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Nigeria Strategy Report H1 2018 Excerpts - Currency: NGN – Cautiously Constructive for 2018

• Over the second half, FX flows were more significant than anticipated in our H2 17 Nigerian Strategy Report. Basically, we had projected a moderate decline in monthly dollar sales by the CBN, from average of $2.9 billion in May/June to $2.0 billion in the review period, underpinned by a reduction in pent-up demand. Much of the cutback was expected to emanate from the special intervention forward contracts which contributed 38% of CBN’s monthly dollar sales in the first half of 2017. To add, we firmed up our upbeat outlook on portfolio flows which should combine with CBN sales to leave the IEW relatively greased with dollar supply. Consequently, our postulation implied a $2.5 billion decline in FX reserves to $27.8 billion by year end (H1 17: $30.3 billion).
• The variance in our expectation compared with actual figures emanated from a combination of robust portfolio inflows and higher oil receipts. For context, CBN average monthly dollar sales over Q3 17 declined by 14% to $2.1 billion relative to $2.5 billion in Q2 17 with September sales printing at $1.5 billion. Notwithstanding the cutback in dollar sales, which largely reflected lower sales at the interbank and parallel market, the naira remained stable over Q3 largely due to higher than expected portfolio flows over the period (average Q3: $1.4 billion, H1 17: $470 million). Against this backdrop, the CBN reduced its supply at the IEW from $845 million in June 2017 to $101 million in September 2017 while also intervening in other segments of the market, particularly the Secondary Market Intervention Sales (SMIS). Furthermore, despite strong (but moderating) dollar sales by the apex bank, external reserves firmed up by 28% over H2 17 to $39 billion on the back of higher oil inflows. Consequently, the premium between the parallel and official market contracted to a 27-month low of 17.0% at the end of December - the naira also gained grounds over the period at the NAFEX and BDC segment, appreciating by 2.8% and 2.3% respectively.
• In framing our currency outlook, we examine developments in the BoP with more emphasis on the fundamental picture. Assuming mean crude price of $60/bbl. and oil production of 2.0mbpd in 2018, we project a 10% YoY increase in goods exports to $47.3 billion. On imports, we estimate a 15% YoY growth to $37.3 billion, as we expect sustained FX liquidity to encourage increased importation of manufacturing products, with sustained reduction in the importation of petroleum products and raw materials should moderate the impact. Overlaying the implied goods trade surplus of $10.2 billion with service and income deficit on our target net current transfers, we estimate the current account to print at $6.3 billion (FY 17E: $8.1 billion). On the financial account, we expect a combination of the gradual unwinding of QE in developed economies – especially rising US interest rates – and bullish economic picture in developed economies to induce net FPI outflows from emerging markets. As a result, we expect a further drawdown in FX reserve as the apex bank intervenes to bridge the lower FPI flows. On balance, we expect the financial account to print at a lower level relative to prior year.
• Having resolved the BoP considerations, we then look to evaluate the potential liquidity picture across the FX markets. While we note the resilience of capital flows into Nigeria from the flexible exchange rate system, which buoyed demand for naira-denominated assets over H2 17, we believe the political related risks ahead of the 2019 election and our expectation of a lower yield environment over 2018 will moderate inflows. Acknowledging the ripple effect of turnover in the IEW on overall naira stability over H2 17, we expect a decline in FPI flows to weigh on overall autonomous flows and drive increased demand for CBN intervention at the window.
• Acknowledging the lower incentives for round tripping in the FX market (with the narrowing gap between the Parallel-NAFEX and BDC-Interbank), we believe the decline in autonomous flows will pressure the apex bank to bridge the short-term demand-supply overlap over 2018. Imputing our inflation and interest rates forecasts on the PPP model, we see fundamental driven pressures as underpinning the scope for down-leg in the USDNGN (8-10% from current levels) over 2018 – which implies average exchange rate of N401.55/$ to N403.54/$ over 2018.