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Nigeria: further monetary tightening unavoidable?

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NGN remains under pressure…The exchange rate has remained under pressure since late Jan, with USD/NGN even reaching the 167 level intra-day on 13 Feb, as foreign capital outflows continued and the domestic market also positioned against the unit. The intermittent FX supply from oil companies (including the NNPC) has simply been insufficient to address the demand-supply mismatch, forcing the CBN to increase its RDAS USD sales and interbank FX interventions. At the time of the writing, the exchange rate appeared however to stabilise somewhat near the 163 area (162.6 on 17 Feb) thanks to the CBN’s proactive stance.

But outperforms EM currencies. While the recent volatility in the heavily managed USD/NGN exchange rate may look significant for a market used to marginal FX fluctuations, the reality is that the NGN has actually held up well relative to other emerging market currencies which have suffered from portfolio outflows and a negative turn in confidence after the FED hinted last year at the forthcoming unwinding of its quantitative easing programme (the FED has cut its monthly bond purchase programme by USD20bn since). Indeed, the NGN has lost 3.2% against the USD over the past year vs 22.0% for the Turkish TRY, 21.8% for the South African ZAR, 21.7% for the Brazilian BRL and 16.7% for the Russian RUB. More recently, Kazakhstan (an oil and raw mineral producer) devalued the KZT by about 19%, mainly to ensure its competitiveness vis-a-vis Russia (and China), despite the country’s robust balance sheet and still adequate fundamentals. Perhaps on a positive note, the EM FX weakness seems to have eased lately, with some of the currencies actually posting gains against the USD. It is not to suggest that the cycle has already turned, and it may take some time before the FX adjustment translates into improved current account positions, but this relative recovery/stabilisation should limit the negative momentum towards the NGN.

Devaluation would be counterproductive. CBN Governor Lamido Sanusi has repeatedly stressed in recent months that the currency would not be devalued given the negative impact this would have on imported inflation, investment and the current account, and because there would be virtually no gains in terms of external competitiveness (oil accounts for around 95% of exports) in this specific case. As such, the debate about a potential overvaluation of the currency has limited practical implications in a country where the efficiency and productivity of the non-oil sector is constrained by significant energy and infrastructure bottlenecks.

CBN steps up FX interventions. The CBN has supported the NGN in recent weeks by extending direct USD sales to banks on top of its bi-weekly RDAS FX auctions (size increased to USD600m on 17 Feb). The CBN interventions in the interbank market last week were more aggressive than usual and took place intra-day rather than before market close, which helped curb the upside for USD/NGN. The central bank is likely to continue to provide USD liquidity to the banks in coming weeks and defend its nominal monetary policy anchor, albeit at the expense of gradually declining FX reserves. Those fell to USD41.9bn on 13 Feb (30-d moving average), from USD43.6bn in late Dec 2013 and a high of USD48.9bn on 2 May 2013. With a merchandise import cover ratio of around 9.1-m, the CBN seems to have enough ammunition to support the currency for some time, but a continued slide in reserves (which were accumulated on the back of large capital inflows in 2012 and early 2013) will have a detrimental effect on confidence, with the potential to reinforce the ongoing foreign exit and a build-up of long USD positions.

Restoring the competitiveness of NGN assets. In this context, we feel the CBN will soon be under pressure to tighten monetary policy further, especially as it needs to ensure the competitiveness of Nigerian debt assets versus other emerging market peers whose currencies also depreciated more against the USD. The yield on the benchmark 10-y bond in Nigeria (Jan 22s [around 13.9% on 18 Feb]) rose by 290 bps between Apr 2013 and Feb 2014, and the rates of similar instruments in Brazil and Turkey increased by 360 bps and 330 bps (190 bps in South Africa). The divergence is however compounded when considering the relative liquidity of these fixed income markets and the large FX depreciations experienced by mainstream emerging economies. Thus Nigeria’s fixed income valuations look less appealing at the moment (Brazil’s 10-y instrument yields 13.2% and Turkey’s 10.0%). Meanwhile, equity investors are more concerned about the present FX weakness than stock valuations and will remain cautious, if not sellers, as long as there is not a more tangible improvement in the fortunes of the NGN.

