The week that was (October 14-25): CBN locks out domestic investors, as inflation and debt track higher
CBN fragments T-bill market, leading to plunge in T-bill trading volumes: Following CBN’s circular in the earlier week, which prohibited bank customers with loans from participating in OMO and NTB auctions, the apex bank issued two additional circulars within the week which barred access to the local investor universe from participation in either the primary and secondary market of the OMO bills leaving them to play in the smaller NTB market. The raft of circulars which would appear to reminiscent of 2015-16 era would appear to stem from a desire to keep a lid on interest costs on CBN’s balance sheet associated with these OMO bills while offering interest rates elevated enough to whet foreign portfolio investors’ appetite to support FX reserves. In the day after the proscription circular, trading across debt markets, in particular the T-bill segment froze with wide bid-offer spreads. For context, trading in T-bills dropped to NGN74billion on Friday vs a daily average of NGN378billion between January and September 2019. This is as across the striated OMO and NTB segments there was little rationale for trading. Offshore investors and banks have equal access to the primary window for OMO bills and as such both have no incentive to trade with the other unless the former intends to exit Nigerian instruments. In the less liquid, NTB market, we are likely to see a drop in actual market trades as the entire domestic investors universe (money market funds, insurance companies, pension funds, corporate treasury departments of Nigerian businesses) have been squeezed into only using NTBs and bank placements as the means of managing any ST liquidity needs.
Figure 1: Outstanding OMO and NTB maturities
Over the week, NTB yields rose 22bps w/w to 12.73% but were lower on Friday (down 11bps) as investors scrambled to find whatever maturities where available. In a similar vein, FGN bond yields closed 10bps lower on average, as the investors embarked on duration hunting.
Figure 2: Naira Yield Curve
Source: FMDQ, NBS
Inflation climbed in September: In a reverse from the declining trend, headline inflation climbed over September (+22bps to 11.24% y/y) with increases reported across the two sub-indices: food (+34bps to 13.51% y/y) and core (+27bps to 8.94% y/y). The unexpected uptick in food inflation, coming in September, which marks the onset of the main harvest season, reflects pressures from the processed food and import basket as farm produce inflation moderated over the month. Thus, it would appear that the recent border closures are providing a stronger than expected impact on food prices. A similar uptick in monthly core inflation which printed at the highest level in 15-months, reversing a declining trend, hints at as energy prices remained essentially flat. What the September CPI report does is to drive an upward review in inflation forecasts for the rest of 2019 from toward 11% levels to a 12% target. Given the announced hike in VAT in 2020 (which will likely pass as it was cleverly included in the 2020 budget and I see little opposition to this in the rubber stamp National Assembly) as well as the now scheduled electricity tariff hike set for July 2020, the medium term inflation outlook is certainly a higher one.
Figure 3: Annual Headline, Food and Core Inflation
Source: NBS *2019 (Jan-Sep)
DMO maintains market neutral posture at bond auction, rules out Eurobond sale in 2019: At the monthly bond auction, the DMO raised NGN143billion (+3% higher than in September) at lower rates on average (-20bps m/m to 14.29%). The lower rates reflected higher system liquidity at the bond segment with the maturity of the October FGN 2019 bond which inflowed NGN234billion. In all, consistent with the pattern all year round, the DMO continued to remain market neutral at the primary bond auction. YTD, gross bond sales amount to NGN1.2trillion vs NGN912billion over 2018. Having held out the prospect of a Eurobond sale earlier in the year, the DMO finally ruled out any plans to tap global bond markets for another Eurobond. As we shall see Nigeria’s debt composition shortly following a raft of Eurobond sales in recent years, the cost implications of increased external debt mean that Nigeria will increasingly place emphasis on concessionary loans as against commercial loans.
Nigeria’s debt continues its uphill climb: The DMO released debt data as at the end of June 2019 which showed that external debt owed by the FGN stood at USD22.9billion (December: USD21billion). Including debt owed by state governments, that number rises to USD27.2billion (December 2018: USD25.3billion). On the domestic front, borrowings by the central government printed at NGN13.4trillion (+5% from December 2018) driven by higher issuance of promissory notes (+73% to NGN833billion) amid muted patterns elsewhere: FGN bonds (+4% to NGN9.7trillion), NTB (-3% to NGN2.6trillion). Using annualized H1 2019 nominal GDP figures and NGN362/$, Nigeria’s debt to GDP ratio now stands at 16.3% (2018: 15.1%). The widely watched debt service to revenue ratio printed at 50% of revenues as at the end of June 2019. Including interest expense associated with CBN financing as reported by the Finance Ministry, which stood at NGN106billion, DSR moves to 55% of reported fiscal revenues.
