MONDAY, 25 OCTOBER 2010 

The onset of the global crisis, concerns about Nigerian banks, falling equity markets, the liquidation of Nigerian assets by offshore investors, and US dollar (USD) gains all impactedon the Nigerian Foreign Exchange (Fforex) markets, increasing demand for forex. After the Central Bank of Nigeria (CBN) restricted forex sales, dollar-Naira spiked higher, eventually resulting in the reestablishment of a parallel foreign-exchange market.

 

The Niger Delta crisis, which had caused levels of Nigerian hydrocarbon production to fall since mid-2005, and the simultaneous collapse of oil prices, from over $140/bbl to $40 bbl, did not help confidence.

 

But this time, things are different. Although the NGN has been pressured in the interbank market in recent weeks, briefly trading above the higher end of the +/-3% band around the 150 level thought to be preferred by the CBN, fundamentals are mostly in better shape. Oil has recovered since the crisis and trades within a stable range.

 

The offer of an amnesty to Niger Delta militants last year allowed Nigerian crude output to recover to its best levels since 2006.  Nigeria has a comfortable current account surplus, and given expectations of a resumption of quantitative easing by the Fed, emerging and (to a lesser but still-significant extent) frontier markets the world over have benefited from a surge in capital inflows, with pressure on their currencies to appreciate.

 

The NGN, however, has stood in isolation from this general trend of USD weakness. Despite favourable fundamentals, Nigeria.s forex reserves have been falling, not rising. Even against what is commonly believed to be a subdued economic backdrop, importer demand has increased, and the CBN . usually responsible for around 30% of the forex supply to the Naira market . has found itself under pressure to increase forex sales in order to defend current levels of the Naira. Nigeria.s political backdrop, more contentious in the run-up to 2011 than is usually the case, may be feeding importer nervousness about the continued stability of the Naira.

 

So far, the policy response (which has included a tightening of monetary policy, targeted Open Market Operations (OMOs), increased FX sales in response to higher demand at the bi-weekly official Wholesale Dutch Auctions (WDAS), as well as occasional forex market intervention between auctions) has largely succeeded in keeping the forex rate stable, but at a cost. Given the accompanying decline in forex reserves, policy measures to date have not yet succeeded in restoring full confidence in the Naira. Despite different fundamentals then, memories of late 2008 are still fresh in the minds of many importers.

 

In 2008, the CBN initially accommodated increased forex demand, only to put in place sudden and dramatic curbs on forex sales as the pressure on forex reserves mounted, thus worsening the Naira crisis.

 

Although the CBN believes that much recent forex demand has been legitimate . associated with a surge in rice and fuel imports . market sentiment has played a significant role in driving dollar-Naira higher, with much forex demand front-loaded.

 

Anecdotally, forex commitments not due for several months, in some instances years, are being brought forward. In this report we consider Nigeria.s economic fundamentals, the policy options still open to the central bank, and the outlook for dollar-Naira.

 

Forex demand spikes higher despite a weak growth backdrop

Analysing the sustainability of forex demand

The sudden surge in importer demand that initially fed greater volatility on the Nigerian interbank forex market remains difficult to square with sub-optimal economic growth. Nonetheless, there are a number of plausible explanations behind this rise in importer demand:

 

•  The recent granting of credit notes to fuel importers by the federal government, which could be discounted at commercial banks, restored the creditworthiness of oil marketers, allowing them to increase fuel imports. Even given the weak economic backdrop, this would have accounted for some of the rise in importer demand.

• Restocking and the associated rise in demand for imports ahead of Christmas are likely to have contributed to a seasonal rise in importer demand.

• Although the sharp increase in government spending ahead of the elections may only impact growth with a lag, more liquid market conditions appear to have fed into increased forex demand even sooner.

 

The CBN has made clear that it saw little evidence of speculative demand, citing dividend payments by telecom companies and increased gasoline and rice imports rather than capital flight for the rise in forex demand. Nevertheless, increased market reliance on CBN, rather than .autonomous. forex sales (forex made available from other sources) is likely to have fed market nervousness, fuelling speculation of an forex shortage and prompting importers to front-load FX demand.

