After Months of Negativity, It’s Time For a Fresh Look At Nigeria 3

It’s hard to find a positive headline about Nigeria these days.

Six months ago, it was all about the failures of a misguided foreign exchange policy; now, the narrative has moved on to the Niger Delta Avengers, the rapid rise of inflation and the ongoing struggles of the industrial sector among a slew of other concerns.

Locally, many look to the government for relief, as if it could wave a magic wand and pull the economy out of recession. Globally, the prevailing view on Nigeria continues to be one of skepticism, even as sentiment towards almost all other emerging markets improves.

Have investors and the media adopted a permanently negative bias towards Africa’s formerly largest economy? It’s time to take a fresh look at how Nigeria is adapting to lower oil prices.

Difficult adjustment

One of the most important aspects of any country’s adjustment to a commodity price shock – and certainly the most problematic for Nigeria – is the behavior of the exchange rate. For all the cryptic statements, the false starts and the misguided attempts at currency management of the past 18 months, the underlying problem is pretty simple: a well-intentioned central bank has been caught between the diktats of a Presidency with little understanding of markets, and the demands of a market with little sensitivity to domestic politics.

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Under the current system, the reference rate published on Bloomberg is subject to a soft peg at 315 naira per dollar while, privately, banks transact at 340-350 to the dollar. This represents something of a working compromise, and is probably the best that investors can hope for right now. But is it enough?

A good place to start is with a comparison of real effective exchange rates, which we tracked across a sample of emerging and frontier markets. Having long been one the most overvalued currencies in this universe – often by 40% or more – the naira is now trading below its “fair value,” and perhaps significantly below if we use the more representative rate of 340-350 per dollar.

One striking sign of this adjustment will be clear to business travelers to Lagos: the price of a luxury hotel room has fallen to below $200 a night. That’s a remarkable drop for anyone who remembers paying $500-800 for a night at the Eko Suites!

lagos nigeria
Oil rig in the yards. Apapa, Port of Lagos, Nigeria

Yet the impression we get from most of our conversations with clients is that 340-350 is still not enough. Some will need convincing that the naira is “fairly” valued for as long as the parallel market trades at a discount to the officially reported inter-bank rate.

Without dismissing this approach entirely, it’s very difficult to know the true depth of the parallel market, and hence its usefulness as an indicator of value. This market will always exist in some form to facilitate trade in banned items – the central bank excludes 41 goods from the inter-bank market – and to move ill-gotten gains offshore. As the government cracks down on corruption, the premium demanded by this shadow market will rise.

Fears of a further devaluation are probably overstated. But expectations have deteriorated to such a point that many investors talk as if no one will give Nigeria cash – at any price.

While we’re not under any illusions about the problems facing Nigeria, we think expectations about the path of the exchange rate – and the economy as whole – have become unrealistically negative. If anything, there’s potential for a rebound in both the oil price thanks to OPEC action and production thanks to a deal with the Avengers. The balance of risk has actually been shifting in favor of the upside. However, the standard bias has become so negative, few investors are willing to recognize the potential for improvement.

Peak rates

Another component to Nigeria’s adjustment is the shift in the local interest rate environment. It’s hard to over-emphasize just how dramatic this change has been.

From a starting point of local Treasury yields in the 1-8% range in early January, T-bill rates have now been pushed up to 17-23%. Most of this shift happened on the back of the foreign exchange reforms in June. While rising inflation during this period has reduced the difference in real yields, the inflation cycle has now peaked and the currency is around fair value.

Although the central bank appears to be stalling on any further hikes in the official policy rate, the outlook for real yields stands to improve as the inflation cycle turns. After a period of exceptionally rapid inflation from January to May – when the overall price level increased by 12% – month-on-month readings have fallen substantially and are now running at 60% of their peak level this year.

The two most important contributing factors here are the ongoing normalization of the foreign exchange regime and the change in the central bank’s official stance, which has allowed it to regain control of inflation expectations. If both of these factors persist, the headline year-on-year inflation readings are likely to be significantly lower from early 2017.

Unseen adjustment

In contrast to the very widely publicized problems around the exchange rate and inflation, less discussed is how certain parts of the economy are responding to the adjustment in the naira.

