Tepid times for NSEASI

Troubling Times

Last week, global equity markets dipped sharply as the European debt crisis worsened and the US congress’ super-committee failed to reach an agreement on budget deficit cuts. In a week that capped of what is on course to be the worst November for global equities since the financial crisis in 2008; the Dow Jones Industrial Average fell 4.8%, the S&P 500 Index dropped 4.7%, the Nasdaq Composite sank 5.1%, the DAX index dipped 2.2% and the CAC 40 index declined 1.9%. In my view, global equity market performance thus far in November has been a response to the high degree of uncertainty surrounding the nearly endless array of negative outcomes that the political deadlock in western nations could impose on the global economy and markets. For the Nigerian equity market, my research shows that global uncertainty is a key drag on performance, due to increased integration with global fund flows and the continued dominance by foreign investors who appear unmoved by attractive valuations.

European Debt Crisis – a global problem

While much of the focus on the Euro debt crisis has been on Greece and its risk of defaulting, in recent weeks, that focus has shifted to a shortage of liquidity in the European debt markets. Global banks, in their struggle to maintain credit ratings, have aggressively reduced exposure to troubled European sovereign debt. This selling pressure has further compounded the problem by triggering a renewed surge in government bond yields and forcing more countries into higher debt burdens and bigger deficits. As things stand, it is clear that the measures taken thus far to stem the crisis have been insufficient and that the risk financial of contagion of global credit markets from a severe European bank deleveraging is more likely.

No silver a bullet

In my view, resolving the Euro crisis will require a variety of adjustments to the European Union treaty to give greater autonomy to the European Central Bank (ECB), as well as a write-down of significant amounts of peripheral European sovereign debt. Furthermore, I suspect that it will also require the creation of a commonly issued Euro-bond to contain the debt crisis. Thus far Germany has resisted this proposal; however there are growing indications that its tone is changing (after an unsuccessful bond auction last week and a significant spike in its borrowing cost) and that this solution may well be in the offing. Regardless of what happens with the debt crisis itself, a recession in Europe now seems to be a foregone conclusion. However, if policymakers are able to come to an effective resolution soon, the recession is likely to be moderated. I am not optimistic about this outcome and have begun to project the extent to which a European recession would impact the global markets.

Outlook: Tepid growth & increased volatility

Lost in all of the Euro debt brouhaha and US political headlines, is the fact the US economic data has shown a gradual improvement (with the notable exception of last week’s downward revision of third-quarter GDP growth) and while growth in China, India and Brazil have slowed, the fundamentals of emerging market growth remains strong. As such, I expect Q4’11 global GDP to come in at better than Q3’11’s as yearend consumer spending boosts economic growth. This should create firmer footing for stocks, however for the time being I believe global markets will remain focused on the short-term headlines, as they have all year.

What does it mean for NSEASI?

My research shows that the performance on the Nigerian Stock Exchange has increasingly mirrored trends in other major frontier markets and, to a lesser extent, patterns in developed markets. In particular, a correlation analysis shows that daily performance of the NSEASI has a 90.63% correlation with the MSCI Frontier Markets Index in 2011. Further analysis reveals that the daily performance of the NSEASI has a -0.847 correlation with the one day lag of the changes in the VIX (Chicago Board Options Exchange Market Volatility Index[1]). These statistics suggest that the Nigerian market are increasingly linked to global capital flows and is unlikely to avoid the significant headwinds likely to affect global markets in 2012.

My outlook suggests continued volatility across global markets. In fact, I have seen the VIX reach 50 during the height of the sell-off in 2010 and 2011. Compared to 2010, the VIX has traded higher in 2011 and with a longer period of heightened volatility. On balance I expect this trend to continue into 2012 and to spike as global headings emerge. In particular, a key risk to the VIX is the European Financial Stability Facility (EFSF) package which “kicked the can down the road” effectively reducing the risk of a small loss at the expense of potentially increasing the chance of a larger one later. All in all my outlook suggest the trading patterns on the Nigerian market in 2012 could resemble 2011’s as it moves in line with increasingly volatile global markets − with even greater volatility.

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[1] The VIX is a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next 30 day period.

Inflation, again?

October inflation trends higher

Last week, the National Bureau of Statistics reported a rise in Year on Year (YoY) inflation to 10.5% for October 2011 (September: 10.3%). This marks the second month in double-digit territory, following two consecutive months of single-digit inflation. On a Month on Month (MoM) basis, inflation rose 0.5% in October, as the Rural All Items Monthly Index rose 0.90% MoM and the Urban All Items Monthly Index declined 0.10% MoM. The largest contributor to inflation was higher fuel prices - kerosene (DPK) and diesel (AGO) accounted for the bulk of the price increase.

Food inflation unexpectedly higher

I expected downward pressure on food prices in October in the aftermath of the year’s major harvest. However, Food CPI rose 9.7% YoY in October, as compared to 9.5% YoY in September. On a MoM basis, food inflation rose 0.2%, compared to 0.9% MoM in September and my forecast of a 1.6% decline MoM. I suspect that the rise in the Food CPI, contrary to my expectation, was the result of higher transportation costs, which resulted from an increase in diesel prices. Farm produce prices have historically trended lower MoM in October, on account of increased supply following the harvest which usually commences in the middle of September[1]. Available data suggested that while prolonged dry spells across the North-East Zone, in September, and excessive rains in the South-West, North-Central and South-South Zones, destroyed farmlands, fishponds and crops[2], these events did not significantly affect farm produce prices. As a result, the Farm Produce index declined 0.2% MoM.

