The Defense of the Naira : Has the Elasticity of Monetary Policy been Breached? The Economist Recently Criticized the CBN s FX Policy

Transcription

1 The Defense of the Naira : Has the Elasticity of Monetary Policy been Breached? Nigeria s ability to withstand global headwinds has been tested over the last 12 months, as low crude oil prices have, yet again, questioned the strength of its fiscal buffers. The attendant decline in federal revenue has exposed the age-long imbalance in the economy; Nigeria s import bill suggests that on average, 60.7% of crude oil receipts is used to pay for imports from abroad annually. Consequently, a larger amount of trade activity in the country is facilitated by the greenback and this exerts undue pressure on the Naira and ultimately, other key macroeconomic indicators. This report attempts to evaluate the call for an adjustment in exchange rate parameters for the third time in just 8 months, as well as convey our opinion on appropriate measures to bell the cat. The Economist Recently Criticized the CBN s FX Policy The Economist questioned the rationale behind excluding select items from the International Foreign Exchange (IFEX) market on a random basis. It opined that a dearth of local capacity to meet demand for consumables such as rice and tinned fish makes its inclusion on the barred list suspect. Finally, it expressed its bewilderment at recent policy measures adopted by Nigeria s CBN as they are in contrast with conventional methods adopted by central banks globally, who usually prop up their currencies if they are worried about inflation, or devalue to depress imports and stimulate exports. The CBN s response Nigeria needs to attain its Full Potentials The CBN, in its response, contended that the decision to remove 41 items from the FX window is not just in response to the depreciating naira but also as an opportunity to change the country s economic structure, resuscitate local production, and expand job creation. Click here for the press release. Analysis of Issues Raised Weakening Naira cum Dwindling Reserves The reverberation of falling oil prices is the soundtrack to a never ending nightmare for oil-dependent countries with weak fiscal buffers. A flight to safety by foreign portfolio investors and some other motives of reasonable magnitude (such as speculative trading on the Naira) led to a continuous depreciation in the value of the Naira against the U.S Dollars (6% year-to-date). That said, owing to the CBN s efforts to support the Naira, the nation s foreign reserves have pared 15% year-to-date even as the current level of reserves can barely cover 5 months of import, according to our estimation. 1

2 Chart 1: Movement in Gross Reserves, Brent Crude Oil Price & Exchange Rate 240 Gross Reserves Brent Price NGN/USD /1/2013 6/1/ /1/2013 4/1/2014 9/1/2014 2/1/2015 7/1/2015 Source: Bloomberg, Greenwich Research The dwindling reserves is the main cause for alarm by the Economists. They expect the CBN to take a bold step by further devaluing the currency to reflect the realities of price mechanism in the parallel market where the pair is trading at around N240/US$. This, in their opinion, is the intrinsic worth of the Naira. Is the Value of the Naira Fundamentally Justified at the Parallel Market Rate? Pundits believe that the exchange rate in the parallel market perfectly mirrors the intrinsic value of the Naira against the Dollar. Is this assumption right? In our opinion, barring any speculative motives in the parallel market, the exchange rate in this market should be a perfect contrivance to gauge market dynamics. However, this is not always true even as some investors demand for Dollar just for rent seeking. As hinted by the CBN in its response, the Naira strengthened to N190/US$ at the parallel market in the week when President Mohammed Buhari was announced the winner of the 2015 presidential election, resulting in an excess supply of the greenback in the parallel market. This suggests that many investors stockpiled Dollars with the intent to make a spread in case the local currency further deteriorates. Thus, we think that this speculative motive coupled with some other inherent reasons are adequate justifications that the parallel market rate does not fully capture Naira/Dollar trade dynamics. Inflationary Pressure; Mounting and Still Looming The devaluation has mounted inflationary pressure via increase in prices of imported commodities, thus putting CBN s primary objective (ensuring price stability) to a test. Case in point, inflation started an upswing fully in January 2015 as a result of the passthrough effect of the first round of devaluation in November 2014 (from N155/US$ to N168/US$) even as the second round of devaluation further degraded inflation numbers. The modest 10bps rise in December 2014 could be partially attributed to festive hike in prices. 2

3 Chart 2: Inflation Rate (%) from August 2014 to June Source: CBN, Greenwich Research Though, inflation rate is still at a single digit, it however hovers around the upper limit of the CBN target of 7 9%. Any further devaluation will dampen inflation outlook as import becomes costlier, a situation which we think the CBN should circumvent. CBN Policy Litmus Test The items classified as Not Valid for Forex chiefly comprise industrial goods, food products, manufactured goods and financial services. According to the CBN, the removal of these items is also an opportunity to ensure that the economy attains its full potentials. In our opinion, the defense of the Naira was the primary motive, while ensuring the country attains full potentials is just a fallout of the policy. Nonetheless, we applaud this effort to stimulate local production, create job opportunities, and thus, enhance economic growth endogenously. Our support for this is based on the strong growth in China, occasioned by its autonomy in local production, especially for commodities with sufficient local capacity. In spite of this bold step, consensus expectation, however, remains the removal of subsidy on premium motor spirit (PMS). We, therefore, benchmark the potency or otherwise of the CBN policy stance against an inclusion of PMS to the barred list. Based on our analysis, we concluded that the CBN s decision is robust enough to cushion the pressure on the Naira as c.66% of FX sectorial utilization were shortlisted in the list. On the other hand, we think that the policy will have a direct bearing on core inflation going forward due to the transferred pressure on the parallel market. Also, the burden on the economy will linger on in the near term until fiscal structures geared towards selfsufficiency are put in place. 3

