Unpegged and liberated

News | 7 September 2016

Nigerian_naira

Ecobank's Gaimin Nonyane says Nigeria's exchange rate reforms promise flexibility and progress, but the road ahead is far more fraught than many realise

After months of defending its policy of not devaluing the Nigerian Naira (NGN), the Central Bank of Nigeria's (CBN) governor, Godwin Emefiele, decided to adopt a flexible exchange rate system from 20 June 2016. This was welcome news for the market, which had been severely constrained by the pegged exchange system (among other things) for several months, resulting in a number of downgrades by global ratings agencies such as S&P and Moody's and Fitch.

The decision came after signs of accelerating inflation since February 2016 (well surpassing CBN's 6-9% inflation target range) and a contraction of the economy in Q1 2016. Real GDP declined by 0.4% year-on-year (yoy) compared with growth rates of 1.8% yoy in Q4 2015, and 3.9% yoy in the same period in 2015 amid the oil price slump since mid-2014 and FX restrictions, which weakened investor confidence further, hampering trade and investment activity.

Although (at the time of writing) Q2
real GDP data are not yet available,
we expect domestic demand to have remained weak during the quarter, evidenced by Nigeria's sustained weak manufacturing Purchasing Manager's Index (PMI) data:
the manufacturing PMI has remained below the 50-threshold mark (which separates expansion from contraction in firms' purchasing activity) since January 2016, reaching 44.1 in July, albeit up from 41.9 in the previous month; the composite PMI for the non-manufacturing sector has also remained below the 50-point threshold (43.2 in July, albeit from 42.3 in June), reflecting declines in business activity, new orders, customers, incoming business received, employment and level of raw materials.

 

This suggests a possible contraction in Q2, effectively putting the economy in a recession, or at most, anaemic growth.

Positively, CBN's move to a floating exchange rate policy has put Nigeria on the right path towards recovery. Under the new system, the CBN will allow the NGN to float through a single market structure in the inter-bank FX market and the secondary market, and to intervene in the market only when necessary. Effectively, this suggests that the new exchange rate policy will be a 'managed float' albeit with no pre-determined target. The CBN will also select a number of FX primary dealers who will be registered authorised dealers designed to deal with the CBN on large trade deals; FX primary dealers will also deal with other authorised dealers in the inter-bank market, improving price competiveness and transparency.

Jumping hurdles

Since the adoption of the new exchange rate policy, the NGN has depreciated by nearly 40% year-to-date, trading around NGN315-322:1US$. The flexible exchange rate has helped to narrow the spread between the official and the parallel exchange rates, reflecting reduced stress in the FX market.

While the new exchange rate system should help to provide some respite in the market, ongoing weak oil prices and weaker-than-expected oil production (undermined by sporadic militant attacks against onshore foreign oil installations) suggest that CBN is likely to remain the main supplier of FX liquidity in the market for some time, sustaining difficulties in the operating environment. Importers will continue to find it difficult to source FX to import goods, thereby constraining trading activity.

Room for optimism

However, there is room for optimism. The exchange rate reform, in addition to the federal government's expansionary 2016 budget (projected to rise by 22% over the previous fiscal year) should help to boost market liquidity and stimulate private sector activity overtime. Assuming that the CBN meets its obligations in the forwards market, this should go some way towards improving investor confidence and boosting growth prospects for the remainder of the year.

So far, the CBN has met its one-month deliverables (amounting to US$700m) in the forwards market (as of late July), but foreign investors are likely to continue to adopt a wait-and-see approach until at least the CBN can meet its two and three month deliverables amounting to US$1.2bn, and US$1.6bn respectively, by end-October. In the meantime, trading activity will continue to be constrained by ongoing shortage of FX liquidity, sustaining Nigeria's high risk profile. NGN volatility is likely to persist and the NGN is likely to trade in a wide range of NGN320-370 to the US dollar over the next three months, given still weak export earnings and investment flows.

Gaimin Nonyane is a senior macroeconomist at Ecobank

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