In this report, we gave our views on the currency over the short and long terms, given the rare twin-shock forcing macroeconomic adjustments across commodity exporters.
In our report titled COVID-19 “Black Swan” Event and Consequences for Nigeria (Published 14 March 2020), we highlighted the vulnerability of Nigeria’s balance of payments and fiscal accounts to a rare twin-shock coming from the C.60% slump in oil prices and the COVID-19 health pandemic. We concluded that a rebalancing of external and fiscal accounts is imminent, of which the de-facto currency peg will likely be adjusted to its fair value range of 382 to 400, and also projected that the 2020 budget deficit assumption will likely be adjusted upward from 1.45% of GDP.
Events in the past two weeks have very much played out in line with our baseline expectation as the CBN engineered a C.4% USD/NGN rate depreciation in the I&E Window, by adjusting its intervention rate upwards to 380 from 366. Also, the CBN adjusted its intervention rate in the BDC segment to 378 from 357, and raised the end-user price to 380 from 360. In the official market, we saw a much bigger devaluation, as the CBN adjusted the NGN peg used for converting government revenue to 360 from 307. On the fiscal side, the Federal Government (FG) is considering a number of measures to salvage the 2020 budget, including reduction in the benchmark oil price assumption to US$30/b from US$57/b and up to N1.5tn cuts in expenditure. Although we are in the early days of the twin-shock, preliminary estimates suggest that the FG could adjust fiscal deficit to N3.0tn or 2.0% of GDP in the revised budget that will be submitted to the National Assembly.
USD/NGN rate adjustments by the CBN
Source: CBN, Chapel Hill Denham Research
Despite the initial policy responses by the monetary and fiscal authorities, opinions are divergent on if the macroeconomic adjustments are enough to contain the external shocks. Notably, S&P ratings, last Friday, lowered Nigeria’s credit rating to “B-“ from “B”, citing that the “administration's policy responses are unlikely to be enough to mitigate the decline in oil revenue, and foreign-exchange reserve levels are likely to come under pressure”.
Q4-2019 Balance of Payments (BoP) data highlight the pre-existing structural imbalances in external accounts. Although the tacit devaluation by the CBN took the NGN towards the lower band of its fair value range implied by long run REER, we think a much deeper adjustment will be required to structurally rebalance the current account. The CBN published preliminary Q4-2019 BoP data last week, which showed that Current Account (CA) deficit for the quarter jumped by 157% qoq to a record high of $6.95bn, equivalent to 5.3% of GDP. This was largely driven by the goods component, which recorded the highest quarterly deficit (US$0.5bn or 1.2% of GDP) since Q3-2016, from a surplus of 2.4% of GDP in Q3-2019. Specifically, we observed a decline in exports (-11.0% qoq to $15.74bn) as well as a surge in imports (+17.0% qoq to $17.24bn). With the Q4-2019 tally in, FY-2019 trade surplus declined to US$2.9bn or 0.6% of GDP from US$22.3bn or 5.6% of GDP in 2018, while CA balance printed at a record deficit of US$17bn or 3.6% of GDP, from a surplus of US$5.3bn or 1.3% of GDP.
Record payments for services weighed on CA Balance in 2019
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Source: CBN, Chapel Hill Denham Research
CA deficit hit a record 3.6% of GDP in 2019
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Source: CBN, Chapel Hill Denham Research
We believe the deterioration in the current account in 2019 requires some contexts. As we have mentioned in previous macroeconomic updates, beyond the lower oil prices in 2019, the recent weakness in the trade account is partly attributable to the importation of large non-recurrent capital goods related to the Dangote Petrochemical Complex and ongoing rail projects. However, the services component requires some attention. Net payments for services have more than quadrupled to a record high of US$33.8bn in 2019 from a trough of US$8.0bn in 2016. Two services components were mainly responsible for the imbalances in this division: 1) Travel-related expenses, including business, education, health tourism and other personal travels, surged to a record high of US$13.5bn from US$1.0bn in 2016, and pre-2014 level of US$6bn. 2) Payments for miscellaneous business, professional and technical expenses, also jumped to US$14.8bn from US$1.8bn in 2016 and pre-2014 level of US$3bn.
The surge in payments for services in the past three years suggest that Nigerians have either grown richer and/or international travel is booming. Yet, per-capita income in USD is yet to recover to pre-2015 level, and international air traffic has grown at a low single digit since the 2016 recession. We believe a more logical explanation is that the huge payments for services have been partly funding the demand for items restricted from the official FX markets. CBN’s data on supply of FX provides some anecdotal evidence to support this view. Since the CBN began imposing controls, demand for FX in the BDC segment has crept up, and accounted for 35% of CBN’s intervention sales in 2019 from 0.4% in 2016 and 17% pre-2014. In fact, between 2013 and 2019, FX intervention sales at official segments (interbank, I&E Window, Invisibles, SME) have fallen by 28% to US$21bn, while sales to the BDC segment have risen by 2.5x to US$13.6bn.
Intervention sales to the BDCs have risen by 2.5x in the past six years to US$13.6bn, while sales to official segments have fallen by 28%
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Source: CBN, Chapel Hill Denham Research
How much adjustment is needed to rebalance Nigeria’s external accounts? The CBN’s strategy appears to be going after the services leakages with the recent restriction on FX sales to BDCs, while conserving external reserves for essential goods import and capital flow repatriation. The CBN justified its decision by arguing that that non-speculative end-user demand for services related payments (such as travelling) has dropped with the closure of national borders around the world to foreign travels. However, as we noted above, international air traffic is not correlated with demand for services payments. As such, we think the CBN may be underestimating the magnitude of the shock in the trade account, and overestimating the anticipated correction in the services account deficit.