4 Chart 3: Sectoral Utilization of Foreign Exchange (in %) as at Q4-14 Other Invisble Trades 13.54% Industrial, 26.10% Financial Services, 20.20% Food, 8.30% Oil, 17.30% Manufactured Products, 10.70% Minerals, 0.20% Transport, 2.80% Agriculture, 0.90% Source: CBN, Greenwich Research Our Position Diversify the Denomination of Foreign Reserves & Revenue Base After a thorough assessment of Nigeria s current macroeconomic environment, we have come to the conclusion that monetary policy alone lacks the efficacy to improve key macro indicators, as it will only delay the inevitable deterioration caused by the nation s fiscal imbalance, except fundamental fiscal policies are put in place. In our opinion, a short term strategy for the MPC at its next meeting is to merge interbank trading activity with that of the Bureau De Change operators, by removing selective access or price determination at the interbank market, thereby eliminating the arbitrage opportunity in the BDC segment of the FX market. It is however not unlikely that the apex bank will succumb to external and domestic pressures to adjust the exchange rate at the interbank in order to bridge the current gap with the exchange rate in the parallel market; a move which we think will only postpone the inevitable, as the exchange rate in the parallel market will gradually trend southwards again once poached by speculators. Also, we suggest that another approach to apprehend the dwindling reserves in the face of falling Naira is that the CBN should diversify the nation s foreign reserves based on a strict pro-rata of the currency of import settlement. We opine that keeping a large chunk of the reserves in U.S Dollars seems suboptimal since U.S. is not the country s leading trading partner any longer. This we think will go a long way in preserving the domestic currency against any disparaging dollar direction and ultimately give some respite to the dwindling reserves. 4

5 Chart 4: Composition of Foreign Reserves (in %) as at Q Other Currencies, 0.00% Swiss Francs, 0.00% Chinese Yuan, 6.43% SPECIAL DRAWING RIGHTS (SDR), 7.09% Japanese Yen, 0.02% Pounds Sterling, 2.33% Euros, 6.46% U.S. Dollars, 77.67% Source: CBN, Greenwich Research Chart 5: Percentage of Importation by Countries in Q Brazil, 2.6% Thailand, 2.8% United Kingdom, 4.9% Others, 30.5% Euro Area, 21.7% Belgium, 7.2% Netherlands, 6.6% India, 5.9% Germany, 3.3% Italy, 4.5% United States, 8.1% China, 23.6% Source: NBS, Greenwich Research Be that as it may, the crux of the matter which both schools of thought have failed to dwell on, in their arguments, is the fiscal imbalance. We opine that the sources of government revenue needs to be critically addressed by finding more sustainable and less volatile sources of income. Agriculture had been the mainstay of the Nigerian economy before being displaced by the oil boom. In spite of the recent initiatives to drive the sector, the recently rebased GDP showed that enormous room for growth exists in that space. Thus, returning government revenue to status quo and/or proper diversification of the revenue base appears imperative to alleviating the fiscal pressure in the long term. In sum, the continuous removal of items from the FX Window and a third, fourth, and possibly continuous devaluation, as well as the use of other monetary policy measures will continue to yield a dead cat bounce. Hence, the quest for a proper diversification of government revenue base and reshuffling of foreign reserves composition seem critical to the realization of long term economic stability. 5

6 DISCLAIMER AND IMPORTANT DISCLOSURES This publication is for general information only and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed in this article represent the current, good-faith views of the analyst(s) at the time of publication. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Greenwich Trust to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy, completeness or otherwise. Opinions expressed are our own unless otherwise stated. Neither Greenwich Trust Limited nor any of its officers or employees accept any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use of this report or its contents. Investments in general and, equities, in particular, involve numerous risks, including, among others, market risk, counterparty default risk and liquidity risk. This material has been issued by Greenwich Trust Limited, which is regulated by the Securities and Exchange Commission. Further clarification on any issue raised herein may be obtained by ing: research@gtlgroup.com Research Team Usoro Essien usoro.essien@gtlgroup.com Abiodun Olayiwola abiodun.olayiwola@gtlgroup.com Oluwaseun Dosunmu seun.dosunmu@gtlgroup.com Nelson Iziogba nelson.iziogba@gtlgroup.com 6