Emerging markets experienced increased asset price volatility in late Jan, as concerns about the unwinding of the QE programme in the US and signs of economic recovery in developed countries precipitated a sell-off in their FX, fixed income and equity markets. The FED actually decided to reduce bond purchases by an extra USD10bn to USD65bn at the 28-29 Jan FOMC after announcing a first USD10bn cut at the 17/18 Dec meeting. Additionally, expectations of lower growth in China, coupled with stress points in Turkey and rather idiosyncratic issues in Argentina and Ukraine, certainly contributed to the negative shift in sentiment towards emerging markets. Ironically, US yields have even trended lower (10-y around 2.7%) despite the QE tapering dynamics amid a flight to safety to US Treasuries and as investors lightened up their exposure to emerging markets. There is however evidence that selected countries are ready to implement tough monetary measures to stop the meltdown, even at the expense of domestic growth, as illustrated by an aggressive hike in policy rates by the Turkish CBRT on 28 Jan to stop the multi-month depreciation of the TRY.
The magnitude of the tightening was largely unexpected (weekly repo rate and overnight lending rates up 550 bps and 425 bps to 10% and 12%, respectively) and helped calm the markets – albeit only temporarily- on 29 Jan. Yet the unexpected 50 bps increase in the repo rate to 5.5% by the South African SARB on 29 Jan was probably too modest to protect the ZAR and the formal reason behind this move was more to address second round inflation concerns than support the currency. Prior to this, Brazil’s BCB raised its Selic rate by a cumulative 325 bps to 10.5% from April 2013, but with limited success on the FX front, and India’s RBI hiked the repo rate by an overall 75 bps to 8% from Q3:13. Looking forward, it may well be that emerging markets with the weakest fundamentals, including those heavily reliant on capital flows to finance large current account imbalances, will still remain vulnerable and episodically under pressure in the ongoing risk reconfiguration.
Meanwhile, the NGN has also depreciated against the USD (USD/NGN at 162.9 on 29 Jan), driven by offshore investors and the domestic positioning against the unit, albeit less aggressively than the currencies of most mainstream emerging markets (losing 1.8% in Jan vs 7.8%, 7.3%, 6.7% and 2.1% for the South African ZAR, Russian RUB, Turkish TRY and Brazilian BRL). This relative resilience of the NGN has been noticeable at times of pronounced stress in global markets in previous years, which reflects the policy-determined nature of the exchange rate in Nigeria.
We do not see the CBN changing the FX stance and departing from its price stability mandate, which points to further direct USD sales to banks in the short term. At this stage, a relatively stable exchange rate and single-digit inflation path will be perceived as CBN Governor Lamido Sanusi’s most critical achievements on the macroeconomic front, and this makes us even more confident that the current FX regime will be preserved by the central bank in coming months. Even the Nigerian government has limited incentive to devalue the currency ahead of a competitive electoral cycle. Although a weaker exchange rate would boost the NGN marginal utility of every USD of oil revenue, the social impact would be disastrous and seriously undermine the political credentials of the current administration. Assuming there is a concerted political push for lower interest rates in the post-Sanusi era, we suspect this stance would also be short-lived as the monetary authorities would be forced to revert to a more restrictive rate regime to save the currency.
Beyond external factors, the NGN weakness in late Jan was fuelled by the CBN’s decision to remove the cap on the amount of FX sales by banks to the BDCs. This unexpected U-turn will push down the parallel exchange rate (which previously peaked around 174), and result in the extra demand for USD coming back to the interbank market. As requested by the CBN, decisive measures are required to curb money laundering activities and illicit capital evasion, and closely track the mysterious FX demand from BDCs, but this is simply beyond the scope of monetary policy. Nevertheless, the pressure on USD/NGN since the decision has been driven more by sentiment rather than actual BDC-influenced volumes. This is because banks have not yet approached the CBN for approval to import FX in order to meet the increase in BDC demand.
On a theoretical level, some will argue that the NGN is overvalued, as evidenced by the appreciating real effective exchange rate in recent years, which they see as the prelude to a devaluation of the nominal exchange rate. We do not share this view and believe that the concept of currency overvaluation has limited practical policy implications in Nigeria’s case.
First and foremost, oil exports account for around 95% of total exports while the non-oil export base remains constrained by significant infrastructure and energy bottlenecks, suggesting that a weaker currency will not improve external competitiveness. On the contrary, it will push up import costs and weigh negatively on the current account balance. Besides, the huge infrastructure gap will eventually have to be addressed via a qualitative pick-up in imports of capital goods, especially if the privatisation of the power sector is successful. This in itself makes the case for a “strong” rather than “weak” exchange rate at this stage of the country’s development process, at least until a basic manufacturing and industrial base emerges and leads to a diversification of the export base.
