In contrast to prior meetings in 2015, the decisions reached at the end of the two day monetary policy meeting by the Central Bank of Nigeria (CBN) this week have generated quite a lot of commentary. Unsurprising you might say, afterall, the CBN eased monetary policy considerably for the first time in six years: by announcing a 200bps cut in its key policy rate to 11%, a further 500bps slash in the cash reserve ratio, albeit conditionally, and an adjustment in the symmetric corridor around the policy rate to an asymmetric one. The latest policy tweak would now result in banks paying 13% to lend from the apex bank while on the flipside receiving 4% for depositing cash into CBN’s vaults. In all the CBN Governor, as ever in his patriotic green tie, pulled no punches in letting markets know: we are going on full scale easing.
Not that domestic markets should have been surprised by the move or even its scale as the Nigerian yield curve had collapsed significantly from the last MPC meeting in September at both the short end, where Treasury bill rates shrank 850bps, and the long end, where bonds contracted 450bps. As my graduate school economics professor once spat out pay heed to the yield curve, it always tells you what is coming to an economy. The yield compression emerged as the CBN began allowing system liquidity levels soar to levels, that previously were an anathema, with market liquidity levels averaging N600 billion in the time between the September and November MPC vs. the tight sometimes negative levels, which spurred intermittent spikes earlier in 2015. The liquidity flowed both from CRR reduction at the prior MPC and maturing OMO bills implying that the apex bank was okay with liquidity levels.
This departure as argued here was a fall-out from the decision by JP Morgan to expel Nigeria from its emerging market government debt index club. With the body language of Nigeria’s fiscal and monetary policy authorities feeling that a 26% NGN devaluation was enough, applying the impossible trinity trilemma meant that monetary policy shifted to addressing domestic macro concerns, as foreign portfolio investments would not be forthcoming. On this front, macro data (softening CPI inflation reading and flagging GDP growth) supported the case for easing, even though, monetary policy in Nigeria is less effective on these matters. Though its fancy theory, and indeed much of the written commentary and debates I got involved with many foreign analysts have revolved around inflation pointing to a tight stance, as I’ve consistently argued it’s a myth in Nigeria. Trend inflation has averaged 11-12% over the last decade and so to argue that because inflation is 30bps above a recently declared target of 9% makes CBN action to ease a loss of credibility displays a childish understanding of the Nigerian economy. If anything the target is what lacks credibility.
Now to the real reason why many of the foreign analysts and indeed some local analysts still clung to the logic of CBN still holding rates high – the NGN. Indeed while the case for elevated interest rates to support the exchange rate is theoretically valid, in the context of the current environment Nigeria has found herself, continued adoption of the theoretical position amounts to sheer dogma. As with oil exporting countries, the collapse of the oil price has meant that the current account surplus which underpinned the nominal FX rate has had to shift. This scenario has been complicated by the now growing feeling that the US Federal Reserve is going to raise interest rates in December 2015 or early next year. While the US Fed has dithered, changing its goal posts, it still has not lost its credibility (wonder why people fret over 30bps?). Now in contrast to other oil powerhouses, the CBN has let the NGN only fall by 26% in nominal terms vs. the nearly 50% drop in Brent Crude. CBN reluctance to bite the devaluation cherry again and the emerging current account deficit (which as at June 2015 amounted to $7billion) is informing the view that rates must remain tight. But I ask the naïve question: what rate of interest would attract FPI to come to a small open frontier oil exporting country ahead of US Federal Reserve hike? Annualising the gap in the current account, Nigeria would need $14 billion worth of FPI to bridge the shortfall in the current account (Peak FPI inflow into Nigeria was $17billion in a 2012 QE world). Quite frankly the prospects of finding those flows would require the CBN to raise rates north of 20% in addition to providing an expensive exchange rate insurance to counter FPI aversion to Nigeria. Now over the last four years, CBN tightened monetary policy at oil prices over $100/b, inflation crashing to multi-year lows of 7% (which emphasizes why people should stop tugging that argument) and GDP growth at 6-7%. Today output growth is sub 3%, oil has sunk to non-transient lows, reluctant FPI and the theory still spits tightening response. That position is obviously impracticable.
Having suspended the FX lever with the OB2WQ, the CBN had figured FPI would not be coming so why keep rates at a level that only generates pointless economic rents. Hence the decision to stop issuing OMO paper. While domestic investors had read the CBN suspension of OMO issuance to imply pending easing, the conventional text book swinging arm chair analysts, still alluded to no forthcoming interest rate cut.
Is the CBN right or wrong? Nigeria is in a crisis and one which requires out of the box thinking. However, unlike other countries, Nigeria does not have a huge external debt burden and even better has some depth in domestic debt markets. The much wider fiscal leg room means CBN easing is a smart move. The only Achilles heel is the FX rate, where a fixation with the nominal rate, and not the real effective exchange rate (REER), in the absence of a modest rebound in oil prices or continued downtrend might result in further devaluation down the road. Again while the typical analyst retort is to imagine a market driven need to allow the naira fall, as I argued in my last blog post and as Charles Soludo recently stated, Nigeria’s FX market is unusual as you have one large supplier and as such the issue is not what the equilibrium USDNGN is but what rate is appropriate for the direction of economic policy. Nigerians like to say diversification but the goal has to be clear. If its manufacturing led then a weaker REER is the way, notice I avoided the use of a nominal rate. What is the naira REER? I would seek to update you on my ideas over that in another post.
CBN Research on Price vs. Output Stability
- Dynamic Stochastic General Equilibrium Model For Monetary Policy Analysis In Nigeria: The Taylor-type monetary policy rule indicates that the CBN accords priority to output stabilization rather than price stability in the conduct of monetary policy.