A week of stunning reversals

Event: Last week, the Central Bank of Nigeria (CBN) released two circulars aimed at addressing ongoing issues within the FX and fixed income market. The first circular was targeted as remittances, which comes after a renewed attack by the CBN governor on the media’s focus on the parallel market rate, while the latter announced the creation of new 90-day T-bill instrument, follows a firm dovish stance adopted by the MPC at the November meeting. Both policies appear to hint at possible CBN unease at developments across FX markets (where the parallel market premium over the IE rate widened to 28%) and fixed income markets (where short-term interest rates are testing the lower zero-bound).

FX circular suggests a desire to influence ‘private’ USD inflows: On the FX side, the CBN announced that recipients of remittance transfers now have the option of receiving USD payments (either in cash or into their domiciliary accounts), a departure from the prior practice of only Naira withdrawals which harks back to the last crisis between 2015-17. Looking at Nigeria’s balance of payments data, remittance flows to Nigeria appear sizable with the annual number over the last 15years averaging ~USD20billion (2019: USD23.5billion). However, looking through actual USD cash flow statements across the economy (available from the CBN), these huge remittances appear to be ‘invisible’ with the CBN data showing only an average of USD1.3billion using data going back to 2014 (2019: USD5.1billion).  That said, CBN also provides a sort of balancing item (called ‘other OTC purchases’) in its USD cash inflow disaggregation which I suspect largely reflects remittance inflows which are not tagged as remittances possibly due to documentation. This number averages USD13billion per annum over the last five years (2019: USD23billion). Using these two numbers, I estimate that remittance flows account for 13-15% of total USD inflows (2019: USD26billion, H1 2020: USD16billion) into the Nigerian economy. (See Chart 1 below)

Chart 1: USD Inflows across the Nigerian Economy

Source: CBN

In looking at USD inflows across the economy, I often find it convenient to classify those inflows that CBN controls or directs (oil and non-oil exports, capital flows, swaps, Eurobond proceeds, etc.) as ‘official’ flows and those inflows that CBN has no control over (domiciliary account inflows and remittances) as ‘private’ flows. Using this categorization, private USD inflows accounted for 40% of total USD inflows into Nigeria as in Chart 2 below (2019: 40%, H1 2020: 49%). During normal periods (i.e. no external account shocks) my suspicion is that these ‘private’ flows had very limited impact on FX pricing as the marginal dollar in the parallel market was an ‘official dollar’. However, in periods of FX pressures, as obtains presently, where the marginal dollar is not an ‘official’ dollar but a ‘private’ dollar, remittance flows via official channels thin out, electing for entry via informal channels.

Chart 2: USD Inflows across the Nigerian Economy

Private v Official

Following the COVID-19 shock which hurt oil prices and foreign portfolio inflows, Nigeria is facing its second USD supply shock in four years. In response, the CBN has allowed Naira devaluation at the official (-19% to NGN379/$) and IE (-7% to NGN393/$) even as it cut back FX sales to the BDC segment, which has resulted in a wider depreciation in the parallel market rate to near NGN500/$. The renewed media focus on the segment, as is the norm during episodes of FX crisis, appears to have forced CBN to focus on tackling Naira depreciation at segment. Obviously the direct route is for CBN to resume FX sales to BDC in line with historic trend, but this option is not available in the light of present FX reserve levels (USD35billion or 6months of import cover), still subdued outlook for oil inflows and the large backlog across the IE window. In all, the CBN probably does not feel comfortable enough to move to re-supply the overall FX market.

Small wins but not yet uhuru for the Naira: In interim, it needs to find ways to incentivize what I refer to as ‘private’ dollars. This is where the FX circular comes in as by mandating the USD option for recipients of remittance USD flows (who ultimately need Naira) the CBN seeks to force private USD flows into directly supply the parallel market. In the near term, the prospects of higher USD supply has weighed on the parallel market rate which has appreciated to NGN475/$. The move also potentially alters the competition between traditional money transfer agents and the fintech agents as the latter’s cost model is now likely more expensive going forward. Does this sustainably solve the current FX illiquidity predicament? Unlikely in my view, rather this will reduce the parallel market premium over the near term. We still have a fundamental USD inflow problem with the shocks to oil prices and portfolio inflows which will need a combination of higher oil prices and interest rate tightening to sort out.  By my estimates, oil prices turn modestly FX reserve accretive over USD60-65/bbl so CBN probably waiting to see if that picture will materialize.

The situation does highlight a major problem with long standing two-tier FX regimes: during episodes of supply shocks, private USD holders, who are more sensitive to valuation mispricing than the CBN, have no incentive to supply the market till the mispricing is corrected. This is a very strong argument for floating, though pending removal of surrender rights on Nigeria’s oil proceeds to the CBN, a managed float with a credible path to REER weakening is a second best option.