 

Official data for the months of January-August 2010 indicate that the CBN supplied approximately 27.1% of the USD 52bn of inflows to Nigeria.s forex market, with .autonomous sources. (oil companies, international institutions, and remittances) accounting for the rest. More recently, however, the CBN has provided a larger share of the forex supply to the market, which may itself indicate an underlying nervousness and market expectations of further Naira weakness.

 

The decline in autonomous forex inflows suggests that exporters have been delaying forex sales, in the belief that they might obtain more favourable dollar-Naira rates if they restrict forex supply for long enough.

 

In the absence of action from the central bank, increasing forex sales and tightening Naira liquidity (making it more expensive to borrow locally), such expectations might have become self-fulfilling.

 

WDAS auction system may be biased in favour of NGN weakness

Part of the problem lies in the nature of Nigeria.s official bi-weekly forex Wholesale Dutch Auction System (WDAS), which creates a bias in favour of exchange-rate weakness. Under this system, banks put in bids for forex on behalf of their clients.

 

The CBN will not necessarily know the full extent of market demand, ahead of deciding how much forex to put on offer at each auction (although the central bank might call around the market, to get a sense of the extent of forex demand). Foreign exchange is then allocated to the highest bidders until the amount of forex allocated to the auction is fully exhausted.

 

The cut-off in the forex auction represents the marginal bid . the lowest rate at which forex is allocated until the funds on offer are fully used up. Not all bids for forex will be satisfied, however. When demand spikes, some orders will not be filled. If this happened for several consecutive auctions, market panic would readily set in.

 

Under the WDAS forex auction system, it is especially important for the central bank to commit to meeting market demand in full, to sustain any given dollar-Naira rate. Because the auction cut-off represents the lowest successful bid, most bids for forex are likely to have been settled at higher dollar-Naira rates, and the interbank market will normally trade at a higher rate than that determined by the WDAS auction. Risks are therefore asymmetric, with a higher likelihood of the NGN weakening than strengthening. A more stable FX system would mean market participants taking on 2-way risk when putting in place FX positions. But under the WDAS auction system, especially when there are doubts about the capacity of the FX supplier to guarantee unlimited supply, things can frequently appear to be a one-way bet.

 

Such a system can only succeed in ensuring FX rate stability if the supplier of FX is comfortably able to anticipate and meet market demand in full. In this case, it would require the CBN to stay ahead of the market, and pre-empt any spike in forex demand.

 

Possible solutions

Develop a forwards market, tighten policy, and remove controls on short-term capital inflows. Although evidence from recent WDAS auctions suggests that the CBN – responding to higher forex demand – sold more forex than the amount it initially had on offer, its earlier record in pre-empting greater market demand has been patchy. However, there are a number of solutions that might help in restoring some calm to the forex market:

• Discussions aimed at establishing a forward market in Nigeria are currently underway. With no means of hedging future risks, importers have been front-loading their forex demand, creating more pressure on the spot market and a more rapid drawdown of official forex reserves. The ability to enter into a forward contract for forex might relieve at least some of the panicked demand currently affecting the spot market.

• The low level of interest rates in Nigeria has allowed for the pre-payment of forex loans, by replacing forex borrowing with Naira-denominated loans. The ability to borrow cheaply in local currency has made it easier for importers to fund their forex demand. It has also allowed the autonomous suppliers of forex to delay any conversion of forex earnings into Naira, by borrowing to meet their local currency obligations.

•  While raising interest rates further would influence domestic demand for forex, attracting short-term capital inflows is likely to be more difficult. Regulations requiring investors in Federal Government of Nigeria (FGN) bonds to obtain a Certificate of Capital Importation (or CCI), effectively force investors to keep their funds in Nigeria for at least a year.

 

The net result is that Nigeria does not attract as much portfolio investment as it might in the absence of such „lock-up. regulations.

 

So even if domestic interest rates spike higher, as has been the case in recent trading sessions (20-year  yields are now 14%, double what they were only a few months ago), there are fewer offsetting yield-seeking inflows from offshore.