Energy inflation – ahead of our expectations

Energy CPI showed a slight moderation in October. The index declined to 14.8% YoY from 18.7% YoY in September (I had forecast Energy inflation of 17.5% YoY). This moderation was primarily due to the impact of a negative base effect—resulting from the electricity tariff hike earlier in the year— which continued to impact Energy CPI for a full annual cycle following implementation. My model suggested that the marked differential between our forecasts and actual YoY energy inflation was the result of an overestimation of the impact of higher electricity tariffs from a hike that occurred earlier in 2011. However, Energy CPI rose 1.03% MoM, largely driven by higher diesel and kerosene prices in rural areas.

My outlook for inflation

Core inflation: Likely to stay in check

My analysis indicates that demand deposits and currency in circulation are important drivers of core inflation – the measure of price increases in components other than food and energy. Currently these monetary aggregates are above the Central Bank of Nigeria’s (CBN) annual target levels and I expect them those aggregates to remain elevated. However, the lagged effect of MPC’s October decisions —particularly raising the benchmark rate by 275 bps and the CRR by 400 bps to 8% —  and expected tightening should moderate the upward pressure on core inflation. Overall, I expect core inflation to remain moderate through the rest of the year. However, I note that higher energy prices could potentially filter through to some core components, exerting upward pressure on core inflation.

Headline risks persist

In spite of the scale of damage in flood ‐ and drought‐affected areas across the country, these areas of below‐average production account for less than 20% of the total annual food production[3]. I note that in 2011, croplands have experienced above average rainfall and increased cultivation.  As such, I expect higher crop yields YoY and a normal to above average harvest.  Accordingly, farm produce prices should moderate in the months ahead -- with the Food CPI following closely in line. However, I note that higher transportation costs and fuel prices portend potential risks to my expectations for food inflation -- as was the case in October. Furthermore, I expect YoY Energy CPI to remain elevated, even as further hikes in electricity tariff and deregulation in the downstream petroleum sector are expected early next year.

Ammunition for the MPC

The initial market reaction to these inflation figures was an almost unanimous 45bp upward adjustment in the yields on OMO bills. This is perhaps understandable in the light of recent comments made by the Governor of the CBN in an interview granted to Reuters on 31st October, 2011, indicating that monetary policy was likely to remain tight for the foreseeable future in order to “ward off inflationary pressures”. With these comments as context, ahead of this week’s Monetary Policy Committee (MPC) meeting, it would appear that the reinforced upward trend in inflation may provide justification for further tightening. Furthermore, the increased frequency and value of Open Market Operations (OMO) following the MPC’s emergency meeting in October (where it increased MPR by 275 bps and raised CRR by 400bps) suggests that the outcome of its policy measures might have been less than satisfactory. At current levels, further OMOs are likely to come at considerable cost to the CBN. Consequently, the MPC is likely to be motivation to explore other monetary options in an attempt to manage inflation, as Naira devaluation and deregulation of the downstream sector take effect.

Stay short, buy the tightening

In view of my outlook for inflation in the near term and the potential upside risks, I would expect the CBN’s hawkish posture to persist as policy makers and market participants come to better grips with unfolding developments in the currency and debt markets. Clearly, this consideration may lead investors to demand higher compensation for risk and supports the view that current yields may trend higher in anticipation of further monetary tightening – or following actual policy action. Accordingly, I believe short dated debt instruments provide the optimal vehicle to exploit such conditions.  Indeed, I note the upward trend in short dated yields pre-MPC decision and highlight the opportunity to selectively increase exposure to this asset class, as it is likely to experience a modest rebound post-MPC decision – partly due to significant liquidity inflows, particularly in the form of higher year end FAAC allocations.

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[1] Fewsnet, NIGERIA Food Security Outlook

[2] Fewsnet, NIGERIA Food Security Outlook

[3] NIGERIA Food Security Outlook

A view from the Top : CBN jumps into inter-bank market

CBN experimenting with new models in currency markets

While the response to the recent tightening measures by the CBN has been a moderation US$ demand at recent WDAS auctions and an appreciation in the official USD/NGN exchange rate to N149.94/US, the Naira has continued to show signs of weakness in the interbank and parallel markets.  On the interbank market in particular, the Naira has declined 4.40% to N158.98/US since the end of Q2’11, as compared to the 2.50% appreciation recorded on the WDAS over the same period. As at yesterday, the divergence between the WDAS and interbank market rates stood at N10.98 (close to the 2011 high of N12.11).  In response to this situation the Central Bank of Nigeria (CBN), yesterday released guidelines on its planned intervention in the interbank market. In a statement explaining the decision, the apex bank noted that it plans to intervene in the interbank market in two ways:

Method A: Intervention through the purchase and sale of US Dollar directly from/to Authorized Dealers.

In this method of intervention the CBN will buy or sell US dollars to Authorized Dealers in the interbank market through the submission of bids and offer rates for specified amounts of USD. This process, while similar to the WDAS, will not replace the bi-weekly auction but instead will enhance the CBN’s capacity to maintain liquidity through increased frequency of sales to Authorized Dealers. Furthermore, the guidelines for Method A noted that the spread between the bid and offer rates presented to the CBN in such bids may not exceed 20pips (20 kobo) and will be settled into the Authorized Dealers’ Trading Nostro Settlement Accounts  as opposed to their FEM Nostro Settlement Accounts, which are used to settle WDAS transitions.

