At Monday’s WDAS auction, the Naira weakened further against the U.S. dollar as demand once again outstrip supply. In what appeared to be a renewed attempt to provide support for a declining Naira, the Central Bank of Nigeria (CBN) sold US$400 million at N150.90/US$, short of the $434.56 million demanded, but higher than the $350 million sold at last Monday's auction. Notably, Monday’s auction was the seventh consecutive auction with demand above $320 million and the highest level of demand since Mid-January. Following Monday’s decline, the Naira fell to an eighteen month low against the US dollar on Tuesday as panic buying appeared to intensify, the naira closed the day at N156.3/US$ in the interbank market.
Some currency market participants have pointed to the impending expiration of the CBN’s guarantee on foreign credit lines of Nigerian banks and the decline in autonomous foreign exchange sales from oil majors (possibly due to concerned about the passage of the Petroleum Industry Bill) as the majors reason behind the recent spike in demand. I also observed that the recent spike in WDAS demand followed closely after the IMF’s report dated February 17th 2011 which noted in its assessment that the Naira is overvalued and stressed the need for greater exchange rate flexibility to avoid further reserve depletion and to prevent one-way bets in the foreign exchange. While it is difficult to determine the exact impact of aforementioned factors, the recent declines in the value of the Naira have prompted a review of my position on currency stability.
A cursory examination of the recent spike in WDAS demand indicates an increase in pressure from trade related demand, particularly in the form of increased demand by companies with unconfirmed letters of credit and payments of foreign credit cards. To better understand the fundamentals of this sudden spike in demand and to estimate its direction, I reviewed Nigeria’s quarterly trade statics between 2005 and 2009 to uncover the likely smyces of trade related WDAS dollar demand in the medium term. In summary, Nigeria’s primary imports are machinery and transport equipment (41%), manufactured goods (25%) and Chemicals and Fuels (17%) while Food, Beverages and Tobacco accounts for only 15% of total imports.
Taking a cue from these statistics I focused on inflationary patterns in Nigeria’s major import partners (China (28%), United States (14%), France (10%) and the United Kingdom (9%)) accounting for their exchange rate movements relative to the US dollar, with a view to estimate future price movements. By doing this, I have been able to estimate the medium term trend of fundamental WDAS trade related demand hence adjusting for what could be considered temporary election related shocks. Using a weighted average of consensus Producer Price Index (PPI) estimates of Nigeria’s major trading partners adjusted for exchange rate movements, I estimate price increases of 7.6% by FY’11 when combined with estimated GDP growth of 7% in 2011 this implies fundamental WDAS trade related demand growth of ~15.13%.
I have also hinged my view on Naira stability primarily on the rate of dollar reserve depletion, which weighs significantly on the CBN’s foreign exchange decisions and on its ability to effectively meet demand at the WDAS. As such, my expectation remains tilted towards the view that the Naira will remain under pressure at the WDAS in H1’11 as it has so far. To estimate reserve accrual I regressed Bonny Light Crude price (US$/b), Oil production (bpd), and quarterly WDAS Sales on Net Reserve Flow (US$). Notably, together these measures explain over 75% of reserve accrual. Based on this model and the conclusion above, I estimated an average reserve accrual of US$1.64 billion in Q1’11, assuming 2.39 million bpd crude oil production, average Bonny Light Crude price of US$110 per barrel and quarterly WDAS Sales of US$ 7.36 billion (i.e. assuming average demand growth of 15.13%), this puts gross reserves at US$34.1 billion at the end of Q1’11.
Several events in the horizon, including further increases in crude oil prices amid improving domestic production could lead to further foreign exchange inflow and higher reserves. In view of the above, my view of the direction of reserve flows is positive and I believe the CBN is well positioned position to defend the Naira. As such, I expect the Apex Bank to widen is support for the Naira going forward in order to avert any speculation even though the Naira/US Dollar rate remains firmly within the -/+ 3% of N150 floating peg band.
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