Reserves Fall below Resistance Level, Bank of America Downgrades Currency-Linked Instruments

Sanusi Lamido Sanusi, suspended Central Bank of Nigeria (CBN) governor has continued to affect the country’s external reserves negatively, in or out of office. While in office, the obsession of the disgraced central bank governor to maintain a single-digit inflation rate and have a strong and stable naira at all cost has reduced the level of reserves. Even, while in suspension, Sanusi, a largely foreign media celebrated hero is still dragging down Nigeria’s external reserves.
The external reserves have fallen to such an extent that, analysts say it is below the psychological resistance level of $41 billion because of the increased frequency and magnitude of CBN intervention in support of the naira.
In this turmoil, the unprecedented and unusual removal of the CBN Governor did not help matters.
“The naira had been under speculative attack in the past four months. With this level of external reserves, Bank of America has downgraded the Nigerian currency-linked instruments on fears of further value hemorrhage in the market”, said Bismarck Rewane, chief executive officer of Financial Derivatives Company (FDC) Limited said in his bi-monthly report. But the Economic Intelligence Unit (EIU) insists that the naira is safe for now.
Given the high sensitivity of the Nigerian economy to exchange rates, the acting governor, Sarah Alade, has reiterated that she will pursue the monetary policy bias and stance of Sanusi, at what cost? However, in order to achieve a feat that is gradually becoming insurmountable, the CBN will have to hemorrhage its external reserves level.
Nigeria’s external reserves, currently at $41.05 billion, have depleted 5.87 percent Year-to-Date (YTD) and 15.98 percent compared to 2013’s peak of $48.86 billion.
“It is only a matter of time before the CBN loses the currency war and allows the naira to weaken”, wonders Rewane.
The naira currency has exhibited significant volatility on interbank markets since the suspension on February 20th of the Central Bank of Nigeria (CBN) governor, Lamido Sanusi, by the president, Goodluck Jonathan. This has prompted speculation as to the fate of the naira’s loose peg to the US dollar, a policy which Sanusi had been a keen exponent of. Although there will be big changes at the CBN in the coming days and weeks, the policy preference for exchange-rate stability is expected to be maintained.
However, given adverse economic fundamentals, it also seems likely that there will have to be some movement in the peg during the next year or two.
Prior to the suspension announcement in the morning of February 20th the naira had been trading at around N163/$, but the announcement saw a spike to N169/$, before trading on local currency and capital markets was suspended. When markets reopened on February 21st the naira recovered to around N166/$ with the CBN selling dollars. The CBN has long managed the naira within a target band against the US dollar, as a hedge against inflation but also because senior policymakers have historically viewed a strong currency as a source of national pride. Currently this band is about three percent either side of N155/$. (The interbank rate then trades at a slight premium to this.)
“We expect this central policy plank of naira stability to be maintained regardless of who heads the CBN. Therefore, we believe that the recent volatility will soon settle down, a sentiment that the finance minister, Ngozi Okonjo Iweala, has been keen to press. In a statement released late on February 20th she commented that the change at the CBN would not divert policies aimed at helping the naira to stabilise.
However, whereas short-term currency stability seems likely to return, some analysts expressed serious doubts about the naira’s medium-term prospects. Others believe that, since change is the only permanent thing, the in-coming central bank chief may have even more interesting policies.
The CBN does allow periodic adjustments to avoid any rapid running-down of foreign reserves, a move that seems increasingly likely later in 2014 or 2015. Sanusi did adjust his stand when there appears no solution at hand. The last such adjustment took place in 2011 when the marker was shifted slightly from N150/$ to N155/$. Larger revaluations were carried out at the height of the global financial crisis in 2008‑09, when the naira target was moved from N120/$ to N150/$. Although the 2011 devaluation helped Nigeria’s reserves to recover over the next year, they fell from $48 billion in the first quarter of 2013 to $43 billion in January 2014.
The economy, and with it confidence in the currency, has been adversely affected by lower oil prices, faltering oil production and political uncertainty. We expect the oil sector to continue to underperform both this year and next.
Meanwhile, political uncertainty, having been exacerbated by the upheaval at the CBN, will continue to increase ahead of the 2015 elections. On top of this will be the effect of the US tapering of its monetary stimulus.
Portfolio investment inflows surged into Nigeria during 2011‑12 and much of 2013, but will fall significantly in 2014‑15, both owing to investor concern about events in Nigeria and as investment flows back towards developed markets.
The timing of a readjustment is less certain.
Although we are convinced that a naira adjustment will take place during the next 18 months, predicting the timing of it is trickier, said Rewane.
There are two main scenarios: the new CBN governor, who will formally take office from
June at the expiry of Sanusi’s term, allows a one‑off depreciation.
He or she (but expected to be Godwin Emefiele, who was nominated by President Jonathan within hours of Sanusi’s suspension) is likely to be concerned by the erosion of reserves and could blame the need for a readjustment on events before their time in office. There would not be a need for a very large depreciation, perhaps to N165 or N170:US1, but such a move would head-off market speculation and give the new governor time to settle in.
Also, a depreciation before the 2015 elections could be considered politically unpalatable, given that it would be unpopular with the electorate, both by raising import prices and as a sign of weakness in the administration’s economic management.
On the other hand, the new CBN governor, put forward by the president (albeit subject to parliamentary approval), may decide that it would be prudent to delay devaluation until after the conclusion of the elections due next February. Such devaluation might need to be larger in magnitude, given that reserves would have fallen further in the meantime. A fractious election period and our expectation of outbreaks of unrest would also further under-mine market confidence in the currency.
On balance, analysts believe that the first scenario is slightly more likely, but would not be surprised to see the second come to fruition. Under either situation, Nigeria’s position as a key frontier market is set to wane over the next 18 months. Although bullish pronouncements—such as Nigeria’s recent inclusion in the “MINT” (Mexico, Indonesia, Nigeria and Turkey) list of future economic giants by a prominent economist, Jim O’Neill—have some merit, recent events highlight the need for extreme caution when analysing the prospects of a country as complex and turbulent as Nigeria. A country with enormous economic potential also brings with it enormous risks.

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