Method B: Intervention through direct market participation

This method entails the CBN, active participation in the interbank market like any other registered bank.  The guidelines stipulated that with effect from Monday October 24^th 2011, the CBN will begin contacting Authorized Dealers and providing bid/offer quotes for the standard trade amount of US$250,000 with the standard spread of 5pips (5 kobo). However, the guidelines further state that Authorized Dealers will be allow the increase their required bid/offer spreads to 20pips (20 kobo) in cases where the CBN opts to demand amount greater than US$250,000.

A departure

In what appears to be a an attempt to enhancement market liquidity, the intervention guidelines allow the resale of US dollars purchased from the CBN on the interbank market to other Authorized Dealers on the interbank market, even as a separate circular (also released on October, 20^th 2011) revised the Foreign Exchange Net Open Position for Authorized Dealers to 3% from 1%, which was pronounce at the emergency MPC meeting last week.  However the guidelines, stipulates that Authorized Dealers would not be allowed to move funds from their FEM Nostro Settlement Accounts to Trading Nostro Settlement Accounts to settle interbank transactions. Furthermore, while Non-settlement of transactions with the CBN would not necessarily result in cancellation of the intervention to Authorized Dealers; defaults on either US Dollar or Naira settlements, within T+2 of the transaction with the CBN would attract suspension from WDAS spot and forward markets.

What is the CBN trying to achieve?

My guess is that this move may be designed to help the CBN gain better visibility into trends in the interbank markets and allow it take greater control of events in that market. However, the CBN is probably also trying to alter the economics behind demand and supply of foreign exchange. By participating in the inter-bank, it is able to adjust its interventions in a more timely fashion, a facility that may, help it fight adverse trends. In a sense, the new system moves us closer to a market structure I have long advocated, where CBN participates, like other dealers, in a common market,  responding to market vagaries as best suits its policy goals.

The impact of the new system could be far reaching and, while it does not entirely remove the ills of the old system, I am sure that it is a step in the right direction. I expect to see a little more volatility in exchange rates and assume that with the adoption of the new regime the CBN could become somewhat more flexible in the WDAS as well. In fact, I suspect that if it is able to achieve its aims of better managing the market the CBN may use this as a stepping stone towards a more “liberalized” regime.

Naira Blues

The naira falls to new low

At last Wednesday’s WDAS auction the Naira declined 0.97% to N156.91/USD, its lowest point since the inception of the current currency regime, as the CBN sold US$400 million, as against US$736.94 million demanded. On the interbank market, the Naira closed at N 164.30/USD, after falling to an all-time low of N167.40/USD during trading, as the parallel market remained at N166.5/USD. Yesterday’s Naira move on the WDAS marked its 55th decline in 74 auctions held this year and leaves the Naira N2.40 above the upper limit of the CBN’s +,-3% of N150 range. Though this spike in demand pressure at the WDAS was not unexpected given the recent breach of the CBN’s peg, the extent of Naira devaluation in recent weeks has increased concerns about the CBN’s currency policy and its ability maintain stability. In response the CBN took severe policy action at yesterday’s MPC meeting where the committee decided to:

·         Raise the Monetary Policy Rate (MPR) by 275bps to 12.0%.

·         Maintain the symmetric corridor of +/-200bps around the MPR.

·         Increase the Cash Reserve Ratio (CRR) by 400bp to 8.0%.

·         Suspension of the averaging method for reckoning of CRR in favour of daily position limits.

·         Reduce the Net Open Position (NOP) from 5.0% to 1.0% of shareholders funds.

MPC decisions should provide ST support

I am of the view that two of the key decisions made at yesterday’s MPC are likely to have a short term impact on the direction on the Naira. On the one hand, the MPC’s decision to hike its MPR by 275bp will improved the Naira’s attractiveness on an interest parity basis. On the other, the MPC’s decision to slash bank’s Net Open Position (NOP) from 5% to 1% of shareholder funds with effect from October 14^th should provide some support for the Naira as it effectively increases the CBN’s US$ position at the expense of the banks. Furthermore, from the next action the MPC has decided to restrict banks access to the Standing Lending Faculty (SLF) to fund WDAS purchases. With these policies, the CBN will able to curtail banks ability of bid for USD while, forcing them to unwind current dollar positions. The joint effect should moderate demand and strengthen the CBN’s dollar position in coming auctions.

Interest party in focus

With interest parity in particular, my review of global currency markets reveals the most major African frontier market currencies have experienced significant declines relative to the US dollar in recent week. In particular the South African Rand (ZAR), Kenyan Shilling (KES) and Ghana Cedi (GHC) have declined 17.52%, 7.51% and 19.70% respectively since the beginning of July. Furthermore, my research shows that, while no statistically significant at the 70% level; the extent off currency declines for each country is uncorrelated to the respective Monetary Policy Rates in 2011. For instance, while South Africa maintained a MPR of 5.50%, the ZAR decline almost as much as the KES, which has a corresponding MPR of 11.0%.

While the above fact does not invalidate the relevance of interest rate parity, it lends some credence to view that interest rates may not be the principal driver of capital flows across Sub-Saharan Africa. For Nigeria in particular, this view is reinforced by the fact that, in spite of consecutive interest rate hikes in March, May, July and September, the value of direct remittances (a proxy for non-trade related WDAS demand composed largely of financial instrument transfers by non-Nigerian individuals and corporations to their home countries) has continued to raise, an indication of continued capital outflows.  

