June 15, 2023/CSL Research

• In a circular released yesterday, the Central Bank of Nigeria (CBN) announced immediate changes to the Nigerian FX market.  A few of the changes include; the collapse of all segments into the Investors and Exporters (I&E) window, the re-introduction of the ‘’willing buyer willing seller’’ model at the I&E window, the re-introduction of two way quotes with bid-ask spread of N1. The CBN noted in the circular that applications for medicals, school fees, and PTA/BTA will continue to be processed through deposit money banks but was silent on applicable rates. Also, the RT200 rebate scheme and the Naira4dollar remittance schemes will end on 30 June.  
• Following the announcement, the I&E window exchange rate closed at N664.04/US$1 yesterday 14 June 2023, after rising to as high as N775/US$, compared with the previous day’s closing rate of N471.67/US$ implying a 40.9% depreciation.  However, the end of day rate remains significantly lower than the black market rate, which sold for as much as N770/$1. Foreign Portfolio Investments (FPIs) have virtually dried up for Africa’s biggest economy with a major deterrent of fresh inflows being the country’s managed FX regime and scarcity. 
• The new administration announced the unification of the rates at the various FX windows and the commencement of a floating rate FX regime as one of the critical policies to be implemented. While we believe this is a pro-market policy that will be positive for the economy in the long term, we are concerned that the shock may be too hard on the fragile economy and the average consumer in the short to medium term. A focus on rate convergence without structural reforms to increase the supply of FX will be a case of treating the symptoms while ignoring the underlying cause of the problem which is an acute shortage of supply amidst a growing demand for FX. 

  Impact of FX unification on macro-economic indicators:  

  Inflation: Importers of eligible items at the I&E window will now have to source FX at a higher rate and will likely push the associated increased costs to the end consumers resulting in increase in the price of goods and services, especially imported goods. Consumers still processing the impact of the removal of fuel subsidies will now have to deal with an additional increase in prices of goods and services associated with a depreciation of the currency. Empirical evidence shows a strong pass-through effect of changes in the exchange rate on consumer prices. 

  Monetary Policy Rate (MPR): The Monetary Policy Committee (MPC) may keep up with increase in the MPR as headline inflation is expected to rise significantly following the fuel subsidy removal and the depreciation of the Naira.

  FX reserves: We expect improved FX liquidity and pressure on the nation’s reserve to reduce as private sector increase inflow of FX into the economy increases and the CBN needs not aggressively intervene in the FX market any longer.

  GDP growth: As we expect this to increase cost of doing business in the short to medium term and also reduce consumer demand, we expect  growth to be stifled in the short term

  Expected impact on the various sectors

Banking sector: Overall positive for banks with significant net long FX positions 

Improved profitability: Banks with significant net long FX positions make windfall gains in the form of revaluation gains whenever there is a depreciation at the I&E window since end of period reports are done using I&E window rates. 

Impact on capital adequacy: The CBN requires that banks with international subsidiaries maintain a capital adequacy ratio (CAR) of 15.0% while banks without international subsidiaries maintain a CAR of 10.0%. The minimum requirement for systemically important banks is 16.0% (although CBN is still giving a forbearance).

Following the implementation of BASEL III, an additional tier 1 capital is required for a Capital Conservation Buffer (CCB1) of 1.0% of TRWA. A Countercyclical Capital Buffer (CCB2), to be determined by the CBN periodically taking into consideration the prevailing macroeconomic conditions and developments within the financial sector may also be required. Banks have been running this in parallel with current Basel requirements?

Devaluation, in theory, challenges capital adequacy ratios (CAR) because the Naira-equivalent value of risk-weighted assets (RWA) rises as these include foreign currency loans. However, the weight of foreign currency loans in RWAs is for the most part moderate (39%-45%), and many banks will likely make windfall gains from net long FX positions which in turn boost profit and capital. ?

Asset quality: With a steep devaluation, bank FX loans to customers who have Naira earnings could deteriorate as these businesses have to service their loans at a significantly higher cost and this could lead to growth in impairments. Impairment growth not only impacts profitability but could also pose a challenge to capital adequacy. If a bank suffers an unexpected rise in cost of risk (COR) that exceeds the capacity of one year’s profits to absorb it, then that bank will be looking at writing down capital. However, banks within our coverage are unlikely to require a capital write down.

Impact on Loans: As the Naira-equivalent value of risk-weighted assets (RWA) rises, many loans may exceed single obligor limits. 

Consumer goods sector: Negative in the short to medium term 

Inflationary pressures will likely impact the players in the consumer goods sector the most. The higher FX costs for companies who previously got FX at the I&E window will lead to an increase in the cost of operations. The natural reaction would have been to transfer these increased costs to consumers, but it is unlikely that this can be done without an impact on sales volumes.  Since 2012, the Nigerian consumer has come under severe pressure. From partial fuel subsidy removals to the free fall in Naira in recent years, to the imprints left by the border closure and insecurity in food processing regions, the Nigerian consumer has been left impoverished. In response, consumers have been trading down on the value chain, switching to cheaper alternatives as living costs rise in the face of generally low-income levels. With the expected rise in inflation following this current depreciation, we expect a further tightening of the consumer purse leading to low demand.

FX losses to grow in the cement sector: The cement players in Nigeria (Dangote Cement, BUA Cement, and Lafarge Africa) have been suffering taking significant foreign exchange losses, which continue to weigh on earnings. The technical depreciation of the currency is likely to increase the cement industry’s FX vulnerability, resulting in rising production costs. We also note that the anticipated increase in costs of funds will have a major negative impact on these players’ profits. We envisage a significant price hike before the end of the year in order for the players to safeguard profit margins, which could in turn impact volumes.

Expected Low Bottom-Line Performance for telecoms operators: The telecommunications industry has also suffered large losses due to currency fluctuations, which have had a significant impact on operating expenses. The impact of foreign exchange losses on lease rental expenses, as well as the rollout of new sites, were noted as major drivers of  the increase in OPEX. We believe that a depreciation of the Naira would have a considerable impact on telecom operators’ aspirations to develop their networks, because the majority of their equipment is purchased in dollars. We expect the added pressure on costs to significantly affect the profits of the players in the sector despite the increasing digital consciousness. Overall, we expect the clamor for an increase in tariffs to become louder this year, as the telecom players try to protect profit margins.

I&E Window (U.S $/?)

Conclusion:  The policies of the new administration such as the removal of fuel subsidies and the floating of the exchange rate are pro-market policies that investors have always clamored for. Announcements of these policies have fueled renewed interest in the stock market, with a strong interest in the banks. While we believe these policies will be positive for the economy in the long term, we are concerned that the shocks may be too hard on the fragile economy and the average consumer, especially without major structural reforms in place. That said, businesses with a significant export business are likely to benefit from the devaluation and the commencement of exports from the Dangote refinery may boost FX supply to support the Naira.