Nigeria’s planned shift to a more flexible foreign-exchange regime could aid the sovereign’s adjustment to lower oil prices and support growth, although implementation may present challenges, Fitch Ratings says.
Establishing the new framework’s credibility will be key to its effectiveness in attracting portfolio flows and FDI to make up for lower oil export receipts. The Central Bank of Nigeria (CBN) on Thursday issued revised guidelines for a single, “market-driven” inter-bank FX market, open to authorised dealers and other entities.
The central bank first indicated that it planned to move to a more flexible exchange rate at its most recent Monetary Policy Committee meeting in May. The CBN’s previous policy of restricting access to the official FX market and supporting the naira, rather than risk the inflationary impact of devaluation, has been negative for Nigeria’s sovereign credit profile.
Defending the naira has lowered reserves and increased external vulnerabilities, while a shortage of hard currency has weighed on the non-oil economy. The change of policy is consistent with our view that the CBN would struggle to defend the naira indefinitely. But a backlog of unmet dollar demand (estimates range from USD4bn to USD9bn) has built up and any inability to clear a significant portion of that backlog early in the transition would hinder the effectiveness of the new framework.
The CBN will introduce a new non-deliverable forward to try to limit exchange-rate volatility under the new system, by moving some of the dollar demand to the futures market and away from the spot market. Even so, the CBN will probably have to deploy a large portion of its international reserves during the first week(s) of implementation. It also reserves the right to intervene by buying and selling FX to smooth market movements, although it has made no specific announcements about trading bands or break points that might lead to intervention.
Nigeria’s unorthodox FX policy has made raising external financing more difficult. Allowing the market to determine the value of the naira could ease this, although we think much potential FDI may remain on the sidelines until a clearer picture emerges of how the new system is functioning. Foreign investment in the domestic bond market is very low and not likely to increase in the near term.
High demand for FXafter a devaluation may also limit the benefit to the current account from recovering oil prices. An increase in FX liquidity would support a potential recovery in growth in 2H16. Nigeria’s GDP contracted 0.36% yoy in the first three months of this year, and we think this contraction has probably continued in 2Q16 due to hard currency shortages, and unrest in the Niger Delta lowering oil production.
Naira devaluation could lead to a further spike in CPI inflation, which rose to a six-year high of 15.6% in May. But we think the inflation pass-through from the official rate is limited and a fall in the parallel rate would be deflationary, which along with the increasing availability of hard currency could lower inflation.
We will assess the implications of Nigeria’s new exchange rate policy on its economy and external finances as part of our next review of the country’s ‘BB-‘/Negative sovereign rating.
Our base case for Nigerian banks is that regulatory total capital ratios will not decline significantly under the new regime. Any impact will be offset by still strong profitability and high levels of internal capital generation. The new FX regime crucially also provides access to US dollars for the banks to meet their internal and external obligations.