Nigeria – Fixed Income Weekly

CBN’s planned changes to Naira banknotes, much ado about nothing: On Tuesday, the CBN announced that it had received presidential approval to change the design of three bank notes (NGN200, NGN500 and NGN1000). In justifying its decision, the CBN cited a discomfort with large currency holdings outside the banking system (September 2022: 85% of currency in circulation) and the supposedly negative impact on the efficacy of monetary policy. Further justification included a desire to ramp up on its cashless policy as well as to clamp down on the instance of counterfeiting by using newer advances in currency production. Lastly, the Governor noted that the global norm was for central banks to redesign and circulate new currency notes every 5–8 years, but that the Naira had not been redesigned in the last 20 years.

Looking at the data, the ratio of currency outside the banking system (COB) relative to currency in circulation (CIC) has been stable at over 80-90% over the last twenty years so what is the fuss about the metric being at 85%. Furthermore, when one examines the ratio of COB to broad money (defined in Nigeria as M3), that number is a declining one from as high as 20-30% in the early 2000s to mid-teens in 2010s and down to 6.5% at the end of September 2022. This declining trend largely reflects increased usage of electronic banking and the wider banking system. Indeed, total demand deposits in the banking sector stood at NGN18.7trillion. As such it would appear puzzling that despite these improvements, the CBN is concerned that the NGN2.7trillion outside the banking system was somehow doing egregious damage to monetary policy than the NGN18.7trillion in demand deposits. While the CBN’s points about crime and counterfeiting have merit, a desire to re-design the currency given the gap in time from the last such exercise is the more likely driver. The monetary policy efficacy argument is an intricate exercise in smoke and mirrors.  

Figure 1: Currency outside banks and Money Supply

Source: CBN

What is the likely impact? Looking at the short window to swap old notes for new ones, there is the potential for distortion in economic activity within the informal sector. As with India’s demonetization plan in 2016, depending on how the roll-out and swap unfolds, the development could drive a slow-down activity within the non-oil sector over 2023. In addition, one could also see an argument for near term FX pressure as players within the shadow economy looking to avoid the administrative headaches with the old note-new note swap look for temporary accommodation in US dollars in the interim. This trade is likely to unwind over 2023 as eventually they will need to cover with Naira liquidity, so any currency weakness is likely to be transient, all things equal. In terms of positives, the development could push more entrants towards Nigeria’s growing agency banking system which is a tailwind for the emerging digital payments system.

September 2022 Money supply data: CBN’s resumption of quantitative tightening: The CBN updated its money supply data through September 2022 which showed that annualized growth across the key monetary aggregates slowed: M3 (+18.9%, down 40bps) M2 (+16.7% down 209bps) and M1 (+22%, down 480bps). Following the 500bps hike in CRR, aggregate CRR debits climbed by NGN949billion over the month to NGN11.8trillion and the CBN appears to have ramped up on securities issuance (SPEB) as its bills outstanding climbed by over NGN565billion. Overall, the money supply data shows that the CBN has now matched the bellicose rhetoric at monetary policy meetings with hawkish activity across money markets which has cascaded into generally tight liquidity conditions. This ostensibly appears focused on draining system liquidity and raising the returns to holding Naira which has shifted local interest rates higher.

Tight liquidity conditions continue to drive increases in NTB yields, bond sell-off continues: Despite a pick-up in inflows from FAAC distributions and FGN bond coupons, liquidity conditions remained tight across Nigeria’s financial system as interbank rates continued to hug the 16.5% level while placement rates are now hovering anywhere between 18-21%. Unsurprisingly at the NTB auction, the stop-rate on the 1-yr treasury bill continued to track higher rising to 14.5%. The auction itself was weak as the CBN sold only NGN109billion relative to the offer of NGN240billion due to low demand. Bond yields sold off following the NTB auction with the on-the-run FGN 2037 clearing the 16% level again. The yield curve continued to bear-flatten reflecting the run-up in NTB yields and mixture of fundamental sellers and strong shorting action in longer dated bonds.