Second, there is an evident relationship between poor NGN confidence, continued capital flight (taking for example the form of the fuel subsidy scam, oil revenue leakages and unexplained FX demand from the BDC market) and the absence of fiscal savings. With the ECA balance having been depleted to a mere USD2.5bn in Jan (0.8% of GPD vs a median fiscal savings-to-GDP ratio of 65% among major oil producers), Nigeria will remain vulnerable to oil boom and bust cycles. Besides, FX reserves have also gradually eroded (USD43.2bn on 28 Jan) and net portfolio flows probably turned moderately negative lately. But even if the exchange rate was hypothetically moved to the 200 or 250 levels, the same quasi-fiscal distortions and confidence issues would persist should the current policy and institutional status quo continue. Hence it is almost useless to devalue a currency that remains under pressure because of an intrinsic inability to accrue meaningful oil savings in the ECA and/or SWF and systemic deficiencies in fiscal management. The focus should be on the cause rather than the effects.
Third, the oil price has remained robust in recent years (USD109.0 pbl on 29 Jan), mitigating a drop in production in 2013. We see limited downside risks in 2014 as global growth and demand recover and offset concerns about the trajectory of US shale gas output. This implies that despite the absence of oil savings and a loose federally consolidated fiscal stance, Nigeria and the NGN should still muddle through. Additionally, significant portfolio outflows are less likely to materialise as long as there is no decline in the oil price below the USD100-95 pbl level. However, since the effective oil fiscal breakeven point now exceeds the actual oil price, a relative – but prolonged – downward pressure on commodity prices in the long run would make Nigeria’s macroeconomic and fiscal positions unsustainable.
In terms of tangible investment opportunities, we continue to like the carry trade in Nigeria and recommend the 6-m and 12-m T-bills. The recent risk aversion in emerging markets, coupled with a pre-emptive domestic positioning, has contributed to the upward re-pricing of the T-bill curve, with the yield on the 364-d tenor reaching 13.8% on 30 Jan. Given that we still do not envisage a qualitative move higher in USD/NGN in 2014, this looks like an appealing re-entry point.
If anything, the risks to the MPR, SDF and SLF rates (maintained at 12%, 10% and 14% at the 20/21 Jan MPC) have shifted to the upside as Nigeria needs to preserve the competitiveness of its fixed income assets vs other emerging countries that also experienced a larger FX depreciation and would theoretically offer more value should risk sentiment improve. And while the increase in the CRR on public sector funds to 75% (from 50%) should not necessarily be seen as monetary tightening, since it is offset by a lack of meaningful new OMO sterilisation, it will at least contain system liquidity in coming weeks – after the 4 Feb withdrawal – and anchor T-bill rates at attractive levels for the time being.
That said, we are less constructive on duration in an environment marked by a weakening of emerging market long-dated bonds and also a likely pick-up in supply domestically as well as an anticipated preference for the short end of the Nigerian curve ahead of the 2015 elections. In this context, it is difficult to imagine how FGN bonds could realistically rally below the 13% mark in coming months even amid a sustained single-digit inflation trend (8.0% y/y in Dec). Yet a further sell-off at the long end (Jan 22s at 13.6% on 30 Jan) will probably be capped by the bid from domestic pension funds and institutional investors which will have appetite for bonds in the 14% area and above. Perhaps the downside risks to yields would come from a shift towards a more accommodative monetary stance in the post-Sanusi period, but even in this case the compression will probably be short-lived as it will subsequently be followed by further upward pressure on USD/NGN forcing the CBN to start tightening liquidity conditions again ahead of next year’s polls.
The equity market recorded an exceptional performance in 2013, with the All-Share Index gaining 48.3% and 44.8% in NGN and USD terms (vs 20.3% for the MSCI FM). The dynamics have been muted in early 2014 as the index advanced 0.5% MTD as of 28 Jan (vs 2.0% for the MSCI FM) and was in negative territory later in the month. Ironically, the dip in MSCI FM in late Jan was also associated with a drop in the S&P 500, extending the surprisingly strong correlation between the two indices since 2012. Should the statistical relationship continue, this would still be positive for MSCI FM and the NSE (but not so much for MSCI EM) as US stocks should benefit from stronger growth and economic activity in America. There is also a favourable technical bias from the growing frontier market investor community and Africa-focused funds that simply cannot ignore the NSE. That said, we see limited interest from global emerging market funds, and more generally, investors are likely to be cautious, if not underweight Nigeria, ahead of the 2015 elections, and considering the uncertainty surrounding the transition at the CBN and concerns about the currency. Moreover, the expensive valuations of consumer names and even somewhat less attractive metrics of the banking sector (those have to be increasingly differentiated) represent a constraint on further offshore appetite. In the meantime, domestic pension funds remain largely underweight equities, a situation unlikely to change given the high yields on offer in the fixed income space.
Nigerian Eurobonds offer limited upside given their tight valuations (spreads ranging between 322 bps and 332 bps on 30 Jan) and taking into account political and fiscal risks down the line as well as the medium-term outlook for US yields; as such, we remain underweight the 18s, 21s and 23s. To be fair, the Nigerian USD bonds have proved more resilient than their SSA peers during the recent emerging market sell-off, probably benefiting from the robust domestic bid from financial institutions, but this makes them even less attractive on a relative value basis, especially if market risk sentiment were to improve. Nigeria is likely to issue new Eurobonds in 2014 as the country seeks to diversify its borrowing base which may potentially represent a short-term trading opportunity, subject to the initial pricing of these instruments.
By: Samir Gadio