The most striking development of the past few quarters is the significant reversal in the net errors and omissions component of Nigeria’s external accounts. Historically, both the net errors and omissions and the other investment asset portions of the balance of payments would be deeply negative, reflecting a combination of informal imports and capital flight – or oil theft.

We always thought the second of these factors was the more important. For example, if Nigeria exported a tanker of crude oil, but could not match the outgoing trade flow against an incoming payment, this would technically give rise to a trade credit, which would then be recorded as “other investment asset.”

Informal non-oil exports are much larger than might be imagined, and are benefiting from a competitive boost following the devaluation in the parallel market. This theory fits with anecdotal evidence from consumer companies, which speak of vibrant cross-border trade in the North, along with the view from neighboring economies such as Cameroon and Niger, where local industry is losing share to Nigerian imports. Some 56% of trade (itself responsible for about 20% of GDP) is informal, a good share of which will be cross-border, according to estimates from the National Bureau of Statistics.

Adding to the improvement in external accounts, savings are being repatriated from abroad. Like most other commodity exporters, Nigeria accumulated a substantial amount of private wealth offshore in the boom years, and to the extent that these savings are now required to meet the foreign exchange needs of related businesses back in Nigeria, they are being repatriated.

Small government

In the same way the market is under-estimating the progress of Nigeria’s external adjustment, it seems to over-estimate the extent to which government action can cure the country’s economic ills. Last week, the local news was full of commentary about a possible ‘Emergency Economic Stabilization Bill’, while some locals – notably Aliko Dangote – have argued that the public sector should accelerate its privatization program as a means of funding. Implicit in each of these proposals is the idea that the government has a significant degree of influence on the direction of the economy – a concept that we think is misguided.

To give a sense of how limited Nigeria’s public resources have become, consider that it collected $117 per capita in 2015, across all three levels of government. And for all its discussion of stimulating growth through infrastructure spending, it managed to implement just $17 per person in capital expenditure last year. Even if this were doubled, it’s unlikely to make a big difference when officially measured GDP per capita is over $2,700. As GDP has continued to expand in nominal terms, the relative importance of government spending has been in decline – capital expenditure almost disastrously so.

The other factor weighing against any meaningful re-allocation of resources by the government is its debt burden. It was among the highest in Africa even before the oil price shock of the past couple of years. The Federal Government spent 1,060 billion naira on debt servicing last year, equivalent to 38% of revenue. Given that revenue is down another 25% in the first half of this year and debt servicing is likely to have risen due to higher interest rates, the government’s position can be expected to have worsened again in 2016. The only way to achieve a significant increase in capital expenditure is to boost borrowing yet further, but this process is already running up against its limits.

Recovery type?

The government’s response to an oil price shock in 2008-9 was to hike recurrent expenditure, quadrupling the public sector wage bill in the four years to 2012. The turnaround this time will depend to a much greater degree on investment – and investment from the private sector in particular.

Not only has the relative importance of the government in the economy declined considerably since 2009, the state has also become significantly more indebted relative to its own resources. That throws doubt on its ability to increase expenditure and sustain it at a high level.

Without a repeat of this transfer of wealth from the government sector to households – and arguably to the richer households – it will be difficult for the listed consumer companies to match the growth rates seen in 2010-12.

Instead, the strategy for 2016 is more about catalyzing private sector investment. The immediate beneficiaries of this process are likely to be banks. Probably more by coincidence than design, the measures taken to attract investment – exchange rate devaluation, interest rate hikes – involve an indirect transfer of wealth from the household and public sector to commercial banks. These transfers take the form of high yields on government and central bank debt, lucrative trading businesses thanks to volatility in the exchange rate, negative real interest rates on deposits, and special on-lending facilities where banks are allowed to earn a free spread on credit directed by the central bank.

Although banks have significant asset quality issues to deal with, the combination of artificially high returns and regulatory forbearance is likely to prevent a full, upfront recognition of these problems in the way that was forced in 2009. Instead, problems will be worked out over time, paid for indirectly (perhaps unwittingly) by transfers from the government and households. How else would banks have been able to deliver a 24% return on equity in the first half of 2016, at a time when the overall economy was slipping into recession?

The same set of circumstances that has created a windfall for banks is opening a window of opportunity for foreign investors in local Treasuries.

Alan Cameron is the Economist for Exotix Partners, the biggest frontier markets brokerage and research firm.

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