Q1 2021 FX Outlook: Risk-on Stages a Comeback


Friday, January 08, 2021  / 10:03 AM / By Vetiva Research / Header Image Credit: Forex Crunch/Ecographics

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SSA Currencies: Risk-on Stages a Comeback

2020 was clearly a turbulent year for emerging and frontier currencies, as the pandemic incited several external sector shocks, from subdued resource and tourism earnings to lower remittance flows. Petrocurrencies have been the worst hit-the Angolan Kwanza (-35.9%) and the Nigerian Naira (-9.7%)- due to insufficient external buffers and a global risk-off sentiment that triggered the reversal of foreign capital. While the Kwanza has been in free fall since its Oct'19 regime change, the Naira saw a dual-devaluation in 2020 as oil prices slumped. The Naira is still largely perceived to be overvalued because of the large divergence between the official and parallel market rates, despite a review of its remittance policy to narrow the FX gap.


Elsewhere, the first and second waves of lockdowns in Europe-a key Kenyan export destination-contributed to the weakening of the Kenyan Shilling (-7.8%), despite interventions from the Central Bank of Kenya (CBK). Reports of a dual exchange rate system also surfaced in the country, as the public sector's official exchange rate diverged from the rate in the interbank window i.e., the market rate. The divergence is suggestive of a price-discovery process in a somewhat restricted market, as the CBK's dollar supply did not increase in tandem with demand.


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Unlike the Shilling, the Gambian Dalasi (-1.3%) absorbed external shocks thanks to strong remittance and official development assistance (ODA) flows, that made up for the slump in re-exports. Similarly, inflows from development partners moderated the depreciation in the Leone (-3.7%), amid foreign currency restrictions. Meanwhile, the Ghanaian Cedi delivered a not so surprising resilient performance, softening by a meagre 2.7% in 2020, despite the country's Presidential election. The surge in gold prices, recovery in cocoa prices and an early Eurobond raise provided support for the Cedi to outperform its four-year average depreciation of 10.5%.


In South Africa, renewed global risk-on sentiment supported the recovery in the Rand (-5.0%) from grossly undervalued levels during selloffs in Q1'20. Higher gold prices, which lifted trade surpluses to a three-decade high in Q3'20, also provided support to the Rand. The appreciation of the outlier, the Liberian dollar (+13.3%) has not been driven by fundamentals, instead being caused by an artificial scarcity of the local currency in the highly dollarized Liberian economy.


Nigeria's FX Conundrum

Following two years of relative stability in the Nigerian foreign exchange market, the pandemic necessitated further adjustments in the Naira exchange rate as demand for FX built up amid constrained oil receipts. Following an initial 18% adjustment in Mar'20 to forestall considerable depletion in reserves, the Naira's quasi-peg was further adjusted by 6% as a pre-condition for accessing a $1.5 billion World Bank facility. Although the World Bank recently approved a total of $1.5 billion for social welfare and state fiscal support, the original $1.5 billion budget support request is still pending. True to the pre-conditions for the loan, the government has implemented reforms in both the energy and foreign exchange markets. However, the dollar still trades at 24% and 8% premiums in the parallel market and I&E window respectively. This breaches the IMF's permissible exchange rate gap of 2%; as such, the currency is still considered overvalued. True to this, the closing 12-month forward rate reflected that the Naira should be trading within parallel market ranges.


In Q4'20, the Naira depreciated in both the I&E and parallel windows to ₦410.25/$ and ₦470/$ respectively driven by demand pressures from both investors and manufacturers. In November, the parallel market rate depreciated to a resistance level of ₦500/$ which triggered a series of circulars from the apex bank to prevent the FX gap from widening further. The Bank had uncovered arbitrage practices perpetrated by some International Money Transfer Operators (IMTOs). In a bid to address this, the apex Bank reviewed its diaspora remittance policy by directing banks to credit beneficiaries of remittances in foreign currency. This move led to a 6% recovery in the parallel market rate.


While the policy sought to improve foreign exchange supply in the parallel market, the benefits may not yield desirable appreciation in the currency due to the slump in remittance receipts since the onset of the pandemic. As of 9M'20, remittances were 66.5% lower y/y no thanks to the pandemic-induced dent on take-home pay in advanced economies. However, pent-up demand from manufacturers will keep demand for FX elevated at the parallel window while weak growth outcome, rising inflationary pressures and negative real yields keep foreign portfolio investors on the sidelines.


BoP Financing, Cheaper Imports Strengthen Reserve Adequacy

The balance of payments (BoP) of several economies encountered numerous pressures from the merchandise, income and transfer segments of the current account to investment flows in the financial segment. During times of BoP crises, countries could resort to swap lines with other central banks, sovereign wealth fund drawdowns or multilateral financing. While advanced and emerging markets seldomly drawdown on reserve assets, less developed economies resort to financing from International Financial Institutions (IFIs). Due to the low levels of intra-African trade and the absence of international reserve currencies in Africa, African countries do not have sufficient reserve levels to partake in credit swap lines. Only two nations in the SSA region have more than $30 billion in external reserves - South Africa and Nigeria.


