The Week that was (April 26-May 7, 2021)
Apologies for the radio silence as I was under the weather last weekend but good to be back. Its been a slow fortnight events-wise but the overall pattern across debt and currency markets remain intact: rising rates and a false calm across the official FX markets amid ongoing USD shortages which is fuelling wider parallel market premiums. Focus is on the FX markets.
Tight liquidity conditions continued to drive interest rates higher: Liquidity conditions across domestic financial markets remained tight which has pushed more banks into the CBN’s discount window where average daily net lending by banks climbed to NGN250billion (prior week: NGN198billion). This compares with a net deposit position by banks all through the first three months of 2021. As a consequence, interbank interest rates remained high with OBB and O/N rates closing the week at 14.75% and 15.25% while short term placement rates for large institutional investors have now moved towards 11-12%. The pressured liquidity conditions filtered through to the fixed income market with front end NTB rates up 36bps over the week to 3.05-8.04%. 1yr OMO rates are around 9.95% in the secondary market while the May 31 SPEB securities are at 6.53%. Bond yields climbed 84bps on average to 10.5-14.2% across the curve as the combination of tight interbank funding and the prospect of higher borrowings continued to drive bearish sentiments across the bond market.
Figure 1: Naira Yield Curve
Source: FMDQ, NBS
FX markets: Ignoring the lessons of history: In 2020, Nigeria’s FX markets ran into trouble as the covid-19 outbreak hurt oil prices and drove a dip in USD inflows to Nigeria’s external reserves. Unfortunately the policy response is a jarring reset to the 2016 episode. Then, as in now, the CBN reduced official USD supply (by ceasing its fortnightly WDAS auctions as well as dollar sales to BDC operators), fixed the exchange rate (by hardening the peg in the interbank market at NGN199/$) and introduced multiple FX tiers. In the current episode, history appears to be repeating itself as the CBN has reduced its own USD sales across FX markets, reinstated some peg control over the IE window rate which always closes at NGN410/$ as well as allowed the reappearance of multiple FX windows. In discussions last week, it has come to my knowledge that, the CBN conducts weekly sales to BDC operators at between NGN393-395/$ for retail end-users who promptly sell at the weaker parallel market rate. So you have three broad tiers though recently, the FGN announced that it would now convert official dollar proceeds at the NGN410/$ IE rate vs. the old official rate of NGN379/$ on the CBN website. Rounding off the hazy system is the increasing conduct of dollar transactions within the wider economy at the parallel market which is anywhere between NGN485-500/$ depending on whether its cash or wire transfer. In summary, the present FX system is broken with lower activity in the official IE window.
Figure 2: Average Daily Traded Value
Source: FMDQ *Jan-April
With official dollar liquidity now at a trickle, the CBN needs to stop the defensive ‘ostrich-in-sand’ approach and take the bold actions that the current situation requires. As I’ve noted previously, Nigerian policy makers must learn to take actions less out of fear but calculated risks. This is not to make light work of genuine concerns about a possible backlash from a citizenry addicted to the false sense of stability engendered by a populist political class. We must have the courage to act!
So what must we do now? In 2020, the dual oil price and covid-19 shocks might have provided a genuine excuse to adopt unconventional tactics. With the swift rebound in oil prices and appearance of a working covid-19 vaccine, focus must now be on a speedy return to normalcy across FX markets. To my mind, this will entail three steps:
- Firstly, to gain credibility the Nigeria will need to bolster FX reserves to a number (possibly close to USD40billion) that allows for a strong intervention to credibly clear FX backlogs. This can be achieved via sizable Eurobond sales or FX borrowings (USD3-6billion) taking maximum advantage of approved plans within the 2021 budget. With oil prices at USD60-70/bbl this action will help improve market perceptions about CBN’s ability re-supply the market.
- The second step, which could be pursued concurrently, would be to tighten monetary policy via a combination of rate hikes, CRR debits and active OMO activity. Unlike the 2017-19 tightening episode, the CBN should avoid turning liquidity management instruments into investment instruments by keeping their tenures short (30-90days) and making the timing of these auctions linked to large liquidity events (vs. a not a predictable cycle). Given DMO’s flexibility around the tenor of debt issuance and imminent convergence between NTB and OMO yields, there is a sufficiently large security supply to meet the investment needs of domestic and offshore portfolio investors. In terms of interest rate levels, the goal should be to raise the rewards for holding Naira to a level that covers the short-to-intermediate outlook (6m-1yr) for underlying inflation trends. To build confidence, the CBN should look to regularly communicate to its internal outlook for its preferred inflation target (which in my view should be core inflation vs. headline which is driven by food) and move key front end market rates towards these levels via its liquidity management operations.
- Thirdly, the CBN must be prepared to allow an adjustment in the spot Naira rate possibly towards some level consistent with its own REER estimates (NGN430-440/$). This devaluation/depreciation need not be a one-swoop adjustment but a gradual approach making use of the forward and futures market to appropriately tailor market expectations.
These measures should be accompanied by prompt discontinuation of the multiple FX windows – in particular the continued USD sales to BDC operators at NGN393-395/$ as these agents are essentially round-tripping these dollars to the parallel market. No matter the good intentions, these sales greatly undermine the credibility of the CBN as they create the impression that the apex bank is directly funneling profits to these BDC agents. Over the medium term, the main lesson from the 1997 Asian financial crisis is that emerging/frontier markets must deliberately look to grow FX reserves, at the expense of modest FX devaluations. It is better to have a large reserve position (a stick) than be looking to offer extreme carry trade differentials (carrots) to manage your currency, Nigeria must learn this lesson.
The week ahead (May 10-14, 2021)
In what looks like a short trading week with Ramadan holidays on the cards, the main inflows are NGN118 billion worth of NTB maturities and NGN20billion in OMO bill maturities. As such there will be an NTB auction on Wednesday to rollover the maturities and I believe the 1-yr stop rate should finally print at 10% converging with the OMO stop rate. Nigeria appears to be in the process of getting a Eurobond show underway. More should come out over the month of May. For interest rates, focus is likely to shift towards the bond auction next week and CBN’s MPC meeting in the subsequent week. Markets are likely to remain dull as investors prefer to play the primary market relative to the secondary market.
BDC – Bureau De-Change
CBN – Central Bank of Nigeria
MPC – Monetary Policy Committee
NTB – Nigerian Treasury Bills
OBB – Open Buy Back
OMO – Open Market Operations
O/N – Overnight
REER – Real Effective Exchange Rate
SPEB – Special Bills
WDAS – Wholesale Dutch Auction System