Impact to be short-term at best

We are of the view that as was the case with prior policy thus far in 2011, the impact the MPC’s policies will be short lived. This is because, while the policies will do much to address possible demand side inefficiencies and speculative attacks on the Naira at the WDAS, it does nothing to correct the fundamental trend in demand, which is largely driven by increasing imports. Of note, import related USD demand at the WDAS, has constituted over 65% of average WDAS demand since H1’09, also average demand at the WDAS has risen 24.42% YoY to US$397.88 million per auction in 2011. In comparison our estimates show that t the CBN’s policy of reducing bank’s NOP will result in a maximum is an inflow of US$520 million[1], barely enough to meet demand at one WDAS auction at current levels.

On the interest party side, while the MPR hike is positive for the Naira, I am mindful that other frontier markets are likely to enter similar tightening cycles in the near future. As result, it is unlikely that interest parity will be the only determinant of capital flows going forward as my research as shown. This fact may have the effect of dampening the support for the naira in the short term.

Reserves never Lie

Try as it may, to regulate the Nigerian Foreign Exchange market, the CBN’s ability to defend the Naira is ultimately limited by the level of foreign reserves, which remains stunted at US$31.30 billion in spite of higher crude oil prices and crude production thus far in 2011. With recent reports indicating  that  Nigeria has struggles to sell Crude oil Cargoes in October and November, it is likely the further accrual to reserves may be delayed even as we enter the peak of the September – November window. As such, while I expect the naira to rebound slightly in the coming days, my expectations for the Naira remain tilted towards the view that it will remain under pressure in the short run as the continued depletion of reserves weighs on the CBN’s ability to maintain stability. 

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[1] Based on shareholders fund provided by CBN , March 31^st 2011

Nigeria's to diversify FX reserves: A stitch in time.

The Plan

On Monday, September 5^th 2011, the Central Bank of Nigeria (CBN) announced that it has concluded arrangements to further diversify Nigeria’s external reserve by including the Chinese Renminbi (RMB) to its currency mix. In a statement explaining the decision, the apex bank noted that it plans to hold 5% to 10% of reserves in Chinese government onshore bonds beginning in Q4’11. At the moment, Nigeria’s external reverse are held in a mix of US Dollars (USD), Euros (EUR) and the British Pound Sterling (GBP) assets, of which, ~79% is held in USD assets[1]. The CBN statement further explained that the expected changes in reserve composition would come primarily in the form of a substitution of Chinese government onshore bonds for EUR denominated assets. The plan also allowed the CBN to enter a currency swap arrangement with the People’s Bank of China (PBoC) which will provide a stock of RMB to be used to settle transactions.

Interestingly, the CBN’s plan to diversify is holding means it will join the Hong Kong Monetary Authority and the Malaysian Central Bank as the only three monetary authorities allowed to invest in China's onshore bond market. While this fact may raise questions about the wisdom of the planned diversification, the CBN Governor has explained that the move to diversify Nigeria’s reserves was driven by the need to protect the value of the reserves, and to gain a strategic advantage for Nigeria by encouraging the flow of RMB into Nigeria, particularly for investment in the energy, agriculture and processing sectors.

A case for diversification

As global economic challenges persist, developed economies have been forced to sustain monetary easing for “extended periods”. These decisions are likely to result in continued weakness of global reserve currencies, while increasing the likelihood of further erosion in their values. As a result of Nigeria’s exclusive exposure to these currencies, its reserves will undoubtedly suffer similar weaknesses, or worse still, erosion in value. A review of the performance of the USD versus the IMF Special Drawing Rights (SDR) since November 2008, when the Federal Reserve Bank of the United States began its first asset purchase program (QE1), shows the impact monetary accommodation thus far. While the effect of reserve currency devaluations on Nigeria’s reserves was blunted by higher oil prices, the offsetting effects were by no means symmetric. Over this period I  estimate that Nigeria’s foreign reserves lost ~7.41% in real value as a result of its exclusive exposure to these reserve currencies.  On the other hand, the RMB has remained stable or appreciated against most reserve currencies during the same period, primarily as a result of strong Chinese GDP growth which averaged ~9.3%[2] during the period and a less restrictive exchange rate policy.

Why now?

In the long term, the ongoing shift in global economics in favor of developing economies supports the CBN Governor’s rational to diversify the reserves, primarily as it relates to economic co-operation. The largest beneficiaries of the recent economic shift have been Brazil, Russia, India and China, the BRICs. Since 2008, when the global financial crisis began, they have maintained an average compounded annual GDP growth rate of 7.57%[3]. As at FY’10, these countries account for 42% of global population, but only 17.56% of global GDP[4]. With supportive demographics and growing income per capita, the BRICs have emerged as the global engines of growth during the recent global economic slowdown. In fact, on a Purchasing Power Parity (PPP) adjusted basis, China’s GDP in 2010 was ~78.7% US GDP and it is expected to replace the United States as the world’s largest economy before 2050. With this in perspective, it would appear that strengthened economic and political ties with China will likely accrue long term benefits for Nigeria.

In the short term, the move appears to be another policy response to trends on the Wholesale Dutch Auction System (WDAS) where the Naira has come under pressure, once again, in recent weeks. While the CBN has successfully maintained the Naira exchange rate within the +/- 3% band to the dollar in 2011, this has done so at a significant cost to the reserves. Nigeria’s external reserves currently stand at US$34.88 billion, US$2.21 billion less than the same time last year. With the CBN’s apparent unwillingness to breach the US$30 billion level in reserves even as it enters the September – November window (traditionally the period with the greatest WDAS demand due to greater import ahead of year end festivities), I looked at trends in Nigeria’s trade to provide insight into the likely short term drivers for the decision to diversify reserves in into RMB.