 

Yet such inflows – currently driven by a powerful global dynamic inspired by expectations of renewed US quantitative easing – may prove an important mitigant for the current strain on Nigerian forex reserves. The authorities should reconsider CCI regulations, especially in light of the swing in Nigeria.s fiscal balance from a comfortable surplus to deficit, in order to accommodate increased pre-election spending. With bond yields at risk from a larger domestic borrowing requirement, easing capital account controls would facilitate offshore financing of Nigeria.s fiscal deficit.

 

Equally significant is that it might help to ensure greater stability in the forex rate.Nonetheless, given the recency of Nigeria.s regulatory intervention in its banking sector, investors may question the authorities. appetite for much higher interest rates.

 

We consider the likely influences on future monetary policy decisions below, looking at whether there might be a trade-off between Fforexmarket stability and the conditions that are required for a banking-sector recovery.

 

Understanding the recent tightening of policy

In response to revised inflation data, resulting from the adoption of a new CPI basket with a lower food weighting, (inflation spiked to 13.7% in August, although it has since declined a touch to 13.6% y/y in September), as well as evidence of a surge in liquidity resulting from steep increases in government spending, the CBN announced a tightening of monetary policy at its last MPC meeting in September, stating that it would:

• Resume OMOs for the purposes of targeted liquidity management

• Raise the Monetary Policy Rate (MPR) by 25bps to 6.25%

• Adjust the lower corridor around the MPR to 300bps below the MPR from the rate of minus 500bps previously. This effectively raises the rate on the standing deposit facility at the CBN – the rate at which banks deposit money with the CBN – to 3.25% from a previous 1% (to 6.25% – 300bps, from 6% – 500 bps earlier)

• The upper corridor around the MPR, the rate on the Standing Lending Facility of the CBN, was maintained at the MPR+200bps. However, given the hike in the repo rate, the discount rate effectively increased to 8.25% from 8.00% previously.

 

How should these measures be interpreted? The actual 25bps hike in the MPR was modest, and may not have been intended as much more than a token move, a signal of the authorities. tightening intentions. Actual tightening . and the influence on market interest rates . was more likely to result from the narrowing of the lower corridor around the MPR, as well as from targeted OMOs.

 

Prior to the CBN.s September 2010 MPC rate decision, overnight rates would typically vary between 1% and 8% depending on market liquidity. With the tightening of the band around the MPR, this was reduced to 3.25% -8.25%, allowing for more effective transmission of the authorities. policy stance (although market imperfections do occasionally allow interbank rates to trade outside of the higher end of this range .

 

Banks do not want to be seen as frequent borrowers from the CBN window, and might prefer to borrow interbank, even at a higher rate. Rates for unsecured lending are even higher).

 

A steeper hike in the MPR might have exerted more influence on bank-loan rates, but this was clearly not the intention of policy makers in September, with the real aim being to tighten market liquidity selectively rather than risk deterioration in already weak credit conditions.

 

For the forex market however, a key consideration is likely to be whether it will be possible to raise interbank rates without worsening the outlook for economic recovery. In the market.s assessment, this is likely to influence how far interest rates will rise, which in turn should have some impact on forex demand.

 

Assessing inflation threats . how far will interest rates rise?

Perceptions of the extent of the inflation threat are therefore important. The inflationary risks that might have prompted the MPC.s surprise tightening in September are diverse, and range from generalised concerns around the amount of pre-election spending, the anticipated new electricity pricing regime due in November, the implementation of a new salary structure in the civil service, and not least, expectations that the long-awaited Asset Management Company (AMC or Amcon), tasked with removing bad loans from banks. balance sheets, will finally be operational.

 

For many market observers, surprised by the September tightening, the policy action was seen as a pre-emptive move, in anticipation of a further injection of liquidity once the AMC or Amcon becomes operational. Although the Amcon is expected to start buying banks. Bad debts within three weeks, and money supply is already growing, for now monetary aggregates remain below CBN benchmarks for the year. Moreover, y/y private sector credit growth, hit particularly severely by the base effect and last year.s regulatory directive that banks bring bankers. acceptances and commercial paper back on to their balance sheets, appears to have slumped.

