JPMorgan Chase & Co expects Naira to US dollar exchange rate to eventually strengthen towards N850 by year-end as the combination of tighter policy, as well as more attractive rates and FX levels deter incremental dollarisation and perhaps attracts some foreign capital.
This is even as JPMorgan expects Nigerian authorities to maintain a willingness for greater flexibility of the exchange rate. Though it said that while a strengthened naira against US dollar exchange rate is crucial, “the large backlog of unmet FX demand and low net FX reserves makes the job challenging”.
“The Central Bank of Nigeria (CBN) appears willing to once again allow a flexible exchange rate without the use of moral suasion to limit the upside. This was initially the case during the first attempt at re-caliberating the FX market, however those efforts lost steam due to inflation concerns.
“We believe recent efforts to restore a flexible FX regime may be sustained given the willingness to accompany it with tighter monetary conditions. The interbank FX rate has risen in recent days to over N900, from N750, thereby significantly closing the gap to the parallel rate which is now just above N1,000,” JPMorgan Chase & Co noted in its November 1 note titled “Nigeria local markets strategy: Getting set for re-opening”.
While noting that unifying the various FX windows and eliminating the longstanding list of ineligible transactions helps simplify the FX policy framework, JPMorgan said that due to still limited FX liquidity in the official market, and the fact that naira isn’t a fully convertible currency, “some FX demand will inevitably find its way to the parallel market.”
“In our opinion, when authorities refer to the FX backlog, they are actually referring to US $6.8billion in FX forward commitments which the central bank has not honored – the majority of which has been covered by commercial banks.
“However, we estimate there is up to a further $$3-4billion (probably less given the FX adjustment) in unmet FX demand needed for goods and services imports. CBN will need to clear both backlogs, a difficult task given the low levels of net FX reserves.
“We previously estimated that Nigeria’s net FX reserves could be as low as $3.7billion at the end of 2022. We do not have new information about the central banks short-term contingent liabilities, however gross FX reserves have further declined by $4.1billion through this year and now amount to around $33.3billion, suggesting the net position could be lower,” JPMorgan noted further.
JPMorgan Chase & Co also believes the current -300 basis points (bp) / +100bp corridor around the 18.75percent policy rate needs to be narrower in order to increase the market (and real economy) relevance of the policy rate.
The CBN earlier this week mopped up around N400billion of liquidity via open market operations (OMO) at a significantly higher yield of 21.2percent for the 1-year bill, compared to 17percent at the previous OMO auction in August, 13.5percent for 1-year treasury bills as at Fridays close and 15.75percent at the central banks deposit window.
“Indeed, as we have noted previously, the CBN appears to be in the process of normalizing monetary policy, despite the fact that a monetary policy committee (MPC) meeting hasn’t held since July. Assuming the OMO auctions are held on a more regular basis, we expect it will result in tighter liquidity conditions, which will in turn help slow dollar demand,” JPMorgan Chase & Co said
JPMorgan Chase & Co said its economists expect the CBN to keep the policy rate unchanged at 18.75percent for the foreseeable future. “While optically and for signalling purposes, this may appear odd, especially if the OMO rate is set above 21percent for an extended period, it may be a necessary compromise given the political sensitivity and preference for lower interest rates (recall the Presidents inauguration speech signaling the need for lower interest rates, see here) particularly as the MPR should typically serve as the base rate for bank loans. Similarly, the CBN might also remain cost conscious by not wanting to pay significantly higher rates on both OMOs and SDFs. In effect, the policy rate won’t matter if short-term rates can move nearer 25percent in order to narrow the current negative real rates while continuous OMO auctions and CRR debits can help to further tighten liquidity conditions, ease FX and inflationary pressures,” it noted.
It noted further that given that domestic debt makes up around 62percent of Nigeria public sector debt, “a further rise in interest rates will increase the interest burden, even as authorities explore ways of improving oil and non-oil revenues. Higher interest rates will also come at a cost to the central bank, a cost which will eventually be absorbed by the federal government”.
“Removal of the limit on remunerable deposits at the central bank needs to be complemented with a symmetric corridor around the policy rate. Reports suggest the CBN may have removed the N2billion per bank limit on remunerable funds placed at its deposit window, the Standing Deposit Facility (SDF).
“Even though there hasn’t been an official public announcement to this effect, the sharp increase in funds placed at this window in recent days and the jump in funding rates to circa 15percent suggests the cap on the SDF has indeed been removed. While this is a significant step in the right direction, we suspect the SDF will once again become less relevant if the CBN issues more frequent OMOs at an elevated rate and given the asymmetry of the corridor around the policy rate,” according to JPMorgan Chase & Co.