In a previous commentary I highlighted the growing importance of import related USD demand at the WDAS, estimating that it constituted over 65% of average WDAS demand since H1’09. I also noted that average demand at the WDAS has risen 24.42% YoY to US$397.88 million per auction in 2011. To further investigate this relationship, I recently reviewed data on Nigeria’s imports since 2007, to gain insight into the major drivers of imports and their origins in order to gain a sense of WDAS dollar demand use. My research reveals that by FY’10 China emerged as Nigeria’s second largest import source after the United States, accounting for 14.4% of all imports. Also, since 2007, China has recorded that greatest increase in its share of imports to Nigeria among its major trade partners, recording a 75.65% increase to N1.1 trillion as compared to 62.85% growths in total imports over the same period[5]. Notably, over the same period, Nigeria’s import from the European Union (EU) has decline 0.82%.

 The facts that 14.4 % (and growing) of Nigeria’s import come from China and that ~65% of dollar demand at the WDAS is import related, suggest that Chinese imports account for ~9.35% of WDAS demand on average. This also implies that Nigeria’s growing trade relationship with China is partly   responsible for the increased pressure on its foreign reserves. With this in mind and with a view to maintain its peg through the September – November rise in demand, CBN appears to have opted to allow importers settle Chinese imports in RMB as a means to divert import related demand away from the WDAS. By so doing, increasing its ability support its dollar peg, while keeping the Foreign Exchange market adequately supplied. This position is consistent with the details of the CBN’s diversification plan, particularly the currency swap agreement signed between the CBN and the PBoC, which provides immediate liquidity in RMB to settle such import related demand.

What does it mean for the Naira?

Clearly, the success of the CBN’s RMB settlement initiative will depend on importers willingness to switch current settlement from USD to RMB. This may present a significant challenge, as importers may be unwilling to make such a switch, especially if doing so limits the importers ability to change suppliers, in the absence of adequate Chinese supply. Furthermore, while the policy to settle trades in RMB may help to maintain the dollar peg in the short term, it does little to increase accrual to reserves and even less to reduce Nigeria’s dependence on imports, both factors which I see as the key drivers of long term Naira value. As such, my expectations for the Naira is tilted towards the view that it will remain under pressure in the short run as the continued depletion of reserves weighs on the CBN’s willingness and ability to maintain stability. However, in the medium to long term, I welcome the CBN’s move to diversify the reserves, as it is should support the value of Nigeria’s reserves and aligning her interest with the emerging global economic power with a growing footprint in Africa.

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[1] Reuters

[2] Trading Economics

[3] Trading Economics

[4] CIA Fact Book

[5] NBS

A case for the banks

In 2011, I have noticed the divergence in performance between the banks and manufacturers on the Nigerian Stock Exchange (NGSE). Interestingly, looking at the performance of the Nigerian Stock Exchange All Share Index (NSEASI) over the past two years, I have found that events in the banking sector have been central to its overall fortunes over the period -as has been the case since the banking sector recapitalization in 2004. In recent weeks, I began to have hinged my expectations for recovery of Banking sector--and overall index--performance on attractive valuations and more importantly, the reduction in the uncertainties that have rocked the sector amid the resolution of the lingering crisis. On the latter point, I see the recent bad-loan purchases by AMCON, prospective merger deals and the approach of CBN deadline as reasons why uncertainty should decrease. However, I would like to demonstrate that this is in fact so.

 In order to achieve this, I examined two measures of market risk: quarterly standard deviation (SD) of the NSEASI daily returns and quarterly down-side deviation (DD) of daily index returns, for trend (I also got identical results in examining monthly figures). Both measures of volatility have declined since Q3’10, when AMCON was inaugurated, and even more so from the peak in Q2’09 when the current crises reached a head. In fact, both measures of volatility are near 5 year lows; suggesting a dissipation of the “fear factor” in market sentiment. In addition, I have verified that much of the market’s woes were indeed caused by the banking sector by comparing the patterns in market volatility to major announcements in the banking sector. My research shows an overall correlation of ~0.6 between banking sector related announcements and index volatility.

In my view, the combination of attractive valuations and a decline in downside deviation presents a compelling entry point into banking stocks, offering relatively limited downside and strong potential upside. In the light of the generally positive earnings results in the banking sector in H1’11 and impending resolution of sector problems (including the recent nationalization of three banks), this analysis buttresses my conviction that the sector presents very favorable opportunities at this point in time.

2011 Budget: A plan to fail?

After initial disagreements with the National Assembly over variant figures in its version of the 2011 budget, President Jonathan signed a N4.5 trillion 2011 budget in May.  As signed, the 2011 budget is a 13.8% contraction in Federal Government (FG) spending from N5.2 trillion in 2010 and is N487 billion less that the N4.9 trillion budget passed by the  National Assembly in March 2011. Of the proposed expenditure, the sum of N2.4 trillion was allocated to recurrent expenditure, N492 billion was allotted to debt servicing, N418 billion was slated for statutory transfers while N1.2 trillion was earmarked for capital expenditure. 