The OPEC oil price war is coming at a time that global demand for oil has been eviscerated by COVID-19, with demand estimated to fall by 0.9mb/d or 0.9% in 2020E, according to the U.S Energy Information Administration (EIA). The collapse in demand has had a more material impact in the physical oil market, with Nigerian crude grades reportedly being sold at a discount to Brent in order to protect market share. Relative to countries in the Gulf region, Nigeria is a high cost producer. Based on the assumptions for preparing the 2019 budget, average production cost ranges from US$22/b for Production Sharing Contracts (PSCs) agreement to US$36/b for Joint Ventures (JVs) fields. At sub-US$25/b, some production fields are barely operating at break-even point. Hence, capital expenditure will likely be cut in line with global peers, implying that the extent to which Nigeria could ramp up production to offset the decline in prices is limited.
Production cost ranges from US$22/b for PSCs to US$35/b for JVs
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Source: Budget Office, Chapel Hill Denham Research
Against this backdrop, we have lowered our 2020E average oil price and production assumptions to US$40/b and 2.0mb/d from US$64/b and 2.05mb/d previously. The implication of this is a 40% or US$25bn collapse in exports to a US$40bn in 2020E, the lowest since 2016 (US$34.7bn). Nigeria has had two episodes of export crash in the past two decades: 34% yoy decline in 2009, and a 58% contraction between 2016 and 2014. Both episodes required a large exchange rate adjustment to rebalance the current account: 22% in 2009 and 56% between 2014 and 2017. Considering the magnitude of the current export shock, and the pre-existing imbalance in the current account, we believe the C.5.5% devaluation by the CBN is the first leg in several adjustments to come. If the past is any indication of the future, we think a c.25% - 40% currency adjustment will be needed to structurally rebalance the current account when the dust settles by year-end.
NGN typically depreciates by a wide margin when export crashes
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Source: CBN, Chapel Hill Denham Research
Are capital controls inevitable? Since the I&E Window was opened in 2017, Nigeria has become increasingly reliant on foreign portfolio inflows to build external reserves and also fund the deficit in the current account, given relatively low Foreign Direct Investment (0.7% of GDP in 2019). Prior to the oil price slump in 2014, FX inflows to the CBN averaged US$3.8bn/month, of which 90% was related to oil & gas exports. The FX reforms undertaken in 2017, particularly the opening of the I&E Window, as well as increased issuance of OMO bills, essentially helped the CBN to structurally change the composition of its external reserves. FX inflows into the CBN have averaged US$4.4bn/month since 2017, with less than 26% related to oil & gas exports. Rather, non-oil inflows accounted for the bulk of inflows to the CBN, as the Bank began selling short-dated OMO bills (with USD returns hedged by the CBN) to foreign investors to rebuild external reserves. Increased FCY borrowing by the FGN (US$9.7bn net Eurobond issuance since 2017) also helped the CBN bolster reserves.
CBN’s FX (US$bn) inflows structurally changed in 2017, but more vulnerable to capital reversals
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Source: CBN, Chapel Hill Denham Research
In our view, the CBN’s strategy for rebuilding external buffers helped paper over the cracks of weak and concentrated exports base, while it also increased the vulnerability of the external accounts and FX rate to tightening external financing conditions. By our estimate, organic external reserves stood at US$15bn in December 2019, excluding the CBN’s SWAP positon (US$8.0bn in December 2019), FPIs holding of OMO bills (US$ 14.bn in December 2019) and the revaluation of its Gold reserves in December 2019 (US$1.0bn). As the tide went out on oil and external financing conditions tightened, capital outflows have accelerated since February 2020, with the CBN estimated to have sold over US4bn in the I&E Window in the past two months. Despite the strong outflows, reserves have remained relatively resilient at US$35.5bn, mainly reflecting the receipt of the Bank of Industry’s (BOI) €1.0bn syndicated loan facility, and likely increase in SWAP position.
Organic FX reserves estimated at US$16bn in December 2019 (including the revaluation of Gold reserves)
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Source: CBN, Chapel Hill Denham Research
Given the increased risk aversion, we expect non-oil inflows to the CBN to decline substantially over the near term, with the impact likely to be worsened by weaker oil prices. Against this backdrop, we expect inflows to the CBN to fall below US$1.5bn/month, which surpasses the current average monthly outflow of US$5bn. Even in the conservative estimate of a decline in committed outflow to US$3.5bn due to stoppage of sales to BDCs, reserves will likely drop below US$20bn by year-end, if the CBN continues to defend the current de-facto FX peg without introducing capital flow restrictions. Given this background, we think the CBN is left with either increasing capital controls or allowing the NGN to adjust to the level required to structurally rebalance the current account. The CBN seems to have adopted some control measures as the first line of defence. In addition to the stoppage of FX sales to BDCs, the CBN has placed some restrictions on offshore FX transfers by individuals and businesses. While these could help conserve FX reserves in the coming weeks, we expect to see wider spread between the official and parallel market rates, which leaves room for arbitrage. Ultimately, some sorts of convergence will likely take place, which we expect to be within the range of N450 – 475/US$ by year-end.
Chapel Hill Denham Research
Omotola Abimbola
