Siginificance of naira's devaluation

1. BTMU Economic Brief | July 20161
BTMU Economic Brief
Nigeria – Making Sense of the
Naira’s Devaluation
AMIR KHAN
ECONOMIC RESEARCH | LONDON
T: +44-(0)20-7577-2180
E: Amir.Khan@uk.mufg.jp
The Bank of Tokyo-Mitsubishi UFJ, Ltd.
A member of MUFG, a global financial group
JULY 2016
n 15 June, the Central Bank of Nigeria announced that it will replace its current
currency peg arrangement – as part of which the Nigerian naira (NGN) was held stable
within a narrow band of 197-199 against the US dollar since March 2015 – in favour of
a market-determined exchange rate regime. In doing so, the currency fell to the tune of
around 42% in the first week that it was allowed to trade freely. As we will highlight in this
note, while this adjustment was much needed and is likely to boost Nigeria’s growth and
investment prospects in the long-run, in the more immediate-term, it will not be without its
costs.
A much needed adjustment…
While, within the emerging markets context, Nigeria is not the only oil producing nation that,
faced with the oil price crash, has succumbed to the temptation of devaluing its currency
recently – Russia, Angola and Kazakhstan have already gone down this road – the move is still
highly significant and has been driven by a number of key factors:
 To begin with, low oil prices and a marked slowdown in capital inflows have created acute
foreign exchange (FX) shortages, exacerbated in recent months by militant attacks on oil
infrastructure that have severely disrupted oil production. In May, oil output fell below 1.5m
b/d, the lowest level in 27 years. The FX regime had become increasingly misaligned with
fundamentals, failing to compensate for adverse price developments in the oil market (see
Chart 1), on which the country is dependent for around 90% of its export revenues.
 The economy contracted by 0.4% y/y in the Q1 of 2016, while the jobless rate has risen to
over 12% as low oil prices, fuel shortages and FX restrictions have hampered the
functioning of the economy. Foreign capital inflows, particularly investment have dried up,
and currency reserves have shrunk to around US$27bn from a figure of above US$40bn at
the start of 2014 (see Chart 2), further eroding Nigeria’s external buffers.
O

2. BTMU Economic Brief | July 20162
In our view, the introduction of exchange rate flexibility will be positive for investment and
growth, and reduce the NGN overvaluation, something which is already evident from the sharp
narrowing of the discrepancy between the actual value of the currency versus forward-looking
market gauges of its price (see Chart 3), though the expectation is for this trend to run further.
This development, in turn, should ultimately help to preserve Nigeria’s much-needed FX
reserves and signal to the market that the country has a strategy that will support growth and
development over the medium-term. Furthermore, a weaker NGN should help to ease fiscal
pressures by boosting the naira value of oil revenues. That said, the benefits of this policy
change will, however, take time to materialise as the NGN finds its equilibrium level and
investors become more comfortable with the new FX regime. Developments in international
and local oil markets, and Nigeria’s ability to attract foreign capital inflows are likely to be
important determinants of how the NGN is valued in the future.
…But the move will not be without its costs at least in the short-term….
While a move towards a more flexible exchange rate is well intentioned, the reality is that the
economy is likely to endure painful adjustment process, as the devaluation pushes up import
costs and adds to already elevated inflationary pressures. Headline inflation has surged this
year, rising to a six-year high of 15.6% y/y in May. This is far higher than the Central Bank of
Nigeria’s 6-9% inflation target range. A substantially weaker NGN risks inflation moving even
150
170
190
210
230
250
270
290
3100
20
40
60
80
100
120
140
01/14 07/14 01/15 07/15 01/16
Brent crude (LHS)
NGN per USD (RHS)
(NGN)
(MM/YY)
(US$/ barrel)
(Source) Macrobond
Chart 1: Despite the sharp tail off in global oil prices, the
currency was maintained within a narrow band until
recently...
After being kept within a
tight band, the decision to
allow the currency to float
has seen it fall >40%
41
27
0
5
10
15
20
25
30
35
40
45
01/14 07/14 01/15 07/15 01/16
(Source) Macrobond
(MM/YY)
Chart 2: ...And this was done by tapping into the
country's FX reserves
(US$ billions)
150
170
190
210
230
250
270
290
310
330
350
370
01/14 04/14 07/14 10/14 01/15 04/15 07/15 10/15 01/16 04/16 07/16
Actual ex. Rate
Market ex. Rate (1m)
Market ex. Rate (6m)
Market ex. Rate (12m)
(Source) Bloomberg
(MM/YY)
(US$/NGN - inverted)
Chart 3: The difference in the actual value of the naira versus market
based measures of its price has seen a sharp compression

