A post mortem of the September 2015 MPC meeting

…I had seen such misery…and I knew behind it all were vain and cynical men, who had closed their eyes, hearts and minds…rather than admit they might have made a mistake. Frederick Forsyth

At this week’s monetary policy committee (MPC) meeting, the Central Bank of Nigeria faced a rapidly deteriorating economic landscape. Firstly, against CBN hopes, J.P Morgan decided to eject Nigeria from its famed Emerging Market Government Bond index (EMGBI) citing investors’ inability to replicate Nigeria’s index weight due to continued lack of transparency and illiquidity in Nigeria’s FX markets. Complicating the economic backdrop was the continued northward movement in headline inflation and quick-slide in economic growth which cratered to a record low of 2.4% under the new rebased GDP series starting in 2010. The latter drove the inclusion of the recession word in MPC communique with the CBN suggesting the economy could experience a contraction in growth for two consecutive quarters in 2016.  The CBN subsequently delivered a cutback in the cash reserve ratio to 25% – the first time an MPC meeting has eased on monetary policy going back to 2011.

Is the CBN about to commence an easing cycle? That is up in the air as with the CBN its more guesswork than a credible predictable economic framework for decision-making.  Now some history here to understand the full picture, starting in 2011, the CBN began a tightening cycle using a combination of MPR hikes, CRR increments, significant open market operations (OMO) and a hotch-potch of administrative measures. The Nigerian policy course was out of sync with conventional reality: the global economy was in a slowdown driven by weakness across the major developed economies while emerging markets were still showing strong growth. Commodity prices were starting to show signs of strain but global oil prices remained above $100/bbl. Economic growth in Nigeria remained in strong: averaging over 6% in the period so why did the CBN begin tightening when everything seemed fine?

OK maybe not all was going well as following the decision to raise PMS prices from N65/litre to N97/litre in January 2012, Inflation, which was knocking at the single digit door in 2011, bombed back firmly into double digit territory. But then in Nigeria, the CPI basket is weighted heavily towards food (which constitutes about 55%) and most factors there are raw material in nature implying supply side issues matter more in inflation trajectory. In this set-up, interest rates simply do not matter as the drivers of inflation do not factor in the cost of money in their movement, thus monetary policy matters little. Indeed research by the CBN and many others have proved consistently proved that monetary policy is statistically insignificant in inflation pathway in Nigeria.

Thus, what economic metric induced the apex bank to commence a tightening run? Look no further than the USDNGN. The naira has been the key variable of interest of all CBN governors at least since the return to democratic rule in 1999. Nigerians desire a strong naira to sustain a satiation with imports and as with other things, her economic managers have sought to at least grant these wishes, regardless of how inimical the desire is to development of a viable manufacturing industry.  As I’ve argued in a previous post, non-natural resource producer-exporter countries desire a weak currency whilst their consumer-importer counterparts prefer a strong one. In order to keep the naira stable, as Nigeria operates a managed float, you need reserves and with oil prices being elevated, it was difficult to reconcile a lack of substantial accretion to reserves in 2011. Consequently, the then CBN governor figured that to grow reserves, we needed to take pressure by allowing another source of inflows: FPI flows. In a low growth, near zero interest rate, quantitative easing world, an osmosis of flows to high rate countries was logical, so in lock-step with a gradual step-up in NGN rates, the CBN loosened restrictions on FX investments which required a minimum one-year holding period. Then governor, Sanusi Lamido Sanusi went even further by guaranteeing an exit for FPI investors via the CBN window to help calm fears.

