BTMU Economic Brief | July 2016 1

BTMU Economic Brief

Nigeria – Making Sense of the Naira’s Devaluation

AMIR KHAN ECONOMIC RESEARCH | LONDON T: +44-(0)20-7577-2180 E: Amir.Khan@uk.mufg.jp

The Bank of Tokyo-Mitsubishi UFJ, Ltd. A member of MUFG, a global financial group

JULY 2016

n 15 June, the Central Bank of Nigeria announced that it will replace its current currency peg arrangement – as part of which the Nigerian naira (NGN) was held stable within a narrow band of 197-199 against the US dollar since March 2015 – in favour of a market-determined exchange rate regime. In doing so, the currency fell to the tune of

around 42% in the first week that it was allowed to trade freely. As we will highlight in this note, while this adjustment was much needed and is likely to boost Nigeria’s growth and investment prospects in the long-run, in the more immediate-term, it will not be without its costs. A much needed adjustment…

While, within the emerging markets context, Nigeria is not the only oil producing nation that, faced with the oil price crash, has succumbed to the temptation of devaluing its currency recently – Russia, Angola and Kazakhstan have already gone down this road – the move is still highly significant and has been driven by a number of key factors:

To begin with, low oil prices and a marked slowdown in capital inflows have created acute foreign exchange (FX) shortages, exacerbated in recent months by militant attacks on oil infrastructure that have severely disrupted oil production. In May, oil output fell below 1.5m b/d, the lowest level in 27 years. The FX regime had become increasingly misaligned with fundamentals, failing to compensate for adverse price developments in the oil market (see Chart 1), on which the country is dependent for around 90% of its export revenues.

The economy contracted by 0.4% y/y in the Q1 of 2016, while the jobless rate has risen to over 12% as low oil prices, fuel shortages and FX restrictions have hampered the functioning of the economy. Foreign capital inflows, particularly investment have dried up, and currency reserves have shrunk to around US$27bn from a figure of above US$40bn at the start of 2014 (see Chart 2), further eroding Nigeria’s external buffers.

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In our view, the introduction of exchange rate flexibility will be positive for investment and growth, and reduce the NGN overvaluation, something which is already evident from the sharp narrowing of the discrepancy between the actual value of the currency versus forward-looking market gauges of its price (see Chart 3), though the expectation is for this trend to run further. This development, in turn, should ultimately help to preserve Nigeria’s much-needed FX reserves and signal to the market that the country has a strategy that will support growth and development over the medium-term. Furthermore, a weaker NGN should help to ease fiscal pressures by boosting the naira value of oil revenues. That said, the benefits of this policy change will, however, take time to materialise as the NGN finds its equilibrium level and investors become more comfortable with the new FX regime. Developments in international and local oil markets, and Nigeria’s ability to attract foreign capital inflows are likely to be important determinants of how the NGN is valued in the future.

…But the move will not be without its costs at least in the short-term…. While a move towards a more flexible exchange rate is well intentioned, the reality is that the economy is likely to endure painful adjustment process, as the devaluation pushes up import costs and adds to already elevated inflationary pressures. Headline inflation has surged this year, rising to a six-year high of 15.6% y/y in May. This is far higher than the Central Bank of Nigeria’s 6-9% inflation target range. A substantially weaker NGN risks inflation moving even

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Brent crude (LHS)

NGN per USD (RHS)

(NGN)

(MM/YY)

(US$/ barrel)

(Source) Macrobond

Chart 1: Despite the sharp tail off in global oil prices, the currency was maintained within a narrow band until

recently...

After being kept within a tight band, the decision to allow the currency to float has seen it fall >40%

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Chart 2: ...And this was done by tapping into the country's FX reserves

(US$ billions)

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Actual ex. Rate

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(Source) Bloomberg(MM/YY)

(US$/NGN - inverted)

Chart 3: The difference in the actual value of the naira versus market based measures of its price has seen a sharp compression

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higher. Mindful of this, we are of the view that a complimentary monetary policy tightening will be needed to respond to the worsening inflation outlook, anchor inflation expectations and to underpin the currency. But while an interest rate rise has not been forthcoming since the changes to the exchange rate regime were announced last month, it is worth noting that the policy rate was increased by 100bps in March to 12%. Despite this move, however, the policy rate continues to lag the prevailing rate of inflation (see Chart 4) which, at 15.6%, means that the policy rate in real – or inflation adjusted – terms remains in negative territory (-3.6%). While this appears to suggest that rates in Nigeria have to rise by upwards of 300bps for the policy rate to reach a level that would bring it closer to neutral levels, in reality we do not see rates rising much beyond 200bps in H2 of this year, especially given the still difficult economic environment in the country, which we think will serve to restrain the hand of the central bank.

Separately, it worth stressing that with the position of the Nigerian household sector increasingly coming under strain recently thanks to, among other things, rising inflation and unemployment – a development which may, at least in the short-term, get worse on the back of the currency devaluation – there is a real risk that this could undermine popular support for the Buhari government going forward, such that it negatively impacts the country’s political stability and the prospects of much-needed reforms. Indeed, if recent opinion poll findings are anything to go by, Buhari’s approval rating has fallen from around 80% at its peak (October 2015) to around 64%, as at May this year. While this was to some extents expected, given the huge scale of the challenges that he faces – ranging from tackling insurgency groups such as Boko Haram and the energy crisis besetting the country – the reality is that, given the protracted nature of some of these problems, if he continues to lose popular support, it will make the task of addressing such problems that much more difficult to achieve.

Finally, in light of Nigeria’s currency devaluation, there is a fear in some quarters that this will make the repayment of external debt more difficult. In this respect, while the growth in external debt in recent years is certainly disconcerting, the point to note is that as a percentage of GDP the country’s external debt remains manageable at around 5% (see Chart 5). Additionally, it is also worth pointing out that – at around US$27bn – the country has sufficient FX reserves to cover its short-term external debt1 by a factor of slightly over 2. Notwithstanding this, vigilance is still required, as there has been increasing preference among Nigerian banks to engage in

1 According to IIF estimates this stood at almost US$13bn as at the end of 2015.

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Real rates (Policy rate - CPI)

Policy rate

CPI (y/y)

(Source) Macrobond(Year)

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Chart 4: Inflation hovers above the policy rate with the result that rates remain in negative territory on an inflation-adjusted basis

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dollar denominated lending in recent years, a development which, under a weaker FX rate, may over time bring loan deterioration, with higher system NPLs.

Concluding thoughts

We welcome the decision to devalue the naira last month and, if anything, feel that it was long overdue, especially given the collapse in global oil prices which – under the Nigeria’s previous pegged exchange regime – the country’s oil dependent economy has struggled to adjust to. Also, Nigeria’s experience during the course of this year reveals all too clearly that, under such an exchange rate arrangement, the need to defend the currency peg during times of uncertainty can prove to be rather costly in terms of using up a country’s valuable foreign exchange reserves. That said, we do not see the decision to move to a more flexible exchange regime on the part of Nigeria as a panacea to all the country’s current economic and other ills. For these to be addressed, the country’s president, Muhammadu Buhari – in keeping with his campaign promises – still has the difficult task of rooting endemic corruption, restoring order to the country’s public finances and defeating the threat posed by the likes of Boko Haram and the Niger River Delta militants, which continue to destabilise the country and ultimately hold back much-needed FDI into the country.

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Total external debt (LHS)

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(US$ billions) (%)

Chart 5: Nigeria's total external debt has been on the rise but as a proportion of GDP it remains manageable

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