The naira (NGN) has been in freefall in recent weeks in the parallel market. After breaching 500/US$ last July and 600/US$ in mid-May, the NGN ballooned to 700/US$ yesterday after opening the day at 675/US$. It now trades at a premium of 65% to the official “NAFEX” rate of 425/US$, a level that has only been breached during the May 2016 sell-off when the NGN was pegged at c200/US$.
Nigeria’s FX imbalances stem from its failed FX regime, with President Buhari and CBN Governor Emefiele opting to defend an overvalued exchange rate peg and limit official FX demand by banning certain actors from accessing the official market (see related reading). However, this has only served to push more demand to the parallel market, exacerbating the depreciation and undermining the stated goal of the peg, which is to limit inflationary pressures.
Indeed, the IMF recently estimated that two-thirds of parallel market depreciation passes through to inflation, meaning stability in the official market means little. The IMF estimated that the NGN was 15% overvalued in real effective terms in 2021 based on preliminary data, with REER depreciation of nearly 20% since implying a 35% overvaluation (or a “fair value” of 570/US$, between the 700/US$ parallel rate and 12m NDF rate of 505/US$, although subject to a high degree of uncertainty).
Rather than recognising this policy failure and allowing the currency to adjust, Emefiele has continued to pin the blame on others. Last year he banned BDCs and data providers, accusing them of market manipulation. This time around, he is blaming Nigerians seeking education abroad as an unnecessary FX leakage, with recent headlines that the CBN would remove or limit access to FX for this purpose (see below).
We do not think a liberalisation of the exchange rate is likely while Buhari and Emefiele are in charge, which means this unorthodox regime will stay in place at least until the February 2023 elections (and potentially beyond if Emefiele is allowed to stay in office until the end of his 5-year term in May 2024). That said, there is increasing dissatisfaction with Emefiele, who has reportedly been summoned to the Senate to explain the NGN’s ongoing collapse.
While there are a number of issues driving Nigeria’s FX imbalances, we summarise some of the more salient explanations below for the NGN’s accelerated depreciation in recent weeks.
Supply shortages in the official market: The overriding issue is, of course, the lack of FX supply in the official market. Nigeria has been unable to take advantage of higher oil prices this year, with production declining from 1.88mbpd in 2019 and 1.51mbpd in 2021 to just 1.2mbpd in June, per OPEC data. Meanwhile, the overvalued currency and tight global financial conditions have slowed foreign investment inflows. As such, monthly FX supply in the official “I&E window” has averaged just US$1.3bn in H1 22 versus US$3.7bn in the last quarter before Covid. Businesses have been complaining that it takes longer to source FX from official channels and that they are getting less of their orders filled, which is likely driving demand to the parallel market.
Spending on education abroad: Nigerians studying abroad are a perennial source of FX demand, and are able to purchase FX at the CBN or interbank rate via “Form A” applications that enable special access to the market for eligible service payments. A few weeks ago, news came out that the CBN would remove “Form A” applications by December 2022. While the CBN has since denied the rumours, banks have since sent notifications of reduced limits on “Form A” transactions. This has sparked some panic buying, and will push more demand to the parallel market when students resume their studies in August and September, which will likely maintain pressure on the parallel exchange rate in the coming months.
Government financing challenges: It has been a tough start to the year fiscally, with revenue dropping 49% below target in the first four months of the year, tipping the scale at a meagre 0.8% of projected full-year GDP (on pace with last year’s 2.4% of GDP). As a result, interest payments have risen from 96% of federally-retained revenue in 2021 to 119% so far this year, with the government forced to borrow to fund all non-interest spending. At the same time, local demand for bonds has dropped due to negative real yields, with the government filling only 55% of its July bond auction.
With Nigeria also locked out of the external debt market, this means that the CBN will continue to monetise the bulk of the deficit via “Ways & Means” advances, which reached NGN4.34tn (2.4% of GDP) last year and funded 60% of the federal deficit, and totalled another NGN2.46tn (1.2% of projected full-year GDP) in H1 22. The printing of local currency to fund the deficit will increase FX demand and cause further exchange rate depreciation (although the DMO has already raised 56% of the total NGN3.5tn earmarked for domestic borrowing in 2022, which may reduce pressure to an extent).
Pre-election spending/campaigning: Pre-election spending and campaigning have been rumoured to drive up US$ demand, as politicians look to the parallel market to fill their coffers before they take to the campaign trail. This was tacitly affirmed by the CBN, which said recently that there is increased money in circulation due, in part, to pre-election spending (M3 money supply growth rose from 12.6% yoy in December to 23.7% yoy in June), which will add to US$ demand. This pressure will likely increase as the February 2023 elections approach.
Beyond pre-election spending, elections often coincide with portfolio outflows as foreign investors de-risk ahead of elections. However, this is unlikely to be as much of a factor this time around, with foreign investors effectively “trapped” (though foreign portfolio liabilities remained high at US$35.25bn in Q1 22, split between US$4.2bn of equities, US$13.1bn of OMO bills, US$1.4bn of T-bills, and US$16.5bn of government bonds).
Panic buying: All the factors above have combined to create an environment of panic buying. Banks are even taking out adverts to encourage people to open a domiciliary account to save in FX. As the NGN continues to spiral in the parallel market, Nigerians will increasingly look to stockpile US$ to hedge against further depreciation, which will create a self-reinforcing cycle by pushing up demand even further.
Where is the parallel exchange rate headed?
Without interventions to balance supply and demand for FX, pressure on the parallel exchange rate will likely persist. As a short-term fix, the CBN could use its reserves to sell more FX in the official market. However, a more durable solution would require FX liberalisation, with the CBN finally letting the official exchange rate depreciate to market-clearing levels.
Current imbalances aside, Q3 and Q4 are generally periods of higher US$ demand due to the payment of school fees in Q3 and increased travelling during the festive period in Q4, which will dovetail with subdued official FX supply, a rising supply of NGN in circulation, higher pre-election US$ demand and panic buying to create a perfect storm for the NGN.
There is no telling where the parallel exchange rate will go in the coming months, and perhaps the market dislocations will finally force the CBN’s hand and prompt them to move towards a more flexible exchange rate, but we have little confidence that the CBN is willing to do what it takes to balance the market and, against this backdrop, think more parallel market volatility is in store.
Nigerian central bank surprises with symbolic 150bps rate hike, May 2022 (Curran, Ogunkoya & Omole)
Nigeria annual macro overview: The song remains the same, February 2022 (Curran and Malik)
Nigeria: Stealth devaluation possibly underway, November 2021 (Curran, Ogunkoya & Omole)
Nigeria: FX overhaul promised post-Dangote refinery, October 2021
Nigeria: Ban of abokiFX furthers FX folly, September 2021
Central Bank of Nigeria adds fuel to the fire by banning BDCs, July 2021 (Curran & Ogunkoya)
Our discussion with Nigeria’s IMF Mission Chief, April 2021
Nigeria policy rate and FX regime left intact, March 2021