On the revenue front, the 2011 budget projections were predicated on an oil price benchmark of US$75 per barrel ($10 more than the 2010 budget benchmark); average crude oil production of 2.3 million barrels per day (bpd); as well as Corporate Income Tax (CIT), Value Added Tax (VAT) and Customs Duty which are projected to increase, 7.8%, 7.8% and 12.5% YoY respectively to N632.8 billion, N625.24 billion and N450 billion. In all, the budget projects revenue of N3.4 trillion in 2011, which implies an estimated deficit of N1.1 trillion or 2.98% of 2010 Gross Domestic Product (GDP)[1], as compared to 6.1% in 2010 or 4.2% passed by the National Assembly. It also put the FG's spending in line with the provisions of the Fiscal Responsibility Act of 2007 (FRA) for the first time since 2007.

Capex takes back seat once again

In spite of recent criticism over the 2010 budget, the 2011 budget remains focused on stimulating consumption. While I  applaud the FG’s rejection of the National Assembly’s budget and its move to cut recurrent expenditure by 17.7% YoY - as compared to the 13.1% reduction passed by the National Assembly - its decisions to make an even deeper cut of 23.1% YoY to capital expenditure - as against the 14.1% increase passed by the National Assembly - leaves much to be desired of the 2011 budget. As a result of this cut, recurrent expenditure as a component of the total spending in 2011 (53%) is even greater in the current budget than in the National Assembly’s budget (51%), which was branded “unimplementable” by the current administration. Moreover, capital expenditure as a share of total spending fell to 26% from 32% in the National Assembly’s budget (Figure 1). In fact, personnel cost as a percentage of aggregate spending has doubled between the 2008 and 2011 budgets, over the same period, the FG capital vote has declined from 33% to 26%[1].While I  are support the FG’s drive to fiscal consolidation, it is common knowledge that Nigeria’s greatest need is infrastructure development which will serve as the catalyst for growth, a point which appears to be obscure to Nigeria’s fiscal administrators, who have fail see capital expenditure as the primary engine of growth.  

A different approach to capex

To justify this reduction in capital expenditure, the FG noted that it intends to fund future development of critical infrastructure through involvement in Public Private Partnerships (PPP). To this end the 2011 budget provides for the creation of a N50 billion Viability Gap Fund (VGF) and a N37billion Multi-Year Tariff Order (MYTO)[1] to fund the government subsidy on its new power pricing regime. The VGF was developed with the sole purpose of providing financial enhancement for infrastructure development projects with potential to successfully deliver specific infrastructure services. The VGF and MYTO are expected to operate in tandem with the newly created Nigerian Sovereign Wealth Fund (NSF) to compensate for the cut in capital expenditure.

A plan to fail

With the limited capital budget for 2011, I am unclear about the FG’s agenda for economic development, particularly as the inability to fully address corruption within the MDAs is likely to remain the primary impediment to full budget implementation in 2011. With PPP in particular, I  am concerned that N50 billion and N30 billion in funding for the VGF and MYTO, which are focused almost exclusively on the power sector, barely scratched the surface of the US$15 billion[2] in estimated funding needed annually to bridge Nigeria’s infrastructure gap. Moreover, PPP in Nigeria has historically required considerable gestation periods and suffered from a lack of human capital, particularly on the government side, needed to properly implement these policy initiatives. As such, my view is that a budget which continues bloating personnel overhead at the expense of investment in Nigeria’s economic fortunes is nothing short of a plan to fail. As such, I  believe 2011 like 2010 is will be characterized by significant recurrent spending with a dismal performance in capital expenditure plans.

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[1] Budget Office of the Federation

[2] Infrastructural Concession Regulatory Commission (ICRC)

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[1] Budget Office of the Federation

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[1] Federal Ministry of Finance

Banking on Bonny Light

Aided by the socio-political crisis in the MENA region, a weak US dollar and a mild recovery in demand form developed economies in Q4’10 and Q1’11, Bonny Light Crude has enjoyed significant price support Year-To-Date. Thus far, it’s has outperformed the traditional US benchmark, West Texas Intermediate (WTI) and all heavier-sourer crudes from the MENA region and Eastern Europe. However, recent indications of an economic slowdown in the United States and falling demand from China and India have put pressure on all crude oil grades of crude including Bonny Light. While, significant head winds to the global economic recovery have emerged, the outlook for Bonny Light remains supported relative to other grades by continued shortage of supply due to cut backs from Libya and the shortage of natural substitute for the grade. Despite pressure in recent weeks, the spread between Bonny light and WTI reached its all time high of US$25.2 per barrel in trading last week. Since May 2011, it has declined 10.6% compared to a 18.3% in WTI. On the back of this performance, the three tiers of Nigerian government accrued ~US$9 billion in excess crude revenues Year-To-Date, recording US$4.5 billion in average monthly, which is 41% above the FG’s budget benchmark.

possibility of fiscal constraints in the H2’11 due to the in FG’s inability to fund its deficit from such extra-budgetary income sources as the sale of assets leading to increased government borrowing with the attendant effects of increasing yields. While this scenario remains a possibility, recent developments including; the passage of the SWF—which provides for up to 60% of all accruals for budget supplementation—and increased crude production provide some reassurance on the FG’s fiscal position. Incidentally, the recently released schedule for Q3 debt auctions by the DMO reveals no marked departures from H1 despite significant increases in commitments coming due during the period, adding to the growing number of pointers towards a more benign outlook for bonds in H2 2011.

