Nigeria – Time to adjust the FX band by Razia Khan

Razia Khan, Regional Head of Research at Standard Chartered Bank

 Some stability has returned to the FX market recently

 However, this is largely because of CBN intervention

 FX reserves are down almost 12% since the January MPC meeting

 We believe the CBN will adjust the NGN FX band at the March MPC meeting

 A hike in the public-sector CRR to 100 percent is also probable

CBN ag gov, Alada

Some calm has been restored to Nigerian markets following the suspension of the Central Bank of Nigeria (CBN) Governor Lamido Sanusi earlier this year. The CBN, under Acting Governor, Sarah Alade, has stepped up the pace of its market intervention, increasing the amount of dollar sales at its bi-weekly retail auctions (the RDAS) as well as selling forex directly to the interbank market. Having reached a high of 169 naira to the dollar in the immediate aftermath of the news, USD-NGN has been more stable around the 165 level on the interbank market in recent trading sessions. The exit of foreign investors, now reassured of the CBN’s intent to maintain relative foreign exchange stability – at least very near-term – has also slowed a touch.
However, the cost to the CBN of its more interventionist stance is clear. Foreign-exchange reserves – which are only published on a smoothed basis – have fallen to $38 billion from $43 billion at the end of January. The actual level of FX reserves is likely to be lower. While this still represents a healthy amount of import cover (we estimate 6.3 months using IMF import projections), the opportunities for the CBN to replenish its reserves in the near future will be more limited. With weak oil earnings currently, and medium-term projections for a more modest current account surplus, the CBN cannot afford to sustain this pace of drawdown on its forex reserves. Market participants recognise this.
Yet the ability to commit to relative stability in the forex rate is necessary for the CBN to fulfill its price-stability mandate. This was the substance of the debate at the January Monetary Policy Committee (MPC) meeting. Should the CBN continue to tighten policy, or has the time come for it to adjust its foreign exchange band?
We believe that an adjustment in the official forex band (currently set at +/-3 percent around a mid-point of 155) is now necessary for the preservation of Nigeria’s forex reserves. Despite earlier CBN tightening efforts, the spread between the official RDAS rate (155.74) and the interbank market (165) has persisted. Reportedly, so has the spread between the interbank and parallel forex markets (172 naira to the dollar). Recognising market realities and allowing for a forex adjustment would relieve the CBN of the pressure to continue to deplete its reserves in defence of an increasingly unrealistic USD-NGN exchange rate. The CBN could recommit to a new forex level, closer to where the interbank market is already trading.
In March, forex reserves received a boost from the injection of an additional USD 1.3bn to Nigeria’s Excess Crude Account (ECA), allowing the ECA to rise to USD 3.45bn from a previous USD 2.11bn. However, the ECA is still down substantially from its 2012 levels of $11bn. Shortfalls in Nigerian oil output, relative to ambitious 2013 budget projections of 2.53 million barrels per day (bp/d), meant that the ECA was used to augment government revenue for much of last year. Given that a 2014 budget has yet to be passed, and output projections may remain optimistic (at 2.39 mln bp/d) when the 2014 budget is effective, it is unlikely that ECA savings will grow meaningfully. Budgeted output levels remain in excess of current production estimates of 2 mln bp/d.
Given the CBN’s longer-term ambition to reduce its role as a provider of foreign exchange to the Nigerian market, we believe that an adjustment to the peg at the March MPC meeting is more likely than not. In order to anchor inflation expectations, the CBN is likely to be more willing to consider the forex adjustment at a time of relative calm in the markets, rather than being forced to adjust the peg when the forex rate is under greater pressure. The adjustment may take two forms, either a widening of the band around the current mid-rate of 155, or a review of the midpoint itself. For example, moving to a +/-7 percent band from +/-3 percent, would encompass current interbank levels. A shift to a mid-rate of 160, perhaps with a more modest band widening to +/-5 percent, would achieve the same, and allow for future flexibility. Given the importance of predictability, as well as the need to avoid very frequent adjustments in the peg, we believe that the second approach – a change to the mid-rate and a modest adjustment to the band, might be preferable.
Longer-term, with Nigeria’s current account surplus narrowing gradually, the authorities may wish to adopt a crawling peg exchange-rate system, as a means of anchoring inflation expectations without creating significant pressure on forex reserves. (Under the terms of the convergence criteria for a West African single currency – admittedly not the key influence for markets at present – import cover of at least six months would be required). Given the current transition at the central bank however, with a new governor due to be appointed in June, we do not believe that long-term exchange rate policies will be formulated just yet.
Other tightening measures
Will an adjustment to the forex band preclude other tightening measures? We doubt this. Traditionally the CBN has had a preference for accompanying any forex adjustment with tightening – in order to reinforce its commitment to price stability. In this case, a rise in the public-sector cash reserve ratio (CRR), to 100 percent, from a previous 75 percent, is the most plausible form of tightening. Since the first significant hike in the public-sector CRR, in July 2013 (to 50 percent), banks have been given plenty of warning to expect further tightening. The preference of the CBN would be to see the establishment of a Treasury Single Account, which would allow public-sector liabilities to remain outside of the banking system. This would also reduce the cost to the CBN of having to mop up excess liquidity through more expensive open market operations (OMOs). In the absence of a Treasury Single Account, the CBN has long been prepared to raise the public-sector CRR to 100 percent. Given the unanimous support demonstrated by MPC members for a hike in the public-sector CRR at the January meeting to 75 percent, we believe this remains the most plausible form of tightening.
Some commentators have suggested that a move to a 100 percent public-sector CRR – effectively removing all liabilities related to public-sector entities from the banking system – would be operationally difficult. This is especially the case when accounts are maintained for transactional purposes – for the payment of salaries and other expenses, for example. With a 100 percent CRR, banks would have to source their liquidity elsewhere, in order to facilitate withdrawals from public-sector accounts. We are not sure if this represents a significant stumbling block to further tightening. With CRR increases usually only taking effect some time after MPC announcements, there might be scope – and time – to better distinguish between more transactional accounts and other banking-sector liabilities. The quantum of public-sector funds still left in the banking system, even after two public-sector CRR hikes, makes it unlikely that all of these deposits are held for transactional purposes.
Although, not our core scenario, it is also possible that the CBN may tighten the private-sector CRR to 15 percent from its current 12 percent. Although suggested by some MPC members at the January MPC meeting, and favoured by three voting members, we see this as a less likely outcome for the time being. The MPC will be meeting at a time when relative calm has been restored to the markets. With more transition underway at the CBN in June, and with the approach of elections in February 2015, there may well be a preference amongst MPC members to save the more aggressive tightening moves for when markets are especially pressured.