The exchange rate has remained under pressure in recent weeks, as capital outflows persisted and domestic confidence remained poor, a trend further reinforced by a gradual – but continued – concomitant decline in foreign reserves. The suspension of CBN Governor Lamido Sanusi on 20 Feb added to concerns about the independence of the central bank and its ability to maintain proactive policies ensuring macroeconomic stability. Yet this development has not really translated into an extra layer of disorderly foreign selling of fixed income and equity assets so far, as one could have initially expected. Perhaps the CBN’s FX interventions in recent days and a reiteration of the commitment to exchange rate stability by Acting Governor Sarah Alade helped ease fears of an imminent devaluation via a shift in the mid-point of the RDAS band.
Meanwhile, the USD/NGN interbank exchange rate appears to have found a new level in the 164-165 area (164.5 on 6 March), but it would have definitively trended higher without direct CBN USD sales to Nigerian banks. The central bank has intervened more vigorously, and at an earlier stage even on an intra-day basis, especially as it sought to reassure the market after the change of leadership at the apex bank. The CBN has also continued to provide USD via its RDAS window (a median of USD400m per auction lately) and resumed FX forward sales to reduce the immediate pressure on the currency.
Nevertheless, FX reserves have steadily decreased, with the pace of the drop accelerating in Feb amid higher direct CBN FX sales and a negative portfolio flow balance. Indeed, the 30-d moving average FX reserves position reached USD39.7bn (around 8.7-m of merchandise import cover on our estimates) on 3 March, from USD43.6bn in late 2013 and a high of USD48.9bn on 3 May. Given the slope of the FX reserves 30-d moving average, the latest figures are probably closer to the USD36bn mark. This would bring us back to the nominal levels recorded in Aug 2010 (USD35.9bn) and not far from the historic lows of around USD32bn posted in 2011. It is however important to note that foreign holdings of Nigerian tradable assets amounted to less than USD4bn in early 2012, of which the fixed income category accounted for roughly 10%. As of Jan 2014, the offshore portfolio balance was closer to USD19.5bn (versus USD20.5bn in Nov 2013), and even if it possibly reduced by a couple of billions or so in Feb, the downside potential for aggregate reserves is more significant than three years ago. This must however be nuanced since real money accounts, in particular those tracking the GBI-EM index, will most likely remain underweight, but will not entirely exit the market; the same applies to equities clients, especially frontier market and Africa-focused accounts (besides, a downturn in the equity portfolio balance would reflect both lower valuations and intrinsic outflows).
That said, the key question is obviously how long the CBN can afford to defend the exchange rate amid a deteriorating FX reserves position and what would be the inflection point below which it would depart from this stance. With a heavily managed currency regime, an unsustainable downward trend in FX reserves is generally the prelude to a devaluation, as a qualitative drop in confidence and positioning against the local unit eventually force the central bank to adjust the exchange rate anchor. Some may refer to the sharp slide in FX reserves in late 2008 as the oil price collapsed and foreign investors pulled out, which simply made it impossible to protect the 117-118 USD/NGN level. Yet the difference this time is that the oil price has remained robust in recent years and that capital outflows have been more gradual (albeit picking up in Q1:14). Besides, as we have always argued, a devaluation will not help address the enigmatic question surrounding the fair value of the NGN and will certainly not improve external competitiveness in an economy where oil accounts for 95% of exports. Should the CBN/MPC eventually decide to push up the mid-point of the FX band (currently +-3% around 155), we suspect the move in the RDAS rate will be moderate, albeit possibly at the expense of the interbank rate overshooting for some time.
Still, decisive steps will be required to stop or at least slow the erosion of FX reserves, restore confidence in the market and boost the competitiveness of Nigerian fixed income securities. Even though emerging FX markets seem to have stabilised and recovered from previous losses lately (Brazil, Turkey, South Africa, Indonesia, etc…), and GBI-EM yields generally drifted lower in Feb, after a multi-month sell-off, the relative move in Nigerian assets over the period still makes them less appealing for foreign investors at this stage.
In this context, a sharp tightening in monetary and liquidity conditions is urgently required if the CBN wants to effectively protect current USD/NGN levels. Whether the central bank will hike the MPR and CRR on public and private sector funds at the next MPC meeting on 24/25 March, and even possibly resume a wave of more aggressive OMOs in the short term, will certainly weigh on the fortunes of the NGN. A neutral monetary stance and policy rate decision would however probably compound upside risks to USD/NGN. It would also reinforce the perception that Nigeria is increasingly behind the curve in terms of monetary tightening vs emerging market peers following a series of hikes in policy rates which in most cases took place to support the exchange rate and boost the incentive to hold local assets.