In previous commentaries I noted the possibility of fiscal constraints in the H2’11 due to the in FG’s inability to fund its deficit from proposed extra-budgetary income including sale of assets, leading to increased government borrowing with the attendant effects of increasing fixed Income yields. While this scenario remains a possibility, recent developments including; the passage of the SWF- which provides for up to 60% of all accruals for budget supplementation- and increased crude production provide some reassurance on the FG’s fiscal position. For instance, the recently released Q3’11 debt issuance calendar shows little signs of a government in fiscal crisis despite significant increases in commitments coming due during the period. In fact, the DMO only increased its total borrowing allowance for each auction in Q3’11 by N10 billion and decreased the issuance rage to N15-20 billion from N35-45 billion. While the FG’s fiscal position remains unclear, its shift in policy direction indicates an increased capacity to meet its deficit obligations.

As it stands, the combination of convexity effects at the longer end of the yield curve and possible increase in demand relative to potential supply is creating greater upside for longer dated instruments than projected downside. This effect may be strengthened as confidence returns to the financial system beyond the timeline set for the resolution of the banking crisis in Q4 2011, with the removal of the interbank guarantees by the CBN prompting a flight to safety. However, the potential restructuring of the revenue allocation formula in Q1 2012 could pose risks if the government is unable to finalise on asset sales beforehand. 

Mandela Toyo

Can Naira withstand the pressure?

At last Wednesday’s WDAS auction the Naira declined 0.14% to N153.59/USD, its lowest point since the inception of the current currency regime, as the CBN once again sold US$400 million, US$67.69 million less than was demanded. Wednesday’s move also left the Naira just 91 kobo shy of the upper limit of the CBN’s stated +,-3% of N150 band. In the interbank market the Naira closed at N157.50/USD, but has since appreciated to N156.35/USD even as the parallel market remained at N160/USD. While demand pressure on the Naira is not unexpected given recent inflationary figures and increasing global risk aversion, the extent of Naira devaluation in recent weeks increases my concern about the CBN’s ability maintain stability in the short term.

 To this end, there appear to be two clear short term drivers of the Naira-Dollar exchange rates. Firstly, judging by the CBN’s reluctance to defend the Naira at 32 of the 39 actions held thus far in 2011, it appears the apex bank has opted to rely more heavily of monetary policy tools to drive it’s the exchange rate policy,   probably in a bid to conserve dollar reserves which have witnessed muted accrual thus far in 2011. To date reserves have accrued just US$228 million in 2011. In view of this fact, coupled with the elevated inflation, continued fiscal expansion and relative recovery in the financial sector, monetary tightening and fixing linkages within the WDAS system presented the logical alternative to reserve depletion.  However, these methods have proven to be ineffective at controlling exchange rates. Of note, the newly introduced document requirements has done little to impact demand, while the CBN’s forward market has accounted for only US$160 million in maturities thus far. Furthermore, in spite a total 150bp hike in Monetary Policy Rate (MPR), portfolio flows remained negative. 

On the demand side, activity appears to be driven by increased portfolio outflows. In particular, direct remittances, a proxy for non-trade related WDAS demand composed largely of financial instrument transfers by Non-Nigerian individuals and corporation to their home countries , has risen to 61.3% of WDAS demand in May from 33.1% in January, likely as a result of increase risk aversion globally and the flight to safety in US assets.  This phenomenon is also the logical explanation for the CBN’s reluctance to supply what it may perceive as “transitory” demand and suggests that policy makers believe that the “fundamental” demand at the WDAS is close to US$400 million. While this may be the case, it remains unclear, how the CBN will choose to respond to the current demand situation, as further declines in the Naira will likely result in even greater demand pressure on the currency as investors rush to hedge currency exposure ahead of a possible breach of the +,-3% band.

In light of the above, I believe that policy action is limited to increased currency supply, as other monetary tools have proven ineffective in calming growing demand and are unlikely to create significant momentum to quell growing speculative activity. As such, more than ever before, I see the rate of dollar reserve depletion as the primary determinant of Naira stability in the short term. As such, my expectations for the Naira is that it will remain under pressure in the short run as the continued depletion of national reserves weighs on the CBN’s commitment to maintain stability. However, this outcome is not inevitable as several events, including significant increases in oil prices; the likely marginal crude oil bidding round and the disposal of PHCN assets are could all lead to significant foreign exchange inflows. In the event that these factors come together, it would significantly decrease pressure on the dollar reserves. 

Mandela Toyo

Signs of renewed interest in DMO Auction

Last Wednesday, April 21st 2011, the Federal Government (FG) sold N35 billion in 3 year and 5 year bonds respectively at marginal rates of 12.14% and 13.19%, a 165bp and 120bp increases from the marginal rates at the last auction in March. Both issues were a reopening of previous issues and the original coupon rates of 10.50% and 4.0% for the 3 year and 5 year bonds respectively were maintained. Also, the Debt Management Office (DMO) reported a 26.4% increase in total subscription MoM to N129.22 billion compared to a decline of 26.9% in March. As I expected, Wednesday’s auction results reinforced the Q1’11 trend of narrower bid ranges and improving bid-to-cover ratios, signs of increase investor interest in the Nigerian debt market. However, I did not anticipated the extent of increase in marginal rates (165bp and 120bp for the 3yar and 5year respectively) as I anticipated significant foreign interest in the bond auction which should have cushioned the rate adjustment, in spite of the increase in inflation MoM to 12.8% from 11.1% in March.