Figure 2: Naira Yield Curve

Source: Bloomberg

Nigeria’s Eurobonds dust-off Moody’s downgrade with a recovery rally:  Nigerian Eurobonds bounced back from the Moody’s downgrade impact with prices up 6% w/w. This likely reflects stronger oil prices (+2.4% w/w to USD95.8/bbl) which drove a positive sentiment across the Eurobonds of oil exporters. Fundamentally, oil production is likely to recover in November with major repair work completed on Forcados and likely resumption of output via Bonny on the cards. It could also reflect the fact that Nigerian Eurobonds are trading at levels which incorporated a downgrade to B3 levels looking at Z-spreads. Presently, the Z-spread on Nigeria’s 10-year Eurobond (NIGERIA 2032) is at 1100bps relative to B3-rated Angola whose 10-year Eurobond (ANGOLA 2032) which is at 835bps. Essentially, markets have more than priced in a downgrade and if any reported improvements in production translate to higher oil receipts, there is a potential rally down the line, once the election related noise washes over.  

Naira slumps at the parallel market, CBN unmoved: At the official window the FX rate weakened slightly 0.7% w/w to close at N444.75/$, while the Naira continued to fall at the parallel market with the NGN800/$ level now in view. The drivers remain limited supply within the official windows as the CBN’s external reserves continued to slide (down 0.42% w/w to USD37.5billion) owing limited USD inflows on the one hand and the higher outflows to supply the official FX segments. Despite higher oil prices, Nigeria’s oil export inflows to external reserves have struggled reflecting a mix of lower oil production (down nearly 1mbpd) and the onerous crude-for-refined product swap which the NNPC has used to maintain artificially low petrol prices. Essentially, as Nigerian policy makers have refused to raise petrol prices to reflect realities, fearing a backlash from the populace, they have had to fund the implied subsidy via an arcane arrangement which sees the NNPC swap a portion of crude products for refined petrol at a ratio which helps keep the petrol price low. However, production headaches means that the portion of oil barrels allocated to the refined petrol swap has risen to a large share. Some context, Nigeria historically alloted around 300-400kbpd of its production to domestic refining which formed the inputs for this crude-refined product swap given low refining output. At 2mbpd, that arrangement was less of a burden, but at 1mbpd, the swaps are no longer trivial. Crucially, more of the production headaches are on-shore-shallow water where the government offtake is higher as against the less disrupted offshore oil fields. Thus, with a higher share of oil production going into petrol subsidies, its rather unsurprising that Nigeria’s external reserves are declining in the face of higher oil prices, depriving the CBN of the ability to stabilise the exchange rate.

Raising petrol prices is a political minefield and while Nigerians bear collective responsibility for this scenario, lack of courage by policy makers and timidity from the political leadership at engaging with their citizens and interest groups deserve equal blame. Thus, the 2023 elections present another window for a new slate of political leaders to have a crack at reforming the fuel subsidy issues after the rather cowardly approach by the outgoing Buhari administration. Pending clarity on the political front and a recovery in oil production, the CBN is unlikely to undertake any sizable devaluation of its peg with no line-of-sight over where USD supply can potentially come from. What is likely to happen are small step-wise changes which move the Naira towards NGN450-460/$ at its IE window. With no avenue for a Eurobond sale or (potentially from the IMF) the parallel market is likely to spiral further with no floor on where things end.

Two events could help change the tide. Firstly, base effects from 2022 are likely to drive lower CPI readings in US inflation over 2023 which could see the US Federal Reserve slow down on its current tightening path. Will this herald a return to the carry trade era of yield chasing US investors hunting for high local currency bond yields? Possibly. But for Nigeria, given the bad policy mistakes of the last six years, these investors will also require changes at the helm of political and economic policy management which could yet occur in H1 2023. If this occurs and the new policy framework is more flexible to reality (ie reduction in petrol subsidy and return to credible interest rate policy) then we could see stabilization in the Naira over 2023, assuming oil prices and production hold at over USD90/bbl and near 2mbpd respectively. Fundamentally, Naira is deeply undervalued, and any sudden influx of dollar supply could drive a re-rating.

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