Looking forward, there is likely to be increased market speculation about the FX and interest rate stance of the CBN Governor designate, Godwin Emefiele (CEO, Zenith Bank). While the MPC decision process has been institutionalised in recent years, and the Governor cannot unilaterally impose his views, he still retains some critical influence in determining the direction in monetary policy. We suspect Godwin Emefiele will soon find himself in a similar dilemma of driving independent and tight monetary policy, while facing the same inefficiency challenges coming from the fiscal side. After all, the root cause of the weak confidence in the FX regime remains the marginal level of fiscal savings which is a function of a loose federally consolidated fiscal stance and/or alleged oil revenue leakages. This is evidenced by the collapse in the ECA balance (USD2.1bn in Jan), despite favourable external fundamentals, and points to a fiscal breakeven point exceeding the Bonny Light price itself (currently USD110 pbl) and well above the USD79 pbl oil price benchmark in the 2013 budget (USD77.5 pbl expected in 2014).
Given the heightened uncertainty in the Nigerian FX market, yields at the short end will have to back up further to compensate international investors for the prospective risk of NGN depreciation. This adjustment process seems to be underway, as the 364-d T-bill printed at a yield of 15.6% at the 5 March auction and given that this tenor is now trading around 14.9% (6 March) in the secondary market, but the upward re-pricing is probably still not sufficient. Thus a hike in the MPR would be useful since it would automatically push up the SDF rate which is the natural floor for the 91-d T-bill; this will have to be combined with CRR and OMO-related measures to curb excess liquidity in the system. Ironically, even if the exchange rate were to be eventually devalued, this would still have to be associated with a subsequent move higher in yields to restore some sort of market stability.
We remain less constructive on duration despite the firm single-digit inflation path (8.0% y/y in Jan). The rebound in yields has been constrained by the bid from domestic pension funds which has helped cap rates around 14% (Jan 22s at 13.9% on 6 March). But this also means that the upward re-pricing at the long end has been less pronounced while there are limited supporting factors that may result in FGN bond yield compression in the medium term. As the country moves closer to the 2015 electoral cycle, investors will probably want to play it safe and will prefer the short end instead. Although the net issuance of bonds has remained benign lately, a trend that the DMO expects to persist, the general market perception is still that the volumes of bond issuance may increase later this year.
The equity market stabilised in late Feb, after a drop in the first part of the month that mirrored the renewed pressure on the exchange rate. The NSE All-Share Index has lost 4.0% and 7.8% YTD in NGN and USD terms (as of 5 March), vs -4.6% and +2.8% for the MSCI EM and MSCI FM indices. Yet this disappointing outcome follows a period of substantial outperformance of Nigerian equities in 2013. Clearly the main source of downward pressure on the NSE comes from the currency weakness experienced lately and the less certain FX outlook rather than specific stock valuations (even though those had become expensive in some sectors [for example, consumers]). While the recent modest recovery in bank stocks may indicate that the market believes hikes in the CRR are now less likely, downside risks potentially stem from the level of foreign currency exposure in the sector and FX mismatches in the loan book. Additionally, concerns about the political and institutional environment ahead of the 2015 elections will also weigh on confidence in the equity market. On the upside, we suspect the NSE will remain supported by the bid from the growing frontier market investor community and Africa-focused clients which cannot ignore the Nigerian market. As domestic pension funds are still largely underweight equities, the risk that they may unwind their positions is also not a particular concern. As such, this will probably place a floor on the performance of the NSE All-Share Index this year, barring more significant than expected FX or political shocks.
Nigerian Eurobonds advanced in late Feb in line with a more supportive global risk environment, having previously lost ground from mid-Jan. With their spreads ranging between 324 bps and 330 bps on 6 March, we still feel the valuations of the 18s, 21s and 23s remain tight considering the institutional, political and fiscal risks expected over the next year, and that the bonds will have to trade wider to the Angola 19s and Gabon 24s. Granted the Nigerian Eurobonds will remain underpinned by the bid from domestic banks and are unlikely to sell off aggressively, especially as further pressure on the exchange rate will make these USD assets a natural hedge for onshore entities, but there is simply no obvious catalyst for further spread compression even assuming that US rates do not rise in the near term. Perhaps some extra support will come from the lack of new sovereign Eurobond issuance this year, which will offset previous concerns about the potential increase in Nigerian USD bond supply in offshore capital markets.
By: Samir Gadio