OMO bills resurrect as CBN bills? On the fixed income side, the CBN announced the introduction of a new security, “CBN Special Bills” citing a desire to deepen financial markets and avail itself of an additional liquidity management tool. These new bills will be of short-term duration (90-days), at a yield determined by the CBN and not available for discounting or repo at the CBN discount window. In analyzing the impact of this security, it is important to note that a day earlier the CBN hinted at the underpinning for this new instrument: a desire to refund banks of the ‘excess’ CRR debits it had made over 2020. At the end of October 2020, CBN had sequestered NGN11.9trillion via CRR debits and if you work out what the exact 27.5% CRR requirement equates to using total bank deposits, the excess CRR number is anywhere between NGN5-6trillion. By opting to refund banks via special T-bills, which will likely be rolled over, the CBN has given away its seeming unease about excess Naira liquidity. Essentially, these new instruments formalize a cash sterilization desire and the prospect of increased supply albeit means the end of the secular downtrend in rates since October 2019. You could argue that the new CBN bills are essentially a reversal of the OMO ban policy. 

Since the announcement, debt market focus has been on likely issuance yield on the instrument which I expect to be <1% levels for the 90-day NTB. Pending when the first round of sales occur, bond markets are likely to react negatively to the prospect of unanticipated front-end supply from the CBN. Bid-offer spreads widened in response to the circulars and investor demand for bonds is likely to thin out which could drive some upward re-pricing in yields over the near term. Clarity will occur once CBN commences sales of its new bills and markets digest the interest rates level which will be calm things down. 

On outlook, my suspicion is that CBN is likely to delay pushing interest rates higher at least until Q2 2021 when the economy exits recession and the only excuse for tolerating deeply negatively real rates evaporates. Furthermore, recent moves to weaken the Naira appear directed at World Bank negotiations on an USD1.5billion loan set for mid-December. Alongside, a planned Eurobond sale in 2021, CBN could get some wriggle room to manage the FX picture. But fundamentally, Naira outlook remains weak going into H2 2021 unless oil rebounds to USD70-80/bbl levels.  In my view, the combination of sizable pressure on the exchange rate, elevated inflation in 2021 (>15-16%) and thin financial system liquidity mean the CBN will look to actively normalise interest rates at some point. Presently, Nigerian debt markets are in deeply overvalued territory looking at historical nominal and real yields and at some point the sell-side of the room will dominate bullish sentiments. Going forward, market participants are now likely to be wary of pricing and could approach 2021 with the mindset that at some point CBN will look to return to the path of interest rate normalization to cultivate portfolio flows and incentivize Naira holding by Nigerians.

Chart 3: Nominal vs. Real Naira Yields

real yeilds

One more thing…

I got some questions on my last post regarding the goal of interest rate policy in Nigeria, given my arguments that inflation was driven by supply side factors. Is the goal for monetary policy to reward portfolio investors?As I noted in my last post, given the primacy of FX rate to Nigerians, it is effectively the policy anchor for monetary policy. As such monetary policy should focus on attaining a balance between a rate that ensures an acceptable medium term inflation level and non-oil export competitiveness.

How do interest rates factor in here? Interest rates represent the price of money. Money has two primary functions: as a store of value and as a means of exchange. Persistently negative real interest rates destroy the ‘store of value function’ of a currency as people look to other assets to save wealth. This is the history of Nigerian monetary policy and why most people are insensitive towards saving money in bank accounts with low rates. The Naira is merely something used for transactional purposes, a means of exchange for present consumption. Not something I save wealth for future consumption. The idea of real interest rates in the Nigerian scenario is thus to ensure that the Naira regains a store of value function vs. only the present medium of exchange use. If interest rates cover inflation, then citizens of a country’s currency have an incentive to save in that currency (vs. building wealth in USD) which curbs USD demand. The recent policy of ultra-low interest rate, under an atmosphere of external account shocks, merely fuels dollarization.  Fighting cost-push inflation requires a concerted effort at directly addressing the supply chain issues that limit productive capacity under large investment programs focused on rail, road, storage, power etc. Only after lowering inflation can Nigeria credibly transit to a low interest rate environment. In the interim, Nigeria’s interest rate policy should seek to prevent the build-up of large FX misalignments that hurt the non-oil economy. This entails an exchange rate which strikes a balance between a feasible medium term core inflation target (my opinion: 9-11%) and an FX rate (the present REER level: NGN433/$) that ensures competitive non-oil exports.    

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