Stall in reform momentum and lower net FX reserves unnerve markets, but we remain cautiously optimistic
Freeze to fuel prices is a pause on the reform path rather than a reversal as no subsidy payments should exist at current prices
We estimate net FX reserves at US$3.7bn, significantly lower than prior estimates, owing to larger-than-expected currency swaps and borrowing against existing reserves
Structural BoP deficit means authorities need to implement reforms that will attract steady external funding, but in the near term the CBN has the ability to source FX at commercial and semi-commercial rates
Lower net FX reserves reduce the willingness to introduce a flexible exchange rate regime in the near term
High private and moderate public sector external financing needs will keep Nigeria reliant on external financing for the foreseeable future
We remain MW Nigeria in the EMBIGD Model Portfolio and neutral on local markets, but on the balance of risks will be looking for opportunities to add in the near term.

Apparent stall in reform momentum and lower net FX reserves than expected unnerve markets, but we remain cautiously optimistic. Nigeria’s sovereign bond prices declined by 2.5-5pts across the curve since the Central Bank of Nigeria (CBN) published its audited financial accounts late last week. Also, the decision to freeze petrol prices at current levels resulted in concerns that fuel subsidies may have been reinstated, further weighing on asset prices. That said, the announcement of a cabinet which appointed technocrats in key positions, such as the Ministry of Finance may slow the eurobond price decline in the near term, even if a likely slower pace of reform implementation could limit bond upside from here. The foreign exchange market will remain in focus given the likely lower starting point for net FX reserves, with an overall balance of payments deficit pointing towards continued FX pressure.

Reform fatigue or pause to reassess? Nigeria's new administration had a blistering start in June, enacting key reform measures including the removal of fuel subsidies,followed by significant adjustments in the FX market. Since then, petrol prices have more than doubled and the naira has depreciated by c.40% against the dollar in the official market. However, in recent days the spread between the parallel market (900) and interbank exchange (770) rates have widened, while the president this week announced there will be no further increase in petrol prices. While we think the FX market could benefit from better price discovery, we do not interpret the freeze on petrol prices as a reversal of the subsidy reform for now. This is because we estimate that at current average retail prices (NGN617/ltr), crude oil prices (US$85/barrel) and the parallel market exchange rate (900), authorities are not currently subsidising petrol (Table 1, here). However, invariably, a further rise in these key variables and government’s insistence on keeping petrol prices flat will result in a return of subsidies.

Pace of reform implementation set to slow, but formation of the cabinet is a positive. While we think the government remains committed to major reforms relating to fiscal adjustments (revenue mobilisation and expenditure rationalisation), FX market reform and oil sector revamp, the pace and momentum could slow given the significant inflationary impact on the population. The president has named his cabinet, which includes some technocrats in key positions, such as the Ministry of Finance (also doubling as the Economy Ministry) and the creation of new ministries of priority such as tourism, digital economy, as well as steel development. Furthermore, junior ministers were appointed to the now split ministries of petroleum and gas resources, suggesting a continuation of the previous administrations approach where the president appointed himself as the Minister of Petroleum and Gas Resources. That said, most other cabinet positions were dominated by politicians.

We expect headline inflation to continue moving higher as reform impact continues to feed through. Headline inflation rose to 24.4%oya in July, from 22.8% in June, just shy of our 24.5%oya expectation and higher than consensus forecasts for a 23.6% lift. On a month-on-month basis, inflation rose by 2.9% from 2.1% recorded in June. Food prices remained the major driver, rising by 3.5%m/m (multi-decade high) from 2.4% in June (Figure 1). Transport and utility prices also surged during the period, rising by 2.8%m/m and 2.6%, respectively, from 2.4% and 1.6%. We believe July’s inflation print is early evidence of the impact of the fiscal and FX reforms which are likely to continue pushing headline inflation higher over the coming months. Higher parallel market rates in recent weeks are also likely to have an impact on August’s inflation reading and will be most notable in higher food and core prices. The core inflation measure (excluding food and energy costs) rose by 20.5% in July, from 20.1% recorded in June.

We now see headline inflation rising towards 28%oya by year-end. Although we expect inflation momentum to start downshifting from 4Q, headline inflation will still remain elevated, particularly on higher food costs. The president’s decision to keep a cap on petrol prices is likely to provide some relief but the exchange rate is likely to remain on a depreciating path and put further pressure on prices, with the impact more broad-based. The CBN has had to tighten monetary conditions by hiking the monetary policy rate (MPR) by a token 25bp last month, while narrowing the corridor around the MPR. Also, the CBN conducted its first Open Market Operation (OMO) this year while charging a cash reserving ratio (CRR) on banks that fall short of its target loan-to-deposit ratio of 65%. Going forward, we think the CBN might focus on using other tightening tools, as opposed to raising rates via the MPR. As such, we keep our call for an unchanged MPR at 18.75% for the rest of the year.

Reading the tea leaves from the CBN’s audited financial accounts
The good - The Central Bank of Nigeria has remained profitable. Last week, the CBN released its financial accounts after several years of hiatus. It showed that the central bank remained profitable and has a positive net assets (equity) position as of end-2022. Total assets have recorded significant growth over the past few years, up to NGN57.9tr (US$129.4bn), from NGN15.5bn (US$78.7bn) in 2015. This was largely driven by significant fiscal financing of the government for which total claims on government rose to NGN30.1tr as at March 2023, from just NGN2.7tr in 2015. It is noteworthy that the government has concluded the re-profiling and restructuring of the bulk of the said overdrafts, reducing the interest rates to 9% (from policy rate + 300bp previously), three-year moratorium on principal repayments and a 40-year maturity extension. The new instrument is likely to remain on the CBN’s balance sheet. However, the CBN’s short-term FX liabilities and obligations were the most talked about post the release and the main catalyst for the market sell-off.