Thus, the Nigerian central bank sought to position Nigeria to benefit from the huge wave of return seeking portfolio flows unleashed as a result of the massive quantitative easing programs across global central banks which began in 2012.  Basically, the CBN sought to entice capital flows while still desirous of a stable exchange rate implying they would have to give up control of the third lever, as dictated by the ‘impossible trinity trilemma’: independent monetary policy. To the uninitiated the impossible trinity holds that central banks desire three things: a stable currency, independent monetary policy and free flow of capital but can only pursue two at a time while having to trade-off a third. Independent monetary policy here does not imply a fiscal erosion of central bank policy making but rather that domestic monetary policy increasing yields to external influences i.e. Monetary policy does not take cognizance of domestic factors in arriving at decisions but rather what the FPI wants are. Indeed to be effective, the CBN declared war on banking system liquidity with the cash reserve ratio which they turned into a sledge hammer with the hike in public deposits to 75% in 2013. To be clear, the constant inflow of public money in the banking system was a key irritant as the elevated liquidity levels worked to depress market interest rates – anti-thetical to the CBN hawkish rate stance. In addition, the CBN constantly bickered that the money created a perverse incentive for banks to avoid lending, electing to deploy the funds into government securities and other less savoury ventures. The CBN consistently argued in its policy communiques that banks used the excess cash to speculate on the USDNGN. Ditto the deployment of several administrative measures and policy circulars that tried to block avenues for speculation, even though the existence of a multi-tiered FX market with varied rates for the same commodity would naturally lead to speculation. The law on one price implies that when a commodity sells for different prices, agents would always try to arbitrage away the price differential adjusted for time and space differentials.

In effect the Nigerian central bank repressed the Nigerian financial system in order to keep FX markets stable while attracting FPI flows. The result of the FPI influence was clear, Nigerian equities flourished with the All-share index bouncing over 75% in 2012-13 while bond yields declined from above 16% pre 2012 to 12-14% over the period. Most important of all, FX reserves began to climb hitting nearly $49billion.

However the party was about to end as starting in 2014, the US Federal Reserve began to unwind its massive bond-buying program even as commodities prices began to plummet with oil prices plunging from June 2014 by over 50%, The aftershock was staggering, FPI flows turned fickle fleeing in the droves from emerging markets, a scenario complicated by onset of heavy political calendar in Nigeria. Put simply, Nigeria was caught in the perfect storm. The rest is history which I wont rehash. The CBN stands at an inflection point, the FPI chase is pointless but we still desire naira stability implying the current scenario provides a window for monetary policy to assume a domestic focus going forward. Indeed sifting through the joint response posted on the CBN website to the JP Morgan ejection, the best of interests of Nigerians would now assume centrepiece going forward. Though how best to achieve that is the matter for debate. The CBN governor seems bent on forcing Nigerians to consume non-competitive expensive products to shrink import and by extension dollar demand. In theory, that’s how pegged currency management should work: control both legs of demand and supply and you should hold the peg. From history, only those countries with an established currency control in place like China hold their peg, rookies like during the Asian crises simply played for time in the hope that sentiment would change. In Nigeria’s case that hope is that somehow commodity prices would rebound. The secular downtrend in commodities represents the rebalancing in the supercycle with the oversupply across board slowing to allow demand catch-up. The recovery in oil prices would not happen for while, implying Nigerian policy makers are interpreting that the current price depression is temporary and not structural implying no need for reform.

The problem here is simple: we have an insatiable desire for imports which we can only replace with cheaper domestic manufacturing. To produce things cheaply here we require the environment to improve: cost of capital, power costs, labour costs etc but these things take time and require investments. There is another alternative preferred by many countries: devalue significantly so that economic agents adjust based on the signals: imports shrink while manufacturers take the cue on what they can competitively produce. Then there’s the current CBN governor’s approach, close your face to the impossible environment that Nigeria is to produce things cheaply, sing a nationalist song, discourage open discussion on the USDNGN and then throw in your restrictions. If the CBN was truly patriotic they would expand the 41 list to include items luxury items consumed by the wealthy – liquor, foreign education school fees, etc But there’s no nationalist fervour to the CBN approach its simply rationalization just as when fuel scarcity exists. I believe no point arguing with the CBN as it has already made up its mind and would waste reserves till it hits the next threshold that either triggers a devaluation or more asinine restrictions.

As per the dictates of the impossible trinity having shifted to a fixed currency desire with no urge to attract FPI, the CBN must now renew control over monetary policy. This assumes greater import with the economy sliding into a recession implying the CBN must commence easing just like fellow EM countries: China, India etc. However the next piece of the jigsaw should emerge with the announcement of the finance minister sometime in the next five days. On obtaining much clearer picture of things, in particular the projected fiscal deficit, monetary and fiscal policy should swing to a broadly supportive one. The current CBN governor is not devaluing for cynical reasons, in my view he’s merely playing for time, hoping (perhaps more exactly praying) that oil prices stage a rebound. If that doesn’t happen then he better hope FX reserves remain resilient at current levels else he might have to eat his own words.

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