Pre-MPC Note: It’s Time to Complete the Policy Backflip

The Monetary Policy Committee (MPC) is scheduled for its 4th meeting in 2016 next week Monday and Tuesday (25th & 26th July 2016) to review recent developments in the global and domestic economy. Since the last MPC meeting, volatility in the global economy has been amplified by Britain’s decision to exit the European Union (EU) at the tail end of last month.

The overhanging uncertainties set in motion by this decision has led the British pounds on a sticky wicket, depreciating 12.0% since the date of the referendum (June 23rd 2016) till date. As against a better-than-expected performance earlier projected for global growth in 2016, we align with the IMF that the decision of the UK to exit the EU has raised downside risk for the world economy.

The IMF has therefore projected global growth will ease by 0.1% to 3.1% from 3.2% in April 2016 despite recovery in commodity prices which have appreciated 7.2% YTD according to the Bloomberg commodity index. Global markets have however been calm and broadly positive with strong risk-on sentiment gaining traction against the backdrop of commitments of systemically important central banks to dovish short term policies and positive economic data in the US. The MSCI World Index touched a 7-month high in the past week while the S&P 500 reached an all-time high even as high yield bonds rallied.

Yet, accelerating general price level, bearish Q2:2016 growth outlook, weak credit expansion to the private sector, rising level of banks’ non-performing loans and volatility in the FX market have continued to pressure domestic economy and financial market. The feedback effect of reforms in the energy sector has taken further toll on price level as June inflation rose to 16.5% in amid higher fuel prices and electricity tariff.

Meanwhile, the implementation of the floating exchange rate regime in the currency market triggered a 41.1% depreciation of the naira as the equities market YTD return rose to 7.0% in anticipation of the return of foreign players. However, the cheery reception of the new interbank market framework was short-lived as the emergence of autonomous players in the FX market has not been as swift as anticipated. Likewise, the non-existence of the expected volatility in the new interbank led to speculations that an “invisible hand” had held the exchange rate in the market, until a week ago. The market has since been volatile with the naira depreciating 4.3% in the last one week at the interbank.

Although assessing the performance of the newly structured currency market may be a bit early, sustained credibility deficit in the system has kept liquidity at low ebb. Coupled with shortage in dollar supply, the decision of the MPC to retain status-quo on the 41 items termed as inadmissible for FX has ensured the parallel market continued to thrive (closing at N378/US$1.00 on 22/07/2016). The 1-year forwards rate (N317.82/US$1.00) also highlights the persistent weakened confidence in monetary policy reflected in Naira trading.

Expectedly, the IMF projected a 1.8% contraction of the Nigerian economy in 2016, a 4.1% downward revision from 2.3% estimated in April. Although far bearish than our 0.4% outlook for the year, we expect Q2:2016 to confirm the economy to be in a recession.

In light of the above, we highlight the need for the monetary policy to be more proactive than reactive in its response to challenges in the economy. The need to regain investor confidence in the aftermath of the newly launched FX framework should be a paramount item on the agenda of the MPC. On the whole, we think the options on the table for the MPC will be either to;

Option 1:
Increase MPR by 100bps to 200bps and keep other rates constant to attract portfolio capital inflows which are yet to respond to currency market flexibility. The CBN and DMO have guided towards this by aggressively mopping up liquidity at high rates. At the last T-bills auction held on Wednesday, the 364-day T-bill was issued at 16.5%, a 7.2% hike from the 9.3% in January. Same as the OMO auction held the following day where the 364-day tenured OMO bills were issued at 17.0% marginal rate from 13.5% the previous month. Sales at both auctions were significantly higher than the offered amounts.

Option 2:
Maintain status quo on all rates whilst reinstating the need to fully implement the currency market reforms to regain its credibility.

Our Prediction
In our weekly market update in January 2016, we affirmed that despite the dovish  move by the CBN in November 2015, “we believe we are already at the end of the monetary easing cycle, while the realities of funding the budget deficit and stimulating private capital inflows (as short to medium term outlook for oil remains bearish) could lead to a more conventional management of monetary policy in the medium term once the impact of the current monetary stance starts to fully reflect in aggregate macroeconomic variables”.

We further reflected that this conventional tightening would commence by Q3:2016. Events in the past one month have justified our previous position and we believe the CBN will adjust benchmark policy rate to reflect this tight policy thrust, thus completing its policy backflip by taking the first option next Tuesday. We believe taking this route will aid the CBN in stabilizing the FX interbank market and buy some time for fiscal and monetary authorities to engage in more long term structural reforms to buoy competitiveness.