The Plan
On Monday, September 5th 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.
