Nigeria: what next for the naira? - Capital Economics
Africa Economics

Nigeria: what next for the naira?

Africa Economics Update
Written by Virag Forizs

We think that Nigerian policymakers will have to allow the naira to weaken further in order to address mounting strains in the balance of payments. But hopes of a unified, flexible exchange rate regime will probably be dashed.

  • We think that Nigerian policymakers will have to allow the naira to weaken further in order to address mounting strains in the balance of payments. But hopes of a unified, flexible exchange rate regime will probably be dashed.
  • Nigeria’s external position deteriorated at the end of 2019; the current account deficit widened to 3.6% of GDP in the final quarter of the year as imports jumped. (See Chart 1.) The risk-off sentiment triggered by the coronavirus, combined with the collapse of oil prices, has exacerbated the strains in the balance of payments. Export earnings have dwindled and capital outflows have picked up sharply.
  • In response to tumbling oil prices, policymakers already loosened their grip on the naira in March in a controlled devaluation. The two main exchange rates were devalued; the official rate by 15% (from N307/$ to N360/$) and the more widely used Nafex rate by 3% (from N369/$ to N380/$). (See Table 1 & Chart 2.)
  • The oil market rout worsened in April, depressing Nigeria’s export revenues further. Although the official and Nafex exchange rates have hardly budged, the naira has fallen against the US dollar on the black market, from N415/$ at the end of March to N455/$ a month later (where it currently sits), widening the gap with the official rate from 13% to 20%.
  • The authorities have turned to the IMF for emergency funds to meet the country’s external financing gap which, by the Fund’s estimates, will amount to $14bn over this year. Even with $3.4bn secured from the IMF, and an additional $3.6bn in the pipeline from other multilateral partners, Nigeria would still be $7bn short of meeting its external financing needs. (See Chart 3.) Policymakers face stark choices.
  • One way to plug the gap would be to draw down foreign exchange reserves. That would take Nigeria’s FX reserves down to $26bn from $33bn in April. (See Chart 4.) Foreign reserves would probably drop below 9-10 months of import coverage that officials seem to prefer holding, making reserve drawdown unlikely.
  • High borrowing costs make tapping global capital markets prohibitively expensive. Spreads on Nigerian sovereign dollar bonds over US Treasuries, based on JP Morgan’s EMBI Index, stand at 870bp, close to the 1,000bp threshold that has historically preceded defaults. (See Chart 5.)
  • Running out of options, we think that Nigerian policymakers will have to let the naira weaken further. Looking at the long-run real exchange rate and its current level, which we have adjusted based on estimates of the use of Nigeria’s multiple exchange rate windows, we think that the fair value of the naira is around N490/$ (27% weaker than the official rate and 21% weaker than the Nafex rate). If anything, the recent collapse in global oil prices would suggest that the naira’s fair value might be even weaker than this.
  • A weaker currency would push up the price of imported goods and depress imports, helping to narrow the current account deficit and therefore the external financing gap. And the shift towards local production tallies with the authorities’ penchant for protectionist polies. Importantly, the government’s budget position would also improve with the rise in the naira value of USD-denominated oil receipts.
  • One downside of the weaker naira will be higher inflation over the coming months. Even so, we think that the Central Bank of Nigeria (CBN) will lower interest rates to support the struggling economy. We’ve pencilled in 100bp of cuts by year-end, to 12.50%. (See Chart 6.)
  • But hopes of a unified exchange rate fully determined by market forces will probably be dashed. The IMF has urged Nigeria to immediately take this step, but Nigerian policymakers do not seem inclined to do so.
  • Instead, policymakers appear to have a fundamental preference to retain a multi-tier FX regime. Talk of currency liberalization in 2017 and a unified naira rate went nowhere. And, after a recent pause in FX provision, the CBN is resuming the supply of foreign currency only for limited purposes (school fees and SMEs), retaining a segmented FX market. The naira will probably be allowed to fall, but it will remain overvalued. We’ve pencilled in a depreciation of the official exchange rate to N400/$ by year-end (10% weaker than its current level), and the Nafex rate to N450/$ (down 14%). (See Chart 2 again.)

Chart 1: Current Account Balance (4Q Sum, % of GDP)

Chart 2: Exchange Rates (NGN per USD)

Chart 3: Nigeria External Financing Gap & Funding
(IMF Estimates, 2020, $bn)

Chart 4: FX Reserves ($bn)

Chart 5: JP Morgan Nigeria EMBI Spread
Over US Treasuries (bp)

Chart 6: Consumer Prices & Policy Rate

Sources: IMF, Bloomberg, Refinitiv, Capital Economics

Table 1: Exchange Rate Windows

Window

Uses

Prior to Coronavirus

Latest
(19th May)

Forecast
(End 2020)

Official exchange rate

All government transactions, oil revenue

307

360

400

Nafex rate / Investors’ and Exporters’ Window

Investors, Exporters, All market players (foreign and domestic)

358-366

387

450

Retail Secondary Market Intervention Window

Local corporates, manufacturers

335-360

Wholesale Secondary Market Intervention Window

Mostly large corporates through banks

335-360

Bureaux De Change, invisibles, travel

Open to all

358-369

Sources: IMF, CBN, Refinitiv, Capital Economics


Virág Fórizs, Africa Economist, virag.forizs@capitaleconomics.com