The week ahead (October 28-November 1): Artificial dislocation to drive inflated prices in a broken market
In the week ahead, system maturities are NGN329billion in OMO maturities and NGN242billion in NTB maturities which means there will be an NTB auction on Wednesday and an OMO sale on Thursday where both the FG and CBN will look to rollover maturities.
CBN back to playing hope-as-a-strategy: In the run-up to Q4 2019, a key concern across domestic fixed income markets was how the CBN was going to handle the deluge of liquidity from maturing open market operation (OMO) bills. Between October and February 2019 in particular, scheduled OMO bill maturities are between NGN7-8trillion. Given the pressures mounting on Nigeria’s external balances following the return of a current account deficit in the first half of 2019, alongside weakness in global crude prices, the CBN was unlikely to allow that much liquidity flow unchallenged into the financial system as it potentially held dire consequences for FX reserves and the exchange rate by extension. In the absence of clear forward guidance on how it was going to tackle the problem, markets rightly guessed that the CBN would need to invert the yield curve at the 1-year segment which forced a build-up across money markets ahead of this time. Accordingly, a pattern emerged where elevated subscriptions at OMO auctions, which the CBN could not take-up, created an arbitrage window appeared wherein participants would participate at the OMO auction on Thursday and sell same in the secondary market where yields were lower. Faced with this scenario and an inability to take out the large subscriptions, which hints at balance sheet issues for the CBN, the apex bank elected to simply shut out local investors from participating in its carry trade offering to foreign investors. As is usual, the diversionary saint-and-sinner arguments are being thrown about of companies using CBN intervention funds to participate at these OMO auctions, but it seems clear enough: we have a surfeit of liquidity in the system brought in no small part by the CBN, which could potentially have damaging impact on yields at a time the CBN is trying to signal higher rates to foreign investors.
In the immediate term, the impact of the OMO ban on local investors is three-fold: firstly, it would drive a price rally across debt instruments as excess demand from building local liquidity chases the thin supply of available NTBs. Secondly, the sudden closure of the large OMO bill market, will cascade into a dip in trading activity along the front end of the NGN yield curve. In addition, chasing duration might become attractive in the short term till FGN bond yields probably hit 12.5% given the prospects for higher inflation in 2020 from higher VAT and programmed electricity tariff hikes. In all the Naira curve will likely normalize but pricing will reflect sizable illiquidity premiums.
Beyond the near term, the CBN will have to hope that debt markets find its ‘kamikaze’ posturing to local investors credible in the face of declining FX reserves. In the event that FX reserves fail to halt the declining trend, which is increasingly likely, given the structural deficit that has re-appeared in the current account, then markets will begin to speculate on the ability of Nigerian banks to act as natural counterparties in the event of foreign sell-offs. For foreign investors, whose holdings of OMO bills exceed that of banks, the worry is how to exit an instrument whose only buyer are banks faced with increased LDR requirements that mandate reducing T-bill holdings. Clearly there will have to be an illiquidity premium applied on OMO bills going forward.
On a more structural level, the increased frequency of circulars speaks to the elephant in the room: the exchange rate has held at NGN360/$ levels for three years propped by the CBN putting its balance sheet on the line via elevated OMO bill sales. That balance sheet now appears broken at a time we have the initial signs of structural current account deficit problem in the offing. Fixing this balance sheet is the underlying issue and provocatively a devaluation might be part of the solution. As is the case with trade-offs across economics, amid declining FX reserve levels, the CBN will soon need to clear up its cognitive dissonance and decide whether it intends to tighten for FX or commit to whole-scale easing under a pretext to support growth, we will be watching.
- OMO: Open Market Operations
- CP: Commercial Paper
- DG: Deputy Governor
- NTB: Nigerian Treasury Bill
- FGN: Federal Government of Nigeria
- CBN: Central Bank of Nigeria
- DMO: Debt Management Office
- PBoC- Peoples Bank of China
- PMA: Primary Market Auction
- FAAC: Federal Accounts Allocation Committee
- I&E: Investors and Exporters Window
- MPC: Monetary Policy Committee
- NBS: National Bureau of Statistics
- REER: Real Effective Exchange Rate