The bad - Net FX reserves are significantly lower than previously estimated. Based on partial information from the audited financial accounts, we estimate that CBN’s net FX reserves were around US$3.7bn at the end of last year, from US$14.0bn at end-2021. In arriving at said estimate we make a few assumptions which if incorrect would substantially change the picture. They include: (i) an addition of US$5.0bn in IMF Special Drawing Rights (SDR) to external reserves in order to arrive at total gross FX reserves of US$37.8bn, broadly in line with the 30-day moving average of US$37.08bn previously published on the central bank’s website; (ii) adjusting the gross external reserves with three key FX liability lines that include FX forwards (US$6.84bn), securities lending (US$5.5bn) and currency swaps (US$21.3bn); and (iii) estimating currency swaps by backing out FX forwards and outstanding OTC Futures balances from an overall aggregate published in the financial accounts.

The (not so) ugly - Low net FX reserves mean continued FX market pressures, but the CBN still has the ability to source FX at commercial and semi-commercial rates. Given the highly profitable nature of the currency swap arrangements between the CBN and domestic commercial banks we expect these to continue for sometime, albeit in smaller sizes and arguably more punitive rates. Furthermore, authorities are in the initial stages of identifying assets for sale, which may provide some medium-term relief. For example, the President’s policy advisory council has recommended the government sell down its stake in the most joint-venture oil and gas assets, a proposal that is estimated to bring in up to US$17bn. In addition, the recently announced US$3bn loan to NNPC could help partly improve FX liquidity conditions in the market. We expect NNPC to sell the dollars to CBN and remit the naira proceeds to the government as upfront payments for oil revenues and taxes. That being said, the large external financing needs of the private sector will sustain FX pressure.

Strategy: Net FX position makes an FX float less likely and halts Eurobond upward price momentum
Nigeria’s exchange rate market remains fragmented (see here). Since the adjustment of USD/NGN at the Investors and Exporters window (now renamed Nigeria Foreign Exchange Market - NFEX) a few weeks ago, interbank FX liquidity has not improved as much as anticipated, partly due to the re-introduction of de-facto controls limiting local trades above 800 and loose monetary policy conditions. Also, the CBN continues to intervene in small amounts at a rate around 740-750, without clearing the backlog of unmet FX demand. Furthermore, the parallel market rate has widened to around 900 due to a combination of seasonal summer increase in FX demand and renewed loss of confidence in the local currency by locals. All this is further compounded by revelations that the central bank’s net foreign exchange reserves may be lower than initially thought.

Lower net FX reserves reduces the ability and willingness to introduce a flexible exchange rate regime in the near term. Owing to a structural balance of payments deficit in Nigeria, and a worse starting point for net FX reserves than previously anticipated (see above), authorities’ ability to transition to a significantly more flexible exchange rate regime is severely hampered. The process of rebuilding reserve buffers is likely to be protracted as significant reforms are needed to attract foreign direct (and portfolio) investment on a multi-year basis. Perhaps short-term fixes could involve a swift improvement in oil output and significantly tighter monetary policy - authorities will have to increase the frequency of OMO auctions, which resumed last week. In the meantime, we remain on the sidelines, but on balance of risks we now believe selling USD/NGN NDFs may be the next trade given the reduced likelihood of further significant near-term FX adjustments.

A lower-than-anticipated net FX reserves position unnerved eurobond markets ending the period of positive reform momentum euphoria. Bond prices declined 2.5-5pts across the curve since the CBN's financials release (Figure 3). The main point of contention behind this price action has been a lower than initially anticipated net FX reserves position where some clarity is still awaited. While gross reserves at $37bn is a positive, higher short-term liabilities do raise a concern in case of roll-over pressures and thus, an increased risk premium is warranted. The recent news around the potential re-introduction of the fuel subsidies at some level (see above) has also raised concerns. That said, already higher oil prices and a relatively flexible exchange rate than pre-May could eventually mean a relatively lower impact. Nonetheless, given the recent spate of concerning newsflow, sovereign bonds could remain under pressure. EMBIGD Nigeria STW has already seen some retracement of the sharp tightening that happened post the speedy reform execution by the new administration (Figure 4). That said, the announcement of a cabinet which appointed technocrats in key positions, such as the Ministry of Finance may slow the price decline in the near term. We are cautiously optimistic on reforms but acknowledge near-term FX-related pressure and remain MW Nigeria in the EMBIGD Model Portfolio.

High debt-servicing needs and relatively lower net FX position make it imperative to continue on the reform path to attract FX flows. While Eurobonds only start maturing from 2025 onwards with continued maturities from 2027 (Figure 5), Nigeria still has to service close to $2.5-$4.5bn of public and publicly-guaranteed debt over the next few years (Figure 6). Along with a structural BOP deficit, this would mean higher FX needs in coming years. With a relatively lower net-FX position providing limited space to plug this gap and borrowing costs on the expensive side with potentially no market access, Nigeria wo uld need foreign direct and other portfolio investments to attract FX inflows. Thus, in our view, continuing on the reform path would be imperative to allay concerns on the external side.