Summary

Lower domestic oil production, higher prices for imports of refined petroleum products and capital outflows are causing foreign-currency (FX) shortages in Nigeria. In response, the central bank has scaled down its FX allocations to local companies, creating a material gap between official and unofficial exchange rates in the country.

Foreign-currency shortages at local companies pose a risk for Nigerian banks

Constrained domestic oil production, higher prices for imports of refined petroleum products and capital outflows are causing acute shortages of foreign currency in Nigeria. Nigeria's crude oil production materially declined in 2022 and the production outlook for 2023 remains uncertain despite a mild uptick in the last quarter of 2022. We understand that oil theft and a lack of investment in an ageing infrastructure are likely among the reasons for the decline in production. The country's crude production fell to an average of 1.1 million barrels a day (mbpd) between January and October 2022 (and modestly increased to 1.2 mbpd in December 2022), compared with an average of 1.3 mbpd in 2021, 1.8 in 2020 and 2.2 mbpd in 2019.

In response, the central bank, the main provider of foreign exchange in the country, has scaled down its foreign-currency allocations to local companies. This has led to a material gap between official and unofficial exchange rates in the country.

The foreign-currency rationing entails reduced, partial or delayed allocation of foreign currency to import-oriented companies, increasing the risk that these firms fail to meet their import-related payments. These commitments are typically covered by traderelated instruments (e.g. letters of credit) issued by the banks. If the company is unable to make the payment, the instruments normally would require the banks to cover from their own foreign-currency reserves the full or remaining amount of the purchase. This would potentially put their FX liquidity under pressure. Foreign-currency shortages faced by importers also limits the volume of cross-border transactions that these companies can conduct with banks, something that will weigh on bank revenue.

We estimate that the aggregate off-balance sheet trade finance-related exposure of rated Nigerian commercial banks amounted to around $9.8 billion as of June 2022, representing over 54% of their FX liquid assets. This off-balance sheet exposure includes traderelated contingent liabilities (in the form of letters of credit) that may partially or fully crystallise should corporate clients be unable to meet their payment obligations. These trade transactions are typically short-term. Specifically, for rated Nigerian banks, as of June 2022, we estimate that an estimated 36% of outstanding credit letters were expiring within the following three months, and an estimated 93% of outstanding credit letters were expiring within the following twelve months.

The banks also carry on-balance sheet trade-related exposure, which would typically be less vulnerable to FX shortages than off-
balance sheet exposure. This primarily includes regular lending (e.g. term loans and working capital financing) extended to companies active in trade transactions. However, we understand that the on-balance sheet exposure also includes some temporary credit lines extended to trade companies that face difficulties in meeting their import-related payments due to a lack of foreign currency.

Risk management practices reduce the risk to banks
Actions taken by Nigerian banks to mitigate these foreign-currency risks vary across banks and tend to be most conservative at the largest banks. Some banks have reduced the overall size of their trade exposures by becoming more selective in the type of customer or the type of transactions for which they are willing to open letters of credit. Others require clients to post a material cash deposit as collateral (either in foreign currency, or in local-currency equivalent with a buffer to cover a potential material currency depreciation) before the opening of letters of credit.
Most banks also try to avoid the risk that a client would be unable to source sufficient foreign currency by, for example, requiring clients to secure a foreign-exchange forward allocation from the central bank before the opening of a letter of credit. Foreign-exchange forwards, (where the central bank commits to sell to a corporate client a predefined amount of foreign currency for settlement at a future date at a pre-agreed exchange rate), help the central bank smooth demand for foreign exchange by moving some of the foreign currency demand from the spot market to a later date. Some banks are also building into their liquidity management the potential for a delay in the central bank delivering promised foreign currency to their clients. Another practice involves banks trying to ensure that export-oriented clients wanting to sell foreign currency prioritise their import-oriented clients.

Nigerian banks have lent large amounts of foreign currency to the central bank
Nigerian banks have placed significant foreign currency with the central bank in the form of derivative transactions (including swaps and forwards). At a time when the central bank is rationing its foreign-currency allocations to the economy, there is a risk that the
central bank may decide to temporarily prolong those contracts beyond their original maturity date. A material delay in repayment could well lead to the banks facing their own foreign-currency shortages and could constrain their ability to repay their own foreign currency liabilities.

Publicly available information on outstanding foreign-currency derivative transactions between Nigerian banks and the central bank is limited. Nonetheless, we estimate that, as of June 2022, Nigerian financial institutions (including commercial and national
development banks) had placed at least $14.2 billion with the central bank through various foreign-currency derivative contracts, including around $10.4 billion placed by rated Nigerian commercial banks.