 

Even leaving aside the base effect, and the distortions associated with the regulatory action necessary to distinguish the healthy Nigerian banks from the less healthy a year ago, the current sluggish nature of credit growth makes it difficult to overplay the inflation risks of money supply trends.

 

This might all change following Amcon.s purchase of bad assets. For now, the bad debt overhang continues to constrain new credit growth in the banking sector.

 

Nonetheless, with inflation already in double digits following the revision to the CPI index, and with the feed-through from a potentially weaker NGN likely to be considerable, the authorities cannot afford to ignore the risks posed by the FX rate. In our assessment, banking-sector concerns will not be sufficient to prevent any tightening of policy, should it be thought necessary.

 

These concerns did not preclude a rate hike in September, even prior to the debt buy-back of the Amcon; they are unlikely to prevent future tightening once the Amcon is operational and Nigeria’s rescued banks are recapitalised. Interest rates will rise if FX market and inflation risks require monetary tightening. Initially through select, targeted OMOs but eventually through more policy tightening, too. Given banks current exposure to the FGN bond market, and the correction in yields already underway, we believe that any tightening will be only gradual. But if FX risks persist, policy tightening will become more of a sure thing.

 

A crisis of confidence

Taking a big picture view, things should not be this difficult. Although Nigeria.s FX reserves are down from earlier peaks, its level of import cover is still healthy. The front-loading of import demand amid a still-subdued growth backdrop suggests that import demand may run out of steam in the near term, with the CBN increasing its FX sales and the level of panic in the market subsiding. The development of a forward NGN market, currently underway, may be the precursor to further market liberalisation, although regulatory changes. Such as reforms to the current CCI framework. Might be needed to attract greater offshore inflows. With the bond market pressured by greater issuance, and foreign investor exposure to FGN bonds minimal relative to pre-crisis levels, the authorities should give this serious consideration.

 

Ultimately however, a full restoration of confidence in the FX market would need foreign-exchange reserves to start rising again. On this front, the near-term outlook for future inflows is at least positive. While there is some uncertainty over whether the licensing of oil blocks will go ahead by the end of the year (this was to involve at least 2bn barrels of oil reserves, although budgeted to net the government a conservative USD 880mn according to press reports), other FDI-related inflows to do with Nigeria.s power-sector reforms, and the privatisation of the state-owned Nitel are also expected. Flows related to some foreign acquisitions of rescued banks are probable, although these may be more small-scale and the process has already been considerably delayed. Lastly, Nigeria is expected to tap international capital markets with its maiden Eurobond of USD 500mn later this year.

 

The inflows are anticipated, but the reasons behind the lack of new accumulation of foreign reserves are unclear. The rise in FX demand is relatively recent. The drawdown of Nigeria’s excess crude savings would have been a negative factor, but even this does not explain adequately why FX reserves have not shown new improvement. Locally, there is talk of arrears of the state-owned Power Holding Company of Nigeria (PHCN) being paid down ahead of sweeping power-sector reforms. There was also some suggestion, in the aftermath of last year’s Niger Delta Amnesty that the Nigerian National Petroleum Corporation (NNPC) arrears on the joint venture payments due to international oil companies needed to be paid before reserve accumulation could get underway. Whatever the reasons, the opacity around Nigeria’s FX reserves and public finances, especially the commitments of state-owned enterprises, does not help.

 

Conflicting media reports about the commitment of the CBN to run down reserves to defend the currency also weighed on sentiment. While the CBN has since taken steps to clarify its position, comments about ¡°multiple equilibria in exchange rates¡±, and current levels of the NGN not needing to be ¡±maintained at all costs¡± might have fed importer nervousness. Nonetheless, the position of the CBN is now clear, as evidenced by their recent action in the FX market, where demand has been met in full, with the CBN frequently selling more than the amount in had initially put on offer at the bi-weekly Dutch auction. With a healthy current account surplus, often thought to be in double-digits as a % of GDP, it is difficult to see why Nigerian reserves cannot be replenished. For now, it is key to the restoration of confidence (and the unwinding of banks. net open positions).

 

Source: BusinessDay