundamentals could play into either group's hands.
The economy's recovery could be viewed as alleviating pressure to devalue and giving the central bank the means to continue defending the peg, or alternatively seen as the ideal time to abandon the peg entirely while the fallout of doing so would be relatively minimal. Either way, this uncertainty will not play in the country's favour and investors are likely to remain cautious until government and central bank policy appears more concrete.
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