3. BTMU Economic Brief | July 20163
higher. Mindful of this, we are of the view that a complimentary monetary policy tightening will
be needed to respond to the worsening inflation outlook, anchor inflation expectations and to
underpin the currency. But while an interest rate rise has not been forthcoming since the
changes to the exchange rate regime were announced last month, it is worth noting that the
policy rate was increased by 100bps in March to 12%. Despite this move, however, the policy
rate continues to lag the prevailing rate of inflation (see Chart 4) which, at 15.6%, means that
the policy rate in real – or inflation adjusted – terms remains in negative territory (-3.6%). While
this appears to suggest that rates in Nigeria have to rise by upwards of 300bps for the policy
rate to reach a level that would bring it closer to neutral levels, in reality we do not see rates
rising much beyond 200bps in H2 of this year, especially given the still difficult economic
environment in the country, which we think will serve to restrain the hand of the central bank.
Separately, it worth stressing that with the position of the Nigerian household sector
increasingly coming under strain recently thanks to, among other things, rising inflation and
unemployment – a development which may, at least in the short-term, get worse on the back of
the currency devaluation – there is a real risk that this could undermine popular support for the
Buhari government going forward, such that it negatively impacts the country’s political stability
and the prospects of much-needed reforms. Indeed, if recent opinion poll findings are anything
to go by, Buhari’s approval rating has fallen from around 80% at its peak (October 2015) to
around 64%, as at May this year. While this was to some extents expected, given the huge
scale of the challenges that he faces – ranging from tackling insurgency groups such as Boko
Haram and the energy crisis besetting the country – the reality is that, given the protracted
nature of some of these problems, if he continues to lose popular support, it will make the task
of addressing such problems that much more difficult to achieve.
Finally, in light of Nigeria’s currency devaluation, there is a fear in some quarters that this will
make the repayment of external debt more difficult. In this respect, while the growth in external
debt in recent years is certainly disconcerting, the point to note is that as a percentage of GDP
the country’s external debt remains manageable at around 5% (see Chart 5). Additionally, it is
also worth pointing out that – at around US$27bn – the country has sufficient FX reserves to
cover its short-term external debt1
by a factor of slightly over 2. Notwithstanding this, vigilance
is still required, as there has been increasing preference among Nigerian banks to engage in
1
According to IIF estimates this stood at almost US$13bn as at the end of 2015.
-10
-5
0
5
10
15
20
10 11 12 13 14 15 16
Real rates (Policy rate - CPI)
Policy rate
CPI (y/y)
(Source) Macrobond
(Year)
(%)
Chart 4: Inflation hovers above the policy rate with the result that
rates remain in negative territory on an inflation-adjusted basis

4. BTMU Economic Brief | July 20164
dollar denominated lending in recent years, a development which, under a weaker FX rate,
may over time bring loan deterioration, with higher system NPLs.
Concluding thoughts
We welcome the decision to devalue the naira last month and, if anything, feel that it was long
overdue, especially given the collapse in global oil prices which – under the Nigeria’s previous
pegged exchange regime – the country’s oil dependent economy has struggled to adjust to.
Also, Nigeria’s experience during the course of this year reveals all too clearly that, under such
an exchange rate arrangement, the need to defend the currency peg during times of
uncertainty can prove to be rather costly in terms of using up a country’s valuable foreign
exchange reserves. That said, we do not see the decision to move to a more flexible exchange
regime on the part of Nigeria as a panacea to all the country’s current economic and other ills.
For these to be addressed, the country’s president, Muhammadu Buhari – in keeping with his
campaign promises – still has the difficult task of rooting endemic corruption, restoring order to
the country’s public finances and defeating the threat posed by the likes of Boko Haram and
the Niger River Delta militants, which continue to destabilise the country and ultimately hold
back much-needed FDI into the country.
0
1
2
3
4
5
6
0
5
10
15
20
25
30
06 07 08 09 10 11 12 13 14 15
Total external debt (LHS)
As % of GDP
(Source) IIF
(Year)
(US$ billions) (%)
Chart 5: Nigeria's total external debt has been on the rise but as a
proportion of GDP it remains manageable

5. BTMU Economic Brief | July 20165
The Bank of Tokyo-Mitsubishi UFJ, Ltd. (“BTMU”) is a limited liability stock company incorporated in Japan and registered in the Tokyo
Legal Affairs Bureau (company no. 0100-01-008846). BTMU’s head office is at 7-1 Marunouchi 2-Chome, Chiyoda-Ku, Tokyo 100-8388,
Japan. BTMU’s London branch is registered as a UK establishment in the UK register of companies (registered no. BR002013). BTMU is
authorised and regulated by the Japanese Financial Services Agency. BTMU’s London branch is authorised by the Prudential Regulation
Authority (FCA/PRA no. 139189) and subject to regulation by the Financial Conduct Authority and limited regulation by the Prudential
Regulation Authority. Details about the extent of BTMU London branch’s regulation by the Prudential Regulation Authority are available
from us on request.
This report shall not be construed as solicitation to take any action such as purchasing/selling/investing in financial market products. In
taking any action, each reader is requested to act on the basis of his or her own judgment. This report is based on information believed to
be reliable, but we do not guarantee, and do not accept any liability whatsoever for, its accuracy and we accept no liability whatsoever for
any loss or damage of any kind arising out of the use of all or any part of this report. The contents of the report may be revised without
advance notice. Also, this report is a literary work protected by copyright. No part of this report may be reproduced in any form without
express statement of its source.
The Bank of Tokyo-Mitsubishi UFJ, Ltd. retains copyright to this report and no part of this report may be reproduced or re-distributed
without the written permission of The Bank of Tokyo-Mitsubishi UFJ, Ltd. The Bank of Tokyo-Mitsubishi UFJ, Ltd. expressly prohibits the
re-distribution of this report to Retail Customers, via the internet or otherwise and The Bank of Tokyo-Mitsubishi UFJ, Ltd., its subsidiaries
or affiliates accept no liability whatsoever to any third parties resulting from such re-distribution.