NSR H2 2017 (10) - CBN’s Volte-Face Narrows FX Markets Premium


Tuesday, August 1, 2017  01.57  PM / ARM Research  

We continue with the serialization of ARM’s  “The Nigeria Strategy Report” focusing on developments in Nigeria’s currency market over H1 2017. This is followed by a careful delineation  of our NGN outlook for the coming months. 

In our H1 17 Strategy Report, we noted that the CBN could maintain its hard peg on the naira at N305/$ as higher oil receipts and proceeds from FG’s planned external borrowings bolster FX reserves. Unsurprisingly, following a strong rise in the nation’s reserves (+17.1% over H1 17 to $30.3 billion), the CBN raised its dollar sales towards the end of February. This, together with the creation of new FX windows and relaxation of some stringent policies, lowered dollar demand at the parallel market. Against this backdrop, the premium between the interbank and parallel market contracted to a 20-month low at the end of June even as the once-elusive portfolio flows began to trickle in. Overall, whilst CBN’s stringent FX policies had hitherto been “a kiss of death” to the currency market, which forced turnover to a record low, its eventual liberalisation policies appears to be springing the market back to life. 

Figure 1: Historical parallel market premium

Fiscal nod hastens FX policy reversal 

Following the instating of a N305/$ currency peg at the interbank in September 2016, the naira held steady fairly around what was prescribed over the first half of the year. At the parallel market however, it remained feebler—falling to a record low of N520/$ in February (December 2016: N490/$) before rebounding in succeeding months. The naira depreciation in the earlier part of the year reflected lower FX liquidity (FX turnover fell to a record low of $1.4 billion in January) as CBN, in response to 2016 shocks to oil receipts, placed emphasis on dollar demand management. Later on though, following the widening of FX market premium between interbank and parallel market to a post-floatation high of 70%1 and improvement in foreign reserves, the CBN made a U-turn with regards to its currency policies. Particularly, the apex bank created a special FX window for invisibles (i.e. personal and business travel allowance, medicals, school fees), wherein permissible users obtained FX at a concessionary rate of N375/$ which reduced demand pressures at the parallel market.  

In addition, the CBN relaxed the preferential FX allocation to manufacturing companies3 and reduced the tenor on its currency forward contracts to 60 days (vs. 180 days previously). The impact of these measures, as well as a two-fold MoM jump in dollar sales to BDCs to a fourteen-month high of $89 million in February, underpinned a 9.5% MoM appreciation in the naira to N450/$ at the end of February. Interestingly, the policy pronouncement came a working day after the National Economic Council4 mandated the apex bank to take actions to stem widening parallel market premiums. The CBN shift also followed the transfer of more executive powers to the Vice President, Professor Yemi Osinbajo, a supporter of greater NGN flexibility relative to the, then, absent President Buhari who opposed naira weakness and advocated for dollar demand curtailment. Overall, the steeper naira gain (+11% MoM to N385/$) occurred in March following an upsurge in CBN dollar sales (doubled MoM to $1.2 billion) and adjustment to the FX offer rate to both BDCs and invisibles FX window to N360/$.

Liberalization pill cures naira of undervaluation adversity

The month of April witnessed the introduction of two new FX windows—a special window for Small and Medium Scale Enterprises as well as one for Investors and Exporters. In the case of the former, each SME applicant could access $20,000 per quarter for eligible imports5 from the CBN to help reduce the quantum of dollar demand at the parallel market. Later in the month, 21st of April precisely, the apex bank created a window, named the Nigerian Autonomous Foreign Exchange Rate Fixing (NAFEX), for investors and exporters. In this window, FX rate was structured to be determined by market forces in order to help re-channel autonomous flows to the official FX market. . Though the CBN reserved the right to intervene from time to time, the primary source of supply to the FX window was expected to be from portfolio investors, exporters, deposit money banks and any other investor needing to convert foreign currency. On demand side, accessibility was restricted to eligible imports (all imports less the banned 41 items). 

In the first week of operation, FX turnover at the IEW printed at $614 million (77% of average weekly FX turnover at the interbank market) as liberalization gained the attention of foreign investors. The closing rate in the market also ranged between N375/$ to N380/$.  

It is our view that investors relied on the parallel market (which closed the month of April at N390/$) to price the nation’s currency at the FX window. 

Figure 2: CBN dollar sales and Interbank FX turnover 


Figure 3: Trend in REER estimated FX rate, BDC and Interbank 

Improving fundamentals guide to stable near-term outlook 

In framing our outlook for the NGN, we start by shaping our view on the country’s fundamental picture through Balance of Payment analysis. On the export leg, we expect higher crude offtake, stemming from the re-opening of Trans Forcados terminal, to moderate impact of declining crude oil prices. Hence, assuming mean crude price of $45/bbl and oil production of 2.0mbpd over H2 17, we project an 11.6% YoY increase in goods exports to $19.8 billion. On the other hand, we forecast a 14.1% YoY rise in imports to $19.3 billion over H2 17 as improved dollar liquidity spur demand for foreign non-oil goods. Overlaying the implied goods trade surplus of $0.5 billion with a $4.5 billion Service deficit (mean 4-year deficit: 4.1% of GDP), we estimate a balance of trade deficit of $4.0 billion. However, given a forecasted net current transfer of $9.3 billion, largely because of workers’ remittances, we expect the current account to print at a surplus of $5.3 billion. On the financial account, we expect a combination of high interest rate environment, improving economic picture and a flexible exchange rate system to sustain the demand for naira assets over the second half of the year. Overall, the positive balance of payment picture suggests little downside risk for the naira. 

Figure 4: FX monthly turnover and Import 


Having resolved the BoP considerations, we then look to evaluate the potential liquidity picture across the FX markets by running scenarios estimating CBN’s dollar sales per month. In our base case scenario, we expect a moderate decline in monthly dollar sales by the CBN to $2.0 billion (May 2017: $2.2 billion, H1 176 average: $1.3 billion) against the backdrop of reduced pent-up demand. In our view, the cutback should emanate from the special intervention forward contracts which contributed 38% of CBN’s monthly dollar sales in the first half of the year. 

Against this backdrop, we are of the view that the apex bank has sufficient ammunition to maintain its current FX sales to the other currency windows. Added to this is our upbeat outlook on portfolio flows which should leave the IEW relatively greased with dollar supply. Though this scenario implies a $2.5 billion decline in FX reserves to $27.8 billion by year end, the steep drop in Nigeria’s imports suggest a comfortable import cover of over seven months vs. 6 months recommended by the IMF. Overall, we expect FX rates to hover at current levels at the various FX windows.

Figure 5: Forecast net FX reserves and import cover 


From ARM’s H2 2017 Nigeria Strategy Report

1.       NSR H2 2017 (9) - Trade Balance to Survive Muddy Waters

2.      NSR H2 2017 (8) - Nigerian GDP: Recovery Signal Speaks

3.      NSR H2 2017 (7) - Nigerian Fiscal: One Step Closer, Several More To Go

4.      NSR H2 2017 (6) - REFORMS: Getting Down to Brass Tacks

5.      NSR H2 2017 (5) - New Regulations set sights on increasing gains for Pension Assets

6.      NSR H2 2017 (4) - Nigeria's Socio-Political Milieu: Just Before That Sigh of Relief

7.   NSR H2 2017 (3) - Supply Glut Underpins Broadly Bearish Trends Across Soft Commodities

8.     NSR H2 2017 (2) - Crude Oil: US Shale Challenges Anticipated Market Re-balancing

9.      NSR H2 2017 (1) - After Bullish Run, Portfolio Flows to EM Look Set To Moderate  



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