February 12, 2020
by Vetiva Research
Policy stance to ensure short-term stability
It is no news that the Naira is overvalued relative to the US dollar by about 10%-15%, confirmed by both the interest rate parity (IRP) and the international fisher effect (IFE) exchange rate models. For months, calls have been mounting on the Central Bank of Nigeria (CBN) to devalue the Naira due to a build-up of pressure on the external reserves and a gloomy outlook for oil and foreign investments. This is believed to be putting pressure on the central bank, constraining its ability to sustain the defence of the Naira.
Foreign exchange market pressure still tolerable
From our findings, the case for a strong depreciation pressure is being nullified by the foreign exchange market pressure (EMP) indices. Our preferred measure of exchange market pressure is Eichengreen’s EMP which consists of a weighted average of the exchange rate, relative interest rates and foreign exchange reserves. Our findings were also confirmed by Girton & Roper’s EMP index which excludes interest rate in estimating pressure in the foreign exchange market.
The EMP index suggests that the current depreciation pressure in the foreign exchange market has not blown out to 2016/2017 levels, before the introduction of the I&E window, even though the risks of a possible devaluation have become more severe. Amid rising risks, the central bank has been able to keep foreign exchange utilization below pre-recession levels.
While the central bank has been able to tame the growth in FX utilization from tangible imports, invisibles have been contributing significantly to the growth in FX utilization. Pre-recession, invisibles constituted about 35% of FX utilization. However, this has changed post-recession as invisibles now account for about 60% of FX utilization – led by the financial services sector (Sep’19: 67%). Although we have seen an uptrend in FX utilization from 2017, we believe dollar demand by domestics is yet to reach a critical point to compel a devaluation by the central bank.
Vulnerability indicators confirm reserves adequacy
Recovery in oil prices, Eurobond issuances and hot money (First mention) inflows have contributed to a modest increase in external buffers, postrecession. The improvement in the country’s external position is confirmed by selected indicators of external vulnerability. While the imports cover serves as a current account based measure of reserves adequacy, the broad money ratio can be an indicator of the potential impact of capital flight. The CBN reported that the country’s $39.00 billion in reserves as at Octâ€™19, could cover 9.15 months of imports. This exceeds the global minimum reserves requirements (3 months) and that of the West African Monetary Zone (6 months).
The broad-money ratio as at Sept’19 also reflected that the external reserves could cover 53% of money supply (M2) – global benchmark is typically set at 20%- if there were to be an increase in the demand for foreign assets from domestic sources or an aggressive reversal of foreign capital (assuming the entirety of money in circulation was foreign sourced). Fortunately, the accommodative outlook on global monetary policy will provide some respite from aggressive portfolio outflows and stem pressure on the external reserves. Also, sectoral FX utilization has averaged between 7%-8% of external reserves annually – since the recession.
This has been due to deliberate efforts by the government to contain imports. This is unlikely to change in 2020 and as such the current level of reserves should be able to support another 12 months of FX utilization at the going pace. With a foreign debt stock of $26.94 billion (as of Q3’19), the gross international reserves (GIR) could absorb the external debt 1.5x (i.e. foreign debts ratio of 151%). However, this deteriorated slightly as at FY’19 as the GIR declined to $38.09 billion.
Steady bid-offer spreads
Since the I&E window was introduced in 2017, the gap between bids to buy and sell the Dollar in the foreign exchange market has been largely steady. This is because of the CBN’s strategic sale of FX in the market, though it has come at the expense of reserves accumulation. A widening or narrowing of the spread suggests a disequilibrium between FX liquidity and local demand for foreign assets. Hence, a steady spread nullifies the case for a buildup of international pressure -from either direction – on reserves and exchange rate.
And the current account deficit?
While an existing deficit implies that Nigeria is spending beyond its means, having a current account deficit is not inherently disadvantageous. A large portion of the country’s exports are commodities – predominantly oil- and fluctuations in commodity prices will impact income flows to the country from time to time, resulting in swings in the current account balance. What is most important, however, is the ability of the country to offset current deficits with future revenue streams.
Consumer spending has been dampened by the devaluation of the Naira, six (out of ten) years of two-digit inflation and high interest rates. Hence, it is safe to conclude that the current account deficit balance is not consumption-driven. Continued FX restrictions by the central bank will also ensure limited growth in imports for consumption, while the anemic outlook for consumer income will continue to weigh on the country’s propensity to import throughout the year 2020.
However, pressure on the current account will come more from investmentdriven imports. The early passage of the 2020 budget, in light of the government’s pro-infrastructure disposition, suggests that more boxes will be checked off the list of infrastructure deliverables. This could result in the increased import of machinery and construction materials, putting downward pressure on the current account.
Also, the likelihood of low international interest rates in the course of the year can also encourage economic units (corporates & government) to borrow from abroad more cheaply, deepening the current account deficit. Unfortunately, the deficit is unlikely to be sufficiently cushioned by 2020 oil earnings, given the downbeat oil outlook.
Although a devaluation at this time could make Nigeria’s exports cheaper in the global market and shrink trade deficits, it could also stoke macroeconomic volatility and result in worse economic outcomes in the near term. A devaluation will result in a rapid rise in inflation as industries which are importdependent have to pay more to acquire their goods. This will translate to higher inflation, exacerbating the impact of the current supply gap on consumer prices. We note, however, that the risks of a devaluation are moderately tilted to the downside.
The bearish forward view of the oil market and the under-allotment of OMO bills by the CBN leaves room for the outflow of hot money to higher-yielding fixed income markets (Ghana, Kenya and Angola). This could set the tone for a downward spiral of capital flight and signals impending pressure on the GIR.
However, we do not expect the GIR to nose-dive to sub-$30 billion levels where it was before the 2017 devaluation. Rather we expect the GIR to close out the year at $35 billion, propped up by foreign borrowings ($3 billion Eurobond sale and concessionary loans) amid continued implementation of FX-demand management policies. This will result in the accumulation of external buffers, increasing the CBN’s capacity to continue its interventionist policy in the foreign exchange market and cushion the effect of capital flight on the Naira exchange rate.
In recent weeks, the management of the CBN has been emphatic about there not being plans to devalue the Naira because it will have no direct impact on the country’s export, being a mono-product economy. The price of crude oil, which accounts for the bulk of Nigeria’s exports, is determined by the global market as such a devaluation will have no direct impact on the country’s major export. In addition, non-oil exports which should ordinarily benefit from a devaluation is not being produced efficiently.
While we align with the views of the CBN, we also posit that reliance on vulnerable financial inflows for building reserves means that the country’s liquid foreign assets offer only a modest liquidity buffer against external shocks. To this end, a further deterioration of the country’s external profile and a weakening of the Naira by 0.1% – to N365/$ by the end of the year – is imminent, but a devaluation is unlikely over the next 12 months.