Nigeria Fixed Income Weekly

The weeks that were: (Jan 20-24): DMO takes up a mouthful and CBN pivots at opening MPC

  • DMO takes up a mouthful at the January bond auction: As I noted last week, the DMO staged a replay of its December bond sale script by taking up more than it offered at the monthly bond auction last Wednesday. In specific terms, the DMO sold NGN412billion relative to its planned offer of NGN155billion as it sought to take advantage of the low interest rate environment and bulging liquidity which resulted in bid-cover ratio of 4x (December: 1.9x). The strong demand at the auction allowed the DMO more than fill its borrowing coffers at an average yield of 11.19%. down 81bps from December. My readthrough is that, as in December, the DMO is essentially bulking up its cash positions ahead of its NGN600billion FGN 2020 bond maturity in February.
  • Divergent trends across the yield curve: There were mixed tunes across the yield curve last week as the front-end witnessed a sell-off as T-bill yields climbed 41bps mostly driven by the 91-day (+112bps w/w) while the long end continued to see declines (-41bps w/w). System liquidity was robust with FAAC inflows (NGN476billion) and OMO bill maturities (NGN435billion) which helped anchor interbank rates at 4% levels. The declines in the long end reflect second order impact of the primary market sale as losers from the auction sought to cover their positions.

Figure 1: Naira Yield Curve

Jan28YC
Source: FMDQ, NBS

  • CBN returns to pragmatism on Naira liquidity, credit growth thesis is now effectively dead: At its inaugural monetary policy meeting for 2020, the CBN surprised markets with a hawkish pivot by announcing a 500bps increment in the cash reserve ratio (CRR) to 27.5% while leaving all other policy parameters constant. The released communique cited concerns over inflation which looks set to rise above the 12% threshold level that the CBN notes is inimical for growth. Furthermore, the apex bank would cite concerns over the heavy liquidity profile from maturing OMO bills held by non-bank investors as necessitating a CRR hike. While the return to the inflation excuse appears poignant, the CBN now seems to have come to terms that the liquidity deluge – which is direct outcome of its policy to proscribe local investor access to its sterilization bills- is probably not a great idea. Safe to say all the dovish talk about bolstering growth is simply illusionary stuff. However, the 27.5% CRR number is odd as presently, the effective CRR using CBN data suggests this number is 29% which sits well with commentary from most banks. This is not new. A fall-out of the liquidity skirmishes during the 2016-18 crisis era was that CBN would adopt an asymmetric application of the CRR with debits on incremental deposits but now rebates for drops in bank deposits. This was even institutionalized with the dynamic CRR (DCRR) introduced in 2018.
  • FX reserves show mixed signs in January: After a momentary respite, FX reserves declined 0.2% w/w to USD38.2billion which translates to 5.3months of import cover. Curiously the CBN omitted to mention the current spot level of FX reserves at the MPC, which possibly hints at concerns over declaring that the number likely was in USD37billion territory. If this omission was deliberate, then the readthrough alongside the move to cull Naira liquidity would imply that the CBN is digging the trenches ahead of the likely FX skirmishes which lie ahead. At the IE window, after the surge in the prior week, market turnover cooled (down 73% w/w to USD600million) with an average daily number of USD120million.

The Week ahead (Jan 27-31): CRR debits to drive uptick in placement rates, short-lived sell-off across the curve

  • In the week ahead, system maturities are at NGN925billion split between OMO (NGN695billion) and NTB (NGN230billion) implying an NTB auction on Wednesday and OMO sale on Thursday. The CRR debits are likely to be effected on Thursday which would see the CBN potentially cull anywhere between NGN800billion to NGN1trillion out of the banking system. As noted earlier, most banks are operating at effective CRR well clear of 27.5% due to CBN’s asymmetric application of this policy which would suggest limited impact. However, the devil is in the details, as the CBN could employ a very flexible definition in computing bank obligations under this CRR with the end goal being to cull Naira liquidity. Whatever the case, this is consistent with the zero-cost thinking behind liquidity management and would clearly force interbank rates high with likely selling pressure on front end yields as banks seek to fund CRR debits. Banks with positions in longer dated bonds could also be tempted to liquidate those positions. However, the scale of yield uptick is likely to be capped by investors with large cash positions but the front-end of the curve is likely to see heavy sell pressure.
  • A descent into the broken balance sheet abyss or mere fine-tuning of CBN’s strategy?
    Over the last few months, the CBN has engineered a dramatic collapse in interest rates facing local investors by proscribing access to its high-yielding OMO bill instruments. Despite the largely out-of-sync nature of the declines, as they drove an expansion in negative real yields under an atmosphere of weak external account balances, the CBN justified the move as part of grand strategy aimed at boosting credit growth to the economy. To further embellish the thesis, the CBN increased the minimum LDR ratio earlier introduced and pushed the idea that a new move to bolster credit growth and drive a structural change in the financial system by the narrative that it was getting banks to lend to the real sector. It also encouraged the belief that via its ‘heterodox’ policies it had conquered the impossible trilemma in economics by the segregation of the OMO market which allowed it cultivate portfolio inflows by offering high yields in the market.
  • However, there is another view, that the current policy settings are driven by CBN’s balance sheet problems with a large negative intermediation gap between the cost of its liabilities (driven by the large OMO bills) and low rates earned by its largest assets (FX reserves and FGN loans). To put in context, I have extracted published data on the CBN’s audited financials for the last six years (CBN is yet to publish its audited 2018 financials a whole year after) and adjusted earnings for Naira devaluation, the CBN has run up large losses in 2014-2017. Given the relative stability of the Naira in 2018-2019, and an estimated OMO bill expense of NGN1.7trillion and NGN2trillion for 2018 and 2019 respectively, it appears as clear as daylight that the CBN ran large losses in its balance sheet over the last two years.

Figure 2: CBN earnings adjusted for FX revaluation gains
CBN PL

Source: CBN, Authors computation

  • Absent a devaluation, which provides revaluation gains on FX reserves, there is no way the CBN can make turn a profit. Faced with this possibility, the CBN has to do the logical thing: cut back on OMO issuances and/or reducing the interest rate on these securities. Given the rising inflation outlook and weakening current account fundamentals, the CBN could not credibly cut back on OMO yields without driving foreign portfolio outflows which it desperately needs to stave off any NGN devaluation. Rather it needed to cut down on the OMO sales by trimming the participants hence the decision to knock off local non-bank investors. Given the high yields on offer and the implied collapse in funding costs its first decision would trigger, it needed to restrain banking sector demand: enter the hike in LDR and introduction of weekly monitoring as this would cap the scope to which banks could create OMO assets. However, as the large maturity from OMO bills from non-bank investors would ultimately find its way to bank balance sheets, this CRR is the requisite tool for CBN’s headache due its unique feature: zero cost liquidity management.
  • In my conclusion, the current monetary track is not some grand design but more a reaction to the crisis state of CBN’s balance sheet. So far external conditions have provided cover but rather than tackle the issue directly, the CBN is playing for time and hope that external conditions remain favourable. Hope is not a strategy!

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