What expert says: Nigerian naira overvalued or undervalued?

Johannesburg, South Africa (Capital Markets in Africa) — The interbank rate was seemingly unmoved at USD/NGN197 in 2Q15, masking the intense backlog of US dollar demand. It is difficult to discern whether domestic liquidity conditions have improved since the election. The MPC’s rhetoric regarding the imbalance in the domestic foreign exchange market continues to favour exchange controls to restrict excess US dollar demand. Partial dollarisation and bouts of speculative activity are believed to have aggravated the existing liquidity squeeze, reinforcing the need for special intervention FX auctions to satisfy legitimate demand. We remain partial to a flexible and price-driven market and believe that the CBN could allow the currency to weaken in an orderly manner, following its continued application of administrative measures to curb US dollar demand.

As our core scenario, this implies a 3Q15 USD/NGN end rate of 248.00 and a year-end level of 217.00. Presumably, this scenario would be more digestible for offshore investors, especially if the oil price remains buoyant at current levels and the naira settles around 220.00. Alternatively, the bank could undertake a once-off devaluation, but this risk unsettling an already unnerved market. An increase in the NOFP from 0.1% to 0.5% could glean good will from J.P. Morgan if daily trading volumes improve, allowing GBI-EM index positions to be more easily replicated. However, two-way trading will be severely hampered by the preclusion of a greater number of importers from the interbank foreign exchange market. The decision to withdraw Nigerian bonds on account of FX-liquidity constraints is unchartered waters for J.P. Morgan. If Nigeria is ejected from the index, it brings into question the credibility of J.P. Morgan’s selection process.

The MPC voted to retain the benchmark interest rate at 13% in May 2015 but elected to change both the public and private sector cash reserve ratios (CRR). The tightening effect, elicited by the harmonisation of the CRR, will prove far more useful once the Treasury Single Account is adopted. We had expected a clear narrative with regards to the central bank’s exchange rate policy but this was not forthcoming at its last MPC gathering. The CBN continues to ration foreign exchange based on its assessment of legitimate demand, but the chronic drawdown in gross reserves, which were reported at US$28bn in June, brings into question the bank’s ability to match interbank orders indefinitely.

While we remain partial to a flexible, price-driven market, the CBN is likely to remain the key provider of liquidity to the economy. That said, we do not expect any changes to be enacted at its meeting in July. Governor Emefiele highlighted that the CBN will continue to review its current approach to FX stability and will amend its process when needed. Further monetary tightening is warranted in 2H15 considering the upside risks to inflation and sustained widening of the output gap. The policy rate might be used to signal the CBN’s intention, though a more formidable stance would entail changes to the current workings of the foreign exchange market. As an aside, the central bank’s management committee is not exempt from change, but the APC is expected to safeguard the independence of the central bank and ensure policy consistency to dispel market concerns, at least in the short term.

By Nema Ramkhelawan-Bhana, Africa Analyst, Rand Merchant Bank, South Africa