I believe Wednesday’s auction was a barometer of sentiment towards naira assets in the aftermath of elections and note that its outcome was likely influenced by post-election violence which erupted in Northern Nigeria. Notably, total bids improved 3.9% MoM even as average bid range across both tenures decline 2.31% MoM on the back of improved activity. Furthermore, average bid-to-cover ratio across both tenures improved 14.2% MoM. While it is premature to view these improvement at Wednesday’s auction is a definitive trend, I believe it is a positive signal of investor interest particularly, when viewed in the context of recent gains in currency stability and the relative exemption of foreign investors to domestic inflation pressures. From this perspective, Nigeria’s attractiveness is directly tied to its relatively attractive yields. Likewise, stricter provisioning guidelines, cheap funding sources and continued risk aversion appear set to encourage continued participation by banks in the debt market. As such I still believe May’s auction will have provide investors the opportunity to fully digest the implications of post-election events possibly providing some upside for bonds as interest could drive bond yields lower though the inopportune post-election turbulence robbed this factor of some momentum.

Mandel Toyo

Done and dusted...what will follow the elections?

Yesterday marked the conclusion of Nigeria’s general elections, as such, it is only fitting to examine the likely implication of its outcome, among other macro factors, for the various assets in the short term.   As we expected, the ruling People’s Democratic Party (PDP) saw its 78% and 72% majorities in the Senate and House of Representatives respectively reduced, however the party managed to maintain its grip on both legislative chambers and the Presidency in an election that has been relatively credible. Accordingly, the elections and its outcome appear to have been well received by the international community and more importantly international investors who currently constitute ~68% of equity market activity. 

Logically, a smooth transition points to the maturation of Nigeria’s democracy, stability of the operating environment and the likely continuity of policy, particularity in the areas of; fiscal consolidation, energy and power sector reforms, peace in the Niger-Delta and electoral reform, factors which improve Nigeria’s overall investment case.  As such I am are optimistic that the impact of the concluded elections on capital markets will be positive. In particular:

Equity Market – is likely to experience an improvement in activity as recent declines in equities ahead of elections – and in reaction to the MENA crisis - resulted in increasingly attractive equity valuations. Notably, from its high of 27,797 on January 25^th 2011, the NSEASI has declined ~11.2%, with YTD performance at 1.9%. Furthermore, equity risk is reduced by the clarity provided by FY’10 earnings releases by banks and non-financials. Whilst recent performance indicators for financials and non-financials leave much to be desired, especially in revenue growth, they suggest intermediate improvements to fundamentals on the back of the significant progress made in resolving banking sector asset quality issues . I recommend that declines be used as an entry points to take positions in attractively valued stocks.

Exchange rates - The CBN has successfully kept the Naira within the pre-specified band at the official market in 2011, in spite of significant demand pressure ahead of the elections. As I expected, following the elections there has been a notable decline in demand at the WDAS even as the CBN has continued to oversupply. I believe the post-election decline in demand is partly due to moderating commodity prices, reduced political spending, and balanced capital flows. As such I expect these factors to combine with significant accrual of the nation’s dollar reserves to provide support for the Naira. On the back of this, I see a reversal of much of the capital flight that may have prevailed through Q1.

Bond Market – The relatively successful conclusion of the elections clearly decreases perceived political risk, implying policy continuity and likely fiscal consolidation which should improve the attractiveness of Nigerian debt, and drive yields lower. The likelihood of further monetary tightening due to rising inflation as well as the supply overhang created by the recent listing N1.7trn of AMCON bonds could temper expectations for yield compression. This is especially so considering the fact that the government’s reform agenda (including deregulation) suggest a less benign outlook for inflation in the short to medium term. I recommend that investors position at the short end of the curve, prospecting further afield only where there is sufficient compensation for risk.

Fiscal Prudence: The FG "appears" to be spending less.

At its last meeting on Monday, April 11th 2011, the Federal Accounts Allocation Committee (FAAC) announced the disbursement of N425 billion to the three tiers of government for the month of March, a 2.7% increase from its disbursement in February. The committee further noted that due to recent maintenance work on platforms at the Qua-Iboe, Bonny and Amenam terminals, and pipeline sabotage at Brass terminal and on the Trans-Niger pipeline, total monthly revenue declined 14.8% to N615 billion in March. In spite of the production setbacks, Nigeria's Excess Crude Account (ECA) rose to US$6.9 billion on the back of higher crude prices. 

While the depletion in the ECA and higher cost of borrowing in H2’10 combined to explain the decline in government expenditure, its reluctance to increase expenditure, in the face of significant ECA accruals in Q1’11, suggests renewed fiscal prudence . My analysis reveals that on an inflation adjusted basis, the FAAC allocation for Q1’11 is 7.1% (N80.2 billion) above allocation in Q1’09 but 24.4% (N294 billion) below allocation in Q1’10. This is also in view of other apparent indications of fiscal discipline, especially with regard to a significant drop in net government borrowing and the attempt to keep the executives 2011 budget proposal (N4.1 trillion) in line with the medium term expenditure framework.

While it is premature to view the current fiscal stance as a structural shift towards longer term restraint, think it is a step in the right direction, especially in the context of broader macro trends and other policy initiatives.  Of these policy initiatives, keeping inflation under control is an obvious benefit of fiscal moderation.  Notably, at its last Monetary Policy Committee (MPC) meeting in March, the MPC cited its desire to counter expansionary fiscal spending as one of the primary reasons for its aggressive upward adjustment of the Monetary Policy Rate (MPR). I believe the improvement in fiscal discipline could combine with softening global commodity prices, currency stability and hawkish monetary policy to moderate inflation in the short term. 

Mandela Toyo