Tuesday,August 27, 2019    / 08:28AM / By Coronation Research / Header Image Credit: Ris Media

The Central Bank of Nigeria(CBN) has been promoting pro-growth strategies recently, while letting marketinterest rates fall to a shade over the inflation rate. The problem with thisstrategy is that the market might question the CBN's determination to hold theexchange rate, even with its high levels of foreign reserves. Market interestrates moved sharply back up in mid-August, showing the CBN is alert to theissue.

FX

The CBN has foreign exchangereserves of US$44.07bn (a three-month moving average), which leads us to thinkthat it can hold the Naira at close to N357.75/US$1 for the rest of this year.However, foreign portfolio investment (FPI) in Naira-denominated fixed incomemarkets was sharply down in June and July, prompting questions over what sortof Naira market interest rates will be needed to attract this money again.

Bonds & T-bills

The yield on a FederalGovernment of Nigeria (FGN) Naira bond with 10 years to maturity fell by 7bpsto 14.25%, and at 3 years fell by 13bps to 14.46% last week. The yield on a364-day T-bill rose by 209bps to 14.26%. The yield on a T-bill with 3 months tomaturity fell by 101bps to 13.27%.

With apologies to our regularreaders, last week we missed the hike in market rates (by one day). 1-yearrates, at 14.26% on Friday, are now 226bps higher than a fortnight ago. Forweeks before this we had written - repeatedly - how we expect 1-year marketrates to be between 250bps-300bps above inflation. The fact that the spread isnow 318bps brings us a degree of comfort. Furthermore, last week the CBN pulledan open market operation (OMO) bill auction, thereby rejecting bids for OMO billsthat were at 14.94% and above. The market and the CBN are having a vigorousdialogue as to where market rates should be.

Oil

The price of Brent rose by1.19% last week to US$59.34/bbl. The average price, year-to-date, isUS$65.24/bbl, 9.00% lower than the average of US$71.69/bbl in 2018, but 19.17%higher than the US$54.75/bbl average seen in 2017.

China responded to new UStariffs by imposing retaliatory tariffs that range between 5-10% on US$75billion worth of American goods. The tariffs, interestingly, included a 5% levyon US shale oil which has enjoyed China as a major customer in recent years. Werate the continuous trade war as bad news for oil prices.

Equities

The Nigerian Stock Exchange(NSE) All-Share Index gained 3.25% last week, easing the year-to-date return tonegative 11.55%. Last week Oando (+20.90%), Fidelity Bank (+20.00%) andHoneywell Flour Mills (+14.58%) closed positive while Okomu Oil Palm (-18.06%),MRS (-9.83%) and Cadbury Nigeria (-9.71%) fell.

The NSE recorded gains infour out of five trading sessions last week as there was renewed buyinginterests in selected stocks following the release of H1 results, and what webelieve is positioning for interim dividends. The reversal in the bearish trendmay be sustained, at least in the short term in our view, as bargain hunterstake advantage of stocks which have reached 52-week lows.

The CBN's balancing act 

Here is the CBN's conundrum:how do you promote growth when conditions are downbeat, and simultaneously keepinterest rates high enough to ensure currency stability? For most of this yearwe have been writing that the CBN, when setting market interest rates throughits open market operations (OMO), might want to set rates at between 250-300bpsabove inflation in order to keep the currency markets happy. With inflationstubborn at around 11.00% (July: 11.08% y/y), this suggests rates need to be atbetween 13.58%-14.08%.

However, our benchmark of aspread (over inflation) of 250-300bps is merely a best guess of what foreigninstitutional investors would like to earn. We do not think of it as a rulebecause global economic conditions change (for example, oil prices have fallenrecently) and the appetites of foreign institutional investors also change withtime. Investors can be fickle.

In theory, the CBN can toshun foreign portfolio investors (theoretically it can pay interest rates lessthan inflation) if it is not concerned about the level of its foreign exchangereserves. Indeed, why should it be concerned with foreign investors and theirUS dollars, when it has reserves of US$44.07bn itself? The CBN has plenty ofmoney with which to defend the Naira.

This is how the CBN appearedto be thinking a couple of months ago. Market interests fell from 13.72% inmid-June to 12.00% at the end of July. The CBN announced pro-growth measures,such as requiring banks to report loan-to-deposit ratios of 60% in a bid tomake them lend more money to the domestic economy. However, the effects seen inthe market came swiftly and were compounded by falling oil prices. Foreigninvestors bought fewer Naira-denominated fixed income securities than before.Foreign exchange reserves began to fall, by around US$1.0bn from late Julyuntil now.

Even then the CBN might notbe concerned. After all, spending a few billion US dollars here and there inthe currency market is well within its range. However, keeping foreign investorshappy is not so easy. Last week Nigeria suffered a blow when reporting on theUS$9.0bn Process & Industrial Development versus Federal Government ofNigeria case made international headlines. We were already aware of it butrealise that once something is reported in the Financial Times it may wellaffect Eurobond investors in Nigeria - and Nigeria has sovereign Eurobondissues planned for later this year. So the CBN began to re-engage with themarkets in mid-August

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