Assessing external vulnerability indicators of SSA countries, many SSA economies have adequate reserves to fund their imports and are less prone to externally influenced banking crises. Several SSA countries have their import cover ratios above the global benchmark of 3 months. While Liberia underperforms select SSA peers, the net-effect of the pandemic on its terms of trade is positive given the overwhelming impact of cheaper fuel imports and higher demand for metal exports. We believe the impressive import cover metrics were supported by cheaper fuel imports (Liberia), concessional financing (Nigeria), development financing (Sierra Leone), current account gains from higher gold prices (South Africa & Ghana) and import substitution efforts (Angola).


Buttressing reserve adequacy levels, the broad-money ratio reflects how loss of confidence in domestic currency by non-residents could affect the banking system. Countries with strong banking systems such as South Africa, Nigeria and Kenya have healthy broad-money ratios, reflecting solid reserve adequacy levels and ability to absorb shocks from sudden capital withdrawals. For emphasis, we believe the strong recovery in the Rand can be linked to the depth of its financial market.


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Currency Levers in 2021: Weaker Dollar, Tighter Monetary Stance and AfCFTA

While the currencies of oil-dependent economies (Nigeria & Angola) remain below pre-pandemic levels, development finance assistance supported the currencies of smaller economies (Sierra Leone & Gambia). The currencies of diversified economies (Kenya) remain at the mercy of further COVID-19 waves in key export destinations, despite stable remittance inflows. With positive vaccine developments, doused health tensions could contribute to the recovery in commodity prices in 2021, and by extension support the currencies of resource dependent SSA economies (Kenya, Nigeria, Ghana). However, upon the mutation of the virus, tourism-dependent economies (Gambia) could witness currency pressures, unless official assistance from development agencies continually serve as buffers. Countries with developed financial markets as South Africa could witness record inflows from portfolio investors because of the prevailing low yield environment in advanced economies.


Following Joe Biden's election as US president, trade tensions are expected to dissipate as the new President adopts a more diplomatic and multilateral approach to international trade. This could help global trade recover from the double whammy of the trade war and pandemic-induced supply chain disruptions. Thus, we expect a recovery in industrial demand to boost external demand for key commodity exports and prop-up reserve levels of resource dependent SSA economies. In addition, the kick-off of the Africa Continental Free Trade Agreement could result in investment flows into countries with the right business environment, pro-manufacturing incentives, strong transport networks and less bureaucratic trade procedures. In the long run, SSA economies could insulate their reserves from shocks and currencies from the volatilities associated with huge exposure to foreign portfolio investments. Attracting more stable capital flows could be essential in keeping currencies afloat in 2021.


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Amid the global liquidity glut from the ultra-dovish monetary policy stances in advanced economies, real negative yields in haven economies could spur continuous capital inflows to emerging markets. Our base assumption is that stimulus packages, high liquidity injections and asset purchase programmes will be sustained in advanced economies until health risks subside significantly. With the recent mutation in the virus, health risks remain imminent despite positive vaccine announcements. Meanwhile, portfolio investors will continually seek refuge in higher yielding environments. With the anticipated increase in oil prices, non-oil economies could deliver rate hikes to rein in inflationary pressures. Petrocurrencies may remain under pressure until fundamentals in the global crude market improve.


SSA Currencies Outlook

With the pandemic as a key issue of concern, petrocurrencies and gold exporters could experience divergent outcomes due to recent developments-vaccine availability and the mutation of the virus. While vaccine administration could provide respite for battered petrocurrencies (Nigerian Naira & Angolan Kwanza), new strains of the virus could strengthen currencies of gold exporters (Ghanaian Cedi & South African Rand). In 2021, negative real returns in advanced economies would fuel investment appetite for emerging assets providing a foothold for the Rand, given South Africa's deep financial markets, capital mobility and floating exchange rate regime. Resource-dependent currencies such as the Ghanaian Cedi, Kenyan Shilling, Angolan Kwanza and the Nigerian Naira would benefit from subdued trade tensions as demand from Asia & Europe gradually improves. Meanwhile, aid flows and development financing will continually serve as buffer for the Leone and Dalasi.


In addition, currency-swap arrangements could spring up within the region to reduce dollar dominance, especially as the AfCFTA kicks off. Before the pandemic struck, a currency swap deal between Nigeria and Sierra Leone was in the works, as Sierra Leone intended to capitalize on the former's currency swap deal with China. We could see a revival of such currency swap deals to reduce dollar dominance and facilitate bilateral trade arrangements. Should African countries take this route, improved intra-continental trade in African currencies could ease currency pressures.


Drilling down on the Naira, the presence of multiple unfavourable macroeconomic factors could exert pressure on the currency. Given the existence of multiple exchange rates, rising inflation and low yielding money market instruments, the Naira could undergo severe pressures if fundamentals in the oil market do not improve. Higher oil prices could enable the country raise funds from the international debt market. In the meantime, inflow from the World Bank is expected to support the CBN's fire power in defending the currency.


According to a Consumer Expectation Survey report conducted by the CBN, consumers expect the Naira to appreciate in 2021. While improved market fundamentals may lead to improved foreign exchange supply, it is highly unlikely that the official exchange rate will be revalued. We believe at best, there could be a narrowing of the foreign exchange gap which could be driven by further adjustment in the official exchange rate or risk-on sentiments by portfolio investors incident upon oil price recovery and a possible reversal in the yield environment.


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