Pre-MPC Note: Maintaining Status Quo While Consolidating on FX Market Gains

This week Monday and Tuesday, the Monetary Policy Committee (MPC) of the Central Bank of Nigeria (CBN) will be meeting to review major developments in the global and domestic space since its last meeting. This 3rd meeting in 2017 is coming at a time when the global economy is viewed to be in a sweet spot following respite in global downside risks related to the US elections, Brexit uncertainty and concerns of slower growth in China. The impact of the expectations of expansionary fiscal policy is evident in the bullish trend in US equities as well as a stronger dollar. Yet, expectations of an expansionary fiscal policy by Trump’s Administration has led to a rate hike by the US Fed as well as expectation of further rate increases in 2017. Commodity prices have also remained strong since the last MPC meeting while OPEC’s May 25th meeting on oil production cut agreement should further support price at this level. We expect that an extension of the production agreement will continue to keep oil prices around US$48.00 – US$53.00 in the near term despite the threat from shale oil production in the US  and Canada.

On the domestic front, there are a number of noticeable signals of a potential rebound in economic activities from Q2:2017. April’s Purchasing Managers’ Index (PMI) which settled at 51.1 points highlighted an improvement in overall business activity and reaffirmed that the economy is on its path to recovery. Also, there has been improvement in government finances occasioned by increase in domestic oil production as well as stability in global oil prices. Similarly, there has been significant improvement in the FX management which in turn has led to a remarkable improvement in FX liquidity. The CBN has continued special wholesale and retail interventions as well as the introduction of the SME window and Investors’ & Exporters’ FX window in which transactions are executed at a market determined rate (NAFEX). Consequently, rates at the I&E window and the parallel market have witnessed a convergence with NAFEX and parallel market rates closing at N381.04/US$1.00 and N381.00/US$1.00 respectively on May 18, 2017.

Relatedly, the pace of increases in Headline inflation has been on a downtrend since February, largely due to high base effect from 2016 and more recently the improvements in FX liquidity. April inflation data released during the week showed Headline inflation easing marginally from 17.3% in March 2017 to 17.2%. Core inflation continued to ease, settling at 14.8% in April 2017 from 15.4% in March. Food inflation however remained a concern, surging to 19.3% in April despite the improvement recorded in imported Food sub-index which moderated to 17.0% in April from 18.1% in March, highlighting continuous pressures in domestic food prices. However, Q1:2017 GDP data (anticipated to be released next week Tuesday) is expected to show that the economy ended the first quarter still in a recession (Afrinvest estimates 1.0% contraction), though we expect a rebound in Q2:2017 GDP due to an improvement in oil production volumes and an uptrend in the services sector.

Interestingly, the impact of the improvement in liquidity and management of foreign exchange has been evident in the performance of the equities market – which surged to a 10-month high of 28,873.44 points – as foreign investors have started returning to the market while domestic participation has also improved.

Accordingly, analysis of the various interesting developments within the economy over the last two months suggests that the May MPC meeting is to “mark attendance “as we are of the view that the Committee would be likely satisfied with the recent traction the economy garnered. Whilst the MPC will likely be comfortable with rate convergence between the street and NAFEX, the Committee  would reason the need to charge the CBN to revert to the recommendation on flexible foreign exchange framework which was approved since the May 2016 Meeting.

Whilst the recent downtrend in Headline inflation, especially the satisfactory moderation in core inflation from 18.1% in Dec-2016 to 14.8% in April-2017, could justify a rate cut, we are of the view that the MPC will resist this temptation as this may be premature. Also, reducing MPR at this time will not necessarily reduce the risk perception of the country more so that a higher rate environment would further dampen bank’s appetite towards real sector lending. Similarly, reducing Cash Reserves Ratio (CRR) defies monetary policy logic given the frequency of weekly OMO mop-ups at a significantly high cost. The latest data show that as at March 2017, Commercial Banks’ Reserves with the CBN settled at N3.3tn with CRR at 22.5%. If CRR is reduced by 2.5% to 20.0% for example, a total injection of N366.0bn would be pumped into the system immediately. It will be therefore counter intuitive to reduce CRR that is at no cost to the CBN only to mop-up with OMO at expensive rate. On the flip side, our analysis completely rules out the possibility of a hike in CRR.

Afrinvest Research is of the view that the argument for maintaining status quo and consolidating on recent positives in the economy will be overriding at this May Meeting. On a balance of considerations therefore, we vote for:
I.   Retention of MPR at 14.0% with the Asymmetric Window at +200 and -500
II.  A hold on CRR at 22.5%; and
III. Retention of Liquidity Ratio at 30.0%; and
We reason that the convergence of multiple FX windows into one truly flexible market determined FX structure will further boost investor confidence and buoy foreign portfolio inflow into the country.