Formal and/or effective monetary tightening? CBN officials have indicated that an emergency MPC meeting looked unlikely before 24-25 Mar 2014. Assuming that the upward pressure on USD/NGN remains manageable in the meantime and that the market starts to price in a tighter interest rate and liquidity management stance at the forthcoming MPC, there will be limited need for bringing forward the date of the March meeting. That said, we recommend a 200 bps hike in the MPR (currently 12%), a decision that would not only send a positive signal to investors, but would also automatically increase the SDF rate to 12% and push up the short end of the yield curve (the SDF is the natural floor for the 91-d T-bill yield). In addition, we expect the CBN to raise the CRR on public sector funds and private sector deposits (possibly to 100% and 15%, from 75% and 12%, respectively), but the latter would be effective if coupled with more aggressive OMOs to drain liquidity in coming weeks. Given the weak monetary transmission mechanism, such measures will ironically have a moderate impact on the real economy (there is limited lending to non-Tier I names and those have generally managed to borrow at preferential rates) and could even partially increase the profitability of selected banks that are natural buyers of high-yielding assets and less exposed to the public sector; yet such steps will help boost confidence in the Nigerian market and the NGN. Moving the MPR to at least 14% will also make it more difficult and time-consuming to potentially revert to a lower rate regime from this high base in the post-Sanusi period.

• Fiscal savings remain critically low. The elevated oil price in recent years (Bonny Light around USD110 pbl) has supported the NGN, but the paradox is that the authorities have been unable to rebuild any decent fiscal buffers. On the contrary, the ECA balance fell to a new low of USD2.1bn (0.7% of GDP) in Feb 2014, pointing to a loose federally consolidated fiscal stance, alleged oil revenue leakages and the absence of a credible framework to accumulate oil savings. This obviously weighs negatively on sentiment in the FX market, perpetuates an elevated interest rate regime and adds to concerns about long-term macroeconomic sustainability, especially considering that the fiscal breakeven point seems to exceed the oil price itself and is well above the oil price benchmark in the Federal Government budget (USD79 pbl in 2013; USD77.5 pbl expected in 2014).

• How to play the market? The foreign sell-off has pushed up the yield curve in recent weeks, which combined with the likelihood of further measures to tighten monetary policy and liquidity conditions, should create attractive re-entry points at the short end (364-d T-bill presently at 14.4%). As such, we will continue to recommend the carry trade in Nigeria, especially as we still do not expect a policy-led qualitative move higher in USD/NGN ahead of a highly competitive electoral cycle. Even though yields at the long end have also backed up, the upside is actually capped by the bid from domestic pension funds. That said, we remain bearish on duration amid a global aversion to long-dated fixed income instruments, a probable preference for the short end given Nigeria’s uncertain political and institutional outlook and the likely pick-up in bond issuance ahead of the 2015 elections. In this context, it is simply difficult to imagine how bonds could rally even amid a persistent single-digit inflation environment (8.0% y/y in Jan) unless there is a shift towards a lower interest rate regime in H2:14. But this would in itself trigger a pronounced period of NGN weakness forcing the authorities to revert to a more restrictive monetary stance before next year’s polls. While tighter liquidity conditions may affect the intrinsic valuations of Nigerian stocks (NSE All-Share Index down 6.5% YTD in USD terms), we suspect the subsequent stabilisation of the FX market would mitigate these negative factors, especially for the strongest names in the banking sector. Despite the various endogenous risks (change of CBN Governor, pre-electoral noise, lack of reform momentum) expected in the medium-term, the bourse should also be supported by the growing bid from the frontier market investor community.

By: Samir Gadio